Key takeaways
- Unpaid sales tax creates financial risk: Post-Wayfair, many businesses face contingent liabilities from uncollected sales and use tax, which auditors must identify and disclose in financial reports.
- Auditors must assess materiality and likelihood: Using FASB standards, firms determine whether potential SUT liabilities are significant and probable enough to record or disclose.
- Proactive compliance protects firms and clients: Early identification of nexus issues, VDAs, and collaboration between audit and tax teams can prevent costly penalties and safeguard both client and firm credibility.
In short: Many businesses still don’t meet the sales tax nexus rules created by the 2018 Wayfair decision. Their unpaid tax is a contingent liability that auditors must judge for materiality and likelihood. That puts your audit team at greater risk.
Many businesses still don’t comply with the sales and use tax (SUT) nexus obligations created by the 2018 South Dakota v. Wayfair decision. What does that mean for your firm? Your client’s non-compliance may put your audit team in a tricky spot during routine audits. This post explains everything you need to know about contingent liabilities. It covers how they relate to SUT compliance, financial reporting, and your audit team’s legal accountability.
What is the value of audits?
For most accounting firms, audits are the biggest business driver. Federal income tax management and filing come a close second.
Audits give businesses of every size a layer of protection. An impartial third party confirms that a company's books and records are sound. Equal owners of a company may run an audit to make sure no financial “funny business” is going on. Investors may request an audit too, during due diligence before backing a business or weighing a merger. This helps them assess a company's risk profile.
How does SUT tie into audit analysis?
When auditors assess risk, they look at many things, including debts and tax compliance. SUT cmpliance has always been a little murky. But it got far more complex with the 2018 South Dakota v. Wayfair decision. This brought in the concept of economic nexus. It also created a way to tax remote sellers with interstate or international sales. As a result, businesses' liability risk from SUT compliance rose sharply.
States also use audits. But for them, the audit works out how much unpaid tax they can recover from a business that doesn't meet its nexus obligations. During the audit, a state-appointed auditor digs into the business's books. They calculate how much the business owes the state in unpaid taxes, penalty fees, and interest charges. For a closer look, see State Sales and Use Tax Audits Are Increasing in 2022: Here's How to Avoid One.
When a company gets an audit notice from a state, it can ask an accounting firm to represent it. The firm can then defend the business and help settle the dispute.
Now, let’s talk about how contingent liabilities tie into financial reporting and audits, and how they can affect your firm.
What is a contingent liability?
A contingent liability is a possible business expense or debt that is often overlooked and easily misunderstood. It is 1) linked to a future event and 2) depends on whether or not the event happens. Lawsuits and future warranty claims are good examples. In the case of economic nexus compliance, unpaid taxes are another excellent example.
Auditors must note contingent liabilities that meet specific criteria in financial reports and audit footnotes. The United States Financial Accounting Standards Board, or FASB, wrote specific criteria for how to assess and disclose contingent liabilities.
To decide if a liability must be disclosed, auditors first judge its materiality. This means how big an impact it would have on the business. They must also judge the likelihood, or odds, of it happening.
How do you determine materiality?
A possible expense is only considered 'material' if it will have a big impact on a company's finances. The auditor decides this using their best judgment. It is usually based on a “materiality threshold”. This is a general percentage of a specific line item in the financial statements. For example, it could be a set percentage of the company’s annual recurring revenue.
Risks that are judged “non-material” don't need to be disclosed. But auditors must note contingent liabilities that meet specific criteria in financial reports and audit footnotes. The United States Financial Accounting Standards Board, or FASB, created specific criteria for assessing and disclosing such liabilities.
If a contingent liability is judged material, it’s time to assess the odds of it happening.
How do you determine likelihood?
If a contingent liability is judged material, the company and auditor must work out the likelihood of the liability in question being realized. They do this by choosing the category that best describes the business's 'chance of loss.'
The three likelihood categories include:
- Remote (pretty unlikely)
Choose this option if there’s only a very slight chance the event will happen. An example is a frivolous lawsuit that’s likely to fade away with no major impact on the company. If a liability is remote, it doesn’t have to be disclosed in financial statements. But it’s usually a good idea to report it. This gives you a safety net if the event does happen. - Reasonably Possible (could go either way)
If the future event is less than likely, the company still doesn't need to make an entry in its accounting records. But it must disclose the nature of the event in the footnotes of its financial statements. The disclosure should also include the most likely loss amount. If no specific amount can be set, give a range. - Probable (will most likely happen)
A contingent liability may be probable, and you may be able to estimate the amount using Generally Accepted Accounting Principles (GAAP). If so, a specific accounting journal entry is advised. If you can't estimate an amount, a footnote is acceptable. Auditors disclosing probable contingent liabilities should make sure to account for debits for legal expenses and credits for accrued liabilities.
Auditors should use their best judgment to decide how likely a contingent liability is. The outcome of such an event can have a big impact on a company's profits. So reporting these liabilities accurately is a big responsibility. And with sales and use taxes, many businesses now face contingent liabilities in the form of unpaid taxes.
Who is responsible for keeping businesses compliant?
The first big wave of post-Wayfair audits is making the rounds. Most businesses are still stumbling through what compliance means for their books.
So audit teams face a much higher contingent liability risk. This is especially true now, as many business owners and leaders don't know their sales tax obligations.
In an ideal world, every business owner with steady sales would hire an accountant from day one. It's much easier to keep squeaky clean books when clients are proactive from the start. Fixing issues before any state contacts a business can save a huge amount of money.
In the best case, the firm gets to know the client's business inside and out, and spots issues early. The firm then uses voluntary disclosure agreements and other bargaining tools. These help the business become compliant in the least painful way possible.
Sadly, many business owners don’t know what they don’t know, especially when it comes to taxes. So company leaders often turn to accounting firms for help only once they’re already in a non-compliance pickle. Often, firms are brought in after the state has already issued an audit request. This limits the business's options for dealing with the costs of non-compliance. Related reading: The True Cost of Sales and Use Tax Non-Compliance.
How can you empower your firm and protect your clients?
Ideally, firms have SUT compliance experts on staff who can brief audit teams. Together, they can ask the right questions and educate clients about possible non-compliance risks. But even in-house experts have limited time, and SUT laws keep changing and are hard to keep up with. Also, some firms have great teamwork between audit teams and tax experts, while others work more in silos.
How can we help?
Firms that enlist the help of smart software are in a much better position. This software offers nexus analysis designed to make risk assessment simpler. With it, you can support clients well by offering proactive SUT advisory and compliance services. With the right data and insights, SUT and audit teams can spot non-compliance risks accurately. They can tell clients their options and stand behind audit results with confidence.
How Taxually handles this
Taxually’s LumaTax runs a nexus analysis on your sales, helps you register in the states where you must collect, and prepares and files multi-state sales tax returns, including Canadian GST/HST. LumaTax is currently available to enterprises and accounting firms. For the full workflow, read how to automate US sales tax filing in every state.
Related guides
Frequently asked questions
What is a contingent liability?
A contingent liability is a potential financial obligation that depends on the outcome of a future event—such as lawsuits, warranty claims, or unpaid sales and use taxes due to non-compliance.
How does SUT non-compliance create contingent liabilities?
When businesses fail to collect or remit sales tax in states where they have nexus, they risk owing back taxes, penalties, and interest. Auditors must assess and disclose these potential liabilities if they are significant and likely to occur.
What criteria do auditors use to report contingent liabilities?
Auditors determine whether a liability is material (significant enough to affect financial statements) and assess its likelihood—remote, reasonably possible, or probable—before deciding how to disclose it.
How can firms reduce contingent liability risks for clients?
Firms can help clients stay compliant by conducting nexus studies, filing voluntary disclosure agreements (VDAs), and ensuring ongoing collaboration between audit and tax teams to catch potential risks early.
Why is this important for audit teams?
Unreported SUT liabilities can lead to misstated financials, audit exposure, and even legal accountability for firms. Properly identifying and managing these risks protects both clients and auditors.
