Caterpillar Inc.: Audit Risks and Tax Avoidance Issues - Essay Sample

Introduction

Caterpillar Inc. faces various problematic areas that increase the audit risks for the 2018 annual report. One of the major problems is the constant clashes with the Internal Revenue Service (IRS) (Jones, 2018). It is noted that the company has a sale and revenue recognition methods that aim at reducing tax liability through tax avoidance. This case is linked to an instance where the company sells products manufactured within the US to customers outside the country while maintaining the sales and profits through Geneva, one of its subsidiaries in Switzerland (Jones, 2018). For example, one of the employees at Caterpillar Inc. outlines that once a customer from outside the US makes an order for a truck, a bulldozer, or any other machinery, their orders are shipped from the main Caterpillar warehouse which is located at Morton, Illinois, the US to Geneva, Switzerland.

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Therefore, although the products are manufactured in the US, the sales and other proceeds are recorded through the foreign account in Switzerland so to reduce the level of revenue to be reported under the company located in the US. In this case, when the level of revenue is lower, it means that the effective tax rate will also be low. By comparing the tax laws in US and Switzerland, Caterpillar Inc. recorded its profits in the Switzerland subsidiary where it was taxed at a lower rate than in the United States yet most of the operations occurred in US (Buedel, 2018). It is noted that Caterpillar has been utilizing this strategy for a long period whereby it pays as low as 4% as the effective tax rate. The matter was forwarded to the US Senate, and Caterpillar Inc. received a penalty from the IRS, but the management insisted that the strategy conformed to the US tax laws (Buedel, 2018).

While tax avoidance is considered to be legal, this strategy is against the US tax laws which create an audit concern within the company. It, therefore, means that the auditors need to conduct substantive tests to acquire an in-depth undemanding of Caterpillar's transactions to determine if they conform to the US generally accepted accounting principles (GAAP) as well as the international financial reporting standards (IFRS). Consequently, some of the employees continue to claim that Caterpillar Inc. employs unlawful tax avoidance mechanisms especially by using the Switzerland subsidiary to build up profits to avoid taxation in the domestic country (US). On the other hand, Caterpillar Inc. management believes that the strategy is legal. The audit process should, therefore, be extensive to ensure that they determine the legality of these processes to address the existing clashes between the company, employees and IRS.

Adverse Economic Conditions

Caterpillar Inc. issued a report claiming that the company was facing a difficult economic situation linked to rapid demand for mining and construction machinery yet the company could not meet this demand (Aeppel & Singh, 2018). Although Caterpillar is the world largest manufacturer of heavy equipment, it was keen to monitor its production process despite the increasing the level of demand (Caterpillar Inc., 2019). This is because in the preceding year (2017), there was an economic recession that affected many companies. For instance, Caterpillar had recorded a constant decline in the level of sales revenues in the third quarter. For this reason, Caterpillar, as well as other big manufacturers, were cutting the costs by managing inventory, retrenching workers, and closing plants as a strategy to thrive in the economic recession (Caterpillar Inc., 2019). Therefore, Caterpillar was getting more cautious about expanding its production immediately after the economic surge that had just occurred.

Due to the economic challenges that occurred in 2017, Caterpillar management is hesitant to expand its operations which is, in turn, creating major problems to the company. For instance, the company has assembly and manufacturing plants that run a few hours a week. In addition to this, the suppliers are also striving to catch up with the impact created by the economic surge (Aeppel & Singh, 2018). As a result, it has extended the lead time taken to deliver the finished products to the dealers. This has created an adverse impact to its customers since it means they will have to wait longer to receive their ordered items.

More importantly, the development of the recent reforms by Trump's administration has also added to the economic uncertainties. For stance, President Trump proposed the motive to cut trade links with China. This is because the policies not only disrupt the trade relations between the two countries but also create the probability of a trade war erupting quickly which may, in turn, affect the global operational efficiency (Aeppel & Singh, 2018). This fear, therefore, makes Caterpillar hesitant in expanding its level of production. The entire situation, therefore, creates an economic uncertainty among the US manufactures yet they highly rely on the international markets who are significant customers to the subsequent products and services.

References

Aeppel, T., & Singh, R. K. (2018). Why Caterpillar can't keep up with a boom in demand. Retrieved from https://www.reuters.com/article/us-caterpillar-supplychain-analysis/why-caterpillar-cant-keep-up-with-a-boom-in-demand-idUSKCN1IO0FW

Buedel, M. (2018). IRS increases Caterpillar tax penalty to $2.3 billion. Retrieved from https://www.pjstar.com/news/20180215/irs-increases-caterpillar-tax-penalty-to-23-billion

Caterpillar Inc. (2019). Caterpillar| About. Retrieved from https://www.caterpillar.com/

Jones, D. (2018). Caterpillar Clashes with IRS -- WSJ -2-. Retrieved from https://www.foxbusiness.com/features/caterpillar-clashes-with-irs-wsj-2