Accounting for deferred taxes under FASB 109.

A standard has finally been adopted for measuring and recognizing deferred income taxes.

In December 1987, the Financial Accounting Standards Board issued Statement no. 96, Accounting for Income Taxes, which was intended to replace Accounting Principles' Board Opinion no. 11, of the same name, which had been criticized for the relevance of the information it provided. However, Statement no. 96 also became a source of controversy because of its complexity and stringent tax asset provisions permitting recognition of deferred tax benefits only to the extent loss carrybacks would result in a refund of taxes previously paid.

In response to these concerns, the FASB issued Statement no. 109, Accounting for Income Taxes, which should result in recognition of additional tax assets and minimize the cost and complexity of implementation (see exhibit 1, page 39, for a comparison of the various methods of treating deferred income taxes under Statement nos. 109 and 96 and Opinion no. 11).

Under Statement no. 109, enterprises will recognize deferred tax liabilities for all taxable temporary differences while deferred tax assets will be recognized for deductible temporary differences and operating loss and tax credit carryforwards. Based on available evidence, deferred tax assets will be reduced by a valuation allowance to amounts more likely than not to be realized in future tax returns.

Unlike Statement no. 96, Statement no. 109 allows enterprises to consider assumptions concerning future economic events in assessing whether a valuation allowance is required. Further, the new standard's tax asset provisions often can be implemented without a detailed scheduling of future years when existing temporary differences will reverse, even when an enterprise concludes a valuation allowance is necessary.

This article provides CPAs with a summary of Statement 109's significant requirements, particularly as they relate to recognition and measurement of deferred tax assets. A comprehensive nuts-and-bolts example is provided to assist CPAs in calculating a valuation allowance for deferred tax assets when it is more likely than not a portion of existing tax benefits will not be realized. The example should help CPAs who must consider amounts and timing of future deductions and carryforwards as well as potential sources of taxable income in determining a valuation allowance.

KEY PROVISIONS

Statement no. 109 establishes rules governing financial accounting and reporting for the effects of income taxes resulting from an enterprise's activities in current and prior years. The amount of income tax payable or refundable reflects the tax effects of events in the period the events themselves are recognized in the financial statements. Deferred taxes reflect the future tax consequences of events already recognized in either the financial statements or tax returns or that result from enacted changes in tax laws or rates.

The new statement's requirements are based on a balance sheet approach, generally referred to as the liability method, introduced in Statement no. 96. Deferred income tax assets and liabilities represent assets and liabilities, not residual deferred charges and credits. Under the liability method, an enterprise recognizes a deferred tax asset or a deferred tax liability for the future income tax effects of the difference between the tax basis of the asset or liability and its reported amount in the financial statements.

An example of this is the book-tax difference arising from accelerated cost recovery system (ACRS) depreciation used for tax purposes and straight-line depreciation used for financial reporting. Such a book-tax difference is called a temporary difference and Statement no. 109 follows its predecessor's lead in requiring a comprehensive application calling for enterprises to consider all material tax effects in determining deferred taxes.

The new rules require a deferred tax asset to be recognized for deductible temporary differences and operating loss and tax credit carryforwards using the applicable tax rate. This requires identifying each operating loss's nature and amount as well as the carryforward period's remaining length. Determining whether a valuation allowance is necessary--a matter of judgment--hinges on whether the weight of all available positive and negative evidence about the future supports a conclusion that realizing existing tax benefits in future tax returns is more likely than not (in general, a probability at least slightly greater than 50%). A deferred tax liability is recognized for the income tax consequences of future taxable amounts.

Measurement of deferred taxes is based on the applicable tax rate. Under the liability method, the goal is to measure deferred taxes by using the enacted tax rate expected to apply to taxable income in periods the deferred tax asset or liability is expected to be paid or realized. In the United States, the applicable tax rate is the regular tax rate and a deferred tax asset (and related valuation allowance, if one is necessary) is recognized for existing alternative minimum tax credit carryforwards for tax purposes.

A deferred tax asset or liability is adjusted in the period of enactment (when the president signs the legislation into law), for the deferred tax consequences of tax rate or tax law changes. To the extent deferred tax balances are adjusted for the effects of such changes, income tax expense or benefit from continuing operations is charged or credited. Where there is a phased-in change in tax rates, estimation of the applicable tax rate requires knowledge of when deferred items are expected to be realized or settled.

Once deferred tax assets and liabilities for the future tax consequences of temporary differences and carryforwards have been measured, the deferred tax provision or benefit is based on the net change in a deferred tax balance during the year. The income tax expense or benefit for the period is derived from the total tax currently payable or refundable and the deferred tax expense or benefit.

ASSESSING WETHER A VALUATION ALLOWANCE IS REQUIRED

Statement no. 109 says deferred tax assets are recognized for deductibles and carry-forwards under the presumption they will be realized, subject to an impairment test. The new rules for asset recognition are based on the "one-event" theory, that is, the event giving rise to the deductible or carryforward is the critical event for recognition purposes. Realization of deferred tax benefits is predicated on whether sources of sufficient taxable income of the appropriate character can be identified.

In determining whether deferred tax assets must be reduced by a valuation allowance, all available positive and negative evidence must be considered. Information concerning recent pretax accounting earnings generally is critical in assessing the realization of deferred tax assets. A judgment that a valuation allowance is not needed may be difficult to support when an enterprise has incurred a material, cumulative loss in recent years, has recently had operating loss or tax credit carryforwards that have expired unused or when a profitable enterprise expects losses in the near future.

When significant negative evidence exists, more compelling positive evidence is needed to support a conclusion that a valuation allowance is not required. It generally is not necessary to quantify the effects of positive evidence unless significant negative evidence exists that leads the enterprise to conclude it is more likely than not some or all of the deferred tax assets will not be realized.

When both positive and negative evidence exist, judgment must be used in evaluating what evidence is more persuasive. The weight assigned to positive and negative evidence generally should correspond to the extent the evidence can be verified objectively. For example, information about gross profit on existing contracts or firm sales backlog is objectively verifiable, whereas information about future taxable income exclusive of reversing taxable temporary differences and carryforwards can be verified with less objectivity. Statement no. 109 provides numerous examples of positive and negative evidence to assess whether a valuation allowance is required.

CONSIDERATION OF FUTURE EVENTS

In considering all available evidence, an enterprise also needs to evaluate if taxable income will be sufficient to realize deferred tax assets. Considering future economic events in assessing the likelihood of realization is a unique provision of Statement no. 109. The new standard suggests the following potential sources of taxable income may be available to realize deferred tax benefits:

* Reversing taxable temporary differences.

* Future taxable income exclusive of reversing taxable temporary differences and carry forwards.

* Taxable income in carryback years.

* Tax planning strategies.

It is not necessary for an enterprise to consider each possible source of taxable income to support a realization judgment. When evidence concerning a taxable income source leads an enterprise to conclude realization of all deferred tax assets is more likely than not, other sources need not be considered. When it is more likely than not some or all deferred tax assets will not be realized, all potential taxable income sources should be considered.

A key Statement no. 96 requirement that sparked concern about the cost and complexity of implementation was that an enterprise, after identifying and measuring its temporary differences, generally must determine the future years the differences will reverse (called scheduling). Statement 109's provisions can, however, in many cases be implemented without scheduling.

If, for example, based on recent historical earnings, an enterprise estimates it will generate future taxable income exclusive of reversing taxable temporary differences and carryforwards sufficient to recognize its deferred tax assets, detailed projections, forecasts or other elaborate analyses may not be necessary. It is essentially a matter of professional judgment how much data analysis of future economic events is necessary to support recognition of deferred tax assets.

Tax planning strategies are another income source that may be available to realize tax benefits. Such a strategy is a prudent and feasible action permitted under tax law over which management has discretion and control. While Statement no. 96 allowed consideration only of strategies that did not involve significant implementation costs, its successor makes no such prohibition. However, under Statement no. 109, the tax benefit of implementing a strategy is, recognized net of any material implementation costs. The FASB believes it is inappropriate to recognize a tax benefit in the current year and postpone recognition of any expenses or losses necessary to generate that tax benefit to a later year. The new standard provides several examples of tax planning strategies.

Exhibit 2, above, shows how to record a valuation allowance when it is more likely than not a part of deferred tax benefits will not be realized in future tax returns.

OTHER MATTERS

According to Statement no. 109, classification of deferred taxes as current-noncurrent corresponds to the classification of related assets and liabilities. Thus, a deferred tax asset resulting from warranty accruals classified as current liabilities in a statement of financial position is considered current. Deferred taxes not related to a particular asset or liability, such as a tax credit carryforward, are classified current or noncurrent based on their anticipated reversal or benefit period. An enterprise preparing a classified statement of financial position would offset its current deferred tax assets and liabilities and report a net current deferred tax asset or liability. In the same manner, a net noncurrent deferred tax asset or liability is calculated and presented. The offsetting procedure is allowed only for deferred taxes for a particular tax-paying component of an enterprise and within a particular tax jurisdiction.

EFFECTIVE DATE

Statement no. 109's requirements must be reflected by an enterprise in accounting for income taxes for fiscal years beginning after December 15, 1992. The FASB does, however, encourage earlier application. In the year an enterprise adopts Statement no. 109, it may elect to restate the financial statements for any number of consecutive prior years or to implement the new tax standard on a prospective basis and report a cumulative effect adjustment (below "income from continuing operations").

EXECUTIVE SUMMARY

* THE FINANCIAL ACCOUNTING Standards Board issued Statement no. 109, Accounting for Income Taxes, replacing the much-criticized Statement no. 96 of the same name.

* UNDER STATEMENT NO. 109, enterprises will recognize deferred tax liabilities for all taxable temporary differences. Deferred tax assets will be recognized for deductible temporary differences and tax credit carryforwards.

* THE REQUIREMENTS of Statement no. 109 are based on a balance sheet approach, generally referred to as the liability method. An enterprise recognizes a deferred tax asset or a deferred tax liability for the future income tax effects of the difference between an asset's or liability's tax basis and its reported amount in the financial statement.

* DEFERRED TAX ASSETS are recognized for deductibles and carryforwards under the presumption they will be realized, subject to an impairment test. Realization of deferred tax benefits is predicated on whether sources of sufficient taxable income of the appropriate character can be identified.

* A UNIQUE PROVISION of Statement no. 109 is the consideration of future economic events in assessing the likelihood a deferred tax asset will be realized.

* STATEMENT NO. 109 MUST BE reflected in financial statements for fiscal years beginning after December 15, 1992, although earlier application is encouraged.

WILLIAM J. READ, CPA, PhD, is professor of accountancy at Bentley College, Waltham, Massachusetts. He is a past member of the American Institute of CPAs audit sampling implementation task force. ROBERT A.J. BARTSCH, CPA, is a manager at Deloitte & Touche, Wilton, Connecticut. A member of the AICPA, he is a past member of the New York State Society of CPAs accounting standards committee.

The authors acknowledge the assistance of John Van Camp, CPA, a partner of Deloitte & Touche in Wilton and a member of the FASB income tax implementation group.