Are changes in store for Statement 96, Accounting for Income Taxes?

Are changes in store for Statement 96, Accounting for Income Taxes? Should the FASB reconsider fundamental aspects of Statement 96, Accounting for Income Taxes, as well as some narrower issues it raises? Since its issuance in December 1987, Statement 96 has generated approximately 140 requests that the Board do exactly that.

Following issuance of an implementation guide to the statement in March 1989, the FASB met with representatives of Financial Executives Institute's Committee on Corporate Reporting to discuss mounting concerns--about the results of applying the new rules and about the difficulties being encountered as companies attempt to implement the complex provisions of the statement.

In order to provide additional time to study the complex issues at its July 12, 1989 meeting, the Board agreed to propose a nine-month delay in the statement's application date. Thus, companies with calendar year ends still would be required to adopt the new rules in 1990, but not until the fourth quarter. Previously, application was required in the first quarter of 1990. The Board hopes to issue an exposure draft proposing the delay of Statement 96's application date sometime in October 1989.

This recent action is the result of a series of meetings that began in April during which the Board focused on the following principal objections to Statement 96:

* The rules relating to the recognition and measurement of deferred tax assets are too severe and should be amended to permit a probability approach.

* The definition of temporary differences is too encompassing and leads to deferred tax calculations that are neither understandable nor explainable.

* The Board's liability method is too complex, and the costs of compliance greatly outweigh the benefits derived.

A majority of the requests dealing with temporary differences and narrower implementation issues were rejected fairly quickly--mainly because the Board felt that the issues had been adequately considered before the statement was issued. Also, in the Board's view, no new information surfaced to substantiate any change. As a result, intercompany transactions--such as inventory transfers--and foreign operations with a U.S. dollar functional currency will continue to give rise to temporary differences for which tax effects must be provided.

The Board also reaffirmed prior conclusions regarding several purchase business combination issues. These include the special transition provisions and the prohibition of recognizing the effects of tax rate changes enacted shortly after an acquisition. Still under consideration, however, are issues relating to the tax effects of temporary differences related to (1) a parent company's investment in the stock of a subsidiary, and (2) goodwill that is deductible for tax purposes in certain foreign tax jurisdictions.

Although the Board decided not to deal with a majority of the requests relating to narrower issues, it has agreed to consider the more significant objections in future meetings. These include whether probable future events should be considered in the recognition and measurement of deferred tax assets and whether a simplified approach to computing deferred taxes could be identified.

Deferred tax assets

Statement 96's strict criteria for recognizing deferred tax assets continue to head the list of the most troublesome aspects of the statement. Two Board members dissented from the statement because of its adherence to a mechanical model that excludes considering the probability of future income or events. However, several Board members now have expressed interest in challeging the basis for that exclusion. At issue is whether the deferred tax consequences of temporary differences that result in future tax deductions constitute an asset. To resolve this will necessitate a reconsideration of whether probable future events should be considered in the deferred tax calculations. The resolution will not be easy, for it involves fundamental issues relating to how assets are defined by the Board's conceptual framework.

In examining how the concept of probability could be introduced into the liability model, the Board considered various ideas, including an incremental approach. Under that approach, deferred taxes would be recognized and measured based on the "future tax consequences" of each future year. These are computed with and without the effects of temporary differences. However, the Board has been unable to reach any agreement on one critical issue: to what extent can future income or events be anticipated for purposes of determining the future tax consequence of a company? Furthermore, because it can be difficult to estimate income in each future year, computing deferred taxes will be much more complex that Statement 96 suggests.

Theoretically, an incremental approach will support numerous possibilities--ranging from a presumption that sufficient income will be available to enable recognition of all potential deferred tax assets to a presumption that there will be no future income (i.e., the Statement 96 model). At least two Board members have indicated an interest in pursuing a middle-of-the-road approach. This would permit recognition of deferred tax assets based on management estimates of future income.

Those who believe that the present recognition criteria are too narrow also believe that the criteria are inconsistent with the FASB's most recently proposed accounting standard dealing with postretirement benefits other than pensions. That proposal contrasts sharply with Statement 96, because it would require the recognition of costs based on anticipated future events, including future employee service and estimated future trends in health-care costs. Considering future events to measure postretirement costs for one standard but not to compute income taxes for another standard is, in their view, inherently incongruous.

Closely related to the recognition issue is the measurement of deferred tax assets. Many believe probable future events sho uld be considered when measuring deferred tax benefits; however, Statement 96 requires that the benefits of deductible temporary differences be measured in a manner consistent with the way they are recognized. Thus, deferred tax benefits might be recorded at carryback rates of 46 or 40 percent, even though the future benefits ordinarily would be at 34 percent. While the FASB argues that a 34-percent benefit is a consequence of earning income in the future, many continue to find it troublesome that assets are included in the balance sheet at amounts that in all probability will not be fully recovered.

The Board considered the probability issues relating to recognition and measurement before issuing the final statement. It concluded that the effects of future income and events should not be considered. Despite the significant number of requests for the expressed interests of some Board members in pursuing an incremental approach, the Board has been unable thus far to reach any agreement on the presumptive criteria that would have to be developed in order to formulate an incremental model.

Because there is a significant doubt that agreement can be reached on an incremental method, the Board also is considering an alternative approach to address complaints relating to the statement's results and the complexities encountered in applying the new rules.

A simplified approach

Although a principal objective of adding the initial project to the FASB's agenda was to reduce the complexities associated with accounting for income taxes, many find it difficult to approach that the new rules meet that objective. Given the continuing concerns about complexity, the Board is now looking at a solution based on the aggregation of temporary difference reversals. For many companies, this approach would result in a significant reduction in the required scheduling effort and would eliminate the need to consider hypothetical tax planning strategies--a major step forward in achieving simplification.

Under Statement 96, deferred taxes represent the sum of the amounts that would be payable or refundable based on the filing of hypothetical tax returns that include only the future reversals of existing temporary differences by year. Because U.S. tax law generally limits refundable amounts to taxes paid in the prior three years, detailed computations are frequently necessary to determine the amount of deferred tax assets that can be recorded for deductible temporary differences. This need to make detailed computations also applies to companies with net taxable temporary differences--if the deductible temporary differences are scheduled to reverse in years after the taxable temporary differences reverse.

In its simplest form, an aggregate approach would require scheduling the reversal of all temporary differences in the year following the balance sheet date. The deferred tax liability would be the amount of taxes payable based on a presumed one-year reversal of all temporary differences. If the one-year scheduling resulted in a net deductible difference (i.e., a net loss), a deferred tax asset could be recognized to the extent it could be recovered in a hypothetical tax-loss carryback. A variation of the aggregate approach, which several Board members appear to support, would require scheduling for additional years in order to determine (1) the balance sheet classification of deferred taxes as either current or noncurrent , and (2) the effects of phased-in tax rate changes.

We believe consideration of probable future events is implicit under the aggregate approach. In effect, companies with net taxable temporary differences could assume that they would realize the tax benefits of deductible temporary differences, either through the tax management of temporary difference reversals or through earning future income. Such a limited probability concept may prove acceptable to the Board.

Several Board members believe that the application of an aggregate approach should be optional. That conclusion apparently stems from the belief that Statement 96 provides the best result--and if companies are willing to make the detailed computations required by the statement, they should not be precluded from doing so. This is likely to be a contentious issue as the Board continues its deliberations on the aggregate method.

In short, while it is encouraging that the Board has taken steps to address concerns voiced by its constituents, it remains to be seen whether a consensus for change can be developed. A decision by the Board to deal with either the incremental approach or the aggregate approach could result in significant changes to the statement and, thus, to the results that will be obtained. Because of the uncertainty at this writing whether any changes will be made, a close tracking of the Board's deliberations has an obvious high priority in all corporate sectors.

Robert K. Herdman and Robert D. Neary

The authors are partners at Ernst & Young. They thank colleagues Alex T. Arcady and Mark L. Fagerholm for their assistance.