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Calculating deferred tax assets.

Calculating Deferred Tax Assets

Statement on Financial Accounting Standards No. 96, "Accounting for Income Taxes," applies to all taxable companies and was to be effective for fiscal years beginning after December 15, 1988. In December of 1988, the FASB issued Statement on Financial Accounting Standards No. 100, "Accounting for Income Taxes - Deferral of the Effective Date of FASB No. 96," which postponed the effective date of Statement 96 for one year. In July of 1989, the board agreed to issue an exposure draft that would propose deferring the application date of Statement 96 for an additional nine months. This additional time will allow the board to consider several issues dealing with Statement 96's fundamental concepts. One of these issues relates to the strict criteria for recognizing deferred tax assets. This article discusses the measurement and recognition of deferred tax assets as required by Statement 96 and examines alternative procedures for determining deferred tax assets that may be more acceptable.

Calculation of Deferred

Taxes - Liability Method

Statement 96 requires use of the liability method for calculating deferred tax assets and deferred tax liabilities. The liability method classifies all temporary differences existing at the balance sheet date as taxable temporary differences (future reversal will result in a higher taxable income) or deductible temporary differences (future reversal will result in a lower taxable income).

These temporary differences are scheduled according to expected future reversals and netted to an overall taxable or deductible difference for each future year. For each of the future years, a tax asset or tax liability is calculated as though a tax return were being prepared with taxable income or operating loss equal to that year's net temporary difference. Future income or losses and other transactions may not be considered in the calculation of future taxable income or loss no matter how likely the events are expected to occur.

Net deductible amounts may be carried back three years to already existing taxable income or to other net taxable temporary differences. Any remaining net deductible amounts may be carried forward 15 years to net taxable temporary differences. Exhibit 1 illustrates application of the liability method. The cumulative temporary differences in existence on 12/31/90, the balance sheet date, are scheduled according to their expected reversal dates. The taxable and deductible (shown in brackets) amounts are netted for each year. The net deductible amount for 1991 is carried back to actual income for 1988 and 1989, resulting in an imaginary refund for 1991.

An imaginary refund creates a deferred tax asset. This deferred tax asset is classified as current since it arises from the year following the balance sheet date. The net taxable amount for 1992 and 1993 results in a noncurrent deferred tax liability. The net deductible amount for 1994 is carried back to net taxable amounts for 1992 and 1993, resulting in another imaginary refund which creates a noncurrent deferred tax asset. The part of the net deductible from 1994 that was not carried back is carried forward to reduce the net taxable amount for 1995. The remaining taxable amount for 1995 results in a noncurrent deferred tax liability.

Note that a deferred tax asset may arise only when a net deductible difference is carried back either to existing taxable income or to a net taxable difference creating an imaginary refund. If the net deductible amount is carried forward, it does not create a refund, but only reduces the net taxable amount and therefore the amount calculated as a deferred tax liability. The calculation of the deferred tax is viewed chronologically. For example, the net taxable amounts for 1992 and 1993 occur before the net deductible amount for 1994. Therefore, imaginary taxes must be paid before the refund, resulting in a deferred tax liability first and then the deferred tax asset.

Nonrecognition of

Deferred Tax Benefit

Net deductible differences are carried back three years and forward 15 years. This results in a deferred tax asset if carried back or a reduction in a deferred tax liability if carried forward. However, if the net deductible amounts exceed actual income and/or net taxable differences, this excess is not recognized as a deferred tax benefit. Exhibit 2 illustrates this nonrecognition concept. The net deductible in 1991 is carried back to the extent possible creating a deferred tax asset. The remainder is carried forward to 1993. The net deductible difference for 1992 exceeds the net taxable difference remaining in 1993 by $40,000. Statement 96 does not allow for any consideration of probable future income or losses no matter how likely income is expected to occur. Therefore the $40,000 has no future income to offset this future loss and no benefit for this $40,000 may be recognized on the 12/31/90 financial statements.

Tax Rates for Calculating

Deferred Tax Asset

Corporate tax rates periodically change. Statement 96 requires the deferred tax asset to be calculated as the benefit of the net deductible carried back three years and then forward for 15 years. The taxable income or net taxable difference carried back or forward may be taxed at rates different from the rate expected to occur in year of reversal for the net deductible difference. Exhibit 3 illustrates the effect of carrying back to different tax rates than expected to be in effect when the temporary difference reverses. The net deductible difference is carried back to years in which the taxes paid were based on a rate of 46%, resulting in a total deferred tax asset of $46,000. However, the reversal and therefore tax benefit will occur when the tax rates are expected to be 34%. The deduction for payment of this liability will reduce taxable income by $60,000 for 1991 and $40,000 for 1992 resulting in a lower tax liability of $20,400 and $13,600, respectively. Although we expect only to benefit by $34,000, a deferred tax asset of $46,000 is recorded on the December 31,1990, balance sheet.

Possible Alternative

Approaches

Consideration of probable future income is one approach which would help reduce the problem of non-recognition of deferred tax assets when net deductible differences do not have taxable income or net taxable amounts to carry back or forward. Adoption of a probability approach would also permit companies to calculate deferred tax amounts at the tax rate expected to be in effect when the difference reverses rather than at tax rates of previous years. The critical issue with this approach is the extent to which future income can be anticipated for purposes of determining future tax consequences.

Another approach being considered by the board is based on the aggregation of temporary difference reversals. This aggregate approach would require scheduling the reversal of all temporary differences in the year following the balance sheet date. The deferred tax would be the amount of payable or refundable based on a presumed one-year reversal of all temporary differences. This approach would significantly reduce the required scheduling effort, but the potential problem of nonrecognition of deferred tax assets would still remain if temporary deductible differences exceeded temporary taxable differences.

It is encouraging that the board is considering alternative approaches to help resolve issues of concern to reporting companies. But it is going to be a difficult task developing an approach which will reduce complexity and at the same time provide meaningful measurements to be included in the financial statements.

Conclusion

The FASB recently has considered re-examining certain provisions included in Statement 96 "Accounting for Income Taxes." The board agreed to issue an exposure draft that would defer the effective date of Statement 96 for an additional nine months. One issue the board has decided to consider is the recognition and measurement of deferred tax assets. The requirements of Statement 96 would, under given circumstances, result in nonrecognition of deferred tax benefits even though these benefits are expected to be realized in the future. In addition, the deferred tax benefits are required to be calculated based on tax rates that may not be expected to be in effect when the benefit is realized.

Alternative approaches are being considered by the board. A probability approach would consider the effects of probable future income in computing deferred tax assets, resulting in less chance of nonrecognition of deferred tax benefits. A simplified approach would be based on the aggregation of temporary difference reversals, resulting in a reduction of scheduling effort and eliminate the need to consider hypothetical tax planning.

It is encouraging that the board has agreed to address concerns about Statement 96. However, whether an approach can be developed which would reduce complexity and provide meaningful measurements remains to be seen.

PHOTO : Exhibit 1 Illustration of Liability Method

PHOTO : Exhibit 2 Illustration of Nonrecognition of Deferred Tax Benefit

PHOTO : Exhibit 3 Illustration of Effect of Different Tax Rates in Carryback Period and Year of Reversal

Arlette C. Wilson is assistant professor in the Department of Accounting at Auburn University in Alabama.
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Author:Wilson, Arlette C.
Publication:The National Public Accountant
Date:Apr 1, 1990
Words:1491
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