FASB 106's deferred tax implications: FASB Statement no. 109 adds another wrinkle to accounting for postretirement benefits.

Financial Accounting Standards Board Statement no. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, changed financial reporting for such benefits from a cash basis to an accrual basis. Companies must accrue the cost of postretirement benefits as they are earned by employees. (Previously, such liabilities were not recognized in the financial statements.) FASB Statement no. 109, Accounting for Income Taxes, requires companies to determine whether a valuation allowance is needed to reduce deferred tax assets to an amount more likely than not to be realized. How do these statements relate to each other? Recording an accrued liability under Statement no. 106 creates a deferred tax asset under Statement no. 109.

For some companies, existing, but previously unreported, postretirement benefit obligations are significant. In 1992, for example, General Motors Corp. and Ford Motor Co. recorded accrued liabilities of approximately $33 billion and $12 billion, respectively. Statement no. 109 requires companies to use an offsetting valuation allowance in placing deferred tax assets on their balance sheets. In deciding the appropriate magnitude of the allowance, CPAs must exercise considerable professional judgment. This article addresses factors that must be evaluated in making this decision.

SERVING TWO MASTERS

The treatment of postretirement benefits is just one example of how financial reporting and Internal Revenue Code tax reporting requirements differ.

Financial statement reporting requirements. The change from pay-as-you-go to accrual-basis accounting for postretirement benefits under Statement no. 106 affects income statements prepared in accordance with generally accepted accounting principles in two important ways:

1. The present value of future benefits already earned by both employees and retirees, called transition obligations by the FASB, must be charged to income. Companies have two options in recognizing this cost: They can (a) charge the entire amount in the year of adoption as the effect of a change in accounting principle or (b) amortize the amount to expense over future periods.

2. The FASB uses the term net periodic postretirement benefit cost (NPPBC) in describing the postretirement benefit expense companies are required to report on their income statements after adopting Statement no. 106. As has been widely reported, NPPBC normally will be significantly higher than previously reported pay-as-you-go costs.

IRC reporting requirements. The timing of postretirement benefit tax deductions will differ from the Statement no. 106 accounting treatment. Most benefit plans are funded on a pay-as-you-go basis and involve either payment of premiums on a monthly basis or payment of benefits from a self-insured plan. In either case, tax deductions are governed by IRC section 162, which requires the payments to be ordinary, necessary and reasonable to be deductible. If payments meet these criteria, they are deductible when paid.

Different rules apply to postretirement benefit plans funded through pension plans or separately funded welfare plans. The former are governed by IRC section 401(h), and the latter, for plans in which payments go into a separate trust, are covered by sections 419 and 419A.

DEFERRED TAX ISSUES

Statement no. 109 says deferred taxes should be recognized when the tax basis of assets or liabilities differs from the financial accounting basis and the resulting differences are not permanent. Deferred tax assets are recognized for temporary differences that will result in future deductible amounts. However, CPAs also must judge whether the deferred tax assets are realizable. If it appears (using a "more likely than not" criterion) a company will not be able to use all the future deductions, an allowance must be established for the tax benefits that may not be realized. While it may be difficult to make such a valuation for postretirement benefits, it's necessary since many companies' largest deferred tax assets are associated with accrued postretirement benefits.

Creation of a deferred tax asset

Journal entries (before income tax accrual)
January 1, 19X1
Cumulative effect of accounting change   10,000
  Accrued postretirement cost                     10,000
December 31, 19X1
Accrued postretirement cost               2,000
  Cash                                             2,000
Net periodic postretirement benefit cost
expense                                   4,000
  Accrued postretirement cost                      4,000
Income tax analysis
Prepaid/accrued postretirement cost (December 31, 19X1)
      Financial basis of liability   = $12,000
      Tax basis of liability         =    -0-
      Temporary difference           = $12,000
Taxable income:
      Net income before Statement
        no. 106                      =$100,000
      Tax deduction                  =   2,000
      Taxable income                 = $ 98,000
Income tax payable:
      $98,000 x 40% = $39,200
Deferred tax asset:
      $12,000 x 40% = $ 4,800
Income tax journal entry:
Income tax expense                       34,400
Deferred tax asset                        4,800
  Income tax payable                              39,200

In the past when companies accounted for postretirement benefits on a cash basis, financial expenses equaled tax deductions, which were based on benefits paid. Since there were no differences between financial and tax accounting, there were no deferred taxes. Statement no. 106 requires accrual of postretirement benefit costs. At any point in time, the balance in the accured postretirement benefits account represents a temporary difference between financial and tax accounting, which requires accural of a deferred tax asset.

The exhibit on page 91 shows the formation of this deferred tax asset. Assume a company adopts Statement no. 106 on January 1, 19X1. The company chooses to expense the $10,000 transition amount immediately, which reduces net income in 19X1 but has no direct effect thereafter. This financial accounting decision does not affect taxable income since tax deductions are based on amounts actually paid, subject to certain restrictions. Assume both net income and taxable income are $100,000 before considering Statement no. 106; NPPBC is $4,000 and the benefit amount is $2,000. Depending on the ratio of currently active to retired employees, NPPBC can be anywhere from 2 to over 40 times as large as the benefit payment. If no temporary differences exist other than those resulting from postretirement benefits, the exhibit shows a deferred tax asset of $4,800 is created.

In the above example, the deferred tax asset is determined easily. A far more challenging tasks is evaluating the need for an allowance account. Deferred tax assets generated by deductible temporary differences will be realizable only if there is sufficient future income to use those deductions. If future income is not adequate, an allowance will be necessary to reduce the deferred tax asset to the amount more likely than not to be realized. In determining the need for a valuation allowance, all positive and negative evidence must be considered.

Several sources of future income should be considered to determine whether an allowance is required. One is the future reversal of temporary taxable differences. The postretirement benefit obligation creates large future deductible amounts. It is unlikely other temporary differences will generate future taxable amounts sufficient to offset the postretirement deductions.

A second source could be future taxable income other than the reversals discussed previously. Future taxable income may be the most significant factor in a CPA's evaluation. Evidence such as a strong history of earnings should be considered, but the timing of the reversals makes estimating future income a complex process. The temporary postretirement differences will reverse, but generally not for many years. It is unusual for it to take less than 20 years for benefit payments to be greater than postretirement benefit expense recorded on the income statement. Because the reversals ultimately will be quite large, CPAs must be able to predict large amounts of future earnings. Predicting such amounts so far in advance is extremely difficult.

Taxable income in prior carryback years is a third source of earnings. This source may be difficult to evaluate: Because the reversals will occur far in the future, it is difficult if not impossible to use carryback provisions.

A separate (and important) issue involves the time value of the tax deductions. A postretirement deferred tax asset is an undiscounted asset whose benefits may not be received for as many as 20 years. What is the present value of an asset to be received 20 or more years in the future? This should not be a factor in determining the allowance according to Statement no. 106, but it is an important conceptual issue the FASB may need to address.

GROWING IMPACT

Statement no. 106 has had a significant effect on the financial statements of companies that elected early adoption. Its impact will continue to grow as more companies comply with the standard. One of the statement's most important consequences is the recognition of deferred tax assets, which for many companies represent the major component of total deferred taxes. As CPAs evaluate all evidence--positive and negative--they may have to consider a significant allowance to value a deferred tax asset properly.

EXECUTIVE SUMMARY

* FINANCIAL ACCOUNTING Standards Board Statement no. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, requires that companies expense the costs associated with such benefits as they are earned by employees. Previously, such costs were expensed when paid on a pay-as-you-go basis.

* FASB STATEMENT NO. 109, Accounting for Income Taxes, requires companies to determine whether a valuation allowance is needed to reduce deferred tax assets to an amount more likely than not to be realized. Recording an accrued liability under Statement no. 106 creates a deferred tax asset under Statement no. 109.

* THE INTERNAL REVENUE CODE says companies should use the pay-as-you-go method, subject to certain limits, to compute their tax deductions for benefit payments. The differences between the financial reporting and tax requirements create significant deferred tax assets.

* SINCE DEFERRED TAX ASSETS are not expected to reverse in the near future (in most cases they do so after a minimum of 20 years), CPAs must consider several issues in determining an appropriate valuation allowance to report a deferred tax asset at the amount more likely than not to be realizable.