FASB 109: planning for implementation and beyond.

Will the new statement reduce the complexity of accounting for income taxes?

The deadline for implementing Financial Accounting Standards Board Statement no. 109, Accounting for Income Taxes is rapidly approaching. The requirements must be reflected in financial statements for fiscal years beginning after December 15, 1992. This article outlines a step-by-step process companies can use to effectively manage the complex Statement no. 109 implementation process. The article also includes comments and suggestions about how companies can plan the resources they will need to devote to meeting the statement's requirements.

IMPLEMENTATION INFORMATION NEEDS

Exhibit 1, page 47, summarizes the implementation steps most companies should follow. Of these, the most time-consuming probably will be those steps dealing with gathering the information needed to make the Statement no. 109 calculations. The key information needed to apply Statement no. 109 is a complete inventory of temporary differences. The checklist suggests an approach to obtaining that information by identifying jurisdictions and entities.

The checklist also emphasizes the need to develop an understanding of the various income tax rates and tax law provisions that may affect the Statement no. 109 calculations. Some of the issues companies may encounter in attempting to gather this information are highlighted below.

Jurisdictions-entities. Statement no. 109 applies to all entities (foreign and domestic) within a company's financial statements. Virtually every company will have to deal with at least two tax jurisdictions, federal and one state; most companies operate in more than one state. While the simplest way to handle multiple-state jurisdictions is to make one aggregate deferred tax calculation covering federal and state income taxes, differences in tax laws between federal and state and among the various states (including allocations and apportionment factors) may make this approach impractical.

Multinational companies have an even more complex task. In the past, companies could rely on employees resident in each foreign country to make the deferred tax calculations required for U.S. generally accepted accounting principles. The deferred method of Accounting Principles Board Opinion no. 11, Accounting for Income Taxes, has been in effect for so long employees of multinationals throughout the world are reasonably comfortable with its application. It will take time for those employees to develop the same level of understanding for Statement no. 109.

Companies may decide to make all Statement no. 109 calculations centrally, at least for the first year or two. Accordingly, their consolidation reporting packages will need to be revised to incorporate instructions relevant to Statement no. 109 and to capture the necessary information.

Inventory of temporary differences. To ensure a complete inventory of temporary differences, a company should consider preparing a comprehensive tax basis balance sheet to compare to its book balance sheet. Companies attempting to identify temporary differences based only on the determination of the tax basis of book balance sheet items may overlook some temporary differences (deferred income for tax method changes, installment sales, etc.). Most companies have not maintained tax basis balance sheets in the past since such information was not needed for either financial or tax reporting purposes. Thus, developing a tax basis balance sheet and the resulting complete inventory of temporary differences may be a time-consuming process, with information drawn from several different sources.

Some companies have maintained records of Opinion no. 11 cumulative timing differences. These records would be a good starting point for obtaining the information needed for implementing Statement no. 109, even though the concept of temporary differences under the statement is much broader than the Opinion no. 11 concept of timing differences. Even companies that did not keep records of cumulative timing differences (and most did not) will be able to obtain valuable information by reviewing prior deferred tax calculations.

Companies also should analyze prior tax returns to identify all significant schedule M items. The amounts shown on schedule M and the information in prior deferred tax calculations under Opinion no. 11 usually reflect only current-year activity. Companies must analyze further the nature and underlying basis differences of these items to develop the information needed for applying Statement no. 109.

Once identified, temporary differences should be categorized by tax treatment (capital or ordinary), by whether a corresponding book asset or liability exists and by source (generally falling within certain major financial statement classifications-- income statement, acquisition accounting, stockholders' equity, etc.). This information is necessary for ongoing application of Statement no. 109. Companies also should document at least a general understanding of the future reversal pattern of existing temporary differences. Companies for which graduated rates may be significant or that need to consider valuation allowances may have to extend this understanding to other estimated future taxable amounts.

Future deductible temporary differences and other items giving rise to deferred tax assets create additional information needs because of valuation allowance considerations. The effects of subsequent changes in valuation allowances may be reported differently in a company's financial statements depending on the source of the related deferred tax asset. For example, a decrease in the valuation allowance for a deferred tax asset established for an acquired net operating loss or future deductible temporary difference is accounted for as an adjustment of the amounts assigned to other acquired assets (goodwill and other noncurrent intangible assets).

The requirement to identify an item's source to determine the current accounting for changes in that item has been called "backward tracing." The FASB attempted to minimize the areas for which backward tracing would be required in applying Statement no. 109. Changes in certain valuation allowances, however, is one area where backward tracing is still likely to be necessary. In developing information about future deductible temporary differences and other items giving rise to deferred tax assets, companies should ensure they capture the information they will need if backward tracing is required in the future.

Tax rates and elections. Statement no. 109 requires measurement of deferred taxes using the tax rate(s) expected to apply to taxable income in the periods the deferred tax amounts are expected to be settled or realized. It follows that all companies will need at least some forward-looking information about tax rates and normal ongoing tax elections. The number and diversity of jurisdictions a company operates in will affect the ease with which this information can be obtained. For example, many jurisdictions apply different tax rates depending on the nature of the item being taxed (capital gains, for example).

Tax rate information also can affect other information needs. For example, if tax rate or law changes have been enacted but are not effective until some future period, companies may need to analyze temporary difference reversal periods (scheduling) to determine the appropriate rate. Such changes also could affect a company's judgments about the realizability of recorded deferred tax assets, thus requiring a reassessment of related valuation allowances. For example, a tax law change might limit companies' ability to carry forward operating or capital losses.

Each jurisdiction may have unique tax rates, elections and systems to consider. Examples include the capital cost allowance in Canada, the advance corporation tax in the United Kingdom, tax basis indexing in Mexico, tax holidays in Ireland and the U.S. alternative minimum tax (AMT). Companies should consider both currently applied tax elections and alternatives and those they may make in the future, when temporary differences are expected to reverse.

The interaction of different tax law provisions within each jurisdiction also must be considered. An example of this is provided by the AMT. Although the AMT's interaction in Statement no. 109 calculations has been greatly reduced compared to its predecessor, FASB Statement no. 96, Accounting for Income TaXes, companies should consider its implications when addressing the need for a valuation allowance. For example, under U.S. tax law, research credits cannot reduce the regular income tax below the tentative minimum tax, possibly jeopardizing the realizability of research credit carryforwards.

Establish ongoing procedures and systems. Early in the Statement no. 109 implementation planning process, companies should determine to what extent their current accounting systems and procedures should be modified to provide implementation information and to meet ongoing Statement no. 109 information needs. Areas companies should address include

* Computer software used for book and tax depreciation calculations.

* Software that may be needed for detailed deferred income tax calculations.

* Reporting packages completed by subsidiary companies.

* Procedures and systems used to estimate effective tax rates for interim financial reporting.

* Accounting policies for intercorporate income tax allocations.

FASB 109 IMPLEMENTATION STRATEGIES

The checklist in exhibit 1 identifies the need to evaluate Statement no. 109 implementation strategies. In some areas the statement permits companies to choose from among several alternatives. For many companies, the choices they make can significantly affect reported financial position and results of operations in the year of implementation and for years to come. Thorough planning is important if a company wishes to ensure its implementation approach best accomplishes its long-term financial reporting objectives. Examples of implementation strategies companies should consider are described below.

Year of adoption. Companies should focus on one alternative immediately--the year of adoption. Calendar-year companies can elect early adoption of Statement no. 109 until their 1992 financial statements are released. A company that already has unusual nonrecurring items in 1992 may want to consider adopting Statement no. 109 early so nonrecurring effects are grouped in one year. Companies also should consider the possible effects of a change in tax rates or laws that may be enacted in the near future and other accounting changes such as those that will be required by FASB Statement no. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions.

Companies should begin gathering data based on the most recent yearend financial statements (for instance, December 31, 1991). This information will be needed to evaluate the early adoption alternative. Even companies that decide not to adopt early may find it is not difficult to roll forward information from the prior yearend and that this approach provides significant advantages over waiting until 1992 yearend information is available.

Cumulative effect versus restatement. In the year of adoption, companies can elect either to report Statement no. 109's catchup effects on all prior years in the current year's income statement as the cumulative effect of a change in accounting principles or to restate any number of consecutive prior years. The restatement approach, for companies with no aversion to restatement, can create substantial financial reporting benefits that should not be ignored, particularly when prior business acquisitions have occurred.

Prior acquisitions. Three Statement no. 109 approaches may be used for prior acquisitions. Two are actual alternatives: restatement (of an acquisition year); and gross-up. The third approach (short-cut) is available if a company does not restate and then only if the gross-up approach is impracticable.

Exhibit 2, page 50, illustrates the effects of selecting each approach. An assumption used in this example is that the tax effects of the acquisition-related basis differences were discounted (not allowed under Statement no. 109) in applying the net-of-tax concept of APB Opinion no. 16, Business Combinations. The cumulative effect under the gross-up approach in this example relates entirely to eliminating the discounting assumption. The example also shows that goodwill is adjusted only in a restatement.

Under the gross-up approach, the facts at the time of the original acquisition are revisited to remove any previously netted tax effects from the remaining asset carrying amount. Under the short-cut approach, the factors giving rise to the present asset carrying amounts are ignored and a new temporary difference is recognized for any remaining book-tax basis differences. This can cause some unexpected results since under the short-cut approach deferred taxes are in effect double recorded. The short-cut approach usually results in lower property, plant and equipment than other methods and an increased cumulative effect charge offset by reduced future depreciation.

Application to subsidiaries. Depending on the circumstances, companies may be able to use different implementation methods in subsidiaries' separate financial statements. In consolidation, however, all consolidated subsidiaries must be adjusted to be consistent with the parent company's implementation method. This requirement does not apply to equity investees, which. could apply Statement no. 109 through restatement, while the investor company adopts through a cumulative effect in a later year. The investee's Statement no. 109 effects flow through the investor's equity pick-up; if material, the investee cumulative effect is reported as a cumulative effect in the investor income statement.

WORKING WITH INDEPENDENT AUDITORS 

The exhibit 1 checklist refers to the need to involve the company's independent auditors at various steps in the implementation process. Because of Statement no. 109's complexities, many companies may turn to their auditors to provide technical advice and to help identify implementation alternatives and areas where management is required to make judgments.

There are a number of subjective decisions necessary to implement Statement no. 109 (including valuation allowances and implementation strategies). These decisions should be made by management, not by the auditors. Since the auditors must evaluate the judgments management makes, preparing thorough, conclusive documentation supporting these decisions is the best way to facilitate this process.

Notwithstanding Statement no. 109's intent to reduce the mechanical complexity of accounting for income taxes, many companies will find their auditors requesting some form of scheduling, particularly when there is uncertainty about the need for a valuation allowance. Even with this documentation, companies may be surprised at their auditors' reluctance to accept forecasted information (inherent in scheduling under Statement no. 109) as a basis for not establishing a valuation allowance. Virtually all major CPA firms have publicly expressed the view that forecasted future profits, by themselves, may not be enough to offset existing negative evidence.

COMPLEX ISSUES

This article has touched on only some of the complex issues companies will have to address in implementing Statement no. 109. Other guidance is available, including implementation guidance from the FASB and monographs published by many of the large CPA firms. Answers do not yet exist, however, for many of the problems companies may encounter but will evolve as companies work with the new standard.

EXECUTIVE SUMMARY

* COMPANIES SHOULD NOW BEGIN planning implementation of FASB Statement no. 109, Accounting for Income Taxes. Changes must be reflected in financial statements for fiscal years beginning after December 15, 1992.

* STATEMENT NO. 109 APPLIES to all entities, foreign and domestic. Virtually all companies will have to consider at least two tax jurisdictions--federal and one state. Since most companies operate in more than one state and many operate overseas, multiple jurisdictions will have to be accounted for.

* TO MEET STATEMENT NO. 109's requirements, a company will need a complete inventory of temporary differences. Companies that maintained records of cumulative timing differences under APB Opinion no. 11, Accounting for Income Taxes, will find this a good (if time-consuming) starting point.

* ALL COMPANIES WILL NEED forward-looking information about tax rates and ongoing tax elections. If enacted changes are not effective until a future period, scheduling may be necessary to determine the correct rate.

* CURRENT ACCOUNTING systems, including computer software and subsidiary reporting packages, should be evaluated to make certain information needed to comply with Statement no. 109 is available.

* COMPANIES FACE A NUMBER of options in implementing Statement no. 109, including whether to adopt it for 1992, if the catch-up effects on prior years should be reported as the cumulative effect of a change in accounting principles or through restatement and how to treat prior acquisitions.

GEORGE J. GREGORY, CPA, is a partner of Coopers & Lybrand in Philadelphia. A member of the American Institute of CPAs and the Pennsylvania Institute of CPAs, he serves as adjunct professor of the taxation of partnerships/corporations and affiliated groups at Temple University, Philadelphia. THOMAS R. PETREE, CPA, is partner in charge of the Pennsylvania operations of Wagner Sharer & Co., Malvern. He is a member of the AICPA and the PICPA and serves on the Financial Accounting Standard Board's implementation group for Statement no. 109. RANDALL J. VITRAY, CPA, is partner in charge of regional consulting on Statement no. 109 for Coopers & Lybrand in Philadelphia. He is a member of the AICPA and the PICPA.