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How utilities will account for income taxes under FASB 109.

Regulators and companies alike need to consider the new provisions' effect on utility operations.

After years of debate, the Financial Accounting Standards Board this year issued Statement no. 109, Accounting for Income Taxes, a landmark pronouncement with significant implications for both regulated and nonregulated industries. Statement no. 109 supersedes Accounting Principles Board Opinion no. 11, of the same name, the tax accounting methodology used for most financial reporting purposes over the last 25 years. Statement no. 109 also. replaces Statement no. 96, Accounting for Income Taxes--its controversial and short-lived predecessor. While Statement no. 109 supersedes Statement no. 96, it retains the overall approach of the latter, particularly the asset and liability focus of determining income tax expense.

The public utilities industry will be affected by this pronouncement, particularly utilities' balance sheets. As a result of the provision requiring a utility to establish a regulatory asset or liability in connection with a deferred tax liability or asset, adopting Statement no. 109 generally will not have a significant income statement effect on regulated operations.

A regulatory asset or liability associated with income taxes generally represents the future increase or decrease in taxes payable that will be received or settled through future rate revenues based on rate-making proceedings. The regulatory asset or liability itself is treated as a temporary difference under Statement no. 109. However, a utility may incur a charge or benefit to earnings for nonregulated operations. Similarly, after adopting Statement no. 109 a utility may report an income statement effect for deferred income taxes recorded under Opinion no. 11 under certain unique circumstances.

APPLICATION TO THE PUBLIC UTILITY INDUSTRY

Adopting Statement no. 109 will require many utilities to make significant changes in calculating deferred income taxes. Among other things, the statement

* Prohibits net-of-tax accounting and reporting (reduction of carrying amounts for related tax benefits) on construction work in progress (CWIP) and plant in service.

* Requires recognition of a deferred tax liability for tax benefits flowed through to ratepayers (when no deferred taxes were provided in the past or in current periods).

* Requires recognition of a deferred tax liability for the equity component of the allowance for funds used during construction (AFUDC).

* Requires adjustment of deferred tax liabilities and deferred tax assets for changes in the tax laws or rates.

Statement no. 109 says a regulatory asset or liability should be recognized according to FASB Statement no. 71, Accounting for the Effects of Certain Types of Regulation, if it is probable as a result of a regulator's action (such as a possible rate proceeding decision) that a future increase or decrease in taxes payable for the last three items above will be recovered through future rate revenues. Requiring a due to-from rate-payers account means applying Statement no. 109 generally will have no income statement effect for regulated operations. The regulatory asset or liability established is itself a temporary difference that, in turn, requires recognition of an additional deferred tax liability or asset, as appropriate.

AFUDC. Consistent with Statement no. 96, Statement no. 109 requires AFUDC to be reported on a before-tax basis. Net-of-tax and aftertax accounting and reporting are expressly prohibited. After adoption of Statement no. 109, both CWIP and plant-in-service amounts must be adjusted to the amounts that would have been reported had the statement applied for all prior periods. AFUDC thereafter must be capitalized on a pretax basis. (Statement no. 109 differs from Statement no. 96 in that the latter did not require a gross-up for the balance of plant in service as of the beginning of the year of adoption. )

Debt component of AFUDC. The gross-up with respect to AFUDC's borrowed funds component is reported as an additional component of CW/P and plant in service. The gross-up requires recognizing a corresponding deferred tax liability, as shown in exhibit 1, page 55.

Equity component of AFUDC. AFUDC's equity component is considered a permanent difference under Opinion no. 11; consequently, no deferred tax liability is recorded for this book versus tax difference. Under Statement no. 109, AFUDC's equity component is considered a temporary difference for which a deferred tax liability must be established. If, based on a regulator's action, it is probable the utility will recover the future increase in taxes payable represented by this deferred tax liability through a rate revenue increase, a regulatory asset is recognized. This regulatory asset itself is a temporary difference for which a deferred tax liability must be recognized. Exhibit 2, page 55, illustrates this requirement.

As noted above, Statement no. 109 requires regulated enterprises to adjust the net-of-tax or aftertax components of CWIP as if the statement's requirements applied to such amounts in all prior years. Subject to the exception discussed below, Statement no. 109 requires the reported balances of plant in service to be similarly adjusted.

When the adjustment to plant in service is determined impractical because either the information necessary to compute the adjustment no longer is available or the cost to develop the information is excessive, Statement no. 109 says the reported plant-in-service amount should not be adjusted. Instead, the difference between the reported amount and the plant-in-service tax basis is a temporary difference for which a deferred tax liability is recognized. If as a result of a regulator's action it is probable the enterprise will recover the deferred tax liability through future rate revenue, a regulatory asset (and related deferred tax liability) is recognized for that probable future revenue.

Flow-through items. The public utility industry is particularly affected by Statement no. 109's treatment of flow-through items. The statement specifically covers regulated enterprises meeting the criteria for applying statement no. 71. In general, such a regulated enterprise is required to capitalize an incurred cost that otherwise would be expensed if both

* It is probable future revenue in an amount at least equal to the capitalized cost will result from inclusion of that cost in allowable costs for rate-making purposes.

* Based on available evidence, future revenue will be provided to permit recovery of the previously incurred cost rather than to provide for expected levels of similar future costs.

Before its amendment by Statements nos. 96 and 109, Statement no. 71 provided a significant exception for regulated enterprises from the general principle of Opinion no. 11 requiring provision of deferred taxes for the income tax effect of book versus tax timing differences. Statement no. 71 prohibited regulated enterprises from recording income tax payable in future years when it was probable such taxes would be recovered through future rate revenue. Statement no. 109 now amends Statement no. 71 to eliminate this restriction. Consequently, after adopting Statement no. 109, regulated enterprises must establish deferred tax liabilities and deferred tax assets for originating temporary differences previously flowed through to ratepayers.

Following the statement's adoption, regulated enterprises must continue to provide deferred taxes for items flowed through to ratepayers. When it is probable based on a regulator's action the enterprise will recover from (or return to) ratepayers the future tax liability (benefit) associated with flow-through items, a regulatory asset (or liability) must be established. The regulatory asset or liability, together with the related deferred tax liability or asset, must be grossed-up to account for the tax-on-tax effect. This requirement is illustrated in exhibit 3, page 56. Change in tax laws or rates. Statement no. 109 requires adjustment of a deferred tax liability or asset for changes in the tax laws or tax rates. Accordingly, the Tax Reform Act of 1986 (TRA) corporate federal income tax rate reduction to 34% from 46% requires a reduction in deferred tax liabilities. Any future tax rate increase would require an increase in deferred tax liability. If a regulator's actions make it probable a tax rate decrease will result in a reduction in rate revenues, a liability to ratepayers should be recorded. Similarly, if a regulator's actions make it probable a tax rate increase will result in increased rate revenues, a receivable from ratepayers should be recorded. Exhibit 4, page 58, illustrates the tax rate change to 34% from 46%.

Congress prescribed normalization requirements for the rate-making treatment of excess tax liabilities (reserves) created by the TRA tax reduction. Amortization of these excess reserves into income must be done consistent with the methodology mandated by Congress. Statement no. 109 does not address the amortization method or period for these excess reserves; amortization or reversals of "protected" (depreciation) differences are determined by the Internal Revenue Code under the normalization requirements of section 168(i)(9) and TRA section 203(e).

Deferred investment tax credits (ITC). Most public utilities use the deferral method of accounting for ITC. ITC claimed on the tax return for the year is capitalized and amortized over the useful lives of the property giving rise to the credit. Deferral treatment is required for many utilities by IRC normalization provisions. Due to the typical lengthy useful life of utility plant for regulatory purposes, utilities employing the deferral method continue to report significant unamortized accumulated deferred /TC (ADITC) as a deferred credit on their balance sheet. Statement no. 109 treats AD/TC as a reduction in the cost of the related asset. Future amortization of ADITC creates a deductible temporary difference for which a deferred tax asset must be recognized. This treatment results in a regulatory liability to the extent the ADITC is to be used to reduce future revenue requirements and a corresponding gross-up in the related deferred tax asset. Exhibit 5, page 59, illustrates the ITC treatment under Statement no. 109.

As discussed below, the amortization of ADITC into income must be consistent with the method applicable to the taxpayer under the ITC normalization requirements of IRC section 46(f).

REGULATORY CONSIDERATIONS TO BE ADDRESSED BY THE INDUSTRY

While many regulated utilities may not report an earnings effect as a result of Statement no. 109, application of the statement by public utilities across the country may ultimately have a considerable impact on the regulatory process.

* Recognition of additional deferred tax liabilities and deferred tax assets will make the effect of regulatory assets or liabilities more explicit in the financial statements. But the "ballooning" of utility balance sheets also will create property tax complications and may require revisions to the Federal Energy Regulatory Commission uniform system of accounts,

* Statement no. 109 shifts the focus of the tax calculation for financial reporting purposes from the income statement to the balance sheet. This change in emphasis may influence regulators to adopt a similar shift in their methodology for determining ratemaking tax expense.

* The rate base treatment of regulatory assets and liabilities recorded under Statement no. 109 must be consistent with the treatment in rate base (that is, inclusion or exclusion) of the associated deferred tax liabilities and deferred tax assets. In certain cases, inconsistent treatment could result in a conflict and possible violation of the IRC's normalization requirements. Violating these requirements may result in the disallowance of accelerated depreciation benefits for tax purposes.

* Statement no. 109 requires adjustment of an enterprise's deferred tax liabilities and assets to reflect changes in the tax rate. Accordingly, deferred tax liabilities established at the old 46% corporate federal rate must be adjusted to reflect that associated temporary differences will become due and payable at the 34% tax rate provided by the TRA. With Statement no. 109, nonregulated companies must make a single, cumulative adjustment for excess deferred taxes (the excess portion is flowed through to the income statement). However, because in virtually all cases regulated utilities must flow these excess deferred taxes back to ratepayers, Statement no. 109 generally requires recognizing of a liability to reflect the reduction in future revenues (together with the gross-up for the tax benefit provided by these reduced revenues).

* The TRA set an annual ceiling on the excess deferred taxes attributable to accelerated tax depreciation on public utility property that may be amortized into rates in a given year. The act specifies the excess deferred tax liability must be amortized into rates no more rapidly than over the regulatory lives of the underlying property (known as the average rate assumption method [ARAM]). Failure to abide by the annual ARAM limitation may result in a normalization violation and the loss by the utility of its accelerated depreciation deductions for tax purposes.

* Neither Statement no. 109 nor Statement no. 71 specifies the period and manner in which excess tax reserves are amortized into rates. The statements, therefore, are not inconsistent with the ARAM methodology Congress prescribed. Nevertheless, the fact that nonregulated enterprises reflect the adjustment for tax rate changes in a single year under Statement no. 109 undoubtedly will encourage some regulators to press the issue on rate proceedings with utilities to the fullest extent possible in the rate-making process. Utilities should exercise caution in this area to ensure the IRC's normalization requirements are not violated.

The above issues must be addressed and resolved by the utility industry on a proactive basis with regulators and other affected parties in the near future. Utilities should consider impact studies and expert testimony on Statement no. 109 for submission to the regulatory commission having jurisdiction over the utilities' rates to assist regulators in understanding the extent and application of Statement no. 109 on utility operations. Statement no. 109's requirements are effective for fiscal years beginning after December 15, 1992. Public companies are required to adopt Statement no. 109 no later than in the first quarter of the fiscal year beginning after December 15, 1992.

HERNAN GONZALEZ, CPA, is a partner of KPMG Peat Marwick and the national market director for public utilities tax services, St. Petersburg, Florida. A member of the American Institute of CPAs and the Florida, New Jersey, District of Columbia, Ohio, Texas and Louisiana state CPA societies, he is also a member of the Edison Electric Institute and the American Gas Association. WILL A. ERKEN, CPA, is a senior manager in KPMG Peat Marwick's national utility tax practice. He is a member of the AICPA.

EXECUTIVE SUMMARY

AMONG THE ENTITIES affected by FASB Statement no. 109, Accounting for Income Taxes, are public utilities. While the statement will not have a significant income statement effect on regulated operations, a utility may incur a charge or benefit to earnings for nonregulated operations.

* THE PUBLIC UTILITY industry is particularly affected by Statement no. 109's treatment of flow-through items. Utilities will now recognize a deferred tax liability for tax benefits flowed through to ratepayers.

* A REGULATORY ASSET or liability should be recognized if it is probable a future increase or decrease in taxes payable will be recovered through future rate revenues due to regulator action.

* STATEMENT NO. 109 PROHIBITS net-of-tax accounting and reporting. Both construction work in progress and plant-in-service balances must be adjusted as if the statement applied for all prior years.

* STATEMENT NO. 109 ultimately may have a significant impact on the regulatory process. Utilities may need to undertake impact studies to assist regulators in understanding the extent and impact of the statement on utility operations.
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Title Annotation:Understanding and Implementing FASB 109: A Much-Needed New Formula on Accounting for Income Taxes Is Issued
Author:Erken, Will A.
Publication:Journal of Accountancy
Date:Dec 1, 1992
Words:2481
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