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SFAS 96 - recognition of assets and liabilities.

SFAS 96 Recognition of Assets and Liabilities

In December 1987, FASB issued one of its most complicated standards, SFAS No. 96, Accounting for Income Taxes. The effective date for this statement was originally established for fiscal years beginning after December 15, 1988. Due to concern expressed as to the degree of complexity involved in applying SFAS No. 96, the board issued SFAS No. 100 deferring the effective date for one full year to fiscal years beginning after December 15, 1989. The purpose of this article is to examine the provision of SFAS No. 96 related to recognition, measurement and recording of deferred tax liabilities and assets by presenting a flow-chart and a set of examples that portray the logic and concepts underlying the new standard. Our examination shows that the rules used in SFAS No. 96 for recognition of liabilities are not consistent with those used for recognition of assets.

Changes Introduced by the

New Standard

The new standard, Accounting for Income Taxes, has introduced some drastic changes from the old rules. Probably the most important change is that of adopting the liability approach to income tax allocation as compared to the deferred method approach that was adopted by APB Opinion No. 11. The liability approach of income tax allocation requires that deferred taxes meet the definition of assets and liabilities before they can be recognized in the books; furthermore, deferred taxes must be measured using the tax rates of the year in which the assets are recovered or liabilities settled, provided that these rates were reenacted and known at the date of measurement.

In addition to this major change, the new standard has revised and sharpened the definition of events and transactions that cause deferred income taxes. The new standard uses the terminology of temporary differences rather than timing differences for these events. Temporary differences include revenues, expenses, gains and losses that are included in the taxable income of an earlier or later year than the year in which they are recognized in financial statements. They also include events that create differences between the tax basis of an asset or liability and its reported amount in the financial statements. Furthermore the new standard states that some of the temporary differences cannot be identified with a particular asset or liability for financial reporting but cause differences between taxable income and pretax financial income. Exhibit 1 presents a number of examples of temporary differences.

For the purpose of recognition of deferred taxes, the new standard distinguishes between temporary differences that generate taxable amounts and those that create deductible amounts. An example of temporary differences that create taxable amounts in the future is recognition of installment sales at point of sales for financial reporting and including it in taxable income when collected for tax purposes. Another example is depreciating a personal property over a longer useful life for financial reporting than for tax purposes. In general, taxalbe amounts are temporary differences that cause future taxable income to exceed pretax financial income. On the other thand, deductible amounts are items that will be deducted for tax purposes in future years. An example of a deductible amount is the accounting for warranty cost on an accrual basis for financial reporting and on a cash basis for tax purposes.

The rules for recognition of deferred tax assets that result from deductible amounts are stricter than the rules for recognition of deferred tax liabilities that are caused by taxable amounts. To recognized deferred tax assets, the deductible amounts have to offset taxable income of current or prior years (within the limitation of the three years allowed under the carryback rules) or against taxable amounts for the current year of future years (within the limitation of the 15 years allowed under the carryforward rules). Furthermore, the taxable amount has to be a result of an event of the current or prior year. Even though the FASB's recognition criteria are consistent with the definition of assets and liabilities, one cannot help but think that the conclusions reached by the board have been influenced somewhat by conservation, especially in case of recognition of deferred tax assets.

Recognition and

Measurement of Deferred

Taxes

According to the new standard, deferred tax liabilities and assets are recognized for all temporary differences arising from events that have already occurred. Deferred tax liabilities and assets that hinge on the occurrence of future events should not be recognized in the current year. Even though the rules for recognition of deferred tax assets are the same as those of liabilities, deferred tax liabilities are almost always recognized because the events that cause them to arise have occurred. However, deferred tax assets are not recognized unless the deductible amount can be offset against taxable income of the current or the prior three years or against taxable amounts according to carryback and carryforward rules.

Generally, income tax expense is equal to income tax currently payable plus deferred tax liability minus deferred tax asset. The measurement of income tax currently payable is computed by multiplying taxable income by the current tax rate or rates (in the case of a graduated tax structure). If an enterprise has only taxable amounts and no changes in taxes are expected, deferred tax liability is measured by myltiplying the taxable amounts by tax rate(s). The measurement of deferred taxes becomes complicated, however, when the enterprise has both taxable and deductible amounts and/or when current and enacted future tax rates are different. In this latter case, a projection of future years in which the deductible amounts are expected to be realized and taxable amounts are settled is required. Net taxable or deductible amount in each future year must then be determined and net deductible amounts are carried back or forward to offset net taxable amounts and/or taxable income. To determine deferred tax asset and/or liability, the net deductible amounts recognized and/or the net taxable amounts are multiplied by the relevant enacted tax rate for each year. In effect, Statement 96 requires preparation of a pro forma tax return for each year affected by temporary differences with temporary differences as the only reportable income or deduction in the tax return.

Figure 1 presents a flow chart that portrays the rules for recognition and measurement of deferred tax liabilities and assets arising from taxable and/or deductible temporary differences. It should be noted from this chart that the rules for recognition and measurement of deferred tax assets are stricter than those of deferred tax liabilities. Deferred tax assets are recognized only if deductible amounts can offset either taxable amounts or taxable income within the carryback and carryforward provisions of tax laws. Deferred tax liabilities, on the other hand, are always recognized. The flow chart also clearly shows that preparation of projection of years in which timing differences are reversed is required for measurement of deferred taxes when current tax rates and enacted future tax rates are different. It is also required for recognition of deferred tax assets.

Exhibits 2-6 present a set of five examples that illustrate the recognition, measurement and recording of income tax currently payable, deferred tax liabilities, deferred tax assets and income tax expense under different assumptions. Exhibit 2 portrays an illustration of an enterprise that has taxable amounts only and tax rates remain unchanged. Exhibit 3 illustrates a situation in which the enterprise has taxable amounts only but tax rates change. Exhibit 4 presents a case where the enterprise has deductible amounts and deferred tax assets are not recognized. Exhibit 5 portrays a case where the enterprise has both taxable and deductible amounts and deferred tax assets are partially recognized. Exhibit 6 illustrates a case where the enterprise has both deductible and taxable amounts and the deferred tax assets are fully recognized.

Conclusion

Adoption of the liability approach to income tax allocation by SFAS 96 is likely to improve reporting of deferred tax liability on the statement of financial position. Only deferred taxes that meet the definition of liability will be recorded and reported as liability in the statement of financial position. This is a welcome change from the deferred mehtod of Opinion II which led to the continued increase in size of deferred tax credits (liabilities) on the statement of financial position for most companies. On the other hand, the criteria that SFAS 96 proposes for recognition of deferred tax assets are restrictive and do not appear to be consistent with the going concern concept nor with the definition of assets in SFAS 96.

The procedures suggested by SFAS 96 for recognition and measurement of deferred taxes are anything but simple; they require projection of the future periods in which each temporary difference is expected to turn around and the use of the relevant tax rate for each of these years to determine the amount of deferred tax assets and liabilities. In effect, SFAS 96 requires companies to prepare a "mini tax return" for each of the future years that are affected by the temporary difference. The preparation of such tax returns would force management to make judgment regarding the expected date of realization of certain assets and settlement of lawsuits and other contingencies that are nearly impossible to predict. Finally, SFAS 96 opens a new loophole that would make it possible for management to manipulate the timing of reversal of some of the temporary differences and reduce its tax expense. In Example 6, for instance, the company managed to reduce its tax expense by $50,000 by assuming that the litigation will be settled and deducted for tax purposes in year 4 rather than year 6.

Abdel M. Agami is a professor of accounting at the Colloge of Business and Public Administration at Old Dominion University in Norfolk, Virginia.
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Title Annotation:FASB Accounting for Income Taxes rule
Author:Agami, Abdel M.
Publication:The National Public Accountant
Date:Jan 1, 1990
Words:1623
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