The FASB's proposed rules for deferred taxes; easing the restrictions of FASB statement no. 96 on recognizing deferred tax benefits.

In its recently issued exposure draft, Accounting for Income Taxes, the Financial Accounting Standards Board proposed new rules that would establish financial accounting and reporting for the effects of income taxes resulting from an enterprise's activities for current and preceding years. The new requirements would supersede American Institute of CPAs Accounting Principles Board Opinion no. 11 and FASB Statement no. 96, both titled Accounting for Income Taxes, which have been the source of much criticism and controversy.

During the relatively short history of Statement no. 96, several prominent groups, including the AICPA accounting standards executive committee, Financial Executives Institute and National Association of Accountants (now the Institute of Management Accountants), as well as many CPA firms have expressed concern that tax asset provisions of FASB Statement no. 96 are too restrictive in allowing recognition of deferred tax benefits only to the extent loss carryback would result in a refund of taxes previously paid. In many situations, the conclusions in the ED should permit recognition of additional tax assets and allow enterprises to avoid the scheduling of temporary differences and consideration of tax planning strategies.

According to the ED, enterprises would measure deferred taxes by using the marginal tax rate expected to apply to the last dollars of taxable income in future years when taxable or deductible temporary differences and operating loss and tax credit carryforwards are expected to be paid or realized. Under the new method, enterprises would measure their deferred tax assets assuming all existing tax benefits will be realized. However, a valuation allowance would be established if it is more likely than not some or all of the deferred tax assets would not be realized based on available evidence. When negative evidence is outweighed by positive evidence, an enterprise might conclude the provisions of the new tax standard can be implemented without making detailed computations, forecasts and scheduling.

The purpose of this article is to provide CPAs with an understanding of some of the ED's key requirements. Specifically, the article addresses how deferred taxes would be recognized and measured under the new approach. A comprehensive nuts-and-bolts illustration, which should be helpful in assessing whether a valuation allowance should be recorded, also is provided.

THE ED's OBJECTIVES AND

BASIC PRINCIPLES

One objective of accounting for income taxes is to recognize an event's tax effects in the year the event itself is recognized in financial statements. This represents no change from existing rules; the amount of tax currently payable or refundable usually follows an enterprise's current tax return. A second objective is to recognize deferred taxes for the future tax consequences of events already recognized in financial statements or tax returns or that result from enacted changes in the tax laws. The FASB's proposed requirements would change significantly the ways deferred taxes, especially tax assets, are recognized and measured.

As with FASB Statement no. 96, the proposed rules are based on a balance sheet approach, which attempts to establish deferred tax assets and liabilities that meet the definitions of assets and liabilities contained in the FASB's conceptual framework. According to FASB Concepts Statement no. 6, Elements of a Financial Statement, assets represent "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events," and liabilities are "probable future sacrifices of economic benefits obtained or controlled by a particular entity as a result of a past transaction or event."

The balance sheet approach requires an enterprise to recognize as a deferred tax asset or a deferred tax liability the future income tax effects of the difference between the financial statement carrying amount of an asset or liability and its tax basis. An example is the book-tax difference arising from an installment sale receivable. As they were in FASB Statement no. 96, such book-tax differences are referred to in the ED as temporary differences. The ED requires that deferred taxes be provided on all temporary differences.

Under the proposed rules, a deferred tax asset would be recognized for all net deductible temporary differences and for operating loss and tax credit carryforwards using the enacted marginal tax rate. This requires identification of the nature and amount of each type of operating loss and the remaining length of the carryforward period. Deferred tax assets would be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not some or all the benefits would not be realized.

Deferred tax liabilities would be recognized for all taxable temporary differences using the marginal tax rate. Exhibit 1, at left, enumerates the procedures for computing, on an annual basis, a deferred tax liability and asset.

The marginal tax rate used for recognition of deferred tax assets and liabilities is the enacted tax rate expected to apply to the last dollars of taxable income in future years in which an item is expected to be paid or realized. In the United States, the marginal tax rate is the regular tax rate, and a deferred tax asset (and related valuation allowance, if necessary) is recognized for existing alternative minimum tax credit carryforwards. A deferred tax liability or asset would be adjusted in the period of enactment for the effect of a change in tax rates or other tax law provisions. The effects of such changes would be charged or credited to income from continuing operations.

Where there is a phased-in change in tax rates or when graduated tax rates are a significant factor, estimation of the marginal tax rate would require knowledge of when deferred items will settled. Estimation of the marginal tax rate also would require knowledge of when deferred tax liabilities or assets will be realized if an enterprise concludes a valuation allowance is necessary to reduce a deferred tax asset to an amount that is more likely than not to be realized.

After measuring a deferred tax liability or asset, the deferred tax provision would be based on the net change in a deferred tax balance during the year, adjusted for acquired deferred tax assets or liabilities. The total of tax currently payable or refundable and deferred tax expense or benefit would be income tax expense or benefit for the year.

IS A VALUATION ALLOWANCE NEEDED?

A valuation allowance would be required when it is more likely than not some or all the deferred tax asset will not be realized, based on the weight of all available positive and negative evidence. A primary indicator of the necessity of a valuation allowance is an enterprise's reported pretax accounting earnings for the current and preceding years. When significant negative evidence exists, such as a material, cumulative pretax accounting loss, it may be difficult to conclude a valuation allowance is not required. Part 1 of exhibit 2, at left, provides other examples of significant negative evidence that may indicate a valuation allowance should be established.

When there is significant negative evidence, positive evidence would be required before a conclusion could be reached that a valuation allowance is not needed. Part 2 of exhibit 2 lists some examples (not prerequisites) of positive evidence that may be available. Quantification of the effects of positive evidence generally is not necessary unless significant negative evidence exists and the enterprise concludes it is more likely than not realization of some or all of the deferred tax benefits will not occur.

An enterprise needs to exercise judgment in assessing whether the negative evidence is more compelling than the positive evidence. The potential effect of positive and negative evidence generally should be weighed according to the ability to verify that evidence objectively. For example, evidence about reversing taxable temporary differences, resulting from the use of accelerated depreciation for tax purposes, is objectively verifiable. However, information concerning estimated future taxable income, exclusive of reversing taxable temporary differences and carryforwards, is less objectively verifiable since it inherently assumes future events.

however, information or evidence not verifiable may nevertheless be significant. In most situations, the greater the negative evidence accumulated, (a) the more positive evidence is necessary and (b) the more difficult it becomes to support a conclusion a valuation allowance is not needed.

In considering all available positive and negative evidence, an enterprise also would have to assess whether future taxable income will be sufficient to realize a deferred tax asset. Future realization of net deductible temporary differences and operating loss and tax credit carryforwards is contingent on the existence of sufficient taxable income within the available carryforward period. Included among the possible sources of taxable income are future reversals of existing taxable temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards and taxable income in carryback years to the extent allowed by law. Tax planning strategies an enterprise expects to implement also may be a source of taxable income. For example, a tax planning strategy might involve switching from tax-exempt to taxable investments.

To the extent evidence about a single source of future taxable income is sufficient to support the amount recognized as a deferred tax asset, other sources need not be considered. However, consideration and quantification of each possible source of future taxable income would be required when management has concluded it is more likely than not some or all the deferred tax asset will not be realized.

The ED does not propose changing the proscription against discounting deferred taxes in effect since the issuance of APB Opinion no. 10, Omnibus Opinion--1966. Thus, tax assets and liabilities should be measured without discounting their future cash flows.

FINANCIAL STATEMENT PRESENTATION

The current-noncurrent classification of deferred taxes is based on the classification of the assets or liabilities to which they relate. For example, a deferred tax liability related to a current installment sale receivable would be classified as a current tax liability. Deferred taxes not related to an asset or liability would be classified according to the expected reversal date of the temporary difference.

In a classified statement of financial position, deferred tax assets and liabilities would be separated into current and noncurrent amounts. All current deferred tax liabilities and assets would be offset and presented as net current deferred tax liabilities or assets for a particular taxpaying component of an enterprise and within a particular tax jurisdiction. The same procedure would be followed for all noncurrent deferred tax liabilities and assets. Offsetting deferred tax liabilities and assets from different tax jurisdictions, however, would be prohibited.

When an enterprise has concluded it is more likely than not some or all the deferred tax assets will not be realized, the amount of the valuation allowance provided at each balance sheet date and the change in this account for each period for which an income statement is presented would be disclosed.

AN ILLUSTRATION

The following comprehensive example shows how the FASB's proposed rules for deferred taxes would be implemented. The calculation of deferred taxes under the more likely than not criterion is shown in exhibit 3, pages 50-51. In this exhibit, the enterprise has two temporary differences (depreciation and warranty expense) and one permanent difference (tax-exempt interest) existing at the measurement date of 19X2. The enterprise also has generated tax credits that may be used in the future.

In the example, the enterprise's deferred tax asset is $259, consisting of $200 in deductible temporary differences and a tax operating loss of $120 incurred in 19X2, which are taxed at 34%, and $150 in tax credit carryforwards. The taxable income necessary to realize total deferred tax benefits is $686, consisting of $245 ($320 - $75) in net operating loss carryforwards and $441 in tax credit carryforwards ($150/.34). Since the enterprise has operated at a profit and all evidence concerning its future is positive, management has concluded a valuation allowance is not required.

Under the balance sheet approach, a net deferred tax asset of $233 ($259 - $26) would be recognized in a classified balance sheet at the end of 19X2. Assuming there is no beginning deferred tax balance, the enterprise records in income a deferred tax expense and a deferred tax benefit of $26 and $259, respectively, in 19X2. Since there is no current income tax payable or refundable, the net deferred tax asset of $233 is the period's income tax benefit.

The recording of a valuation allowance when it is more likely than not some or all of the deferred tax asset will not be realized is illustrated in exhibit 4, pages 52-53. The enterprise has a pretax accounting loss of $165 at the measurement date 19X2. In 19X1, pretax accounting income was $330. In addition to a tax operating loss of $180 incurred during 19X2, of which $150 is carried back for a refund of $51, and a tax credit carryforward of $150, the enterprise has identified two temporary differences (depreciation and warranty expense) and one permanent difference (tax-exempt interest).

Based on available positive and negative evidence, the enterprise has concluded it is more likely than not some portion of the deferred tax assets of $194 will not be realized. How much, if any, of a valuation allowance will be required depends on identifying possible sources of future taxable income. In addition to an existing $50 taxable temporary difference scheduled to reverse during the carryforward period, the enterprise has identified $350 in estimated future taxable income exclusive of reversing temporary differences and carryforwards. The enterprise also has identified $150 of taxable income from 19X1 available for a loss carryback refund of taxes paid.

After preparing a schedule of realizable tax benefits, the enterprise has determined $58 of the deferred tax assets will not be realized in future tax returns. In addition to establishing a valuation allowance in this amount, a deferred tax expense of $17 and a deferred tax benefit of $194 are recorded. The net deferred tax asset of $119 ($194 - [$58 + $17]), which may be displayed in the statement of financial position with the amount of the valuation allowance disclosed in the footnotes, and the refundable income taxes of $51 are the income tax benefit for the year.

Forecasts, projections and detailed analyses similar to those illustrated in exhibit 4 may be necessary when negative evidence is more compelling than positive evidence and the enterprise hopes to avoid recording a valuation allowance. In this example, the enterprise would have needed to identify sources of taxable income of at least $721 to avoid recording a valuation allowance.

MORE MEANINGFUL FINANCIAL

INFORMATION

The ED would continue the exception from recognition of deferred tax liabilities on unremitted earnings of foreign subsidiaries and investments in foreign corporate joint ventures considered permanently invested. However, all other exceptions from recognition of deferred income taxes, (bad debt reserves of stock savings and loans, policyholders' surplus of stock life insurance companies, deposits in statutory reserve funds by U.S. steamship companies and undistributed earnings of domestic subsidiaries and joint ventures) would be eliminated on a prospective basis.

The proposed tax standard would be effective for fiscal years beginning after December 15, 1992. The FASB, however, encourages earlier application. Financial statements for any number of consecutive fiscal years before the effective date may be restated to conform to the provisions of the standard. Initial application of the proposed statement would be as of the beginning of an enterprise's fiscal year.

The FASB believes the new provisions will make accounting for income taxes more understandable and easier to implement than its original Statement no. 96. Given the significance of the deferred tax issue, it's important members of the accounting profession and others in the economic community become involved in the FASB due process system by taking time to understand and comment on the tentative conclusions described in the ED. The comment period expires September 6, 1991.

If adopted in its present form, the proposed new method would change significantly the criteria for recognition and measurement of deferred tax assets and liabilities. The new approach should reduce computational complexity in many situations and increase the tax debits an enterprise may record.

WILLIAM J. READ, CPA, PhD, is associate professor of accountancy at Bentley College, Waltham, Massachusetts. He is a member of the American Institute of CPAs. ROBERT A. J. BARTSCH, CPA, is a manager in the national office of Deloitte & Touche in Wilton, Connecticut. He is a member of the AICPA.