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Accounting for income taxes: new standards.

The Financial Accounting Standards Board (FASB) has issued a new pronouncement, Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, which could have an enormous impact on the earnings reported by many companies in the year implemented. Financial ratios and possibly compliance with debt covenants could also be affected, since adoption of this pronouncement will likely cause shifts between deferred taxes and equity.

The issuance of this standard on accounting for income taxes will be viewed by most business groups as a welcomed change given the shortcomings of current guidance in this area. This new standard will supersede Statement of Financial Accounting Standards No. 96 (SFAS 96) and Accounting Principles Board Opinion No. 11 (APB No. 11). It is effective for fiscal years beginning after December 15, 1992.

Significant Changes

Companies today either use APB No. 11 or SFAS 96 in accounting for income taxes on their financial statements--assuming their financial statements are prepared in accordance with generally accepted accounting principles. The new standard, SFAS 109, differs from APB No. 11 and SFAS 96 in many respects. The most significant changes from APB No. 11 include the following:

* The income statement approach to accounting for deferred income taxes using the "with-and-without" calculation is discarded in favor of a balance sheet approach focusing on the future tax consequences of assets and liabilities that have a difference between their tax basis and book basis.

* Recording of deferred tax assets for net operating losses is made easier. A deferred tax asset can be established if its realization is "more likely than not."

* Tax credit carryforwards can be recorded as deferred tax assets but they are subjected to a realization test of "more likely than not."

* The term "timing difference" is replaced with the term "temporary difference" to describe those items of revenue, expense, gain or loss that affect taxable income in a period different from when they affect financial statement (book) income.

* Deferred tax assets and liabilities are revised for changes in future tax rates in the year enacted, resulting in a more accurate reflection of these future benefits or payments.

The most significant changes from SFAS 96 that are made by SFAS 109 include the following:

* Deferred tax assets may be recorded for net operating losses and tax credit carryforwards but these assets are subjected to a "more likely than not" realization test.

* The recording of net deferred tax assets is allowed for future deductible amounts which under SFAS 96 are limited to an amount that does not exceed the income taxes currently payable or paid during the current year and the previous two years. This results from the fact that under SFAS 109 future taxable income can be considered in the determination of the realizability of deferred tax assets. Under SFAS 96 the only source of future taxable income that can be considered is the reversal of existing deferred tax liabilities.

* The onerous task of preparing a schedule of the annual reversals of temporary differences is eliminated, except in limited circumstances.

* Alternative Minimum Tax (AMT) rates do not have to be considered in the determination of deferred tax assets and liabilities.

Exhibit 1 summarizes the major differences between SFAS 109, SFAS 96 and APB No. 11.

Mechanics of the New Rules

The new standard is similar to SFAS 96 in that it applies an asset and liability method of accounting for income taxes. It focuses on those assets and liabilities that have a difference in their book and tax basis, including assets and liabilities acquired in a business combination accounted for as a purchase. These differences are referred to as temporary differences. See Exhibit 2 for examples of temporary differences.

The total tax provision under SFAS 109 is the sum of the current tax provision or benefit and the deferred tax provision or benefit. The current tax provision is the amount payable based on current year taxable income. While the calculation of the current tax provision is generally straightforward, the calculation of the deferred provision is more challenging. Computing the year-end deferred tax position involves the following five steps:

1. Identify and quantify all temporary differences existing at the balance sheet date including future deductible amounts, future taxable amounts and operating loss and tax credit carryforwards.

2. Calculate the total deferred tax liability by multiplying the future taxable temporary differences by the applicable tax rate, which is the average enacted tax rate expected to apply in the year the deferred tax liability is expected to be settled.

3. Calculate the total deferred tax asset for future deductible temporary differences and operating loss carryforwards, again using the applicable tax rate, and add to this amount all tax credit carryforwards.

4. Reduce the deferred tax assets by a valuation allowance if, based on available evidence, it is more likely TABULAR DATA OMITTED than not that some portion (or all) of the deferred tax assets will not be realized.
Exhibit 2:
Common Temporary Differences
 Effect on
 Deferred Taxes
 in Year Originated
Description of
Temporary Difference Debit Credit
Income that is taxable later than it is X
recognized for books. (Example: In-
stallment sale profit recognized for
books in the year of the sale but recog-
nized for tax when collected.)
Expenses that are deductible for tax X
later than when they are deducted for
books. (Example: Warranty expenses
that are deducted for books at the
time the related products are sold but
are not deductible for tax until paid.)
Income that is taxable before it is rec- X
ognized for books (Example: Cash re-
ceived on service contracts that are not
included in book income until the ser-
vices are performed.)
Expenses that are deductible for tax X
before they are deducted for books.
(Example: Accelerated depreciation
used for tax purposes but a straight-
line method for computing deprecia-
tion is used for books.)


5. Combine the deferred tax liability and the deferred tax asset reduced by the valuation allowance, if any, to determine the net deferred tax liability or asset.

Once the year-end deferred tax position is determined, this amount is compared to the beginning of the year deferred tax position in order to make any necessary adjustments to the deferred income taxes account. This adjustment is the deferred tax expense or benefit for the year.

It can be seen from the methodology used to compute the year-end deferred tax position that an adjustment to deferred income taxes may be needed even if there is no change in gross temporary differences during the year. This would happen, for instance, if there were a change in tax rates or when it is determined that the valuation allowance account needs adjustment due to a change in judgement about the realizability of the related deferred tax assets.

The AMT credit carryforwards taken from prior year tax returns are to be included as deferred tax assets. They are subjected to a "more likely than not" test just as all deferred tax assets are.

An Illustration of the Three Standards

The example below illustrates how the SFAS 109 differs from APB Opinion No. 11 and SFAS 96 by showing the tax provision entry under each of the standards.

Assumptions:

* Pre-tax financial income for the current year 1991 is $2,000.

* No operating loss or tax credit carryforwards exist.

* No taxes were paid in any of the prior two years.

* Temporary differences for 1991 are:

1. Tax depreciation exceeds book depreciation by $200.

2. Warranty expenses of $700 were deducted for book purposes but none were paid.

* At the beginning of 1991 the book basis of fixed assets exceed their tax basis by $300.

* Since the prior year's tax rate was 30%, the balance sheet reflects a deferred tax liability of $90 at the beginning of 1991.

* The tax rate for the current year is 40% and no rate changes have been enacted for the future.

* All temporary differences at the end of 1991 are expected to reverse 50% in 1995 and 50% in 1996.

* Taxable income in the next five years is expected to be sufficient to absorb any net deferred tax assets.

APB No. 11 Tax Provision

Using the "with-and-without" method of calculating deferred taxes, the tax provision is shown below.
 Without With
Pretax financial income $2,000 $2,000
Less excess depreciation (200)
Add nondeductible warranty
expense 700
 2,000 2,500
 x 40% x 40%
 $ 800 $1,000
The journal entry is:
Tax expense 800
Deferred income taxes 200
Taxes payable 1,000


SFAS 96 Provision

Taxes payable does not change from the amount determined above but the change in deferred taxes requires: 1) preparation of a temporary difference reversal schedule to determine whether a net deferred tax liability results; 2) multiplying the net deferred tax liability by the appropriate tax rate to determine the year-end deferred tax position; and 3) comparison of the unadjusted year-end balance in deferred taxes to the balance calculated in step 2 as follows:
 Reversal Schedule
 Year Expected to Reverse
Temporary Difference 1995 1996
Fixed Assets $250 $250
Warranty accrual (350) (350)
Net deferred debit $(100) $(100)


Deferred tax assets can only be recognized to the extent that deferred tax liabilities will reverse in the future since anticipation of income from other than the reversal of deferred tax liabilities is prohibited under this standard. A net deferred liability does not result from the reversal schedule above so, in summary, there should not be any deferred tax asset or liability recorded at the end of 1991.
Deferred tax asset/(liability) should be: $0
Deferred tax asset/(liability) as recorded: (90)
Deferred tax provision: $90
The journal entry is:
Tax expense: 910
Deferred income taxes: 90
Taxes payable: 1,000


SFAS 109 Provision

Consistent with the prior two standards, the current tax provision is unchanged at $1,000.

Following the five steps outlined previously, the first step is to identify all temporary differences. As stated in the assumptions, the temporary differences are:
 Debit/(Credit)
 Amount
Excess tax depreciation (300 + 200) $(500)
Warranty expense disallowed 700


Second, the deferred tax liability is calculated:

Deferred tax liability = $500 x 40% = $200

Third, the potential deferred tax asset is calculated:

Deferred tax asset = $700 x 40% = $280

Fourth, reduce the total deferred tax asset by a valuation allowance if it is more likely than not that some or all of the deferred tax assets will not be realized. No such valuation allowance is needed here based on the above assumptions, so all deferred tax assets can be recognized.

Fifth, combine the deferred tax liability with the deferred tax asset:
Total deferred asset $280
Total deferred liability (200)
Net deferred asset needed at year-end 80
Net deferred credit recorded (90)
Deferred provision $170
The journal entry is:
Tax expense $830
Deferred income taxes 170
Taxes payable 1,000


The deferred tax provision under APB No. 11 is a result of the "with-and-without" calculation, in this case representing 40% times the current year net timing difference of $500. No attempt is made to "prove" the year-end deferred tax balance.

Under SFAS 96 and SFAS 109, the year-end deferred tax balance is adjusted to an amount derived from a review of the year-end cumulative temporary differences which are then tax affected using future tax rates. The debit to deferred taxes is larger under SFAS 109 compared to SFAS 96 because the net deferred tax asset of $80 ($200 x 40%) is recorded under SFAS 109 but not under SFAS 96. Under SFAS 96 net deferred tax assets are treated as net operating losses, which under current tax law can be carried back three years and forward 15 years. Accordingly, these net deferred assets could have been recorded under SFAS 96 if there were sufficient deferred tax credits reversing within the appropriate carryback/carryforward period of 1995 and 1996.

Valuation Allowance

Intended to alleviate the complexity of SFAS 96, SFAS 109 has its own complexities. Most notably, the requirement that a valuation allowance be used to assess the value of deferred tax assets will be an exercise laden with subjectivity. It requires that once the total potential deferred tax assets are determined, management must consider whether it is "more likely than not" that some portion of the assets will not be realized in the future based on the weight of all available positive and negative evidence.

SFAS 109 defines "more likely than not" as meaning slightly more than a 50% chance. The need for a valuation allowance depends on whether or not there will be sufficient future taxable income to allow for realization of deferred tax assets. This will require that management obtain the appropriate evidence to establish that their taxable income projection has a more than 50% chance of occurring. Trying to pass the "more likely than not" criterion will be a seemingly insurmountable task for the management of most companies. Due to the nature of their business, in many cases it is difficult for management to project with much certainty the income for the next two months, not to mention income for the next 15 years (e.g., the net operating loss carryforward period).

Sources of taxable income that may be available to offset future deductible temporary differences under SFAS 109 include:

* The future reversals of existing taxable temporary differences;

* Future taxable income exclusive of existing reversing temporary differences (e.g., estimated future book income adjusted for estimated future temporary and permanent differences);

* Taxable income in a prior carryback year, if carryback is permitted under the tax law.

SFAS 109 provides examples of negative and positive evidence that should be weighed when assessing the need for a valuation allowance. As negative evidence increases, the greater the amount of positive evidence that will be needed to justify not recording a valuation allowance. Examples of negative evidence include the following:

* A history of having operating loss or tax credit carryforwards expiring unused;

* Losses expected in future years; and

* Unsettled circumstances or contingencies that, if unfavorably resolved, would adversely affect future profits.

Examples of positive evidence that may be available to offset any negative evidence include the following:

* Existing contracts or sales backlog that, given the existing sales price and cost structure, would produce more than enough taxable income to realize the deferred tax assets in question;

* Existence of built-in gains (e.g., excess of fair market value over tax basis) on the enterprise's net assets; and

* A strong earnings history coupled with a prediction that the strong earnings will continue in the future, despite the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference).

Exhibit 3 illustrates the derivation of a valuation allowance account.

Transition and Disclosure

The new standard is effective for fiscal years beginning after December 15, 1992.

Companies may restate prior year financial statements to enhance comparability or they can elect to include the entire effect of SFAS 109 in the financial statements of the year it is first adopted. If prior year financial statements are restated, management must use the facts and circumstances as they existed in the year restated, as the use of hindsight is prohibited.

If no prior year is restated, for the earliest year restated or for the year the standard is first adopted if no prior year is restated, the effect of applying the new standard at the beginning of the fiscal year should be reported as the effect of a change in accounting principle as described in APB Opinion No. 20.

Many of the disclosure requirements of the new standard are similar to those required in SFAS 96, including:

* A description of the types of temporary differences, carryforwards and carrybacks that give rise to significant portions of deferred tax liabilities and assets.

* Disclosure of the significant components of income tax expense attributable to continuing operation for each year presented.

* Income tax expense attributable to continuing operations must be reconciled to the income tax expense that would result from applying Federal tax rates to pretax income from continuing operations. A nonpublic enterprise should disclose the nature of significant reconciling items but may omit a numerical reconciliation.

SFAS 109 includes additional disclosure requirements including:

* The total of all deferred tax liabilities and deferred tax assets should be disclosed along with the total valuation allowance and the net change during the year in the total valuation allowance.

* A description of the types of temporary differences, carryforwards or carrybacks that give rise to significant portions of deferred tax liabilities and assets should be disclosed.

The disclosures of net operating loss and tax credit carryforwards under the new standard will only include these amounts for tax purposes. Such disclosures for book purposes have no significance and will no longer be calculated.

Earnings Impact

Assuming restatement of prior year financial statements is not elected, the effect that the new standard will have on the earnings reported by companies in the year of implementation will depend on its particular facts and circumstances, including whether the company is currently using APB No. 11 or SFAS 96.

Those companies currently using APB No. 11 with a net deferred tax credit position will generally experience a reduction in tax expense in the year implemented. This is because the deferred credit balance is generally comprised of higher rates than those in effect for the future.

Financially strong companies currently using SFAS 96 with unrecorded deferred tax assets should experience a tax expense reduction in the year the new standard is implemented. For some, this may just be a reinstatement of those deferred tax assets written off when SFAS 96 was adopted. For example, many property and casualty insurance companies wrote off deferred tax assets when they adopted SFAS 96. This resulted from the requirement that the reserves for future claims payments had to be discounted for tax purposes but not for book purposes. Also, many banks wrote-off net deferred tax assets from excess loan losses deducted for book purposes but not for tax purposes.

All companies with a financially strong future that have operating loss and tax credit carryforwards should generally experience a tax expense reduction in the year of implementation as these deferred assets are established.

Companies electing to restate prior year financial statements having the same circumstances as the above-mentioned companies (e.g., overstated net deferred tax credits, unrecorded deferred tax assets or operating loss or tax credit carryforwards) should reflect an improved balance sheet going into the year the standard is adopted. This is because beginning retained earnings are adjusted for the effects of the standard rather than current year net income.

Conclusion

SFAS 109 provides new rules that dramatically change the approach to accounting for income taxes, especially with regard to deferred taxes. It gives companies the ability to record additional deferred tax assets that should result in a more accurate reflection of the value of future tax benefits. A greater reliance will be placed on management's judgement in applying the new rules, especially in assessing the need for a valuation allowance.

Exhibit 3: How a Valuation Allowance is Derived

Assumptions:

1. The following types and amounts of existing temporary differences, operating loss and tax credit carryforwards exist at the end of the current year, 1992:

a) Deductible temporary differences resulting from warranty accruals = $500 b) Net operating loss carryforward to expire in 15 years = 200 c) Tax credit carryforwards to expire in 15 years = 50

2. No taxes were paid in the current or prior two years.

3. Estimated taxable income for the next 15 years is $500.

4. Built-in gain exists on appreciated real estate of $100.

5. The financial position of the company is strong even though it has incurred operating losses over the last few years.

6. The enacted tax rate is 40% for all years.

TABULAR DATA OMITTED

Thomas L. Leffelman, CPA, is a tax supervisor with Sikich, Gardner & Co. in Aurora, Illinois. He has over nine years of public accounting experience with specific expertise in income and estate taxation. He received his Bachelor of Science degree in Accounting and Economics from Northern Illinois University.
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Author:Leffelman, Thomas L.
Publication:The National Public Accountant
Date:Aug 1, 1993
Words:3331
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