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Accounting for income taxes - one more time.

Accounting for income taxes - one more time

Most prepares, auditors, and users of financial statements used to think they understood the liability method of interperiod tax allocation. That is, until they encountered the rigid methodology that the FASB imposed in Statement 96. In fact, about the only aspect of the liability method put forth in 96 that most expected to be part of the liability method was the statement's provision for immediate adjustment of deferred taxes to reflect changes in tax rates.

Statement 96, issued in 1987, very quickly became the statement everyone loves to hate. And so, a little more than a year after issuing the statement, the FASB began to reconsider its provisions and has delayed twice the effective date for mandatory adoption. Now, after spending more than two years examining alternatives, the FASB has issued an exposure draft (the ED) that would supersede Statement 96 and considerably change the methodology for the liability method. The FASB clearly wishes to mitigate, if not cure, the major criticisms of Statement 96.

The exposure draft resembles Statement 96 in several ways. As does 96, the ED applies a balance-sheet approach, or liability method, to tax allocation. A company must still identify and quantify its temporary differences - the differences between book and tax bases of assets and liabilities - rather than timing differences between pretax income and taxable income. And deferred taxes are treated as the future tax effects of reversals rather than as past tax effects of originations. But it is here - in the measurement of deferred taxes - that Statement 96 and the ED part company.

What's wrong with 96?

Under Statement 96, the deferred tax liability or asset is computed as the future tax payable or refundable assuming "no future events" other than reversals of temporary differences. So Statement 96 could require companies to prepare hypothetical tax returns, possibly including the alternative minimum tax, for all future years, reflecting the year-by-year reversal of the temporary differences. The FASB staff's special report on Statement 96 provides detailed rules for determining the reversal pattern of various types of temporary differences, and "scheduling exercise" entered the accounting jargon with Statement 96 to describe the process of allocating reversals to specific future years. It's not surprising that one of the main complaints about Statement 96 is the extensive number-crunching companies would have to go through to implement it.

The other major concern with Statement 96 is that, because it assumes "no future events," the tax benefit of deductible temporary differences and carryforwards can be recognized only to the extent that they offset either actual taxable income reported in the carry-back period or future reversals of taxable differences. Thus, Statement 96 frequently does not permit recognition of the benefits of future deductions even when their realization is virtually certain. For example, reversals (the tax deductions) of many book accruals would not be scheduled until distant future years after the reversals that generate taxable income. Now, with accrual accounting for other postretirement benefit (OPEB) obligations, this provision is particularly burdensome. The revesals (tax deductibility) of such accruals could be delayed far in the future. The result, under Statement 96, may be that these deductions are not used. And, so far at least, no one has come up with tax-planning strategies for OPEB obligations under Statement 96 that would correct the problem.

The new ED model

So what has changed? The big difference in the exposure draft is in how the future tax effects of reversals are measured. Under the Statement 96 assumption of "no future events," the reversals are the first, and indeed the only, items entering into future taxable income. By contrast, the ED treats reversals as the last items entering into future taxable income. So the deferred tax liability or asset should approximate the incremental effect that reversing temporary differences will have on the future taxes payable or refundable, probably what most users of financial statements expect the deferred tax liability or asset to represent.

The calculation of the future incremental effect under the ED is extremely simple, at least in comparison with Statement 96. First, the ED segregates temporary differences into two primary categories: those whose reversals will generate taxable income and those that will generate deductions. Second, deferred tax liability is determined by multiplying the gross amount of taxable temporary differences by the enacted marginal tax rate, and a deferred tax asset is determined by multiplying gross deductible temporary differences and operating loss carryforwards by the enacted marginal tax rate. Deferred tax assets are also determined for any credit carryforwards. Finally, the ED provides a valuation allowance for the deferred tax assets to the extent it is more likely than not they will not be realized. (The ED distinguishes between deferred tax assets and deferred tax liability arising in a single deferred-tax computation. However, the assets and liability for each tax-paying component of an enterprise within each taxing jurisdiction are offset for presentation in the balance sheet.)

Marginal tax rate

The marginal tax rate used in these calculations is the tax rate expected to apply to the last dollars of taxable income in the period when the reversal will increase or reduce taxes payable. To a certain extent, the ED confines the complexity of scheduling under Statement 96 to the determination of the marginal rate. And the marginal rate will recognize whether the reversals will result in capital gain or ordinary income or other categories of taxable income in jurisdictions other than the U.S. The rate used must reflect the enacted tax law and cannot anticipate expected changes in the law.

The U.S. marginal tax rate, as specified in the ED, is the regular tax rate, not the AMT rate. AMT is considered in the deferred tax computation only in that (1) minimum tax credit carryforwards existing at the balance-sheet date would be a deferred tax asset with a valuation allowance, if appropriate, and (2) AMT provisions may make it more likely than not that some regular tax-deductible differences and carryforwards will be lost. Operating loss and foreign tax credit carryforwards for AMT can be ignored. This treatment of AMT makes the new method considerably simpler than Statement 96. And it can be justified on the basis that AMT is essentially a prepayment of the regular tax, not a separate tax system.

Realization test

You need to establish a valuation allowance for a deferred tax asset when it is more likely than not - a probability level of more than 50.0 percent - that it will not be realized. Of course, realization is dependent upon taxable income within the carryback and carryforward periods available under the tax law.

The ED identifies four sources of such taxable income. Two of these sources are generally prerequisites for recording deferred tax benefits under Statement 96: first, actual taxable income within the available carryback period; second, reversing taxable temporary differences that offset either in the reversal year or in the applicable carryback and carryforwards periods. A third source, tax-planning strategies, is carried forward to the ED from Statement 96, but with a significantly different meaning. (More on that later.) The ED establishes another source - taxable income expected to be generated in the future other than from reversing temporary differences - that was precluded by Statement 96. This source typically will require the greatest attention in assessing if a valuation allowance is necessary.

This assessment should be based on the evidence at the balance-sheet date, with greater weight given to evidence that can be verified objectively. The ED gives examples of objective negative evidence: cumulative losses in recent years, a history of potential tax benefits expiring unused, uncertainties whose unfavorable resolution would adversely affect future results, and brief carryback and carryforward periods in certain circumstances. Examples of the objective positive evidence that might be necessary to avoid a valuation allowance when there is such negative evidence are a firm backlog of profitable sales orders, unrealized appreciation in assets, and a strong earnings history (excluding from consideration any loss that is demonstrably aberrational).

The ED would lower considerably the threshold for recording the benefits of loss carryforwards that can't be applied to reduce deferred taxes for taxable timing/temporary differences. APB 11 decreed that realization must be assured beyond a reasonable doubt, and the SEC has taken the view that this standard can be met only rarely. Nevertheless, in Statement 96, not even this degree of assurance would justify recording such carryforward benefits. Under the ED, an asset is automatically recorded for a loss carryforward, and the asset is reduced by a valuation allowance only if it is more likely than not that the benefit will be lost.

Tax-planning strategies

Another simplification promised by the ED is in tax-planning strategies. Under Statement 96, the tax computation must reflect the use of feasible and prudent strategies the company would use if its future taxable results were those depicted in the Statement 96 scheduling exercise. Thus, under Statement 96, the company must search, not for strategies it actually expects to use, but for the strategies it would use in hypothetical circumstances.

Under the ED, tax-planning strategies are considered only in determining the need for a valuation allowance. And the only tax-planning strategies to be considered are those you would actually expect to use.

There is another big difference between the ED and Statement 96 rule. Under the ED, a strategy is not precluded if it will involve a significant cost, as it is under Statement 96. But the ED specifies that the benefit recorded for a tax-planning strategy would be net of any expense or loss to be incurred. In effect, the expense would have to be accrued as part of the deferred tax liability.

Realization test causes volatility

The ED's realization test for deferred tax assets may cause considerable volatility in reported results. The test is applied to deductible differences and carryforwards that have originated over a period of years and not just to those arising in the current year. Thus, the adjustments, up or down, to the valuation allowance for deferred tax assets may far exceed pretax income or loss. While probability assessments cannot be quantified with precision, in theory, a relatively small change (at the extreme, from 50.1 percent to 50.0 percent or vice versa) could result in substantial charges or credits to income.

Volatility may be mitigated in that the valuation allowance for a deferred tax asset is not an all-or-nothing decision. The estimated future benefit more likely than not to be lost may vary from year to year. If the company's prospects decline or improve gradually over a period of years, the valuation reserve may be increased or decreased correspondingly, thereby avoiding the sudden, distortive effects of dramatic adjustments.

Companies that have massive loss carryforwards are especially vulnerable to swings in reported results. Each year the company must estimate the extent to which the future benefit of the loss carryforward is more likely than not to be lost and adjust its valuation allowance accordingly. The ED's recognition (and derecognition) of loss carryforward benefits contrasts with Statement 96 treatment, in which the benefit of such a carryforward would generally not be recognized until the carryforward is used.

Good-bye to scheduling?

With the ED, scheduling reversals will be the exception rather than the rule. The ED even requires balance-sheet classification of deferred taxes primarily on the basis of the classification of the asset or liability that gives rise to the deferred tax amount rather than the timing of reversals. This provision is not the conceptual preference by the Board, but rather a pragmatic way to avoid scheduling reversals for even one year.

Some knowledge of the pattern of reversals may be necessary in determining the marginal tax rate and in assessing the need for a valuation allowance. You will have to consider scheduling in the following circumstances:

* The marginal rate applicable to the last dollar of taxable income is expected to vary by year in a taxing jurisdiction that has graduated tax rates. (This could be the situation for many smaller U.S. companies.) The company could be required not only to schedule reversals but to estimate what its actual future taxable results will be in each future year. * The company has a deferred tax asset, but the likelihood of future taxable income from sources other than reversing temporary differences does not provide sufficient assurance of realization to avoid a valuation allowance. The company must determine to what extent reversals of taxable differences assure realization through offsetting. This situation could occur when future prospects are marginal or worse, and in foreign or state jurisdictions where carryback and carryforward periods are limited and future results are expected to be erratic. * A change in the tax rate is enacted but will not take effect until a future year. The company must determine the amount of temporary differences for which the current tax rate is the marginal tax rate and the amount of temporary differences for which the rate enacted for the future is the marginal rate.

Of course, even in these circumstances, aggregate calculations or other shortcuts might approximate the results that full-scale scheduling would give.

The bottom line on scheduling? The scheduling superstructure will survive, but its use will be exceptional and usually limited.

The ED's effect on APB 23

APB 23 provides that a deferred tax liability should not be recognized for certain specified temporary differences, most notably unremitted earnings of subsidiaries, when reversal is indefinite. In the exposure draft preceding Statement 96, the Board set off a storm of controversy by proposing the complete repeal of APB 23. The Board ultimately acquiesced to leaving APB 23 in place, but it continued to believe conceptually that deferred taxes should be provided for the APB 23 areas. The ED's presumptive recognition (i.e., before a valuation allowance) of deferred tax assets for all deductible differences and carryforwards reinforces the Board's belief that a deferred tax liability should be established for the taxable differences currently exempted by APB 23.

The current ED repeals APB 23, but only prospectively. Temporary differences existing at the effective date of the FASB continue to be exempted, provided the indefinite reversal criteria continue to be met. A key exception to the repeal of APB 23 is unremitted earnings of foreign subsidiaries and foreign corporate joint ventures; calculating the U.S. taxes payable on repatriation is too complicated. However, the ED permits recognition of a net deferred tax asset for foreign tax credit carryforwards only to the extent that they reduce a recognized liability for foreign unremitted earnings or other taxable differences that will generate foreign source income.

The repeal of APB 23 for domestic subsidiaries is likely to be a non-event. The provisions of the U.S. tax law and available strategies should make it possible to anticipate that the parent will ultimately receive the unremitted earnings free of U.S. tax. However, provision for deferred state taxes may be necessary. And deferred taxes will have to be provided on unremitted earnings of domestic corporate joint ventures recognized after the effective date of the statement.

Management's judgment

and the auditor

There has been a trend in accounting standards toward the "cookbook" approach: detailed rules covering practically every possible circumstance and leaving minimal room for judgment or subjectivity in application. Statement 96 is in the mainstream of this trend, specifying mechanical rules for calculations. With the new ED, the FASB is about to do an about-face. The ED's recognition of deferred tax assets will be based on management's assessment of its future prospects when reversals of temporary differences will generate net deductions, either in the aggregate or over a span of future years. While the ED emphasizes the importance of objective evidence in making the assessment, the ultimate conclusion is bound to be subjective in many situations.

There is in the U.S. a 19-year period for loss utilization (the loss year, a three-year carryback period, and a 15-year carryforward period). Given this large window, employees, shareholders, and financial analysts might interpret a valuation allowance as a message that management's assessment of the company's future is dim. So management may well be pressured to conclude that no valuation allowance is necessary. But there are other circumstances - when management is in life-and-death negotiations with its unions or creditors, for example - when it might want to paint a very gloomy scenario for the future.

Making the valuation allowance assessment will be especially challenging for a company with a large operating loss carryforward (one that is not aberrational). It will be necessary to determine the portion of the carryforward for which a tax benefit can be recognized. Is there sufficient positive evidence in the loss year(s) to recognize at least some of the benefit? AS the company starts to earn profits, how much can the valuation allowance be reduced? Such an assessment will be necessary each year until the operating loss carryforward is actually realized or expires unused.

How is management's judgment to be audited? Ther are bound to be situations in which the auditor cannot agree with management's assessment. Can the auditor insist that his or her crystal ball is more reliable than management's? If they can't agree, does the auditor's opinion include an explanatory paragraph for uncertainty, or is it qualified for departure from GAAP? These questions will not be easily resolved.

Of course, the company, in preparing for its audit, will need to document its deferred tax computation for various taxing jurisdictions - how it arrived at its determination of the marginal tax rate, for example, and the necessity for and the amount of any valuation allowance. This will be important not only for the auditor but for the company itself if its financial statements are later challenged.

What's next?

In general, the ED is viewed as a significant improvement over Statement 96. It's not a perfect answer, but of the various approaches the Board has examined, it appears to have, on balance, more positives than any of the other approaches.

The FASB staff has conducted a field test, using companies that adopted Statement 96. After it has analyzed written comments and held a public hearing, the Board hopes to publish a statement embodying the new model in the first quarter of 1992. The effective date will not be until 1993, giving a further one-year delay to those companies still on APB 11.

The new model

at glance

* It is based on a liability or balance-sheet approach, and it looks to future tax effects) of temporary differences (differences between book and tax bases of assets and liabilities). * It uses the enacted marginal tax rate expected to be applicable to reversals. * It provides deferred tax liability for taxable temporary differences. * It recognizes deferred tax liability for deductible temporary differences and carryforwards. * It provides a valuation allowance for tax assets to the extent it is more likely than not they will not be realized.

The new model - not

a panacea

The proposed revision of Statement 96 has two primary objectives: to reduce complexity of application and to provide greater recognition of future tax benefits. The ED does a reasonably good job of addressing both of these issues. But what about the other complaints lodged against Statement 96?

Problems that the ED "solves"

* The 46-percent carryback. Statement 96 measured the benefit of net deductions reversing in early years based on a hypothetical carryback and not be actually realized. * Hypothetical tax-planning strategies. A company had to search for strategies solely for purposes of the Statement 96 computation. * Deferred intercompany profit. Under the lialibility method, the deferred tax asset relates to the deduction in the buyer's jurisdiction. The absence of carryback availability in many foreign jurisdictions may have precluded recording tax assets under Statement 96. Looking at actual expected results of the buyer should eliminate this problem. * AMT. The considerable complexity of separate AMT calculations has been eliminated. * Tax-deductible goodwill. This will be treated like any other temporary difference. * Leveraged leases. Integration of the Statement 13 leveraged lease accounting with the overall deferred tax computation should be much simpler.

Problems that remain

* U.S. dollar functional currency. The difference between current and historical rate translations of nonmonetary assets and liabilities will continue to be a temprorary difference on which deferred foreign taxes must be provided. * Deferred intercompany profit. When an intercompany sale is made, the difference between the taxes paid by the seller and the deferred tax asset recorded for the buyer's deduction would be reflected in consolidated net income even though no pretax income is reported in the consolidated financial statements. * "Outside basis" differences in subsidiaries. Differences between book and tax bases of a parent's investment in subsidiaries were frequently not timing differences when they arose in business combinations or reorganizations. But they are temporary differences under the liability method if the sale or liquidation of the subsidiaries will result in taxable income or deductions. * Inclusion of effects of tax rate changes entirely in continuing operations. When a deferred tax liability has been provided by direct charge to equity, many believe adjustments should also be reflected in equity. * Deferred investment credit. This will continue to give rise to a temporary difference.

And there are "sleepers"

* ESOP dividends. The provision of Statement 96 that reflects the tax benefit of deductible dividends in income has been popular. The ED would credit directly to equity the portion attributable to unallocated ESOP shares. * Intercorporate allocation. Methods that are inconsistent with the basic model for accounting for income taxes would be prohibited. * Domestic corporate joint ventures. The APB 23 exemption will be repealed on a prospective basis. PHOTO : Panorama of Washington City, lithograph, c. 1861

This long panorama of Washington was printed to familiarize the Union troops occupying the city during the Civil War with local landmarks. Originally one long sheet, it shows the major buildings and landmarks, from Goergetown on the far left to St. Elizabeth's Hospital on the far right.
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Title Annotation:Corporate Reporting; includes related articles
Author:Petzing, Lawrence N.
Publication:Financial Executive
Date:Sep 1, 1991
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