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Accounting for income taxes.

In December 1987, the Financial Accounting Standards Board (FASB) issued Statement No. 96, "Accounting for Income Taxes." Superseding Accounting Principles Board Opinion No. 11, which had been in effect for 20 years, Statement 96 drastically overhauled the method of accounting for deferred income taxes.

Unfortunately, Statement 96 received heavy criticism primarily due to its complexity and internal inconsistencies. Poorly received by the business community and accounting profession, Statement 96's implementation date has been postponed twice, and it is presently scheduled to become effective for fiscal years beginning after December 15, 1991. However, it is questionable whether Statement 96 will ever be implemented in itspresent form. On June 5, 1991, the FASB issued an Exposur Draft (ED) which proposes several changes to the asset-and-liability (A&L) approach required by Statement 96. This article provides a brief description of the A&L method advocated by Statement 96 and the changes proposed in the new ED.

The Asset-and-Liability


A key concept under the A&L method is a temporary difference which is a difference existing at the end of the current year between the tax basis of an asset or liability and its reported amount in the financial statements. This temporary difference will result in taxable or deductible amounts in future years when the reported amount of the asset is recovered or the liability is settled. Temporary differences arise primarily because certain revenue and expense items are recognized in one period for accounting purposes and another period for tax purposes.

The main points of the A&L approach are provided below:

1. The balance in a deferred tax liability or asset account is based on taxes expected to be paid or refunded in the future as a result of the reversal of existing temporary differences. This requires a scheduling of temporary differences and a separate computation for each year affected.

2. The amount to be reported for deferred taxes on the balance sheet is calculated using enacted future tax rates. If graduated tax rates apply, they should be used to compute deferred taxes.

3. Deferred tax expense (benefit) on the income statement is a "residual" amount because it simply reflects the net change during the year in the deferred tax liability or asset amount.

4. Deductible amounts are usually limited to offsetting taxable amounts; any unused deductible amount is treated like an NOL deduction and carries back three years and forward 15 years to offset taxable amounts in those years. Net deductible amounts will result in deferred tax assets only when the tax benefits of net future deductible amounts could be realized by carryback to reduce income taxes currently payable, income taxes paid in prior period, or a deferred tax liability classified as current.

5. Tax planning strategies may be used in estimating the years in which temporary differences will result in taxable or deductible amounts. For example, by applying such a strategy, amounts may become taxable for before a deductible carryforward expires.

6. Deferred tax liabilities and assets shall be classified in two categories in the balance sheet--the net current amount and the net noncurrent amount. The current amount is the net deferred tax consequences of temporary differences resulting in taxable or deductible amounts during the next year.

7. The balance sheet deferred tax account(s) are to be adjusted for any subsequent changes in the tax rates or laws.

These concepts can best be demonstrated with an example. Assume Noluck Company has taxable income in 19X1 of $30,000 and has a cumulative temporary difference of $100,000 resulting from using different depreciation methods for tax and accounting purposes. This temporary difference will result in taxable amounts of $20,000 each of the next five years. The firm also has a $70,000 warranty liability expected to result in deductible amounts in future years as follows: 19X2--$15,000; 19X3--$10,000; 19X4--$10,000; 19X5--$10,000; 19X6--$25,000. The enacted tax rates for all years are 25% of the first $5,000 of taxable income and 30% of taxable income above $5,000. The computations and journal entry to record income tax expense, deferred income taxes, and incourrently payable at December 31, 19X1 are shown in Table 1.

Some important aspects of the A&L method demonstrated are:

1. The scheduling and netting of future taxable and deductible amounts.

2. Deductible amounts are used primarily to offset taxable amounts.

3. The net deductible amount in 19X6 did not result in a deferred tax asset because its carryback did not result in a reduction of current

period taxes, prior period taxes, or a deferred tax liability classified as current.

4. The current portion of deferred income taxes results from the taxable income caused by the temporary difference reversing within one year (i.e., 19X2).

5. The income tax expense for the year is simply a residual amount. With the basic understanding of the A&L approach under Statement 96 provided above, it is now possible to demonstrate the FASB's proposed changes to this method.

The Asset-and-Liability

Approach Under the New ED

The focal point of the new ED is simplifying the controversial and complex provisions of Statement 96. The provisions of Statement 96 relating to nonrecognition of deferred tax assets, scheduling requirements, balance sheet classification, measurement of deferred tax accounts, and the use of "hypothetical" tax-planning strategies are all addressed in the ED.

The ED calls for the recognition of a deferred tax liability based on all future taxable amounts and a deferred tax asset based on all future deductible amounts. This treatment of the deferred tax asset is considerably different from that required under Statement 96. Statement 96 allows recognition of a deferred tax asset only if the future deductible amount could be used through carryback provisions to offset either taxes already paid, taxes of the current period, or a deferred tax liability classified as current. The ED proposes that the recognition criteria for both a deferred tax liability and deferred tax asset be essentially the same.

The one exception to the general recognition criteria is that a deferred tax asset will not be recognized if, based on all available evidence, it is "more likely than not" that some or all of the deferred tax asset will not be realized. In order for a deferred tax asset to be realized, a firm must have taxable income in the future which the deductible amounts can reduce. If the available evidence indicates that some or all of the deferred tax asset will not be realized, then a valuation allowance account is established for that portion of the deferred tax asset account. [TABULAR TABLE OMMITTED]

The determination of whether a valuation allowance is needed requires the use of judgment. The ED provides some quidance in this area by giving examples of both positive and negative evidence. An example of positive evidence, evidence indicating a valuation allowance is not needed, would be a "strong earnings history." Examples of negative evidence include "a history of operating losses or tax credit carryforwards expiring unused or losses expected in early future years (by a presently profitable entity)."

The recognition criteria of the ED would eliminate, for the most part, the need for the complex scheduling requirements presently mandated by Statement 96. Under the ED, taxable and deductible amounts occurring in future years are not offset and the recognition of a deferred tax asset is not dependent upon the deductible amount being carried back to offset other tax items. Therefore, scheduling out the future reversals of existing temporary differences is not needed. In the example presented earlier, Noluck Company would have $100,000 of taxable amounts (from the depreciation temporary difference) which would result in a deferred tax liability. Noluck would also have $70,000 of deductible amounts (from the warranty temporary difference) which would result in a deferred tax asset.

The ED also proposes a change in how the deferred tax liability or asset is measured. Statement 96 presently requires that appropriate graduated tax rates be used to measure deferred tax accounts. The ED proposes that a firm's marginal tax rate be used. The marginal tax rate is the rate that would be applicable to the firm's last dollar of taxable income. In the previous example, if Noluck is expected to have taxable income, including hte effects of the two temporary differences, of greater than $5,000 each year then the marginal rate would be 30 percent. With a 30% marginal tax rate, Noluck would report a $30,000 deferred tax liability (100,000 * .30) and a $21,000 deferred tax asset (70,000 * .30). The ED retains the requirement that the deferred tax accounts be adjusted for any change in the enacted tax rates.

The ED would also change the determination of whether a deferred tax account is current or noncurrent. Under Statement 96, this determination is based on when the reversal of the temporary difference occurs. Since the ED will eliminate the need for scheduling, the determination of the current/noncurrent status of the account will be based on the current/noncurrent status of the asset or liability giving rise to the temporary difference.

A final major area of change in the ED is in tax-planning strategies. Statement 96 requires the use of "hypothetical" tax-planning strategies within the scheduling process to reduce deferred tax liabilities and increase deferred tax assets. Both the business community and the accounting profession found these requirements to be confusing and complex to implement. Under the ED, a taxplanning strategy is considered to be a source of positive evidence indicating that a valuation account is not needed for a deferred tax asset. If the weight of positive evidence already exceeds the negative evidence, then there is no need for tax-planning strategies.

The ED will retain the basic tenets of the asset and liability approach of accounting for income taxes but will greatly simplify the technical requirements. The reduced complexity of the accounting provisions should lead to greater acceptance by the business community and the accounting profession. If the ED becomes a Statement, it will be effective for fiscal years beginning after December 15, 1992.

Charles E. Jordan, CPA, DBA is an assistant professor of accounting at the University of Southern Mississippi in Hattiesburg. He received his DBA from Louisiana Tech University and has previously published articles in numerous journals including the National Public Accountant.

Stanley J. Clark, CPA, PhD, is an assistant professor of accounting a the University of Southern Mississippi in Hattiesburg. He received his PhD from the University of Kentucky. Prior to returning to academics, he gained his practical experience working for a public accounting firm in Mississippi.
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Author:Jordan, Charles E.; Clark, Stanley J.
Publication:The National Public Accountant
Date:Nov 1, 1991
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