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Finally a reduction in deferred income taxes?

The issuance of Statement of Financial Accounting Standards No. 121 (SFAS No. 121) "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" in March, 1995 by the Financial Accounting Standards Board, provides standardization in the methods used to account for declines in the values of fixed assets. Prior to this pronouncement, there was a great deal of diversity in the way changes in the value of fixed assets were reported. Some firms did not record declines in the values of fixed assets at all, as they contended the cost of these assets would eventually be charged to expense as depreciation or depletion. Other firms recorded the decline in value by a charge to expense in the period in which it occurred.

While the standardization of recording of the impairment in value of fixed assets should increase the comparability of financial reporting, it may also bring about a significant, decrease in the amount of reported deferred income tax liabilities. One of the major temporary differences for most companies is the difference between the book value of fixed assets for accounting purposes and for tax purposes. For tax purposes most assets are depreciated using MACRS, while for accounting purposes, the straight-line method is used. This results in a larger book value for accounting purposes than for tax purposes in the early years of the asset's service life. This temporary difference causes a deferred income tax liability to be recorded. In subsequent years, when the temporary difference "reverses," the accounting depreciation is larger than the tax depreciation. If a decline in the value of a fixed asset is recorded for accounting purposes, then the difference between the accounting book value and the tax book value would be decreased. The decline in value would represent an immediate reversal of a temporary difference. The reduction in the magnitude of the temporary difference would cause a corresponding decrease in the amount of the deferred tax liability. This article will examine the conditions under which this could occur.

The Provisions of SFAS No. 121

SFAS No. 121 establishes accounting standards for:

* the impairment of long-lived asset (including identifiable intangibles and goodwill) which are to be held and used.

* the impairment of long-lived asset (including identifiable intangibles and goodwill) which are to be disposed of.(1)

Long-lived asset are normally recorded at historical cost. Historical cost and fair value are typically the same only at the time of purchase. The historical cost basis is usually reduced by some sort of depreciation or amortization. If there is a material decline in value (impairment of value), the asset is written down to a new (lower) value and a loss recorded. Prior to this Statement, there were no accounting standards to define when impairment losses should be recognized and how the amount of impairment losses should be measured. SFAS No. 121 applies to all entities.

SFAS No. 121 does not apply to the following:

* Financial Instruments.

* Long-term customer relationships of a financial institution (for example, core deposit intangibles and credit cardholder intangibles).

* Mortgage and other servicing rights, deferred policy acquisition costs.

* Deferred tax asset.(2)

It does not apply to asset whose accounting is prescribed by:

* FASB Statement No. 50, Financial Reporting in the Record and Music Industry.

* FASB Statement No. 53, Financial Reporting by Producers and Distributors of Motion Picture Films.

* FASB Statement No. 63, Financial Reporting by Broadcasters.

* FASB Statement No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.

* FASB Statement No. 90, Regulated Industries-Accounting for Abandonments and Disallowances of Plant Costs.(3)

There are two categories of asset which are covered by SFAS No. 121: (1) Asset to be Held and Used, and (2) Asset to be Disposed Of. The Statement was originally intended to apply only to asset to be held and used. In order to prevent the "management" of impairment losses (by moving impaired asset into the "asset to be disposed of" category), the accounting treatment for the impairment of value of asset that were to be disposed of also needed to be defined.

Asset to Be Held and Used

An entity shall review long-lived asset and certain identifiable intangibles to be held and used for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable.

The following are examples of events indicating the recoverability of the carrying value of an asset should be assessed (this is not meant to be an exhaustive list):

* A significant decrease in the market value of an asset.

* A significant change in the extent or manner in which an asset is used or a significant Physical change in an asset.

* A significant adverse change in legal factors or in the business climate that could affect the value of an asset or an adverse action or assessment by a regulator.

* An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset.

* A current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast demonstrating continuing losses associated with an asset used for the purpose of producing revenue.(4)

When to Recognize an impairment Loss

If one of the events listed above, or another event, occurs which indicates impairment of an asset has taken place, the entity shall estimate the future cash flows expected to result from the use of the asset and its eventual disposition. Future cash flows are the future cash inflows expected to be generated by an asset less the future cash outflows expected to be necessary to obtain those inflows. If the sum of the expected future net cash flows (undiscounted and without interest charges), is less than the carrying amount of the asset, the entity shall recognize an impairment loss. If the sum of the expected future cash flows is more than the carrying amount of the asset, no impairment loss is recognized. In estimating expected future cash flows for determining whether an asset is impaired, asset shall be grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of asset.(5) One could argue the requirement for estimation of future cash flows would allow a certain amount of "management" of SFAS No. 121 mandated impairment losses. The magnitude of the estimated future cash flows could be increased or decreased enough to either prohibit or require an impairment loss to be recognized.

Measurement of the Impairment Loss

The impairment loss to be recognized shall be measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value of an asset is the amount at which the asset could be bought or sold in an arms length market transaction (not a forced or liquidation sale). The problem is determining a surrogate for fair value if no organized market for the asset exists. Quoted prices in active markets are the best evidence of the fair value of an asset. However, if no organized market for an asset exists, an estimate of fair value must still be made. Any estimate of fair value should consider prices for similar asset and the availability of valuation techniques.

Examples of valuation techniques include:

* The present value of expected future cash flows using a discount rate commensurate with the risks involved.

* Option-Pricing Models

* Matrix Pricing

* Option-adjusted spread models

* Fundamental analysis

After an impairment loss is recognized, the reduced carrying amount of the asset shall be accounted for as its new cost. Restoration of previously recognized impairment losses is prohibited.(6) Hence a recognized impairment loss should be a permanent loss.

Goodwill

If an asset being tested for recoverability was acquired in a business combination accounted for using the purchase method, the goodwill which arose in that transaction shall be included as part of the asset grouping in determining recoverability. If some, but not all, of the asset acquired in that transaction are being tested, goodwill shall be allocated to the asset being tested for recoverability on a pro rata basis using the relative fair values of the long-lived asset and identifiable intangibles acquired at the acquisition date. If goodwill is identified with asset subject to an impairment loss, the carrying amount of the identified goodwill shall be eliminated before making any reduction of the carrying amounts of impaired asset.(7)

Reporting and Disclosure

An impairment loss for asset to be held and used shall be reported as a component of "income from continuing operations before income taxes" for entities presenting an income statement and in the statement of activities of a not-for-profit organization.

An entity recognizing an impairment loss shall disclose all of the following in financial statements that include the period of the impairment write-down:

* A description of the impaired asset and the facts and circumstances leading to the impairment.

* The amount of the impairment loss and how fair value was determined.

* The caption in the income statement or the statement of activities in which the impairment loss is aggregated if the loss has not been presented as a separate caption or reported parenthetically on the face of the statement.

* If applicable, the business segment(s) affected.(8)

Asset to Be Disposed Of

All long-lived asset and certain identifiable intangibles which are not covered by APB Opinion No. 30 (Reporting the Results of Operations-Reporting the Effects of a Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions), shall be reported at the lower of carrying value or fair value less cost to sell. Costs to sell an asset to be disposed of generally includes the incremental direct costs to transact the sale of the asset such as broker commissions, legal and title transfer fees, and closing costs which must be incurred before legal title can be transferred. Costs generally excluded from cost to sell an asset to be disposed of include insurance, security services, utility expenses, and other costs of protecting or maintaining an asset.

Subsequent revisions in estimates of fair value less cost to sell shall be reported as adjustments to the carrying amount of an asset to be disposed of, provided the carrying amount of the asset does not exceed the original carrying value of the asset before an adjustment was made to reflect the decision to dispose of the asset.(9)

Reporting/Disclosure

Impairment gains and losses from asset held which are to be disposed of shall be reported as a component of "income from continuing operations before income taxes" for entities presenting an income statement and in the statement of activities of a not-for-profit organization.

The following must be disclosed for asset to be disposed of:

* A description of asset to be disposed of, the facts and circumstances leading to the expected disposal, the expected disposal date, and the carrying amount of those asset.

* If applicable, the business segment(s) in which asset to be disposed of are held.

* The loss, if any, resulting from changes in the carrying amounts of asset to be disposed of that arises from application of this Statement.

* The caption in the income statement or the statement of activities in which the gains or losses are aggregated if those gains and losses have not been presented as a separate caption or reported parenthetically on the face of the statement.

* The results of operations for asset to be disposed of to the extent those results are included in the entity's results of operations for the period and can be identified.(10)

Effective Date and Transition

SFAS No. 121 was effective for financial statements for fiscal years beginning after December 15, 1995. Earlier application was encouraged. Restatement of previously issued financial statements was not permitted. Impairment losses resulting from the application of this Statement shall be reported in the period in which the recognition criteria are first applied and met.

The initial application of this Statement to asset being held for disposal at the date of adoption shall be reported as the cumulative effect of a change in accounting principle. A business enterprise shall report the amount of the cumulative effect in the income statement between the captions "extraordinary items" if any, and "net income." A not-for-profit organization shall report the cumulative effect of a change in accounting on each class of net asset in the statement of activities between the captions "extraordinary items," if any, and "change in unrestricted net asset." The pro forma effects of retroactive application are not required to be disclosed.

Impact of SFAS No. 121 on Deferred Income Taxes

In order to illustrate the manner in which the application of SFAS No. 121 might decrease deferred income taxes, the following simplified example is used:

* Equipment with a cost of $50,000 is purchased. The equipment will be depreciated for financial accounting purposes using the straight line method over a ten year service life with no salvage value.

* The equipment is appropriately classified as seven year property for tax depreciation purposes. The maximum depreciation allowed by the Tax Code will be taken.

* Section 179 additional depreciation is not elected for the purposes of this illustration.

* Eight percent is the appropriate discount rate.

* The effective corporate tax rate is 34%.

The depreciation for both tax and financial accounting purposes and the amount of the deferred tax liability account is presented in Table 1.

By the end of the third year of the asset's service life, the cumulative difference between the asset's book value and tax basis is $13,135. This represents a temporary difference which results in a deferred tax liability of $4,466 ($13,135 x .34).

The book value for accounting purposes and the book value for tax purposes (Tax Basis) at the end of the third y, ear in the useful life of the asset is presented in Table 2.

Now let us assume during the fourth year of the asset's service life, the carrying value of the asset is evaluated in light of the requirements of SFAS No. 121. The book value of the asset is $35,000 ($50,000 cost less three years depreciation at $5,000 per year). The net cash flows for the remaining service life of the asset (7 years) are estimated to be $4,800 per [TABULAR DATA FOR TABLE 1 OMITTED] year. The undiscounted sum of these estimated future cash flows is compared to the book value of the asset to determine if an impairment loss should be recognized.
Table 2

Book Value Versus Tax Basis Before Impairment

 Accounting Tax

Cost $50,000 Cost $50,000

- Financial (15,000) - Tax Depreciation 28,135
Depreciation

= Book Value $35,000 = Tax Basis $21,865
Table 3

Book Value Versus Adjusted Basis After Impairment

 Financial Tax

Cost $50,000 Cost $50,000

- Financial (15,000) - Tax 28,135
Depreciation Depreciation

- Impairment Loss (10,011)

= Book Value $24,989 = Tax Basis $21,865




Sum of Estimated Future Book
Values $33,600
Book Value of Asset 35,000




Since the book value of the asset is larger than the sum of the estimated future cash flows, an impairment loss is required to be recognized. In order to determine the amount of the impairment loss, the fair value of the asset must be determined. In this example, the estimated future cash flows are used as a surrogate for the fair value of the asset. Discounting the estimated future cash flows at 8% results in an estimated fair value of $24,989. The amount of the impairment loss to be recognized is $10,011 ($35,000-24,989). In accordance with SFAS No. 121, the following entry would be made to record the impairment loss in year 4. If this equipment had been held for disposal at the date of the impairment, the reduction in the carrying value would have been handled as a cumulative effect of a change in accounting principle.
Loss On Permanent Reduction of Equipment to Fair Market

Value $10,011
Equipment $10,011




The loss would be shown on the income statement prior to Income from Continuing Operations.

The impact of the impairment on book values is illustrated in Table 3. Note that the impairment in value of $10,011 is recorded during year 3. The new reduced book value of $24,989 must be depreciated over the remaining 7 years of the useful life [TABULAR DATA FOR TABLE 4 OMITTED] of the asset. This results in a new depreciation charge of $3570 per year for accounting purposes.

The difference in the book value and the tax basis has now been reduced to $3124. The deferred income tax liability shows a corresponding decrease to $1062, a reduction of 76% as compared to the level prior to the impairment.

The temporary differences and deferred income tax liabilities for the life of the asset subsequent to the impairment are presented in Table 4.

Prior to the impairment, the maximum deferred income tax liability was $4889 in year 4. Subsequent to the impairment, the maximum deferred income tax liability is $2883 in year 7. The impairment of $10,011 represented 20% (10,011(50,000) of the cost of the asset). This resulted in a 41% decline in the maximum deferred income tax liability balance ([4489-2883] divided by 4489). This is a significant decrease in the deferred income tax liability.

Summary

Many recent pronouncements by the Financial Accounting Standards Board (FASB) have resulted in an ever-increasing amount of deferred income taxes. The prescribed recognition of income or expenses for accounting purposes is often very different from the methods required by the Internal Revenue Code (IRC). SFAS No. 121 is unusual in that it is counter to this trend. It represents a significant change in the valuation of long - lived asset. Long-lived asset are now required to be valued based upon the lower of book value or fair value. The resulting impairments will often narrow the gap between the accounting book value and the tax basis of an asset. This brings about a decrease in the deferred income tax liabilities associated with depreciable asset. As illustrated in this example, these decreases in the deferred income tax liabilities are often very material. While the valuation of the asset may be more complex, the deferred income tax liability is decreased. In extreme cases, the deferred income tax liability may be reduced to an immaterial level.

Statement of Financial Accounting Standards No. 121 "Accounting for the Impairment of Long - Lived Asset and for Long - Lived Asset to Be Disposed Of" (Stamford: Financial Accounting Standards Board, 1995) par 1.

Ibid, par 3. Ibid. Ibid, pars. 4,5. Ibid, par. 6. Ibid, pars. 7-11. Ibid, par. 12. Ibid, par. 13,14. Ibid. par. 15-17. Ibid, par. 18,19. Ibid, par 34,35. PAGE 9 PAGE 16
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Title Annotation:implications of the issuance of Statement of Financial Accounting Standards No. 121
Author:Oxner, Thomas H.; Bechtel, Terry; Culpepper, Robert C.
Publication:The National Public Accountant
Date:Aug 1, 1997
Words:3139
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