Accounting for Income Taxes sfas 109 Smith, Darlene A., Freeman, Gary r the cpa journal



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Accounting for Income Taxes - SFAS 109 Smith, Darlene A.Freeman, Gary R.The CPA Journal. New York: Apr 1992.Vol.62, Iss. 4;  pg. 16, 9 pgs
Copyright New York State Society of Certified Public Accountants Apr 1992

Earlier this year, the FASB issued SFAS 109, "Accounting for Income Taxes," effective for fiscal years beginning after December 15, 1992, with earlier adoption encouraged. This statement supersedes SFAS 96 (and several other pronouncements) issued in 1987, whose effective date was three times deferred, and which in turn replaced APBO 11 and several other pronouncements. SFAS 96 had generated extensive criticism, and the deferral of its effective date was designed to allow for due process in preparing its replacement. SFAS 109 is the Board's response.

PROBLEMS WITH APBO 11 AND SFAS 96

APBO 11, issued in 1967, required the deferral method of accounting for income taxes. The recognition and measurement of deferred income tax liabilities and assets were based on an income statement approach. Income tax expense was computed by applying the current tax rate to financial statement income before taxes but after adjustment for permanent differences in taxable and financial statement income. The current tax liability was the amount of taxes to be included on that year's tax return. Income tax expense in excess of the current tax liability created a deferred tax credit. A current tax liability in excess of tax expense reduced the deferred tax credit or created a deferred tax charge. This process was often referred to as the with-and-without method. Due to changes in tax rates in subsequent periods, the effect of timing differences often entered the deferred tax credit account at one tax rate and was removed later at a different tax rate. A principal criticism was that the resultant deferred tax credit eventually became meaningless--just the result of a mechanical process.

The major purpose of SFAS 96 was to make the balance sheet accounts for deferred taxes more meaningful in keeping with the FASB's conceptual framework. Accordingly, it required the recognition and measurement of deferred tax liabilities and assets under the liability method. This approach is also used in SFAS 109. Income tax expense now is to be the result of several computations. First, the current tax expense or benefit is the amount expected to be reported on the current year's tax return as the tax payable or refundable. Then, the deferred tax liability or asset at the end of the period is computed by applying the enacted tax rate expected to apply to the temporary differences when they reverse and become elements of income or expense on the tax return. The change in the liability or asset from the beginning of the year is the deferred component to be added to or subtracted from the current tax payable or refundable to arrive at financial statement tax expense or benefit.

There were numerous criticisms of SFAS 96, with two major matters creating the most controversy. SFAS 96's recognition and measurement methods resulted in much complexity and confusion in the recognition and measurement of deferred tax assets. The application of federal tax law coupled with the prohibition to consider any future taxable income created this problem. In addition, extensive scheduling was required to determine the future reversal of temporary differences. It was argued that this scheduling was an overwhelming burden.

RECOGNITION OF TAX ASSETS AND SCHEDULING REQUIREMENTS

To allow for recognition of deferred tax assets in situations where benefits from temporary deductible differences are expected to be realized but were not allowed under SFAS 96, the basic objectives adopted in SFAS 96 had to be modified. Under SFAS 96, the basic objective of accounting for income taxes was to recognize the amount of current and deferred income taxes payable or refundable at the date of the financial statements 1) as a result of all events that had been recognized in the financial statements and 2) as measured by the provisions of enacted tax laws. Under SFAS 109, the objectives of accounting for income taxes are 1) to recognize the amount of taxes payable or refundable for the current year and 2) to recognize deferred tax liabilities or assets for the future tax consequences of events that have been recognized in the financial statements or tax returns. The primary difference in SFAS 109 is that the future tax consequences of currently recognized events are allowed to be considered. SFAS 96 specifically disallowed any consideration of the tax consequences of earning income in future years.

The Board believes that a reduction in the scheduling burden has been achieved through the procedures now required to recognize deferred tax assets and liabilities. For many companies, this objective appears to have been achieved. For others, the burden may still be substantial.

RECOGNITION OF DEFERRED TAX LIABILITIES AND ASSETS

The new statement specifies the procedure to be used to determine an enterprise's deferred tax expense (or benefit), liabilities, and assets. The change in the deferred tax assets and liabilities is the deferred tax expense or benefit of the period. The financial statement preparer is required to:

* Identify 1) the types and amounts of existing temporary differences and 2) the nature and amount of each type of operating loss and tax credit carryforward and the remaining length of the carryforward period;

* Measure the total deferred tax liability for taxable temporary differences using the enacted tax rate expected to apply in years the temporary differences will reverse;

* Measure the total deferred tax asset for deductible temporary differences and operating loss carryforwards using the enacted tax rate expected to apply at the time of reversal or realization;

* Measure deferred tax assets for each type of tax credit carryforward; and

* Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.

Deferred tax assets are initially recognized and then all available evidence must be considered to determine whether a valuation allowance must also be recognized for some or all of these assets. This is a major departure from SFAS 96, which would not allow recognition of deferred tax assets on a presumption of future income basis.

The more likely than not criterion is a new concept to financial accounting standards. But it is an approach that the Board introduced because of conceptual problems that arise if measurement of the tax asset is made dependent upon predicting future taxable income. The term embodies the concept of likelihood of recovery that is at least slightly more than 50%. In other words, if the tax asset is likely to be realized, do not provide a valuation allowance. If the tax asset is not likely to be realized, provide a valuation allowance sufficient to reduce the net asset to the amount likely to be realized. Although this seems rather straightforward in the saying, there will no doubt be many problems and uneasiness in the doing. It is an entirely new approach to asset valuation and may very well test preparers' and their independent auditor's skills in its application.

VALUATION ALLOWANCES FOR DEFERRED TAX ASSETS

Since future realization of a deferred tax asset is an unknown that cannot be accurately predicted, judgment must be used to determine whether a valuation allowance is necessary. Realization of this asset ultimately rests on the realization of sufficient taxable income of the right kind at the right time.

SFAS 109 lists four possible sources of taxable income:

* Future reversals of existing temporary differences;

* Future taxable income exclusive of reversing temporary differences and carryforwards;

* Taxable income in prior carryback year(s) if carryback is permitted under the tax law; and

* Tax-planning strategies that would, if necessary, be implemented to, for example:

1. Accelerate taxable amounts to utilize expiring carryforwards.

2. Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss.

3. Switch from tax-exempt to taxable investments.

SFAS 109 goes on to indicate that to the extent evidence about a single source of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered. Consideration of each source is required, however, to determine the amount of any valuation allowance that is recognized.

In deciding whether a valuation allowance is necessary, all evidence, positive and negative, must be considered. Examples of negative evidence include:

* Cumulative losses in recent years; * History of operating losses or tax credit caryforwards expiring unused; and

* Losses expected in early future years by a presently profitable entity.

Examples of positive evidence that might be necessary to support a conclusion that a valuation allowance is not needed when there is negative evidence include:

An excess of appreciated asset value over the tax basis of the entity's net assets in an amount sufficient to realize the deferred tax asset; and

* A strong earnings history exclusive of the loss that created the future deductible amount.

The process of recognizing tax liabilities, assets and valuation allowance accounts is illustrated in Figure 1. (Figure 1 omitted)

EXAMPLE. The following example illustrates the computation of income tax expense, liabilities and assets under APBO 11, SFAS 96 and SFAS 109.

Assume that Newco, a manufacturing company, has financial statement income before taxes of $1,000,000. This amount includes warranty expense of $100,000. Of the warranty costs for Year 1 sales, $30,000 was paid in Year 1, $30,000 is expected to be paid in Year 2, $20,000 in Year 3, $10,000 in Year 4, and $10,000 in Year 5. Since warranty costs are deductible for tax purposes only when paid, this situation creates a deductible temporary difference of $70,000. Assume that the income expected over the next four years will be such that the enacted applicable tax rate will be 34%, that this is Newco's first year, and that there are no other temporary differences. The computation of income tax expense for Newco under the three pronouncements is shown in Figure 2. (Figure 2 omitted)

ALTERNATIVE MINIMUM TAX

Alternative minimum tax (AMT), while the bane of most tax preparers and taxpayers, is dealt with quite simply under the new statement. SFAS 109 simply states that a deferred tax asset is recognized for alternative minimum tax credit carryovers. Since the alternative minimum tax credit does not expire, this would seem logical for companies that expect to be in a regular tax position in the foreseeable future. At that time the alternative minimum tax credit would operate to reduce regular tax liability and the deferred tax asset will be realized. However, if circumstances were such that it is more likely than not that all or a portion of the AMT carryforward would not be realized, a valuation allowance should be appropriately provided.

HAVE SCHEDULING NEEDS BEEN REDUCED?

A major criticism of SFAS 96 has been the overwhelming burden of scheduling the reversal of temporary differences to determine net taxable and net deductible amounts for future years. One of the Board's stated objectives in issuing the new statement is to reduce the complexity of scheduling.

For companies with a strong earnings history and the expectation of strong earnings in the future, it would appear that the Board has achieved that objective. For purposes of filing tax returns, extensive scheduling is almost always required by an enterprise that utilizes different methods for financial statement purposes and for tax purposes. However, that scheduling should provide enough information for these enterprises to evaluate the eventual reversal of temporary differences and the likelihood of realization of deferred tax assets.

However, in less straightforward situations, it would appear that additional extensive scheduling might still be required. When there is not sufficient evidence that there will be future taxable income exclusive of reversing temporary differences to allow realization of the deferred tax assets, the other sources must be evaluated.

The first source of sufficient taxable income is future reversals of existing temporary differences. Scheduling similar to that required by SFAS 96 would be required in most cases to determine if this single source of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary. If no single source of taxable income is sufficient, consideration of all sources may be required to determine the amount of the valuation allowance that is recognized. Again, how would one consider all the sources that conceivably may be available without extensive scheduling?

The third source of sufficient taxable income to allow realization of tax assets is taxable income in prior carryback years. Again, since net deductible amounts can be carried back only three years under federal tax law, scheduling would be required to determine how much of the deductible temporary differences reverse during the next three years. This scheduling might often be substantially less than that required under SFAS 96.

The fourth source of sufficient taxable income to allow realization of the tax assets is the use of tax-planning strategies. SFAS 96 required consideration of tax-planning strategies that maximized the amount of tax benefits recognizable in the current year. Under SFAS 109, however, tax-planning strategies come into play as a possible source of positive evidence that a valuation allowance is not needed. To be considered positive evidence, the tax-planning strategy must be prudent, feasible, and primarily within control of management. The tax benefit of implementation of a tax-planning strategy should be recognized net of the costs to implement it; the use of tax-planning strategies might require substantial scheduling.

Another situation is not relevant at the present time, but, with a Congress that often tinkers with the tax law, could present problems in the future. The tax rate used to measure a deferred liability or asset may vary, depending upon when the difference is expected to reverse. If tax rates were enacted for future years that change from year to year, it would appear that substantial scheduling would be required to determine when the differences would reverse and which tax rate should be applied.

Another situation requiring substantial scheduling would be for a company that has a history of paying the alternative minimum tax and does not expect to pay regular taxes in the foreseeable future. Some feel intuitively that such AMT will ultimately be usable as a reduction or regular income tax. Others feel that companies in this position may want to present evidence of sufficient future taxable income by scheduling future reversal of existing temporary differences or by presenting appropriate tax-planning strategies to allow use of the alternative minimum tax credit.

APPLYING THE TAX RATE

The statement requires that deferred tax liabilities and assets be computed using the enacted tax rate that is expected to apply in the year the temporary differences reverse. Graduated rates must be considered only if they constitute a significant factor. For companies with taxable income in excess of $335,000, the U.S. income tax rate becomes a flat rate of thirty-four percent of all income. That rate should be used for companies whose taxable income is expected to be in that range or greater. This would appear to apply to most large companies, making the selection of the applicable tax rate a straightforward process.

However, if a company has lower levels of taxable income and graduated rates are a significant factor, an average graduated tax rate for that level of income would be applied to differences reversing in that year. This concept suggests that scheduling would be needed for those business enterprises subject to graduated rates thus creating a burden for smaller companies. To alleviate this burden, guidance provided in an appendix to the statement states that a detailed analysis to determine the net reversals of temporary differences in each future year usually is not warranted because the other variable--taxable income or loss--for determination of the average graduated tax rate for each year is no more than an estimate. Therefore "an aggregate calculation using a single estimated average graduated tax rate based on estimated average annual taxable income in future years is sufficient."

OTHER PROVISIONS

Figure 3 illustrates the major provisions contained in SFAS 109 and contrasts these provisions to the treatment required under APBO 11 and SFAS 96. (Figure 3 omitted)

CLASSIFICATION AND FINANCIAL STATEMENT DISCLOSURE

Under SFAS 96, classification of a deferred tax liability or asset as current or noncurrent depended on the timing of the reversal of the temporary differences. SFAS 109 requires that a deferred tax balance have the same classification as the related asset or liability for financial statement purposes. Deferred tax amounts that are not related to a financial statement asset or liability are classified according to the reversal date of the temporary differences. This treatment is consistent with APBO 11 and SFAS 37, "Balance Sheet Classification of Deferred Income Taxes."

For each taxing jurisdiction, all current deferred tax assets and liabilities are netted and presented as a single amount and all noncurrent tax assets and liabilities are netted and presented as a single amount. Total deferred tax liabilities, total deferred tax assets, the total valuation allowance, and the net change in the valuation allowance must be disclosed in the financial statements. For public enterprises, the tax effect of each type (if temporary difference and carryforward that gives rise tto a significant portion of deferred tax liabilities and assets must be disclosed. For nonpublic entities, the types of temporary differences and carryforward must be disclosed, but the effects may be omitted. Significant components of tax expense (current tax expense, deferred tax expense, etc.) must be disclosed. SFAS 109 provides guidance for allocation of tax expense or benefit to continuing operations and other items in the financial statements.

Alternative minimum tax is dealt with quite simply under the new statement.

The tax effect of the income/loss from continuing operations is allocated to continuing operations, along with the tax effect of changes in tax laws or rates, changes in tax status, tax-deductible dividends paid to shareholders, and revised expectations as to the realizability of tax assets. The remainder is allocated to other items in proportion to their individual effects on tax expense for the year. SFAS 109 contains a list of specific items that are allocated directly to stockholders' equity. Public enterprises must present a reconciliation between the actual and expected tax rates.

APBO 23 AND U.S. STEAMSHIP ENTERPRISE TEMPORARY DIFFERENCES

SFAS 109 proposes new treatment for certain items covered under APBO 23 and for U.S. Steamship Enterprise temporary differences. On a prospective basis only, the following types of temporary differences will result in a deferred tax liability in all situations and a deferred tax asset in limited situations:

* Undistributed earning of subsidiaries (foreign or domestic) except for undistributed earnings of a foreign subsidiary that are essentially permanent in nature;

* Investments in corporate joint ventures that are essentially permanent in duration (foreign or domestic) except for undistributed earnings of a foreign corporate joint venture that are essentially permanent in nature;

* "Bad debt" reserves of savings and loan associations that arose in tax years beginning before December 31, 1987 (the point at which the tax laws changed);

* "Policyholder's surplus" of stock life insurance companies; and

* Deposits in statutory reserve funds by U.S. Steamship Enterprises.

These types of temporary differences that arose prior to the effective date of SFAS 109 will result in a tax liability or asset only when it becomes apparent that these differences will reverse in the foreseeable future.

BUSINESS COMBINATIONS

When a business combination is accounted for as a purchase, the statement requires that the asset and liabilities acquired be recorded at their fair value, not net of taxes. The differences in their assigned values and their tax bases are treated as temporary differences and result in deferred tax liabilities and assets generally required under the statement. Deferred taxes are not recognized at the time of acquisition for temporary differences related to non-deductible goodwill, leveraged leases, and acquired APBO 23 items. Tax assets related to the acquisition for which a valuation allowance is recognized, when realized, will reduce goodwill related to the acquisition, then other noncurrent intangible assets related to the acquisition, and then income tax expense.

MISCELLANEOUS

The meaning of temporary differences in SFAS 109 is the same as in SFAS 96. As with SFAS 96, the list of temporary differences includes some items that are not treated as timing differences under APBO 11.

The Board prohibits discounting deferred tax liabilities and assets.

The Statement requires that the effect of initially applying the new statement be treated as a cumulative effect change in accounting principle with exceptions for some items. Restatement of prior years' financial statements is allowed, but not required.

OBJECTIVES HAVE BEEN ACHIEVED

It would appear that SFAS 109 will achieve the Board's primary objectives to a great extent. Tax assets that are expected to be realized can be recognized. The major stumbling block of non-recognition of an entity's likelihood of earning future revenue in SFAS 96 has been removed.

The scheduling problem also appears to be significantly lessened. Enterprises will have a great deal of flexibility in presenting positive proof to avoid recognizing valuation allowances. For most companies, this should substantially reduce the extensive scheduling required by SFAS 96.



Darlene A. Smith, PhD, CPA, is an Assistant Professor of Accounting at the University of Tulsa. Dr. Smith is the author of articles published in a number of periodicals dealing with taxation.

Gary R. Freeman, PhD, is an Assistant Professor of Accounting at the University of Tulsa.


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