Accounting for income taxes - one more time.

• Author: Stepp, James O.
• Position: Includes related articles - Corporate Reporting

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...