Measuring tax benefits under FIN 48 - eliminating some of the agita.

• Author: Garofalo, William

The Financial Accounting Standards Board's Interpretation No. 48 (FIN 48) has generated much agita (1) for corporate tax departments. While several parts of FIN 48 are responsible for this stomach acid, measuring benefits under the FASB pronouncement maybe at the top of the list.

FIN 48 prescribes a two-part process for evaluating a corporation's tax positions and determining reserves for tax contingencies, a process referred to by FIN 48 as "measuring tax benefits." First, the corporation must determine whether a tax benefit may be recognized at all. Corporations may only recognize tax benefits that will more likely than not to be sustained upon examination. (2) Second, the corporation must evaluate or measure the tax benefit. The corporation measures the tax benefit "at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement." (3)

The FASB mandates several assumptions for recognition and measurement of tax benefits. The most crucial assumption is that corporations must presume that the taxing authority will examine the benefit and will have full knowledge of all relevant information. (4) In addition, corporations must examine each position on its own merits, without considering the possibility of offset or aggregation with other positions. (5) Finally, the measurement must assume that the corporation will settle the issue with the taxing authority and not litigate. (6) Thus audit roulette, horse-trading, and possible litigation results are not factors in the measurement analysis.

FIN 48 Probability Matrices

The appendix to FIN 487 utilizes probability matrices to measure the largest amount of benefit that is greater than 50 percent likely of being realized. While FIN 48 does not actually state that corporations must prepare probability matrices to measure tax benefits, many seem to have jumped to this conclusion. To prepare a probability matrix, a corporation first determines possible outcomes (i.e., amounts of tax benefits that the corporation may obtain by settling the issue under consideration with the tax authority) and lists these outcomes in the probability matrix. The corporation then determines the percentage likelihood that each outcome will occur. Finally, the corporation computes the cumulative probabilities for each outcome as well as the outcomes with a higher tax benefit. The measured tax benefit under FIN 48 is the highest tax benefit with a cumulative probability of more than 50 percent. The primary FASB example of such a matrix is set forth below:

A21. In applying the recognition criterion of this interpretation, an enterprise has determined that a tax position resulting in a benefit of $100 million qualifies for recognition and should be measured. The enterprise has considered the amounts and probabilities of the possible estimated outcomes as follows:

Possible Individual Cumulative Estimated Probability Probability Outcome of Occurring (%) of Occurring (%) $100 5 5 80 25 30 60 25 55 50 20 75 40 10 85 20 10 95 0 5 100 A22. Because $60 is the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement, the enterprise would recognize a tax benefit of $60 in the financial statements.

Practice Prior to FIN 48

Before FIN 48, corporations measured tax benefits without probability matrices and the other previously discussed guidelines. Corporations might (or might not) take into account the likelihoods that the tax authority would detect an issue on audit (the audit lottery concept), that an issue was so complex that the tax authority might not obtain sufficient facts to develop an issue, or that the tax authority would agree to some overall settlement of a group of tax issues. In addition, corporations could take into account (at least to some degree) tax benefits that were unlikely to occur. (9) FIN 48 has improved the consistency of financial statements by promulgating rules that require corporations to determine tax benefits in a consistent manner. There are alternatives to using a probability matrix concept, however, that are more akin to prior practice.

Measuring Tax Benefits Prior to FIN 48

Before FIN 48, corporations generally measured tax benefits by estimating the current settlement value of the issue. The corporation might adjust this settlement value to reflect the "audit lottery" or similar factors, but FIN 48 now prohibits taking such factors into account. "Settlement value" normally reflected the corporation's chances of prevailing on the issue at...