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Ernst & Young
Tax Educators’ Symposium 2006
Accounting for Income Taxes
Jean Oglethorpe and Ricci Obert

1               November 17, 2006
Ernst & Young Tax Educators’ Symposium 2006




  Accounting for Income Taxes
  Fundamentals of FAS 109




 2                   November 17, 2006
Ernst & Young Tax Educators’ Symposium 2006
 NOTICE

  • These slides are for educational purposes only, and
    are not intended, and should not be relied upon, as
    accounting advice.
  • Any tax advice contained herein was not intended or
    written to be used, and cannot be used, for the purpose
    of avoiding penalties that may be imposed under the
    Internal Revenue Code or applicable state or local tax
    law provisions.


 3                   November 17, 2006
Agenda
•   Basics of the Liability Method
•   FAS 109 SALT Considerations
•   Preparing a Tax Provision
•   Valuation Allowances
•   Interim Reporting
•   Purchase Accounting
•   Stock Compensation
•   APB 23
•   Reconciliation and Remediation


4                      November 17, 2006
Accounting for Income Taxes
    History of US GAAP



      APB 11      FAS 96        Superseded
                                              FAS 109
    (Dec. 1967) (Dec. 1987)                  (Dec. 1992)




5                   November 17, 2006
FAS 109 – Introduction
• FAS 109 addresses financial accounting and reporting
  for the effects of income taxes that result from an
  enterprise’s activities during the current and preceding
  years




6                   November 17, 2006
Application of FAS 109
• Domestic federal (national) income taxes and foreign,
  state, and local (including franchise) taxes based on
  income
• An enterprise’s domestic and foreign operations that are
  consolidated, combined, or accounted for by the equity
  method
• Foreign enterprises in preparing financial statements in
  accordance with U.S. generally accepted accounting
  principles (US GAAP)
7                   November 17, 2006
FAS 109 – Scope
• FAS 109 establishes standards of financial accounting and
  reporting for income taxes that are currently payable and for
  the tax consequences of:
    Revenues, expenses, gains, or losses that are included in taxable
    income of an earlier or later year than the year in which they are
    recognized
    Other events that create differences between the book and tax bases of
    assets and liabilities
    Operating loss or tax credit carrybacks for refunds of income taxes paid
    in prior years and carryforwards to reduce future taxes payable



8                        November 17, 2006
Key Terms and Concepts
• Taxable income
• Total tax expense/(benefit)
    Current tax expense/(benefit)
    Deferred tax expense/(benefit)

• Permanent differences
• Temporary differences
    Deferred tax liabilities (DTLs)
    Deferred tax assets (DTAs)
     • Valuation allowance
9                       November 17, 2006
FAS 109 – Definitions
• Taxable income – The excess of taxable revenues over tax-
  deductible expenses and exemptions for the year as defined by
  the governmental taxing authority
• Current tax expense/(benefit) – The amount of income taxes
  paid or payable (or refundable) for a year as determined by
  applying the provisions of the enacted tax law to the taxable
  income or excess of deductions over revenues
• Deferred tax expense/(benefit) – The change during the year in
  an enterprise’s deferred tax liabilities and assets


10                    November 17, 2006
FAS 109 – Definitions (continued)
• Permanent differences – Not specifically defined in
  FAS 109
     In general, book-tax differences that increase or decrease current
     tax liabilities without any future tax implications affecting tax
     expense




11                      November 17, 2006
Examples of Permanent Differences
• Book revenues/gains that will never be taxable due to
  statutory exclusion, for example:
     Municipal bond interest

• Book expenses/losses that will never be deductible for
  income tax purposes, for example:
     Fines, nondeductible meals and entertainment (M&E), officer’s life
     insurance expense

• Items taxable or deductible for tax purposes but not included
  in financial statements, for example:
     Stock option deduction, transfer pricing adjustments

12                        November 17, 2006
FAS 109 – Definitions (continued)
• Temporary differences – A difference between the book and tax basis
  of an asset or liability that will result in taxable or deductible amounts in
  future years when the reported amount of the asset or liability is
  recovered or settled
• DTLs – Recognizes the deferred tax consequences attributable to
  taxable temporary differences
• DTAs – Recognizes the deferred tax consequences attributable to
  deductible temporary differences and carryforwards
• Valuation Allowance – The portion of a DTA for which it is more-likely-
  than-not that a tax benefit will not be realized


13                         November 17, 2006
FAS 109 – Definitions (continued)
• Carrybacks – Deductions or credits that cannot be used
  on the tax return during a year that may be carried back
  to reduce taxable income or taxes payable in a prior
  year
• Carryforwards – Deductions or credits that cannot be
  used on the tax return during a year that may be carried
  forward to reduce taxable income or taxes payable in a
  future year


14                  November 17, 2006
Inside vs. Outside Basis

      Inside Basis          Parent



     Outside Basis



     Inside Basis         Subsidiary


15                   November 17, 2006
Liability Method Basic Principles
• Focus: Balance sheet
• Objective: Measure taxes payable/refundable based on difference
  between book basis and tax basis of assets and liabilities
     Deferred tax assets are recognized subject to valuation allowance considerations

• A current tax liability or asset is recognized for the estimated taxes
  payable or refundable on tax returns for the current year.
• A deferred tax liability or asset is recognized for the estimated future
  tax effects attributable to temporary differences and carryforwards.




16                          November 17, 2006
Temporary Differences Summary
                 Asset            Liabilities   Tax Carry-
                                                 forwards
Deferred Tax
  Benefit/     Tax Basis >       Tax Basis <
   (DTA)                                          Only
               Book Basis        Book Basis

Deferred Tax
 Expense/      Tax Basis <       Tax Basis >
   (DTL)       Book Basis        Book Basis


17                  November 17, 2006
How DTAs Arise
• Expenses currently recognized for book purposes but
  not for tax purposes
• Revenues currently recognized for tax purposes but not
  for book purposes


 FUTURE                         Book          Taxable
 (as items reverse)             Income    >   Income

18                    November 17, 2006
Examples of DTAs
• Expense items
     Allowance for bad debts
     Compensation accruals (vacation, bonus, commission)
     Contingency reserve accruals (legal, environmental)

• Revenue items
     Advance receipts for goods (revenue deferred for book but not tax)

• Tax carryforward items
     Foreign tax credits in worldwide taxation regimes that allow credits for
     foreign taxes paid
     Net operating losses

19                         November 17, 2006
How DTLs Arise
• Expenses currently recognized for tax purposes but not
  for book purposes
• Revenues currently recognized for book purposes but
  not for tax purposes


 FUTURE                         Taxable       Book
 (as items reverse)             Income    >   Income

20                    November 17, 2006
Examples of DTLs
• Expense items
     Fixed assets (tax depreciation > book depreciation)
     Intangible assets (tax goodwill amortization > book goodwill
     impairment)

• Revenue items
     Installment sale receivable (revenue deferred for tax but not book)
     Completed contract tax accounting method




21                      November 17, 2006
Liability Method Basic Principles:
Measurement

• Measurement of current and deferred tax liabilities and
  assets is based on provisions of enacted tax law;
  effects of future changes in tax laws or rates are not
  anticipated
• Measurement of DTAs is reduced by the amount of any
  tax benefits that are not expected to be realized (i.e., a
  valuation allowance)


22                  November 17, 2006
Measurement of DTAs and DTLs
 1. Identify types and amounts of cumulative temporary differences and
                            carryforwards.



                                              3. Measure total deferred tax
                                            asset for deductible temporary
     2. Measure total deferred tax        differences and loss carryforwards
     liability for taxable temporary      using applicable enacted tax rate,
      differences using applicable            plus tax credit carryforwards.
             enacted tax rate.


 4. Reduce the deferred tax asset by a valuation allowance if, based on
    the weight of available evidence, it is more likely than not that some
         portion or all of the deferred tax asset will not be realized.
23                          November 17, 2006
Computation of Tax Expense
• Current tax expense/ benefit =
      Current tax levy (generally, includes changes in liabilities for tax exposure
      items)
• Deferred tax expense/benefit =
     Net change in deferred tax liabilities and assets (adjusted for special items)
• Total tax expense =
      Current tax expense + deferred tax expense
• Consider other items
     Prior-year provision-to-return reconciliation items (both permanent and
     temporary)
     Previously unrecognized benefits of NOL carryforwards or other DTAs
     (adjustments to valuation allowance)
24                           November 17, 2006
Why Bother With Deferred Taxes?
• Matching of tax expense with economic income earned
  by the entity
• When an “event” is recognized in the financial
  statements, the eventual tax consequences of the
  “event” should also be recognized (i.e., “match” the tax
  to the same financial statement period that includes the
  gain or loss).
• Economic results are the focus, not the timing of tax
  payments.
25                  November 17, 2006
Deferred Taxes Exercise:
“With and Without” Example

• Company earns $100 of interest income in both Year 1
  and Year 2.
• Company sells a product in Year 1 and recognizes $100
  of book income.
• Due to their tax method of accounting, the $100 gain on
  the sale will be taxable in Year 2.

26                 November 17, 2006
Computation of Tax Expense Without
Deferred Taxes
                                              Year 1   Year 2
           Pre-Tax Book Income                 $200     $100
     +/-   Permanent Differences                   0        0
     +/-   Temporary Differences               (100)      100
      =    Taxable Income                      $100     $200
      X    Tax Rate                             35%      35%
      =    Current Tax Expense                 $ 35     $ 70
      +    Deferred Tax Expense                    0        0
      =    Total Tax Expense                   $ 35     $ 70

           ETR                                17.5%    70.0%

27                        November 17, 2006
Computation of Tax Expense With
Deferred Taxes
                                              Year 1   Year 2
           Pre-Tax Book Income                 $200     $100
     +/-   Permanent Differences                   0        0
     +/-   Temporary Differences               (100)      100
      =    Taxable Income                      $100     $200
      X    Tax Rate                             35%      35%
      =    Current Tax Expense                 $ 35     $ 70
      +    Deferred Tax Expense                   35     (35)
      =    Total Tax Expense                   $ 70     $ 35

           ETR                                 35%       35%

28                        November 17, 2006
 Exceptions to Providing Deferred Taxes
 Under FAS 109

• APB 23, permanent reinvestment exception
• Temporary differences related to deposits in statutory reserve
  funds by U.S. Steamship enterprises
• Leveraged leases
• Goodwill (or portion) not deductible for tax purposes
• ARB 51, intercompany transactions
• Foreign currency translation adjustments
29                     November 17, 2006
Agenda
• Basics of the Liability Method
• FAS 109 SALT Considerations
• Preparing a Tax Provision
• Valuation Allowances
• Interim Reporting
• Purchase Accounting
• Stock Compensation
• APB 23
• Reconciliation and Remediation
30                     November 17, 2006
FAS 109 Applied to State & Local Taxes
(SALT)
• FAS 109 applies at the entity level
• This approach considers the impact of SALT, net of federal
  benefit
• Multistate companies must apportion taxable income
• Generally, apportionment is based upon three factors:
     Property
     Payroll
     Sales receipts
31                     November 17, 2006
SALT Effective Tax Rate (ETR) – Example
     SALT Jurisdictions   Apportioned         Tax Rate       Tax
                            Income
A (separate co. 1)          $7,000             7%           $490
A (separate co. 2)          $6,000             7%           $420
B (unitary)                $12,000             9%          $1,080
C (combined)               $10,000             8%           $800
Total SALT                                                 $2,790
Total Pre-Tax Income       $35,000       SALT ETR           7.97%
                                         (before federal
                                         benefit)

32                        November 17, 2006
FAS 109 – SALT Deferred Taxes
• If DTAs or DTLs for a particular SALT jurisdiction are significant,
  FAS 109 requires a separate deferred tax computation
• If state/local taxes are based on U.S. federal taxable income,
  aggregate computations of DTAs and DTLs for at least some of
  those SALT jurisdictions might be acceptable
     In assessing whether an aggregate calculation is appropriate, consider
     matters such as differences in tax law between jurisdictions
       • Tax rates
       • Loss carryback and carryforward periods




33                         November 17, 2006
SALT ETR on Deferred Taxes
• FAS 109 does not specifically address the
  apportionment of income for future years when
  temporary differences will reverse
• One approach would be to estimate future allocations to
  state based on historical relationships
     Adjusted for known changes, and
     Absent evidence to the contrary




34
Franchise Taxes
• Taxes based on income
     Reported in the period that income is earned

• Franchise taxes based on net capital
     Generally recognized in the period the entity has the privilege to
     operate in the jurisdiction




35
Agenda
• Basics of the Liability Method
• FAS 109 SALT Considerations
• Preparing a Tax Provision
• Valuation Allowances
• Interim Reporting
• Purchase Accounting
• Stock Compensation
• APB 23
• Reconciliation and Remediation
36                     November 17, 2006
Tax Provision Process
1.   Adjust pretax income for permanent differences
2.   Identify cumulative temporary differences and
     carryforwards and determine effect on current taxable
     income
3.   Calculate the current income tax expense or benefit
4.   Determine changes to liabilities for tax exposure items
5.   Compute the current taxes payable balance


37                    November 17, 2006
Tax Provision Process (continued)
6.   Measure DTAs and DTLs with applicable enacted tax
     rate
7.   Evaluate the need for a valuation allowance
8.   Calculate the deferred income tax expense or benefit
9.   Record income tax-related journal entries
10. Prepare the financial statements and disclosures


38                 November 17, 2006
Tax Provision Process: Steps 1 – 3 (Example)
     Pre-Tax Income                                  $1,000
     Permanent Differences
          M&E                                          310
     Temporary Differences
          Litigation Accrual                  30
          Inventory Reserve                   10
          Depreciation                       (100)
     Total Temporary Differences                        (60)
     Taxable Income                                  $1,250
     Statutory Tax Rate                              x .40
     Current Tax Expense (Benefit)                    $ 500

39                             November 17, 2006
Tax Provision Process: Steps 4 – 5
• Compute the current taxes payable balance by performing
  the following:
     Agree the beginning balance to the prior year’s working papers and the
     ending balance to the company’s GL
     Add the current-year tax provision to the beginning balance
     Adjust balance for tax payments made and refunds received
     Reflect accrual-to-return adjustments (if any)
     Include liability accruals for tax exposure items
     Include other amounts affecting the taxes payable account (e.g., stock
     options and purchase accounting)



40                       November 17, 2006
Tax Provision Process: Steps 6 – 7
Recognize Deferred Tax Assets and Liabilities
(assume no valuation allowance is necessary)
DEDUCTIBLE (TAXABLE)                         Cumulative    Current Year   Cumulative     Deferred Tax
                                             Temporary     Differences    Temporary     Asset/(Liability)
TEMPORARY DIFFERENCES:                       Differences                  Differences     @ 40.00%
                                                 BOY                          EOY
Current Temporary Differences:
Litigation Accrual                             20,000        30,000         50,000           20,000
Inventory Reserve                                 -          10,000         10,000           4,000
Subtotal Current Temporary Differences         20,000        40,000         60,000           24,000
Noncurrent Temporary Differences:
Accumulated Depreciation                      (50,000)      (100,000)      (150,000)        (60,000)
Subtotal Noncurrent Temporary Differences     (50,000)      (100,000)      (150,000)        (60,000)
Total Temporary Differences                   (30,000)       (60,000)      (90,000)         (36,000)
Applicable Tax Rate                            40.00%        40.00%         40.00%
Deferred Tax Asset (Liability)                (12,000)       (24,000)      (36,000)

41                                       November 17, 2006
Tax Provision Process: Step 8
Calculate Deferred Income Tax Expense or Benefit
DEDUCTIBLE (TAXABLE)                        Cumulative    Current Year   Cumulative     Deferred Tax
                                            Temporary     Differences    Temporary     Asset/(Liability)
TEMPORARY DIFFERENCES:                      Differences                  Differences     @ 40.00%
                                                BOY                          EOY
Current Temporary Differences:
(A) Litigation Accrual                        20,000        30,000         50,000           20,000
(B) Inventory Reserve                            -          10,000         10,000           4,000
Subtotal Current Temporary Differences        20,000        40,000         60,000           24,000
Noncurrent Temporary Differences:
(C) Accumulated Depreciation                 (50,000)      (100,000)      (150,000)        (60,000)
Subtotal Noncurrent Temporary Differences    (50,000)      (100,000)      (150,000)        (60,000)
Total Temporary Differences                  (30,000)       (60,000)       (90,000)        (36,000)
Applicable Tax Rate                           40.00%         40.00%         40.00%
Total Deferred Asset (Liability)             (12,000)       (24,000)       (36,000)
EOY Deferred Tax Asset (Liability)           (36,000)
BOY Deferred Tax Asset (Liability)           (12,000)
Deferred Tax Expense / (Benefit)              24,000


42                                      November 17, 2006
Tax Provision Process: Step 9
Illustrative Journal Entries –
• FAS 109 introduced a balance sheet or liability
  approach to accrue for income taxes. The following
  journal entries are intended to illustrate a basic
  methodology for recording for income taxes.
     In most cases, US GAAP requires a more complex accounting for
     income taxes than reflected in these simple illustrations




43
Tax Provision Process: Step 9 (continued)
Recording a current tax liability
     Income Tax Expense               xx (Dr.)
         Current Income Tax Payable          xx (Cr.)


Recording a deferred tax liability
     Income Tax Expense               xx (Dr.)
         Deferred Tax Liability              xx (Cr.)
44
Tax Provision Process: Step 9 (continued)
Recording a deferred tax asset
     Deferred Tax Asset                 xx (Dr.)
         Income Tax Expense/(Benefit)           xx (Cr.)


Recording a liability for a tax exposure item
     Income Tax Expense                 xx (Dr.)
         Current/Noncurrent liability           xx (Cr.)

45
Tax Provision Process: Step 10
• Required Disclosures
     FAS 109
     SEC

• Current Taxes
• Deferred Taxes
     Valuation Allowance

• APB 23
• Tax Rate Reconciliation


46                         November 17, 2006
Agenda
• Basics of the Liability Method
• FAS 109 SALT Considerations
• Preparing a Tax Provision
• Valuation Allowances
• Interim Reporting
• Purchase Accounting
• Stock Compensation
• APB 23
• Reconciliation and Remediation
47                     November 17, 2006
Overview
• Deferred tax assets represent future tax deductions (or
  tax carryforwards/tax credits) whose realizability is
  dependent upon future taxable income
     Appropriate character (i.e., capital vs. ordinary)
     Evaluate separately for each “taxpaying component” (i.e., legal
     entity or group of entities that consolidate for tax purposes in a
     given tax jurisdiction)
     Evaluation regarding realizability of deferred tax assets is made on
     a gross as opposed to a net basis



48                      November 17, 2006
Overview (continued)
• A deferred tax asset must be reduced by a valuation
  allowance if, based upon the weight of available evidence, it is
  MORE LIKELY THAN NOT (i.e., likelihood of more than 50%)
  that some portion, or all, of the DTA will not be realized
• Valuation allowances do not deal with existence of the asset;
  instead they address the realizability of an asset
• All available evidence, both positive and negative, should be
  considered


49                    November 17, 2006
Overview (continued)
• Companies with deferred tax assets should carefully
  consider whether a valuation allowance is necessary
• Assessing the need for, and the amount of, a valuation
  allowance for DTAs requires significant judgment




50                 November 17, 2006
Illustrative Journal Entries
Recording a Deferred Tax Asset
     Deferred Tax Asset                 xx (Dr.)
         Income Tax Expense/(Benefit)          xx (Cr.)


Recording a Valuation Allowance
     Income Tax Expense                 xx (Dr.)
         Valuation Allowance                   xx (Cr.)
51
Negative Evidence
• It is more difficult to conclude a valuation allowance is
  not needed if negative evidence exists:
     Cumulative losses in recent years
     Carryforwards expire unused
     Expected losses in near-term
     Contingencies with material adverse long-term effect
     Brief carryforward/carryback periods




52                     November 17, 2006
Positive Evidence
• Positive evidence can outweigh negative evidence
     Contracts/backlog
     Appreciated assets
     Strong earnings exclusive of specific event

• Refers to the existence of one or more of the four
  sources of taxable income




53                      November 17, 2006
Four Sources of Taxable Income
• FAS 109 identifies four sources of taxable income that may
  be available to realize a tax benefit for deductible temporary
  difference and carryforwards (listed in order of the least
  subjective to the most subjective)
     Taxable income in carryback period if carryback permitted under the tax
     law
     Future reversals of existing taxable temporary differences
     Prudent and feasible tax planning strategies
     Future taxable income exclusive of reversing temporary differences and
     carryforwards


54                       November 17, 2006
Four Sources of Taxable Income (continued)
• If a single source of taxable income is sufficient to eliminate the need
  for a valuation allowance, then other sources do not need to be
  considered
• However, if a valuation allowance is necessary, it is mandatory to
  consider each source of taxable income to determine the amount of
  the valuation allowance
• By considering the four sources of taxable income in order of the least
  subjective to the most subjective, assumptions about the future will be
  necessary only if the more objectively determinable sources of taxable
  income are inadequate to support the realizability of the deferred tax
  asset

55                       November 17, 2006
Source 1: Taxable Income in Carryback Period
• Consider appropriate character, or nature, of the taxable
  income in the carryback period
     Ordinary income vs. capital gains or losses

• Evaluate carryback potential by jurisdiction
     Consider specific carryback rules
     Take into account changing state apportionment factors




56                      November 17, 2006
Source 2: Future Reversal of Existing
Taxable Temporary Differences

• Offset of gross deferred tax assets against gross
  deferred tax liabilities
     Match DTAs and DTLs by jurisdiction

• Detailed scheduling of the reversals of existing
  temporary differences is not required
     May be necessary in certain circumstances



57                     November 17, 2006
Source 2: Future Reversal of Existing
Taxable Temporary Differences (continued)

• Issues resulting from reversal patterns
     Indefinite-lived assets
     Market value adjustments of FAS 115 securities
     Minimum pension liabilities
     LIFO reserves

• Changes in tax laws or rate


58                     November 17, 2006
Source 3: Tax Planning Strategies
• Strategy is prudent and feasible
     If not prudent, management probably would not undertake
     If action is not considered feasible, management would not have the ability
     to implement
     Implementation of the strategy must be primarily within the control of
     management
     Management must have the ability to implement the strategy and expect to
     do so unless the need is eliminated in future years

• Action management ordinarily might not take, but would take if
  necessary
• Would result in the realization of deferred tax assets
59                        November 17, 2006
Source 3: Tax Planning Strategies
(continued)

• Tax planning strategies are actions that could
     Accelerate taxable amounts to use expiring carryforwards
     Change the character of taxable or deductible amounts from ordinary to capital

• Not optional—must be considered before a conclusion can be
  reached about the amount of a valuation allowance
     Must make reasonable effort to identify significant qualifying tax-planning
     strategies

• Consideration of significant expenses
     Reduce tax benefit by any significant expenses


60                          November 17, 2006
Tax Planning Strategies – Examples
• Sale-leaseback of operating assets
• Sale of appreciated assets—not key to future operations
• Pre-funding of pensions and other obligations
• Disposal of obsolete inventory
• Sale of loans at reported value
• Delaying discretionary expenses
• Timing maturity of deferred tax liabilities
• Changing filing methods for tax purposes
• Sale of appreciated marketable securities (FAS 115)
61                         November 17, 2006
Transactions That Do Not Qualify as Tax Planning
Strategies

• Sale of a money-losing subsidiary
• Cost reduction initiatives and similar plans
• Sale of essential operating assets
• Anticipating a change from taxable C corporation status to
  nontaxable S corporation status




62                     November 17, 2006
Tax Planning Strategies – Other Considerations
• Repatriation of subsidiary earnings- consistency with APB 23
  assertions
• Effect of AMT




63                    November 17, 2006
Source 4: Future Taxable Income Exclusive of
Reversal of Existing Temp. Differences and
Carryforwards

• Most subjective of the four sources
• Consideration of future originating differences and subsequent
  reversals is implicit in estimates of future taxable income
• Objective verification is mandated by FAS 109
     Generally projections are limited to relatively short periods
     Existence of negative evidence will affect the amount of evidence required




64                          November 17, 2006
Other Considerations
         Tax Benefit Substitution vs. Realization
                                            Book       Tax
 Yr 1: Loss from ops                        $(600)   $(600)
 Yr 2: Loss from ops                           -0-      -0-
 Yr 2: Temp Diff Increases TI                  n/a     250
 Yr 2: Partial Utilization of Yr 1 NOL         c/f    (250)
 Yr 2:Taxable Income                                    -0-

65                      November 17, 2006
Tax Benefit Substitution vs. Realization
Beg of Yr 1 Deductible Temp Differences       -0-
Year 1 Loss From Ops                         600
End of Yr 1 Deductible Temp Differences      600
Yr 2 Deductible Temp Diff – Deferred comp   250
Yr 2 Use of Yr 1 Loss from Ops              (250)
End of Yr 2 Deductible Temp Differences      600
Tax Benefit                                   -0-


66                   November 17, 2006
Agenda
• Basics of the Liability Method
• FAS 109 SALT Considerations
• Preparing a Tax Provision
• Valuation Allowances
• Interim Reporting
• Purchase Accounting
• Stock Compensation
• APB 23
• Reconciliation and Remediation
67                     November 17, 2006
Relevant Guidance: Interim Periods
• APB Opinion No 28, Interim Financial Reporting
     (As modified by FAS 109)
     Use the best estimate of the annual effective tax rate for the year to
     record taxes in the current period
     Do not include the tax related to “significant unusual or extraordinary
     items” in estimated annual effective tax rate (EAETR)
     FIN 18: “Accounting for Income Taxes at Interim Periods”
     Interpretation of APB 28
     Guidelines for specific circumstances and examples



68                       November 17, 2006
Estimating Annual Effective Tax Rate
• Estimate the annual effective tax rate by modifying the federal
  statutory tax rate by the following types of items:
     State and local statutory tax rate
     Foreign tax rates
     Permanent tax items (M&E, tax-exempt interest, etc.)
     Tax credits
     Projected deferred tax effects of year-end temporary differences
      • Include the tax effect of a valuation allowance expected to be necessary at
         end of year for deferred tax assets related to deductible temporary
         differences or carryforwards originating during the year




69                         November 17, 2006
Computing Income Tax Provisions in Interim
Periods

• Compute year-to-date income tax expense (benefit)
     Estimate annual effective tax rate
     Multiply EAETR by year-to-date ordinary income (loss) at end of
     the period
     Add tax expense (benefit) of discrete items and other exceptions
     to the general rules

• Compute interim income tax expense (benefit)
     Difference between year-to-date income taxes expense (benefit)
     and amounts reported for prior interim periods

70                     November 17, 2006
Example: Computing Income Tax
Provisions in Interim Periods
                                     Q1           Q2       Q3          Q4
Projected Income at Quarter     $ 4,000      $ 4,000    $ 4,000    $ 4,000
Projected Permanent Items            -         (200)       (200)      (200)
Tax at 40% Statutory Rate          1,600      1,520       1,520      1,520
EAETR                                40%          38%      38%         38%
Pre-Tax Income at Quarter          1,000      1,000        1,000     1,000


Year-to-Date Tax                    400           760      1,140     1,520
Interim Period Tax                  400           360        380       380
Current Quarter ETR                  40%          36%      38%         38%
Year-to-Date ETR                     40%          38%       38%        38%

71                            November 17, 2006
Companies Subject to Tax in Multiple
Jurisdictions
• One overall EAETR should be used, unless
     In a separate jurisdiction, a loss is anticipated for which a tax
     benefit cannot be realized
     Enterprise is unable to estimate annual effective rate in dollars in a
     foreign jurisdiction
     Otherwise enterprise is unable to make a reliable estimate of
     ordinary income (or loss) or of the related tax (or benefit) in a
     foreign jurisdiction




72                       November 17, 2006
Companies Subject to Tax in Multiple
Jurisdictions (continued)

• If exception applies, separately compute interim tax (benefit) for
  jurisdiction as it reports ordinary income (loss) for the period:
     Exclude both income (loss) and related tax expense (benefit) from calculation of
     EAETR
     Tax (benefit) related to income (loss) in a jurisdiction may include tax (benefit) in
     another jurisdiction that results from providing taxes on unremitted foreign
     earnings, foreign tax credits, etc.




73                           November 17, 2006
Example: Companies Subject to Tax in Multiple Jurisdictions
– Without Applying Exception
                            Est. Ord.
                             Income       EAETR   Est. Tax
     Jurisdiction 1          $ 2,500        30%    $ 750
     Jurisdiction 2            2,000        40%       800
     Jurisdiction 3           (1,000)       0%          0
         Group                $ 3,500     44.3%    $ 1,550


                           Q1 Actual      EAETR    Tax Q1
         Q1 – Group           $ 1,200     44.3%     $ 532

74                    November 17, 2006
Example: Companies Subject to Tax in Multiple Jurisdictions –
Exception Applied
                                Est. Ord. Income   EAETR   Est. Tax
     Jurisdiction 1                     $ 2,500     30%    $ 750
     Jurisdiction 2                       2,000     40%       800
                                        $ 4,500    34.4%   $ 1,550
     Jurisdiction 3                     (1,000)                  0
          Group                         $ 3,500            $ 1,500

                                      Q1 Actual    EAETR    Tax Q1
     Q1 – Jurisdictions 1&2             $ 1,600    34.4%    $ 550
     Q1 – Jurisdiction 3                  (400)                  0
          Q1 – Group                    $ 1,200             $ 550
          Q1 – ETR                       45.8%
75                            November 17, 2006
Losses in Current Periods
• Benefits of losses arising in the current year should be
  included in the EAETR computation if either one of the
  following applies:
     Benefit is expected to be realized during the current year
     Benefit is expected to be recognizable as deferred tax asset at end
     of the year




76                      November 17, 2006
Losses in Current Periods (continued)
• If YTD ordinary loss exceeds anticipated ordinary loss
  for the year, the benefit recognized for the YTD loss
  shall not exceed the amount of benefit that would be
  recognized if the YTD loss were the anticipated ordinary
  loss for the fiscal year




77                 November 17, 2006
Losses in Current Periods (continued)
• If tax effects of losses that arise early in the year are not
  recognized in that interim period:
     Recognize in later interim period if realization becomes more likely
     than not
     No tax provision shall be made for income that arises in later
     periods until tax effects of previous interim losses are utilized




78                      November 17, 2006
Discrete Items
• Tax (benefit) related to “ordinary” income shall be
  computed at the EAETR, and the tax (benefit) related to
  all other items shall be individually computed and
  recognized when the items occur. (FIN 18, Par. 6)
     Extraordinary items, gains or losses from disposal of a component
     of an entity, and unusual or infrequently occurring items shall not
     be prorated over the balance of the fiscal year




79                      November 17, 2006
Tax Uncertainties
• The projected tax effect of tax positions arising in the
  current year are reflected as a component of the annual
  effective tax rate
• Any adjustment or reversal of a prior-year tax
  contingency reserve should be recognized in full in the
  interim period in which the event causing the change in
  judgment occurs



80                  November 17, 2006
Changes in Tax Laws or Rates
• Effect on deferred tax balances
     Included in income in the interim period that includes the enactment date

• Effect on current-year taxes payable or receivable
     Reflected in the computation of the annual effective tax rate beginning as
     of the first interim period that includes the enactment date of new
     legislation

• Retroactive legislation
     Enactment date is the date the bill becomes law
     Prior interim periods should not be restated


81                        November 17, 2006
Changes in Valuation Allowance
• Benefit expected to be realized because of:
     Current year’s “ordinary” income
      • Effect of the change included in the EAETR
     Current year’s income other than “ordinary” income
      • Effect of the change included in the interim period that includes the other income
     Future year’s income
      • Effect of the change recognized as a discrete event as of the date of change in
         circumstances
     Both current and future years’ income
      • Effect of the change allocated between the interim period that includes the date of
         the change and inclusion in the EAETR

• Increase in a valuation allowance for assets recorded in a prior annual
  period is a discrete event
82                            November 17, 2006
Provision-to-Return True-Up
• Include as a discrete event in the interim period in which
  the adjustment is identified




83                  November 17, 2006
Agenda
• Basics of the Liability Method
• FAS 109 SALT Considerations
• Preparing a Tax Provision
• Valuation Allowances
• Interim Reporting
• Purchase Accounting
• Stock Compensation
• APB 23
• Reconciliation and Remediation
84                     November 17, 2006
Purchase Accounting Overview
• Deferred tax should be established on cumulative book/tax differences in
  opening balance sheet
• Opening balance sheet
      Assets/liabilities are established at fair values
      Excess of purchase price over identifiable fair values is goodwill
      Can include temporary differences for restructuring or other reserves that are not
      deductible until paid

• If tax basis of assets exceeds book basis, establish deferred tax asset
  with offset decreasing goodwill
• If book basis of assets exceeds tax basis, establish deferred tax liability
  with offset increasing goodwill
• Similar treatment for basis differences in liabilities
85                             November 17, 2006
Accounting for Business Combinations
• FAS 109, paragraph 30:
     Deferred tax asset or liability shall be recognized for the differences
     between the assigned values and tax bases of the assets and liabilities
     (except non-deductible goodwill, negative goodwill, leveraged leases,
     and acquired APB 23 differences) recognized in a purchase business
     combination

• FAS 141 – Business Combinations
• FAS 142 – Goodwill and Other Intangible Assets:
     Replaced book amortization of goodwill and indefinite-lived intangible
     assets with impairment reviews


86                        November 17, 2006
FAS 142: Impairment of Goodwill and Indefinite-
Lived Assets

• When the FMV of an asset is determined to be less than the
  book carrying value of the asset, a “write-down” is required by
  FAS 142
• An impairment loss also can be recognized when recovery of the
  book carrying value is not anticipated
• An impairment loss can be recognized for indefinite-lived
  identified intangible assets and goodwill


87                     November 17, 2006
Purchase Price Allocation
• Determination of Total Purchase Price:
     Cash paid
     Fair value of other consideration
     Fair value of liabilities assumed
     Transaction costs




88                      November 17, 2006
Purchase Price Allocation (continued)
• Purchase price assigned to assets and liabilities based
  upon estimated fair value:
     Can differ for book and tax purposes

• Goodwill arises when the purchase price exceeds
  assigned values of assets acquired minus liabilities
  assumed




89                     November 17, 2006
Tax Uncertainties
• FAS 109 – temporary differences
     Use best estimate of final tax basis allocation
     Subsequent adjustments generally affect goodwill

• EITF 93-7 – other tax uncertainties
     Same approach as FAS 109




90                     November 17, 2006
Non-Deductible Goodwill
• Non-deductible/amortizable tax goodwill
     Deferred tax is not recorded for book-tax basis difference in
     goodwill
     Exception to deferred tax reporting due to “gross up” effect
      • Deferred tax liability for goodwill would increase goodwill, which
         increases deferred tax liability, which increases goodwill
     Goodwill is viewed as “residual,” different from other identifiable
     intangibles for which deferred taxes should be established




91                      November 17, 2006
Tax-Deductible Goodwill
• Amortizable/tax-deductible goodwill
     Separate both the book and tax goodwill into two components
       • First component for each: lower of book goodwill or tax-deductible
          goodwill
       • Second component: remainder
     Recognize deferred tax on the difference in the first component in future
     as tax amortization creates a book-tax difference
     If tax basis of second component exceeds book, recognize tax benefit as
     realized and record first as a reduction to goodwill, then other non-current
     acquired intangibles, and if there is any excess, reduce tax expense



92                        November 17, 2006
Tax-Deductible Goodwill Example: Assumptions
• As of the combination date, the book basis and tax basis of
  goodwill are $600 and $800, respectively
• For tax purposes, amortization of goodwill will result in tax
  deductions of $400 in each of years 1 and 2
• Those deductions result in a current tax benefit in years 1
  and 2
• Goodwill has not been impaired for financial reporting
  purposes
• The tax rate is 40 percent for all years
93                     November 17, 2006
Goodwill Example: Components
At the combination date, goodwill is separated into two
components, as follows
                                           Book Basis     Tax Basis
First component (lesser of goodwill for
financial reporting
or tax-deductible goodwill)                      $600         $600
Second component (remainder)                        –         $200
Total goodwill                                   $600         $800


94                     November 17, 2006
Goodwill Example: Deferred Taxes
• Deferred tax liability is recognized at the end of each year
  for the excess of the reported amount over the tax basis of
  the first component of goodwill
• Deferred tax asset is not recognized for the second
  component of goodwill; the tax benefit is allocated to reduce
  goodwill when realized on the tax returns for years 1 and 2




95                   November 17, 2006
Goodwill Example: Tax Benefits
• The second component of goodwill results in a tax deduction of
  $100 per year in years 1 and 2
• Those tax deductions provide $40 of tax benefits realized in each
  of years 1 and 2
• Allocation of those realized tax benefits to reduce the first
  component of goodwill produces a deferred tax benefit by
  reducing the taxable temporary difference related to that
  component of goodwill



96                      November 17, 2006
Goodwill Example: Allocations
• Total tax benefit allocated to reduce first component of
  goodwill in each of years 1 and 2 is the sum of
     The realized $40 tax benefit allocated to reduce goodwill
     The deferred tax benefit from reducing the deferred tax liability
     related to goodwill




97                      November 17, 2006
Goodwill Example: Total Tax Benefit
Formula

              Total Tax Benefit (TTB) =

     Component 2 Tax Deduction x Tax Rate
               (1 - Tax Rate)



98                 November 17, 2006
Goodwill Example: Calculation of TTB
     TTB = realized tax benefit plus (tax rate times TTB)
     TTB = $40 + (.40 x TTB)
     TTB - .4 TTB = $40
     .6 TTB = $40
     TTB = $40 / .6
     TTB = $67



99                        November 17, 2006
Goodwill Example: Summary
                                    Year 1     Year 2
Book basis                              $533   $466
Tax basis (component 1)                 $300   $ –
Taxable temporary difference        $233       $466




100                 November 17, 2006
Negative Goodwill
• Generally, negative goodwill (excess of net fair value of net
  assets acquired over purchase price) is allocated to reduce the
  value of specified non-current assets, and residual (if any) is
  recorded as an extraordinary gain
• Reduction of book basis from negative goodwill creates
  temporary differences; any resulting deferred tax changes
  negative goodwill
• The calculation is iterative and requires simultaneous
  equation/gross-up to solve


101                    November 17, 2006
Future Tax Benefits
• Deferred tax assets:
      Consider §382 and SRLY limitations

• Valuation allowance adjustments resulting from the
  business combination
      Acquired company valuation allowance increased or decreased
       • Included as part of purchase accounting
      Acquiring company valuation allowance increased
       • Included in expense
      Acquiring company valuation allowance decreased
       • Included as part of purchase accounting

102                      November 17, 2006
Post-Acquisition Events – Impairment Loss
• Identifiable intangible asset or tax-deductible goodwill
      Reversal of existing taxable temporary difference
      Creation of deductible temporary difference
      Increase to existing deductible temporary difference

• Non-deductible goodwill
      Permanent difference

• Allocation may be required between tax-deductible and
  non-deductible goodwill

103                      November 17, 2006
Post-Acquisition Events – Reduction in
Valuation Allowance

• Benefits resulting from subsequent reductions in
  valuation allowances recorded in purchase accounting
  are applied in the following order:
      First reduce goodwill
      Then reduce other intangible assets
      Remainder reduces income tax expense




104                    November 17, 2006
Post-Acquisition Events – Reduction in
Valuation Allowance (continued)

• Benefits resulting from subsequent reductions in the
  acquiring company’s valuation allowance recorded
  prior to the business combination
      Reduction of income tax expense

• Pre- and post-acquisition benefits
      Tax law usually determines ordering
      If sequence cannot be determined, recognize tax benefit on
      proportionate basis

105                     November 17, 2006
Post-Acquisition Events –
Change in Tax Law or Rates

• Include adjustments in income from continuing
  operations for the period that includes the enactment
  date




106                 November 17, 2006
Post-Acquisition Events – Change in Liabilities for
Tax Exposure Items

• Decreases to liabilities for tax exposure items established in a
  purchase business combination are applied as follows
      First reduce to zero any goodwill related to the acquisition
      Then reduce to zero other non-current intangible assets related to the
      acquisition
      Lastly, reduce income tax expense
• Increases to acquired company income tax contingencies existing at
  the acquisition date are generally adjusted through goodwill
• Future interest accruals are included as a component of expense


107                          November 17, 2006
Agenda
• Basics of the Liability Method
• FAS 109 SALT Considerations
• Preparing a Tax Provision
• Valuation Allowances
• Interim Reporting
• Purchase Accounting
• Stock Compensation
• APB 23
• Reconciliation and Remediation
108                    November 17, 2006
Intrinsic Value Method – APB 25
• Compensation is measured as the intrinsic value on the
  measurement date
• Usually the intrinsic value on the measurement date is zero,
  so no compensation expense is recognized
• If the number of shares or exercise price is unknown on the
  grant date, the options are subject to variable accounting
      If, after the grant date, the number of shares or exercise price changes or
      the term is extended, a new measure of compensation is required and may
      result in variable accounting



109                        November 17, 2006
Fair Value Method – FAS 123(R)
• Provides the accounting guidance for share-based payments to
  employees (including employee stock purchase plans)
• Fair value of an equity award is estimated on the grant date
  without regard to service or performance conditions (“modified
  grant date”)
• Fair value is generally amortized as book compensation expense
  over the “requisite service period” for all awards that vest (i.e.,
  over the period during which an employee is required to provide
  services in exchange for the award)


110                    November 17, 2006
Overview of Tax Treatment
• Statutory stock options, e.g., incentive stock options,
  generally do not yield a tax deduction
      Deduction in the case of a disqualifying disposition if employee
      sells stock within one year of the date of exercise or two years of
      the date of grant
       • Tax deduction equal to fair market value of the option less
         exercise price

• Nonqualified stock options will generally result in tax
  deduction equal to fair market value of the option less
  exercise price
111                      November 17, 2006
Recording of Tax Effects
• Under FAS 123(R) or intrinsic value method, tax effects
  of stock-based awards are recognized for book
  purposes only for awards that normally result in a tax
  deduction
      Nonqualified stock options
      Nonvested stock (e.g., restricted stock units)
      Tax deduction equal to intrinsic value when option is exercised or
      when shares vest

• Consider tax rules in foreign jurisdictions

112                      November 17, 2006
FAS 123(R) – Estimating Forfeitures
• Compensation cost is not recognized for awards that do not
  vest because service or performance conditions are not
  satisfied
      Employer must estimate forfeitures resulting from the failure to satisfy
      service or performance conditions when determining compensation cost
      Employer must reconsider its estimate of forfeitures at the end of each
      reporting period and adjust as appropriate
      Changes in estimated forfeitures are recognized through a cumulative
      catch-up adjustment in the period of change




113                        November 17, 2006
FAS 123(R) Income Tax Considerations
• No change in U.S. income tax treatment
      Tax deduction is generally realized when the option is exercised,
      stock is received, and the employee recognizes income

• Book-tax difference results from GAAP compensation
  expense
      Timing of compensation: over service period vs. upon exercise of
      option (temporary differences)
      Amount of compensation: fair value of option vs. intrinsic value
      measured at exercise date (permanent differences)


114                      November 17, 2006
FAS 123(R) – Calculating Deferred Taxes
• Calculating deferred taxes for deductible awards
      Recognized compensation cost for awards that will result in a tax
      deduction multiplied by entity’s statutory tax rate
       • Deductible temporary difference
      Estimate of forfeitures are included indirectly as they affect the
      total recognized compensation cost




115                      November 17, 2006
Example 1
• Assume:
      10,000 nonqualified options with four-year cliff vesting
      Estimate that 8,000 options will ultimately vest
      Market price of shares and strike price of options – $20
      Fair value of options – $6
      Statutory tax rate 40 percent




116                      November 17, 2006
Example 1 (continued)
• Annual compensation cost:
       ($6 x 8,000 shares) ÷ 4 years = $12,000



• Annual deferred tax benefit:
      $12,000 x 40% = $4,800




117                   November 17, 2006
Example 1 (continued)
• Annual journal entries
      Compensation cost (P&L)             $12,000
         Additional paid-in capital                 $12,000

      Deferred tax asset                  $ 4,800
          Deferred income tax benefit (P&L)       $ 4,800




118                        November 17, 2006
Valuation Allowance Considerations
• Valuation allowance on deferred tax assets
      Record a valuation allowance if it is more likely than not that some
      portion of the DTA will not be realized
      Consider whether future taxable income will be sufficient to realize
      the DTA
      Changes in the intrinsic value of the award are not considered
      when determining if a valuation allowance is required




119                      November 17, 2006
Realization of Tax Benefits
• Tax deduction when options are exercised
      If tax deduction is greater than recognized compensation cost
        • Excess tax benefit recorded as increase to additional paid-in
          capital (APIC)
        • Only record excess tax benefit if it is realized
            When the benefit reduces current taxes payable
            If company has an NOL that is increased by the deduction, the benefit is
            not realized and the excess tax benefit is not recorded in APIC (but must
            be tracked offline for later potential realization/recognition)
      Under APB 25, excess tax benefit was also recorded as increase
      to APIC

120                        November 17, 2006
Realization of Tax Benefits (continued)
• Tax deduction when options are exercised
      If tax deduction is less than recognized compensation cost
        • Deficiency is recorded against any credits in APIC resulting
          from excess tax benefits (“APIC Pool”)
        • Remaining deficiency recognized in the income statement
        • If options expire unexercised, no tax deduction
            Must write off DTA as if exercised (i.e., against any credits in
            APIC, if available; if none available, recognize in the income
            statement)




121                       November 17, 2006
Example 2
• Assume
      Options granted in previous example are fully vested
      4,000 options exercised when market price is $28 and the
      deduction is realized, which reduces taxes payable

• Tax benefit
      Tax deduction       $32,000 = ($28 - $20) x 4,000 options
      Tax benefit         $12,800 = $32,000 x 40%
      Deferred tax asset $9,600 = (4,000 x $6) x 40%
      Tax benefit exceeds recorded deferred tax asset by $3,200, or
      $12,800 - $9,600
122                     November 17, 2006
Example 2 (continued)
• Reverse DTA:
      Deferred income tax expense (P&L)     $ 9,600
        Deferred tax asset                                  $ 9,600

• Record current income tax benefit:
      Current income taxes payable          $12,800
        Current income tax benefit (P&L)                    $ 9,600
        Additional paid-in capital                          $ 3,200

                                                      Excess Tax
                                                        Benefit


123                     November 17, 2006
Example 2 (continued)
• Assume:
      4,000 options exercised when market price is $24 and the
      deduction is realized, which reduces taxes payable
      There is a credit of $2,800 in APIC relating to previously
      recognized excess tax benefit

• Tax benefit:
      Tax deduction:      $16,000 = ($24 - $20) x 4,000 options
      Tax benefit:        $6,400 = $16,000 x 40%
      Deferred tax asset:   $9,600 = (4,000 x $6) x 40%
      Recorded deferred tax asset exceeds tax deduction by $3,200
      ($9,600 - $6,400)
124                      November 17, 2006
Example 2 (continued)                                Excess tax benefit
                                                        previously
• Reverse DTA                                        recorded to APIC

      Current income taxes payable          $6,400
      Additional paid-in capital            $3,200
      Deferred income tax expense (P&L)     $6,400

       • Current income tax benefit (P&L)                   $6,400
       • Deferred tax asset                                 $9,600




125                     November 17, 2006
Pool of Excess Tax Benefits
• Pool of Excess Tax Benefits available to offset tax
  deficiencies includes:
      Excess tax benefits generated from awards within the scope of
      Statement 123(R), plus
      Excess tax benefits for awards based on:
       • The requirements of Statement 123 [per FAS 123(R),
         paragraph 81] or
       • The elective alternative transition method to determining the
         pool [per FSP FAS 123(R)–3] for the period from the effective
         date of Statement 123 to the adoption of FAS 123(R)


126                     November 17, 2006
Non-Tax-Deductible Awards
• Tax effect of awards that normally do not result in a tax
  deduction (e.g., ISOs, ESPPs)
      Do not create deductible temporary differences
      Tax deduction may result from a future event
       • Disqualifying disposition
            Sell shares during the required holding period




127                        November 17, 2006
Disqualifying Disposition of
ESPPs/ISOs
• Accounting for a disqualifying disposition
      Do not estimate disqualifying dispositions
      Account for in the period the disposition occurs
      Recognize tax benefit – the lesser of
       • Actual benefit of the tax deduction
       • Cumulative recognized compensation cost x Company’s
         statutory tax rate




128                    November 17, 2006
FAS 123(R) Complexities
• Method of adoption
      Modified prospective
      Modified retrospective

• Determination of actual cash tax benefit realized
      Interaction with NOLs

• Calculation of APIC pool



129                      November 17, 2006
Agenda
• Basics of the Liability Method
• FAS 109 SALT Considerations
• Preparing a Tax Provision
• Valuation Allowances
• Interim Reporting
• Purchase Accounting
• Stock Compensation
• APB 23
• Reconciliation and Remediation
130                    November 17, 2006
Inside vs. Outside Basis
       Inside Basis          Parent



      Outside Basis



      Inside Basis         Subsidiary



131                   November 17, 2006
Undistributed Earnings Temporary Differences

• Temporary difference results from undistributed
  earnings of a subsidiary included in the pretax
  accounting income of the parent, either through
  consolidation or equity method of accounting
• General presumption for a domestic subsidiary is that
  deferred tax liability should be recorded unless tax law
  provides a means by which investment can be
  recovered tax-free


132                 November 17, 2006
FAS 109, ¶31(b) Exception
• A deferred tax liability is not recognized for the following
  types of temporary differences unless it becomes
  apparent that those temporary differences will reverse in
  the foreseeable future
      Undistributed earnings of a domestic subsidiary or a domestic
      corporate joint venture that is essentially permanent in duration
      that arose in fiscal years beginning on or before December 15,
      1992




133                      November 17, 2006
Foreign Subsidiaries
• Domestic subsidiaries and foreign subsidiaries are
  treated differently
• FAS 109 retained the APB 23 exception for foreign
  subsidiaries
      APB 23 reinvestment exception available for all foreign
      subsidiaries and foreign corporate joint ventures
      APB 23 reinvestment exception only available for domestic
      subsidiaries and domestic corporate joint ventures for
      undistributed earnings prior to December 15, 1992 (and
      permanently reinvested)

134                     November 17, 2006
APB 23 – Where Does It Fit In?
• U.S. Parent (USP) computes deferred taxes on book-tax
  basis differences (inside-basis differences)
• Controlled foreign corporation (CFC) computes deferred
  taxes in much the same manner as USP (US GAAP
  book v. relevant tax basis)
• USP also must compute deferred taxes on outside basis
  in CFC shares:
      This is where APB 23 applies.


135                     November 17, 2006
APB 23 Exception
• FAS 109 retained exception contained in APB 23
• A deferred tax liability is not recognized for the following
  types of temporary differences unless it becomes
  apparent that those differences will reverse in the
  foreseeable future:
      An excess of the amount for financial reporting over the tax basis
      of an investment in a foreign subsidiary or a foreign corporate joint
      venture… that is essentially permanent in duration



136                      November 17, 2006
APB 23 Exception for Foreign Subsidiaries
• Flexibility of APB 23:
      Year by year
      Sub by sub
      Dollar by dollar

• As circumstances change, an increase and decrease in
  required deferred tax liabilities for repatriation taxes are
  recorded directly to the income statement



137                      November 17, 2006
Domestic vs. Foreign
• A determination of whether an entity is a domestic or
  foreign subsidiary is made under a bottom-up approach
  based on the entity’s immediate parent company.




138                November 17, 2006
Domestic vs. Foreign Example
• U.S. Parent (USP) is a U.S. corporation
• Foreign Holdco (FHC) is incorporated in Country A, and is 100%
  owned by USP
• Foreign sub (FSA) is also incorporated in Country A, and is 100%
  owned by FHC
• Foreign sub (FSB) is incorporated in Country B, and is also 100%
  owned by FHC
• Both FSA and FSB plan to reinvest their earnings for the indefinite
  future
• Dividends paid by FSA and FSB are fully taxable in Country A
139                      November 17, 2006
APB 23 – Domestic vs. Foreign Example
(continued)


• Is FHC required to recognize a deferred tax liability for
  the undistributed earnings of its subsidiaries?




140                 November 17, 2006
Domestic vs. Foreign Example (continued)
• FHC’s investment in FSB is “foreign” and will not trigger a
  deferred tax liability as long as FHC’s investment in FSB is,
  essentially, permanent in duration (FAS 109, ¶31a)
• FHC’s investment in FSA is “domestic,” not foreign; FHC
  might be required to provide a deferred tax liability on
  undistributed earnings after 12/15/1992, unless the
  investment will be realized in a tax-free manner (FAS 109,
  ¶32a, 33)



141                  November 17, 2006
Domestic vs. Foreign
                                           USP

                                                        1

                                           Swiss
                            2                               1
                            `

                                   Swiss           UK

1. Foreign Subsidiary – Eligible for APB 23                     2
   Exception
                                                   UK
2. Domestic Subsidiary – The APB 23
   Exception is not available

142                             November 17, 2006
APB 23 Disclosure
• FAS 109 ¶44 establishes that the following information shall
  be disclosed whenever a deferred tax liability is not
  recognized
      Description of the types of temporary differences for which a deferred tax
      liability has not been recognized and the types of events that would
      cause those temporary differences to become taxable
      Cumulative amount of each type of temporary difference
      Amount of the unrecognized deferred tax liability for temporary
      differences related to investments in foreign subsidiaries or a statement
      that determination is not practicable



143                        November 17, 2006
APB 23: Sample Disclosure
• Deferred taxes have not been provided on the excess book basis
  in the shares of certain foreign subsidiaries in the amount of $xxx
  because these basis differences are not expected to reverse in
  the foreseeable future. These basis differences could reverse
  through a sale of the subsidiaries, the receipt of dividends from
  the subsidiaries, as well as various other events.
• It is not practical to calculate the residual income tax that would
  result if these basis differences reversed due to the complexities
  of the tax law and the hypothetical nature of the calculations.


144                    November 17, 2006
Foreign Equity Method Investees and
Corporate Joint Ventures

• The APB 23 exception for foreign subsidiaries and
  foreign corporate joint ventures does not apply to 50%-
  or-less-owned investees that are not corporate joint
  ventures, as defined by APB 18




145                 November 17, 2006
Foreign Equity Method Investees
and Corporate Joint Ventures (continued)

• Companies are required to provide deferred taxes for
  temporary differences related to foreign investments
  accounted for by using the equity method (other than
  foreign subsidiaries or corporate joint ventures)
      Investor does not have the ability to control the investee in such a
      manner as to conclude that the undistributed earnings will be
      invested indefinitely, rather than be remitted in the form of
      dividends.


146                      November 17, 2006
Can a deferred tax asset be recognized for outside basis
differences?




147                 November 17, 2006
Deferred Tax Assets on Outside Basis Differences
• FAS 109, ¶34 prohibits recognition of a deferred tax asset for an
  investment in a subsidiary or corporate joint venture unless it is
  apparent the temporary difference will reverse in the foreseeable
  future
• Because the tax attributes of partnerships and other flow-through
  entities are taxed at the investor/partner level, FAS 109, ¶34
  probably does not apply




148                    November 17, 2006
Agenda
• Basics of the Liability Method
• FAS 109 SALT Considerations
• Preparing a Tax Provision
• Valuation Allowances
• Interim Reporting
• Purchase Accounting
• Stock Compensation
• APB 23
• Reconciliation and Remediation
149                    November 17, 2006
           Top 12 Reconciliation Issues
1. Provisions are not “trued-up” properly (deferred and current)
2. Accounts payable balance contains hidden contingencies
3. Tax provisions related to “topside” adjustments are not pushed
   down
4. Currency translation adjustment (CTA) is not computed
5. Purchase accounting, restructuring reserves, intercompany profit
   elimination, etc.
6. Multi-ledger accounting – where are the non-U.S. deferred balances
   recorded?

150                     November 17, 2006
       Top 12 Reconciliation Issues (continued)
 7.   Missed book/tax differences, changes in local tax rules not
      identified
 8.   U.S. GAAP-to-statutory differences treated as “permanent,”
      other miscategorization of book/tax differences
 9.   Carryforwards, NOLs, etc., are not based on updated amounts
 10. Valuation allowances – partial or full?
 11. Business unit vs. legal entity reporting not reconciled
 12. Liability for income tax exposure items – no controls on
     identification and recording


151                     November 17, 2006
Unreconciled account balances
• Company cannot meet basic FAS 109 objectives:
      Recognition of amount of taxes payable or refundable for the
      current year
      Recognition of deferred tax assets and liabilities for the future tax
      consequences of events that have been recognized in an
      enterprise’s financial statements or tax returns




152                       November 17, 2006
 FAS 109
 Reconciliation Issue                     Implication
• Failure to maintain tax basis         • Unable to validate/reconcile
  balance sheets                          book/tax differences – both
                                          domestic and foreign

• Purchase accounting                   • Tax provision errors
• Consolidations/Push downs
                                        • Inconsistent and erroneous
                                          accounting results and support
• Provision to return true-up           • Restatement



153                        November 17, 2006
 What Happened                                Implication
• Lack of roles, responsibilities,      • Errors in judgment remained
  policies, procedures, oversight         undetected
• Judgments re: valuation
  allowances and contingencies          • Failure to apply appropriate rules
• Lack of tax accounting and
  technical knowledge
                                        • Widespread calculation errors
• Lack of timely, effective,
  documented reviews


154                       November 17, 2006
 What Happened                               Implication

• Failure to link foreign tax knowledge   • Errors in foreign tax accounting and
  with US GAAP knowledge                    foreign deferred tax balances

• Poor communications                     • Missing, erroneous, late or unusable
                                            information
• Lack of respect for tax’s information
  needs




155                          November 17, 2006
 What Happened                               Implication

                                          • Inadequate documentation
• IT reporting systems                    • Incorrect journal entries
                                          • Inefficient use of tax accounting
• Erroneous data inputs
                                            data
• Poor ERP system interface               • Undetected errors in re-keyed
                                            data
                                          • Reporting not consistent with
                                            underlying data


156                           November 17, 2006
What Happened                         Implication

                                   • Haphazard calculations
• No tax provision software
                                   • Inconsistent application of
                                     accounting rules
• Poor spreadsheet skills/usage
                                   • Spreadsheet errors,
                                     inefficiency




157                    November 17, 2006
What Happened                                 Implication


• Lack of segregation of duties   • Missing controls, duplication
                                    of tasks, conflict of interests

• Fraud
                                  • Criminal charges, bad
                                    publicity, civil liability




158                   November 17, 2006
Corporate Tax Function - Areas of Focus
                                                              Tax Controls,
                Tax Accounting                             Processes and Risks


          “Getting the Numbers Right”                            “Keeping the Numbers Right”
  •   FAS 109 technical complexities                             •   SOX 404 documentation and testing
  •   Tax account remediation                                    •   Controls remediation
  •   FIN 48                                                     •   Performance and data improvement
  •   International Financial Reporting Standards (IFRS)         •   Training
                                                                 •   Tax risk




159                                          November 17, 2006
Ernst & Young Tax Educators’ Symposium 2006

  Questions?




 160                 November 17, 2006
                                      Americas Tax




      Thank you for your participation and
                  feedback!

161               November 17, 2006

								
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