FASB ARITHMETIC
109+115=?

By Paul Munter and
Thomas A. Ratcliffe

The FASB spent approximately a decade debating the issues associated with reporting income taxes in the financial statements before ultimately finalizing the matter with the issuance of SFAS No. 109, Accounting for Income Taxes. In another important deliberation, the FASB established market-value accounting provisions for many marketable securities when it issued SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.

While these two documents appear to address fundamentally different issues, companies may find that when the two of them are combined, there are interesting effects on the financial statements. In particular, the tax effect associated with the market-value adjustments on securities classified as available-for-sale can create significant aberrations in the statement of income in certain situations.

Treatment of Available-for-Sale Securities

SFAS No. 115 requires all applicable securities be classified as either trading, held-to-maturity, or available-for-sale. SFAS No. 115 defines the first two categories and specifies that all securities not classified as either trading securities or held-to-maturity securities are classified as available-for-sale securities. Included within the portfolio of available-for-sale securities would be both debt and equity securities. The portfolio of available-for-sale securities is to be reported on the balance sheet at market value with the unrealized holding gains and losses being reported as a separate component of equity.

An important issue about this equity component is that the amount represents a temporary difference in accordance with SFAS No. 109. This means the equity component should be reflected along with its related tax effect. It is through the interrelationship of these two statements that companies can experience interesting results from their available-for-sale securities.

Treatment of the Tax Effect on Equity Components--SFAS No. 109

SFAS No. 109 requires deferred tax assets and liabilities be established and subsequently adjusted on all temporary differences using the currently enacted tax laws and tax rates. Paragraph 36 of SFAS No. 109 specifies that the tax effects for items included directly in equity should be reflected as an adjustment to the equity component. This means that, for available-for-sale securities, the net holding gain or loss would be included as a component of equity on a net-of-tax basis.

While this provision of SFAS No. 109 seems straightforward, two additional issues exist:

* If a net holding loss exists, a deferred tax asset is recorded. For this item, the entity must evaluate whether it is "more likely than not" that the tax benefit will be realized in determining whether or not a valuation allowance should be established.

* Once the deferred taxes are established, if there are subsequent enacted changes in tax rates, the existing deferred taxes will have to be adjusted to reflect the effect of the newly-enacted rates.

Applying the "More Likely than Not" Test to Net Holding Losses

Companies cannot automatically recognize the tax effect associated with a deferred tax asset. To realize the tax benefits, the company must have income to offset against the deductible amount. To the extent it is considered more likely than not (a likelihood of more than 50%) that the recognition of a deferred tax asset will result in a future tax benefit, the recognition of the deferred tax asset results in the net holding loss being reported in equity on a net-of-tax basis. Conversely, if it is considered not more likely than not that a deferred tax asset will result in a future tax benefit, the offsetting credit to the deferred tax asset will be to an allowance account. This would result in the net holding loss being included in equity without a reduction for the tax effect. To illustrate this treatment, consider the following examples.

Example 1: Assume ABC Company has acquired available-for-sale securities this period for the first time. The carrying value of the securities is $1,500. At the end of the period, the market value of the securities is $1,300. As such, ABC will establish a net holding loss (to be included in equity) of $200 by making the following entries:

Equity--Net holding loss on

available-for-sale securities $200

Allowance for decline in

market value $200

Assume the company is subject to a 35% tax rate. As a result, it will need to establish a deferred tax asset of $70 ($200 x 35%). If the company determines the more-likely-than-not test is met, it will reduce the equity component. If, conversely, the company determines that the more-likely-than-not test is not met, it will establish a valuation allowance against the deferred tax asset with no effect on equity.

More-likely-than-not test met:

Deferred tax asset $70

Equity--Net holding loss on

available-for-sale securities $70

More-likely-than-not test not met:

Deferred tax asset $70

Allowance $70

The equity component would be $200 if the test is not met and $130 if the test is met.

As can be seen, the more-likely-than-not assessment has a direct impact on the net amount reported in equity. The assessment of the more-likely-than-not test is particularly difficult because the loss on these securities likely would be subject to capital loss rules for many companies. Under current tax law, capital losses cannot be directly offset against ordinary income. Rather, the tax benefit of capital loss items can only be recognized by offsetting the capital loss against capital gains. Generally, these capital losses can be carried back for three years against previously-recognized capital gains or carried forward for five years against future capital gains.

One of the major issues companies face is a continuing requirement to make the more-likely-than-not assessment on deferred tax assets. Paragraph 26 of SFAS No. 109 requires that, "The effect of a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years . . . shall be included in income from continuing operations."

Since companies must assess the need for a valuation allowance each period, they may find that circumstances change from one period to the next. For example, a company may sell some securities at a gain (even though the remaining securities are in a net unrealized loss position). This, coupled with the expected holding period for the available-for-sale securities, may cause the company to conclude that a valuation allowance is no longer needed on the deferred tax asset. This change would have a direct impact on income.

Conversely, if there is a change in the market value of the available-for-sale securities resulting in a change in the deferred tax asset and an equal change in the valuation allowance (i.e., there is no change in the assessment of the more-likely-than-not test), there would be no impact on earnings since the entire amount would be reported in equity. To illustrate these two concepts, consider Examples 2 and 3.

Example 2. Assume the information from Example 1 is true and, assume further, that ABC Company had established a valuation allowance equal to the balance of the deferred tax asset. During the next period, there were no transactions affecting the available-for-sale portfolio. Thus the cost remains at $1,500. At the end of that period, the market value is now $1,200--representing an additional $100 decline in the market value during the period. Assume the company continues to have concerns about the ability to utilize the tax benefits associated with these unrealized losses and determines that a valuation allowance equal to the balance of the deferred tax asset should remain (applicable tax rate continues to be 35%). The following entries would be needed.

Equity--net holding loss on

available-for-sale securities $100

Allowance for decline in

market value $100

Deferred tax asset $35

Allowance $35

The equity component would be $300 in the balance sheet.

Assume that in the next period, ABC sold some of its securities and realized a gain of $400. The remaining available-for-sale securities had a cost of $800. At the balance-sheet date, the market value of these securities was $500. Since a $300 market adjustment already exists from the previous periods, no additional unrealized loss (as a component of equity) needs to be recorded.

However, assume that as a result of the realized gains, the company determines that it is no longer necessary to have a valuation allowance associated with the deferred tax asset. As a result, the following entry would be recorded:

Allowance $105

Tax benefit (expense) $105

This change, unlike that above (which is all contained within equity), results in an increase to current income because it is deemed to be attributable to the change in the need for a valuation allowance.

Example 3. Assume the same information from the previous examples except the company had originally determined a valuation allowance was not needed on the deferred tax asset and the equity component was $195 in the balance sheet.

Assume that in the next period, there are no additional transactions on the available-for-sale securities (thus, no realized gains are generated). Further, assume that market value continues to be $300 below carrying value for the portfolio. However, assume that because there continues to be no realized capital gains, the company now believes it is necessary to establish a valuation allowance equal to the balance of the deferred tax asset. As a result, the following entry would be recorded:

Tax expense $105

Allowance $105

This change results in a reduction to current income because it is deemed to be attributable to the change in the need for a valuation allowance.

As these examples indicate, companies are better off making an initial determination that a valuation allowance is needed since any subsequent change in the valuation allowance would have a positive affect on earnings. Conversely, if the company had originally determined no valuation allowance is needed, if it is subsequently determined a valuation allowance is needed, the result will be a reduction of current earnings.

Treatment of Changes in Tax Rate or Tax Status

SFAS No. 109 requires the measurement of the deferred tax liabilities and assets be based on provisions of the currently enacted tax law. Thus, the effects of future, not yet enacted, changes in tax laws or tax rates should not be anticipated in applying the provisions of SFAS No. 109. Deferred tax assets and liabilities are measured using tax rate information enacted as of the financial statement date.

When tax law or tax rate changes, paragraph 27 of SFAS No. 109 requires the existing deferred tax liabilities and assets be adjusted for the effects of these enacted changes, and these effects should be included in determining income from continuing operations for the period that includes the change in the tax laws or tax rates.

Again, SFAS No. 109 calls for the entire rate change effect on deferred taxes to be included in income for the period regardless of whether the underlying deferred tax has previously been included in income or in equity. To illustrate this situation, consider Example 4.

Example 4. Assume the company has available-for-sale securities at the balance sheet date with a carrying value of $5,000 and an aggregate market value of $7,000. At the balance-sheet date, the currently enacted tax rate is 35%. Since there is an unrealized gain on the available-for-sale portfolio, a deferred tax liability would be recorded. Thus, the following entries would be made.

Provision for increase in market

value $2,000

Equity--net holding gain on

available-for-sale securities $2,000

Equity--net holding gain on

available-for-sale securities $700

Deferred tax liability $700

The equity component is $1,300 in the balance sheet.

Assume that, in the following period, the tax rate is increased to 40%. Further, assume there is no change in either the carrying value or market value of the available-for-sale securities. As a result, the net holding gain would remain as $2,000. However, the deferred tax liability would need to be increased to $800 ($2,000 x 40%) and the following entry would be needed:

Tax expense $100

Deferred tax liability $100

Thus, as Example 4 indicates, not only is the income statement exposed to potential changes in the more-likely-than-not assessment, but it also is exposed to changes in enacted tax rates even though the underlying item giving rise to the deferred tax (the net holding gain or loss) is a component of equity. *

Paul Munter, PhD, CPA, is KPMG Peat Marwick Professor and chairman, Department of Accounting, University of Miami. Thomas A. Ratcliffe, PhD, CPA, is a professor and chairman, Department of Accounting, Troy State University.

[Editor's Note: In November 1995, the FASB issued a Special Report, A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities--Questions and Answers. The deferred tax accounting for valuation allowances for deferred tax assets relating to net unrealized losses on available-for-sale securities is covered in questions 54 to 57 of such special report.]

Editor:

Douglas R. Carmichael, PhD, CPA

Baruch College