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August 1989

Interim financial reporting under SAS 96. (statement of accounting standards)

by Bartsch, Robert A.J.

    Abstract- The Financial Accounting Standards Board Statement of Accounting Standard 96 requires companies to change from the deferred method to the liability method of income tax accounting. The requirement for companies to compute interim income taxes under a liability approach will result in complex calculations, including: estimating year-end temporary differences; preparing a schedule of anticipated reversals; and creating and applying tax strategies. There are two schools of thought regarding interim accounting reports and the annual report: treating each interim period as a separate accounting period in the same manner as annual report; or treating each interim period as an integral part of the annual reporting period. Income tax accounting for interim periods will require forecasts of anticipated temporary differences for year-end inclusion in the estimated annual effective tax rates, both current and deferred.

The topic interim financial accounting and reporting was excluded from the scope of SFAS 96, despite the fact that, the liability method is a discrete approach that measures a deferred tax liability or asset at a certain point in time, and does not consider future transactions or events. As a result, the principles of interim tax accounting as prescribed by APB Opinion 28, Interim Financial Reporting and FASB Interpretation 18, Accounting for Income Taxes in Interim Periods, essentially remain intact. Because these pronouncements incorporate the view that each interim period should be treated as an integral part of the entire year, they will have the effect of requiring companies computing interim income taxes under SFAS 96's liability approach to estimate income for the future and to make multiple complex calculations. For example, in determining their interim income tax provisions enterprises will be required to: 1) estimate what their temporary differences will be at the end of the current fiscal year; 2) prepare a schedule of anticipated reversals; and 3) consider and apply tax planning strategies.

The matter of interim accounting under SFAS 96 is particularly timely and important when one considers that interim financial statements must incorporate the procedures set forth in this Statement. Thus, those companies that elect early adoption effectively have less than one year to obtain a thorough understanding of the new tax standard in preparing first quarter results. Even for those calendar-year enterprises now permitted under SFAS 100 to defer Statement 96 until 1990 (i.e., years beginning after December 15, 1989), there is no extra time to study Statement 96 and to implement its rules in first quarter reports in April of that year.

Interim Reporting: The Discrete and Integral Views

Generally speaking, there are two conceptually different views of the association regarding interim accounting reports and the annual report. Those who share the discrete view, believe that each interim period should be treated as a separate accounting period in the same manner as the annual period. Thus, the same principles used to report deferrals, accruals, and estimated items in the annual report would also be employed in preparing interim reports. In accordance with the discrete approach, there generally would be no allocation to other interim periods of expenses incurred in one interim period.

Those who share the integral view believe that each interim period is an integral part of the annual accounting period. Under this perspective, deferrals, accruals, and estimates reported in each interim period reflect the accountant's belief of what is likely to transpire relative to the results of operations for the entire year. Essentially, interim-period allocations are components of interim accounting reports prepared by the integral approach.

In an effort to reduce alternative approaches to preparing interim period reports and thus, generate greater comparability in interim financial reporting, the APB issued Opinion 28 in 1973. In this Opinion, the Board favored the integral approach. Furthermore, in paragraph 10, the Board indicated ?that the results of each interim period should be based on the accounting principles used by an enterprise in the preparation of its latest annual financial statements." For the most part, the GAAP that are articulated in Opinion 28 address profit and loss items. According to Opinion 28, revenues should be recognized for interim periods in the same manner as they are for the annual period. For example, if the percentage-of- completion method is used to account for revenues from long-term construction contracts on an annual basis, then revenues should be recognized in interim periods on that basis. Similarly, costs and expenses that are directly associated with products sold or services provided should be matched against revenues in interim reports on the same basis as for the annual report. These product costs include direct materials, direct labor, and manufacturing overhead. With respect to inventory cost flow assumptions, enterprises generally should use the same methods (FIFO, LIFO, average) employed for annual reporting.

Costs and expenses, other than product costs, may be expended totally in an interim period when they have no obvious benefit to other periods. Or, in the case of costs that benefit other periods, they may be allocated among interim periods on the basis of time expired, benefit received, or activity associated with the periods. For example, if a company in a seasonal business realized only 20% of its annual revenues in the first quarter, then 20% of their fixed, annual selling, general and administrative (SG&A) costs might be allocated to that quarter's interim report under the integral method. Unlike many other costs, the accounting for income taxes in interim periods represented a peculiar reporting problem for some companies.

Accounting for Income Taxes in Interim Periods

Because of the progressive characteristic of corporate income tax rates, some confusion existed as to whether companies should accrue interim income taxes at the actual tax rates that correspond to their earnings to date, or should their interim income taxes be based on an estimated annual effective tax rate that takes into consideration projected annual earnings?

In paragraph 19 of Opinion 28, the Board attempted to resolve this problem by requiring a company at the end of each interim period to make its "best estimate of the effective tax rate expected to be applicable for the full fiscal year. The rate so determined shall then be used in providing for income taxes on a current year-to-date basis. "The estimated efffective annual tax rate should incorporate the effects of expected permanent differences, tax credits, and other available tax planning alternatives. However, it should not incorporate any unusual or infrequent items, extraordinary items, discontinued operations and cumulative effects of accounting changes. The tax effects of these items shall be individually computed and recognized when the items occur.

Despite these guidelines, there remained some confusion among companies as to how an estimated annual effective tax rate was to be applied. In what has proved to be a definitive guideline on this issue, paragraph 9 of FASB Interpretation 18 requires that "the estimated annual effective tax rate shall be applied to the year-to-date ordinary income (1) (or loss) at the end of each interim period to compute the year-to-date tax or benefit. The interim period tax (or benefit) related to ordinary income (or loss) shall be the difference between the amount so computed and the amounts reported for previous interim periods of the fiscal year."

As pervasive as Statement 96 may be, it does not amend the method of allocating income taxes to interim periods as prescribed in Opinion 28 and Interpretation 18. Thus, income taxes will continue to be allocated to interim periods in accordance with the integral view. However, what will change with the adoption of the new standard is the manner in which the estimated annual effective tax rate is computed. Under Opinion 11, the computation of the rate is relatively simple requiring only one estimated income tax provision computation. The rate is equal to the anticipated annual income tax expense divided by expected annual pretax income adjusted for permanent differences and tax credits. It is not necessary to consider separately the effects of any deferred tax provision (or benefit) resulting from timing differences. Simply, the effective tax rate is applied to the period's (year-to-date) timing differences to determine the increase or decrease to the deferred tax accounts.

Under SFAS 96, the calculation of an estimated annual effective tax rate will be considerably more complex because it necessitates a computation of a current income tax provision as well as a deffered income tax provision. The current tax expense reflects not only permanent differences and tax credits, but also temporary differences between pretax accounting income and taxable income that are anticipated at the end of the annual period. In accordance with Statement 96's liability approach, the deferred element of the rate calculation requires estimation of a net deferred tax liability (or benefit) as of the close of the fiscal period. In effect, this step would require companies to prepare a schedule of temporary differences that are expected at the end of the year and to consider and apply appropriate tax planning strategies. Thus, the calculation of interim income tax provisions under the new tax standard is a combination of the current period's actual tax payable plus or minus the change in the net deferred liability.

When computing interim income taxes under Statement 96, the effects of changes in tax laws or rates resulting from new legislation are to be reflected in the period of enactment. Prior to being amended by SFAS 96, APB 28 (paragraph 20) required that changes resulting from new tax legislation should be reflected after the effective dates prescribed in the statutes. For example, if legislation that changes tax rates in 19X2 was enacted in the last quarter of 19X1, the tax provision woul d not reflect the new rates until the first quarter of 19X2. Before enactment, anticipated changes in tax laws or rates should not be considered when estimating an effective tax rate for interim reporting. Further, under the provisions of Statement 96, retroactive changes in tax legislation will no longer require restatement of prior interim periods.

An Illustration of Accounting for Income Taxes in Interim

Periods Under APB 11 and SFAS 96

Examples illustrating the computation of interim income taxes under APB 11 and under SFAS 96 are shown in Exhibit 1 and Exhibit 2, respectively. To keep the computations relatively simple, the examples include only one permanent and three temporary (timing) differences between financial reporting and taxable income. Furthermore, the assumptions in the examples ignore tax credits and the alternative minimum tax (AMT) system.

Inc calculating an effective tax rate of 37.3% in Exhibit 1, it is not necessary to consider timing differences when estimating taxable income for the year. Simply, the estimated annual income tax expense ($112,000), which is derived after multiplying the estimated adjusted pretax income ($280,000) by an enacted tax rate of 40% is divided by pretax income ($300,000) for the year. Any tax credits available to the company, would have been subtracted from the estimated tax of $112,000 and would have produced a lower estimated effective tax rate.

The lower portion of Exhibit 1 shows the computation of the company's income tax provision for the second quarter. Based on its most recent estimate of the annual effective income tax rate and year-to-date pretax income, a year-to-date income tax provision of $42,895 is estimated. The second quarter's income tax expense is then equal to the change in the year-to-date income tax provision ($42,895-$22,000) from the preceding interim period (i.e., first quarter).

In contrast to Exhibit 1's example, the computation in Exhibit 2 of an estimated annual effective tax rate under Statement 96 is considerably more complex. Specifically, because the liability method attemps to measure the actual tax-return effects of temporary differences, these differences must then enter into the computation of an estimated currently payable (or refundable) tax as well as an estimated net deferred tax liability (or benefit) at year-end. Since the final section of this article discuss how enterprises need to consider and apply appropriate tax-planning strategies, Exhibit 2 illustrates calculations for a "before-tax strategy" scenario, as well as an "after- tax strategy" scenario.

In Exhibit 2, the anticipated end-of-year current tax provision, which subsequently enters into the calculation of an estimated annual effective tax rate, is $110,000. Before any deferred tax provision (or benefit) can be computed, the cumulative temporary differences anticipated at year-end must be schedules by year of reversal. According to the scheduled differences in Exhibit 2, the estimated net deferred tax liability at year-end, under the "before-tax strategy" scenario, is $6,400. This amount is based on the enacted future tax rates and reflects the tax rules for carryback and carry-forward of net deductible items summarized on the schedule.

With both the estimated current and deferred tax provisions completed, the estimated annual effective tax rate can be calculated. After dividing total estimated annual income tax expense ($116,400) by estimated annual pretax income ($300,000), an estimated tax rate of 38.8%, which exceeds the rate computed under APB 11, results. The primary explanation for the difference in rates is the loss in the tax benefit of the deferred compensation item that is scheduled to be deductible in 19X9 under the "before-tax strategy" assumption, and which cannot be used to offset net taxable amounts in its carryback on carryforward period.

Before use of a tax-planning strategy, an income tax provision of $22,620 for the second quarter of 19X1 is calculated. The steps employed in determining this amount are identical to those used to calculate interim income tax expense in Exhibit 1. That is, income tax expense for the second quarter is the difference between the year-to- date income tax provision ($44,620) and the income tax expense ($22,000) recognized in the prior interim period.

In Exhibit 2, a deferred tax provision year-to-date of $220, before use of a tax-planning strategy, is computed. This amount represents the difference between the total income tax provision year-to-date ($44,620) and the current tax expense year-to-date ($44,400). Further, under the "before-tax strategy" scenario, an estimated deferred tax benefit of $2,780 is computed. This amount reflects the change in the deferred tax liability ($220-$3,000) from the prior interim period. In arriving at the current and deferred tax provisions to date, assumed amounts were used for the one permanent and three temporary differences in this example.

Use of Tax-Planning Strategies

As noted earlier, when calculating interim income taxes under Statement 96, a company is required to consider and apply appropriate tax-planning strategies when estimating a deferred tax asset or liability. Generally, these strategies may be used only to alter the timing of the reversal of temporary differences that exist at year-end. Strategies that contemplate the tax consequences attributable to events of transactions in future years are not allowed. According to paragraph 19 of SFAS-96, management must not only have the ability and intent to implement a particular strategy, but the strategy must be prudent and feasible and it cannt involves significant cost to the enterprise.

To illustrate the use of a tax planning strategy, consider the temporary difference involving the deferred compensation item in Exhibit 2. If the company has both the contractual right and the available funding, an appropriate tax-planning strategy might involve acceleratng from 19X9 to 19X2 the payment of the deferred compensation. If these conditions are met, the deferred compensation item could propery be carried back to 19X1 and used to offset taxable amounts that are tax effected at 40% rate. As shown in Exhibit 2, an estimated annual effective tax rate of 36.1% is computed using this tax-planning strategy. Further, the reduction in the rate would have the effect of reducing the interim tax expense from $22,620 to $19,515. Finally, under the "after-tax strategy" scenario, a deffered tax benefit year-to- date of $2,885 is estimated. Since a deferred tax liability of $3,000 was assumed for the first quarter, an estimated deferred income tax benefit of $5,885 is recorded for the second quarter of 19X1.


It should be apparent that accounting for income taxes in interim periods will be more complicated than under APB 11. In calculating interim tax provisions, enterprises will need to forecast temporary differences expected at year-end for inclusion in the current and deferred portions of their estimated annual effective tax rates. For companies doing business in multiple taxing jurisdictions, this task may be considerably more complex and time-consuming since separate detailed computations will be required when financial reporting and tax bases of assets and liabilities are significantly different.

(1) Paragraph 5a of FASB Interpretation 18 defines ordinary income as "income (or loss) from continuing operations before income taxes (or benefits) excluding significant unusual or infrequently occurring items. Extraordinary items, discontinued operations, and cumulative effects of changes in accounting principles are also excluded from this term. The term is not used in the income tax context of ordinary income v. capital gain."

The authors acknowledge the assistance of John Van Camp, Partner, Advisory Services--national accounting and auditing staff of Touche Ross, who is a member of the FASBs Statement 96 Income Tax Implementation Group Task Force.

William J. Read, PhD, CPA, is an Associate Professor of Accounting at Bentley College, Waltham, Massachusetts. He is a former member of the American Institute of CPAs Audit Sampling Implementation Task Force.

Robert A. J. Bartsch, MBA, CPA, is a Manager in the National Office of Touche Ross. He is a member of the Financial Accounting Standards Committee of the NYSSCPA.

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