Income Taxes and Purchase Accounting

1
Income Taxes and Purchase Accounting

• FAS 109 governs Income Tax Accounting Under GAAP
• Generally requires Deferred Income Taxes on
  Temporary Differences. Temporary differences are
  defined as differences between the Tax Basis and
  Book Basis of Assets and Liabilities
• Purchase accounting may result in temporary
  differences.

2
Purchase Accounting-NARUC

• For regulatory purposes, original cost of Plant
  in Service and Accumulated Depreciation
  previously recorded on books of acquired entity
  are recorded on books of purchaser at same amount
• Difference between purchase price and original
  cost is recorded as Plant Acquisition Adjustment
  (PAA)

3
Plant Acquisition Adjustment

• PAA is evaluated in rate proceedings and may or
  may not be included in rate base.
• Amortization of PAA is evaluated in rate
  proceedings and may or may not represent a
  recoverable cost.
• Usually depends on statutes or whether utility
  can demonstrate ratepayer benefits of purchase.

4
Purchase Accounting--GAAP

• FAS 141 requires the purchase method. Prior to
  FAS 141, companies were permitted to use the
  pooling of interests method as well, depending on
  whether certain provisions of APB 16 were met.
• Under FAS 141, purchased assets and liabilities
  acquired are recorded at fair value.
• Normally, current assets and liabilities are
  already recorded at fair value, so much of
  valuation effort is for non-current amounts (such
  as PPE).

5
Purchase Accounting--GAAP

• Regulatory Assets and Regulatory Liabilities
  would generally be included as acquired amounts
  at their recorded value.
• Fair value is a subjective determination and
  normally may require appraisers or financial
  modeling.

6
Purchase Accounting--GAAP

• For GAAP, difference between purchase price and
  fair value of assets net of liabilities acquired
  represents intangible assets (or liability).
• Intangibles should be analyzed to identify
  specific intangible assets (i.e., franchises,
  customer lists, patents, etc.).
• If a difference still exists, goodwill results.

7
Purchase Accounting--GAAP

• Identifiable intangibles (apart from goodwill)
  are generally amortized.
• Goodwill is not amortized for financial statement
  purposes, but is subject to an annual impairment
  test.
• The annual impairment test compares the fair
  value of the future net cash flows of the
  acquired enterprise to determine if such cash
  flows will cover the recorded goodwill.

8
Purchase AccountingGAAP/Regulatory

• Future cash flows of a regulated utility, under
  traditional ratemaking, can be projected based on
  return on and recovery of plant, and recovery of
  operating expenses.
• Generally, regulated plant assets are not fair
  valued like enterprises in general would fair
  value plant assets. This is because regulated
  cash flows are limited to those generated in the
  regulatory process (recovery of and return
  on). In effect, book value (original cost)
  equals book value for a regulated utility.

9
Purchase Accounting-GAAP/Regulatory

• If the excess purchase price is permitted in the
  regulatory process as a Plant Acquisition
  Adjustment, it will be amortized (generally over
  the life of the related plant).
• If the excess purchase price is not permitted in
  the regulatory process, for financial statement
  purposes, it becomes goodwill and is not
  amortized.

10
Purchase Accounting-GAAP/Regulatory

• GAAP requires deferred income taxes on all
  temporary differences.
• Deferred income taxes on the temporary
  differences of the acquired entity should be
  recorded in the purchase.

11
Purchase Accounting-Tax Considerations

• For income tax purposes, excess purchase price is
  analyzed and attributed, if possible to various
  intangibles (i.e., customer lists).
• Identified intangibles are deductible over an
  appropriate amortization period.
• Generally, the balance represents deductible
  goodwill, which is amortized for income tax
  purposes over 15 years.

12
Purchase AccountingGoodwill Issue

• Situation Goodwill (not PAA) not amortized for
  books, amortized for tax
• FAS 141 and FAS 142, require the entity to
  recognize deferred income taxes that are
  associated with these assets, in accordance with
  FAS 109. As a result, deferred tax liabilities
  related to goodwill and indefinite-lived
  intangible assets will not reverse (be settled)
  until some indefinite future period. The reversal
  of these temporary differences will occur only
  when the assets either become impaired, are
  disposed of, or, in the case of indefinite-lived
  intangible assets, are reclassified as an
  amortizable intangible asset. Nonetheless,
  deferred taxes are required on this difference.

13
Purchase AccountingGoodwill Issue (Continued)

• If the acquired entity does not have the required
  deferred income taxes recorded, the difference
  will affect goodwill.

14
Purchase Accounting-Transaction Costs

• Transaction Costs
• May be deductible for tax
• Considered as purchase price under FAS 141
• Alternative accounting
• Method 1
• Establish a deferred income tax liability for the
  tax effect of the transaction cost
• Method 2 (PwC preferable method)
• Treat the tax benefit of the deductible
  transaction costs as reduction of goodwill

15
Issues

• Book basis vs. Tax Basis will be different,
  especially for PAA, Goodwill and other
  intangibles.
• If PAA is not permitted for regulatory purposes,
  any related tax effects should be recorded below
  the line. Same with other temporary differences.
  Tax effects should be handled consistent with
  regulatory treatment.
• GAAP presentation may not Regulatory
  presentation. Regulatory USOAs generally do not
  have an account for Goodwill.

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Questions?