Ernst

1
Ernst Young Tax Educators Symposium 2006

• Current Developments in Accounting for Income
  Taxes
• Dick Larsen and Chester Abell

2
Current Developments in Accounting for Income
Taxes

• FIN 48 Accounting for Uncertainty in Income
  Taxes
• Disclosures
• Other Areas of Focus

3
Accounting for Tax Exposure Items

• Current state - Liability model
• FAS 5 Accounting for Contingencies
• Accrue liability when it is probable of
  occurring and the amount can be reasonably
  estimated
• FIN 48 Benefit recognition model
• Tax position must meet minimum recognition
  threshold before being recognized in financial
  statements

4
Objectives of FIN 48

• Clarify accounting for income taxes
• Provide greater consistency in criteria used to
  recognize, derecognize, and measure benefits
  related to income taxes
• Establish consistent thresholds, thereby
  improving relevance and comparability of
  financial statement reporting

5
Scope FIN 48

• Applies to all income tax positions including
  those recorded as a result of business
  combinations
• FAS 5 will continue to apply to other
  contingencies
• A tax position is defined as a position taken in
  a previously filed return or expected to be taken
  in a future return

6
Scope FIN 48 (continued)

• A tax position can result in a permanent
  reduction of taxes (permanent differences), a
  deferral of taxes (temporary differences), or a
  change in the expected realizability of deferred
  tax assets (tax planning strategies)
• Also encompasses decisions not to file returns,
  jurisdictional allocations (i.e., transfer
  pricing), and characterization of income

7
Highly Certain Tax Positions

• FIN 48 applies to all income tax positions
• Distinguish between highly certain and
  uncertain tax positions
• Highly certain tax positions
• Based on clear and unambiguous tax law
• Clearly meets the more likely than not
  recognition standard and greater than 50 likely
  that 100 of benefit will be sustained
• Consider
• Current accounting methods for income and expense
  items
• Tax implications of permanent differences and
  credits

8
Uncertain Tax Positions

• Uncertain tax positions are subject to the
  two-step process
• Appropriate Unit of Account for a tax position is
  a matter of judgment and requires consideration
  of
• The manner in which the enterprise prepares and
  supports its tax return, and
• The approach the enterprise anticipates the tax
  authority will take during exam

9
A Two-Step Process

• The application of FIN 48 to uncertain tax
  positions requires a two-step process that
  separates recognition from measurement
• Step One Recognition threshold
• More likely than not
• Step Two Measurement of the benefit

10
Step 1 Initial Recognition

• FIN 48 reflects a benefit recognition approach
• A tax benefit is recognized when it is more
  likely than not to be sustained based on the
  technical merits of the position
• Conclusion regarding financial statement
  recognition takes into account tax technical
  merits, facts and circumstances
• Assumes that tax position will be examined by
  taxing authority
• Each position must stand on its own merits
• Administrative practices and precedents deal with
  limited technical violations of the tax law
• Authority will not take issue with the tax
  position or limit scope
• Broad understanding in practice

11
Step 2 Measurement

• A tax position that meets the more likely than
  not recognition threshold shall initially and
  subsequently be measured as the largest amount of
  tax benefit that is greater than 50 percent
  likely of being realized (cumulative probability
  concept)
• Based upon facts and circumstances determined at
  the reporting date

12
Measurement Scenario 1

• 60 is the largest amount of tax benefit that is
  greater than 50 likely of being realized

13
Measurement Scenario 2

• 75 is the largest amount of tax benefit that is
  greater than 50 likely of being realized

14
FAS 5 Versus FIN 48 Example One

• Facts
• Uncertain tax position of 100 has 40 likelihood
  of being sustained based on technical merits
• Estimate of what will ultimately be paid to the
  tax authority is 45
• FAS 5 analysis - net benefit of 55
• 100 benefit based upon the filing position,
  less
• (45) contingent liability under FAS 5
• 55 net tax benefit
• FIN 48 analysis - benefit of 0
• Step 1 Recognition
• Is the asset more likely than not to be realized
  (gt50)?
• No 0 benefit to be recorded

15
FAS 5 Versus FIN 48 - Example Two

• Facts
• Uncertain tax position of 100 has 60 likelihood
  of being sustained based on technical merits
• Estimate of what will ultimately be paid to the
  tax authority is 45
• The amounts and related individual probabilities
  of possible outcomes are as follows
• 10 likelihood of realizing 100
• 30 likelihood of realizing 60
• 40 likelihood of realizing 30
• 20 likelihood of realizing 0

16
FAS 5 Versus FIN 48 - Example Two (continued)

• FAS 5 analysis net benefit of 55
• 100 benefit based upon the filing position,
  less
• (45) contingent liability under FAS 5
• 55 net tax benefit
• FIN 48 analysis - benefit of 30
• Step 1 Recognition
• Is the asset more likely than not to be realized
  (gt50) ?
• Yes go on to measurement
• Step 2 Measurement
• Cumulative likelihood of 80 relates to a benefit
  of 30

17
FAS 5 Versus FIN 48 - Example Three

• Facts
• Uncertain tax position of 100 has 60 likelihood
  of being sustained based on technical merits
• Estimate of what will ultimately be paid to the
  tax authority is 45
• The amounts and related individual probabilities
  of possible outcomes are as follows
• 10 likelihood of realizing 100
• 50 likelihood of realizing 55
• 30 likelihood of realizing 30
• 10 likelihood of realizing 0

18
FAS 5 Versus FIN 48 - Example Three (continued)

• FAS 5 analysis - net benefit of 55
• 100 benefit based upon the filing position,
  less
• (45) contingent liability under FAS 5
• 55 net benefit
• FIN 48 analysis - benefit of 55
• Step 1 Recognition
• Is the asset more likely than not to be realized
  (gt50) ?
• Yes go on to measurement
• Step 2 Measurement
• Cumulative likelihood of 60 relates to a benefit
  of 55

19
Change in Judgment

• Subsequent recognition, derecognition or change
  in measurement
• Requires new information vs. new evaluation
• Reporting date vs. financial statement issuance
  date
• Change from current rules under FAS 5

20
Subsequent Recognition

• Subsequent recognition occurs when any of the
  following conditions are met
• The more likely than not threshold is met by
  the reporting date
• The tax matter is ultimately settled through
  negotiation or litigation
• The statute of limitations expires

21
Subsequent Derecognition or Change in Measurement

• Derecognize a previously recognized tax position
  in the first period that it is no longer more
  likely than not
• Changes in measurement should also be reflected
  in the period that such change occurs

22
Change in Judgment Interim Period Reporting

• A change in judgment that relates to a position
  taken in a prior annual period is treated as a
  discrete item in the period in which the change
  occurs
• A change in judgment that relates to a position
  taken in a prior interim period within the same
  fiscal year is taken into account over the
  remaining periods in the fiscal year pursuant to
  APB 28 and FIN 18

23
Interest and Penalties

• Interest is a period cost
• Interest accrual is based upon the difference
  between the amount of tax benefit recognized in
  the financial statements and the amount
  recognized in the tax return
• Accrue statutory penalties when a tax position
  does not exceed the minimum statutory threshold
  required to avoid penalties

24
Interest and Penalties (continued)

• Tax law provisions that address interest and
  penalties may vary between jurisdictions, periods
• Classification of interest and penalties is an
  accounting policy election

25
Classification

• Difference between tax benefit as (or to be)
  reflected in the tax return and the amount
  recorded in the financial statements should be
  classified as either
• A reduction of deferred tax assets resulting from
  a deductible temporary difference or tax NOL or
  tax credit carryforward, or
• A current or noncurrent liability, based on the
  expected timing of cash flows
• The only liability that should be classified as a
  deferred tax liability is one that arises from a
  taxable temporary difference that meets the
  recognition threshold

26
FIN 48 Disclosure Requirements

• Tabular reconciliation of aggregate beginning and
  ending unrecognized tax benefits
• The following items must be presented separately
  in the table at the end of each annual period
• The gross amounts of the increases and decreases
  in unrecognized tax benefits as a result of tax
  positions taken during a prior period
• The gross amounts of the increases and decreases
  in unrecognized tax benefits as a result of tax
  positions taken during the current period
• The amount of decreases in unrecognized tax
  benefits relating to settlements with taxing
  authorities
• Reductions to unrecognized tax benefits as a
  result of lapse of the applicable statute of
  limitations

27
FIN 48 Disclosure Requirements (continued)

• The amount of unrecognized tax benefits that, if
  recognized, would change the effective tax rate
• The classification of interest and penalties, the
  amount of interest and penalties included in the
  income statement each period, and the total
  amount of interest and penalties accrued in the
  statement of financial position

28
FIN 48 Disclosure Requirements (continued)

• If it is reasonably possible that estimate of the
  tax benefit will change significantly within 12
  months, then disclose
• The nature of uncertainty
• The nature of the event that would cause the
  change
• An estimate of the range of the reasonably
  possible change, or state that an estimate cannot
  be made
• Description of open tax years by major
  jurisdiction
• Consider, for public companies, the Reg. S-X
  quarterly disclosure requirements

29
Cumulative Effect Adjustment

• Cumulative effect adjustment represents the
  effect of applying FIN 48 to uncertain tax
  positions that existed at date of adoption
• Record as adjustment to beginning retained
  earnings (or other appropriate components of
  equity or net assets)
• FIN 48 did not change current guidance regarding
  classification of subsequent adjustments to tax
  positions acquired in a purchase business
  combination
• Different treatment for interest and penalties
  attributable to pre- and post- acquisition periods

30
Effective Date and Transition

• Effective date
• Fiscal years beginning after December 15, 2006
• Transition
• The cumulative effect of applying FIN 48 is
  reported as an adjustment to the opening balance
  of retained earnings (or other appropriate
  components of equity or net assets in the Balance
  Sheet)
• SAB 74
• Requires companies to disclose a description of a
  new accounting standard in the period that the
  new standard is issued and also a discussion of
  the expected impact, if known, on the financial
  statements when adopted

31
FIN 48 Implementation Considerations
Re-design or Enhance Processes and Controls

• Federal
• Accounting Methods
• Revenue Expense
• Capitalization/Depreciation
• Inventory/LIFO
• RD Credit
• Section 199 Deduction

• International
• Permanent Establishment
• Structuring
• Non-US positions
• Subpart F
• Transfer Pricing

• Controversy
• Procedure
• Federal, state and foreign
• Penalties and interest
• Exam status
• Statute of limitations
• Procedural options

• Assess Tax Positions
• Understand processes for identifying uncertainty
  in tax positions (including highly certain tax
  positions)

• Analyze Uncertainty in Positions
• Recognition analysis (Step 1)
• Determine level of disaggregation
• Measurement analysis if more likely than not
  (Step 2)
• Prepare documentation
• Calculate interest and penalties

• Report and Disclose
• Determine SAB 74 disclosure requirements
• Calculate cumulative effect adjustment
• Evaluate disclosure requirements

• Establish Ongoing Procedures
• Continue application of FIN 48
• Design process for subsequent recognition,
  derecognition or change in measurement

• Transactions
• Business combinations
• Dispositions
• Tax attribute carryovers/limitations
• International positions

• State
• Nexus issues
• Structuring
• State and local audits
• Transfer pricing