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FAS 109 and the International Financial Reporting Rules
Chicago Tax Club June 26, 2008
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Presenters Rick Bodnum – Partner, Deloitte Tax LLP, Chicago
Maggie Zellers – Partner, Deloitte Tax LLP, Chicago Jon Oleksyk – Partner, Deloitte Tax LLP, Chicago Joe Fahndrich – Manager, Deloitte Tax LLP, Chicago
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Keep in Mind The views expressed do not necessarily represent Deloitte & Touche LLP or Deloitte Tax LLP policy The outcome of any specific matter depends upon the specific facts and circumstances in which the matter arises The views expressed cannot be relied upon as accounting or tax advice Check with a qualified advisor before taking any action Standard caveat slide. The goal of this session is not to provide you with accounting advice but to help you identify issues. Financial Statements are the responsibility of management and we want to help you be in a position to identify issues and talk them through.
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FAS 109: A Reminder on Why it Matters
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Why it Matters – Example (Facts)
Mr. Bigbucks wants to purchase Without 109 Corporation. He reviews the balance sheet of Without 109 Corporation and offers to purchase the company from Mr. Seller for its net book value of $400. The offer is accepted. Without 109 Corporation never implemented FAS 109. Fixed Assets $1,000 Bank Loan $ 600 ______ Equity 400 Total $ 1,000 Additional Facts: Assume the tax rate is 40% The tax basis of fixed assets if $0 due to accelerated depreciation.
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Why it Matters – Example (Facts – cont.)
The day after the purchase is complete, Mr. Bigbucks decides to sell all the fixed assets for $1,000 (the net book value). He expects to use the proceeds to repay the bank loan and have $400 to buy inventory. His accountant informs him he will need to use the remaining $400 to pay the taxes resulting from the $1,000 gain on sale of the fixed assets. Mr. Bigbucks calls Mr. Seller and claims that the financial statements of Without 109 Corporation were incorrect and he will be hearing from his attorney, F. Lee Fasbey. He believes he should have been able to sell all the assets of the company at book value, pay all the liabilities and have cash remaining after the sale equal to equity. Instead, all the assets are sold and no net cash is remaining. You are Mr. Bigbuck’s consultant. Briefly explain what is missing from the financial statements.
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Why it Matters – Example (Basis Difference)
Book Tax Book > Tax Fixed assets $1,000 $ 0 Tax rate 40% Deferred tax liability required, not recorded $ 400 Journal Entry: Deferred Tax Expense $ 400 Deferred Tax Liability $ 400
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Why it matters – Example (Solution)
The book basis of the fixed assets of Without 109 Corporation are $1,000 higher than the tax basis. The financial statements of Without 109 Corporation are missing deferred taxes. The future tax liability of $400 associated with the tax gain in excess of the book gain needs to be recorded on the financial statements, and equity needs to be reduced to zero. This liability should have been accrued as the accelerated depreciation was taken with the offsetting debits to deferred tax expense. The revised balance sheet is shown below: Fixed Assets $ 1,000 Bank Loan $ 600 Deferred Taxes 400 Equity Total $ 1,000
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FAS 141(R)
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Considerations – Business Combinations
When does it matter? When you acquire a business What matters? Is the acquisition taxable or non-taxable Why does it matter? To correctly state the company’s deferred balances
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General Accounting Rules
APB No. 16, Business Combinations SFAS No. 109, Accounting for Income Taxes SFAS No. 141, Business Combinations SFAS No. 141R, Business Combinations effective for years beginning after 12/15/2008 SFAS No. 142, Goodwill and Other Intangible Assets
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SFAS 109 Guidance Business Combinations – ¶30 Appendix A – ¶127- ¶138
Appendix B Business Combinations – ¶259 Nontaxable Business Combinations – ¶260 Taxable Business Combination – ¶261 and ¶262 Carryforwards – Purchase Method – ¶264 – ¶267 Subsequent Recognition of Carryforward Benefits – Purchase Method – ¶268 and ¶269 Exceptions – ¶9(d)
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SFAS 141(R) Fundamental principles of the acquisition method
Recognition principle - The acquirer recognizes all of the assets acquired and all of the liabilities assumed Measurement principle - The acquirer measures each recognized asset acquired and each liability assumed and any non-controlling interest at its acquisition date fair value Notable exceptions include deferred tax assets and liabilities, unrecognized tax benefits and related indemnities Effective date Fiscal years beginning after December 15, 2008 Transition Prospective application for transactions consummated after the effective date, with an exception for two of the several changes related to income taxes Future adjustments to income tax recognition, measurement, and changes in valuation allowances include amounts related to transactions consummated before the adoption of Statement 141(R) 13
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New FAS 109 ¶30 The effect of a change in a valuation allowance for an acquired entity’s deferred tax asset shall be recognized as follows: a. Changes within the measurement period that result from new information about facts and circumstances that existed at the acquisition date shall be recognized through a corresponding adjustment to goodwill. However, once goodwill is reduced to zero, an acquirer shall recognize any additional decrease in the valuation allowance as a bargain purchase in accordance with paragraphs 36–38 of Statement 141(R). b. All other changes shall be reported as a reduction or increase to income tax expense (or a direct adjustment to contributed capital as required by paragraph 26).
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FAS 141(R) – Business Combinations
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Measurement Period
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FAS 141(R) – Tax Basis Uncertainties and Release of VA
77. For business combinations in which the acquisition date was before the effective date of this Statement, the acquirer shall apply the requirements of Statement 109, as amended by this Statement, prospectively. That is, the acquirer shall not adjust the accounting for prior business combinations for previously recognized changes in acquired tax uncertainties or previously recognized changes in the valuation allowance for acquired deferred tax assets. However, after the effective date of this Statement: The acquirer shall recognize, as an adjustment to income tax expense (or a direct adjustment to contributed capital in accordance with paragraph 26 of Statement 109), changes in the valuation allowance for acquired deferred tax assets. 1 b. The acquirer shall recognize changes in the acquired income tax positions in accordance with Interpretation 48, as amended by this Statement. 2 1 Par. 30/37/268/43 of FAS 109 modified 2 EITF 93-7 nullified
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Valuation Allowances Under SFAS 141(R)
Current GAAP Increases to valuation allowances after acquisition are generally charged to tax expense Decreases to valuation allowances after acquisition (or actual usage on tax return): First, reduce goodwill to zero Second, reduce other intangible assets to zero Third, reduce income tax expense SFAS 141(R) Increases to valuation allowances treated the same as under current GAAP Decreases to valuation allowances after acquisition are now recorded as a reduction to tax expense Changes in tax uncertainties and valuation allowances are recorded in the income statement (discrete items for interim reporting purposes)
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Example - Valuation Allowances
Assumptions Company A acquires Company Z in 2005 At the date of acquisition, a $100,000 valuation allowance is established for an acquired entity’s tax benefits Goodwill of $200,000 is also recorded at acquisition The following changes in the valuation allowance are reported: $40,000 reduction in 2006 $30,000 increase in 2007 Questions: #1 What is the entry to record the change in 2006? #2 What is the entry to record the change in 2007? #3 How would this change under FAS 141R?
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Example – Valuation Allowances (Solution)
Question #1 – Journal Entry: DR Valuation Allowance $ 40,000 CR Goodwill Question #2 – Journal Entry: DR Income Tax Expense $ 30,000 CR Valuation Allowance
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Example – Valuation Allowances (Solution)
Question #3 – Journal Entry: DR Valuation Allowance $ 40,000 CR Income Tax Expense DR Income Tax Expense $ 30,000 CR Valuation Allowance
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Uncertain Tax Positions – Prior to FAS 141(R)
Uncertain tax positions are accrued as part of opening balance sheet (under FIN 48) and must be specifically tracked Increases after acquisition date go to goodwill Decreases: Reduce goodwill to zero Reduce other noncurrent intangibles recorded in acquisition to zero Finally, go to income statement Changes should not impact tax expense
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EITF 93-7 Under existing rules, changes in an acquired entity’s deferred tax assets and uncertain tax position balances are generally recorded through goodwill, regardless of whether such changes occur during the allocation period or thereafter. For example: On January 15, 2007, Company X acquired 100 percent of Company Y. As part of the purchase accounting, X recognized a liability associated with an uncertain tax position. DR Goodwill $ 2,000 CR FIN 48 Payable On February 2, 2008, X increased the liability to reflect a change in its best estimate of the ultimate settlement with the taxing authority. In accordance with EITF 93-7, X recorded this adjustment as an increase to goodwill. $ 800
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SFAS 141(R) Statement 141(R) requires that any adjustments to an acquired entity’s deferred tax assets and uncertain tax position balances that occur after the initial determination to be recorded as a component of income tax expense. On January 15, 2007, Company X acquired 100 percent of Company Y. As part of the purchase accounting, X recognized a liability associated with an uncertain tax position. DR Goodwill $ 2,000 CR FIN 48 Payable On February 2, 2009 (assumed post-measurement period under SFAS 141(R)), X increased the liability to reflect a additional change in its best estimate of the ultimate settlement with the taxing authority. In accordance with SFAS 141(R), X recorded this adjustment as a component of income tax expense. DR Income Tax Expense $ 800
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Components of Goodwill
If there are differences between the book and tax basis of the first component of goodwill in future years, a temporary difference is created and a deferred tax liability or asset is recognized However, no deferred tax asset or liability is created for the second or “remainder” component (¶262) If the remainder component is tax deductible in future periods (i.e., tax deductible goodwill > book goodwill), when the tax benefit is realized on tax return it: First, reduces financial reporting goodwill to zero Second, reduces other noncurrent intangible assets to zero Third, reduces income tax expense
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Purchase Accounting
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Goodwill DTA – FAS 141(R) Deferred tax assets should be recognized as part of the acquisition accounting if tax deductible goodwill exceeds goodwill recorded as part of the acquisition accounting. Setting up DTA requires a simultaneous equation because goodwill is a residual asset for financial reporting (example in ¶263)
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Business Combinations - Transaction Costs
Transaction Costs Capitalized Expensed Under FAS 141, there commonly was a purchase accounting question related to “what to do” with the tax benefit related to transaction costs deducted for tax but capitalized for book (with tax usually being able to deduct a subset of the total). Under FAS 141(R), purchase accounting question will be how to do tax accounting for amounts expensed for book but potentially capitalized for tax into either Section 197 or stock basis – (the problem is the opposite of the historical problem)
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Business Combinations – Transaction Costs: Initial Thought
Prior to Closing DTA is recognized in periods prior to close since the closing of a transaction should not be contemplated (no transaction = “busted transaction” = full deduction) At Closing Bad perm (DTA w/o) if carryover basis transaction for tax (Par. 34 is the issue with “retaining” DTA since it now pertains to an outside basis difference) No provision consequence from “closing” if a transaction results in a step-up for tax – the DTA would “attach” to corresponding Section 197 cost that would be treated as having an origin related to continuing operations (vs. being an acquired basis difference affecting G/W)
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Best Practices and Challenges
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Computing the Provision – 10 Steps
Identify permanent and temporary differences Compute current payable or receivable Compute return to accrual adjustments Analyze deferred taxes and compute deferred tax expense or benefit Account for uncertainties Analyze the need for valuation allowances Compute total income tax expense or benefit Reconcile tax accounts and record journal entries Prepare rate reconciliation Prepare financial statement disclosures Note: The 10-steps are on a jurisdiction-by-jurisdiction basis.
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Fundamentals to Remember
Accounting for the tax consequences of a transaction or event in the same period that it is recognized in the enterprise’s financial statements Compute the tax provision by enterprise and by jurisdiction Jurisdictions include federal, state and international or non-US Assess recognition and measurement of FIN 48 uncertain tax positions (FIN 48) Current provision is the liability expected on the current year tax return adjusted for any return to accrual adjustment and the impact of FIN 48 Deferred provision is the change in deferred tax assets and liabilities Not necessarily able to measure change based on the balances shown on the balance sheet The deferred provision in continuing operations is not exactly as simple as the change in deferred tax items due to intra-period allocations of expense to equity or OCI.
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Fundamentals to Remember (cont.)
Deferred tax assets and liabilities Recognize a deferred tax asset for future deductible amounts and loss or credit carryforwards Recognize a deferred tax liability for future taxable amounts Measure deferred tax assets and liabilities using the applicable enacted tax rates Measure at the rate expected to apply when the temporary difference reverses Effects of future changes in tax laws or rates are not considered Reduce deferred tax assets to the amount “more likely than not” to be realized with a valuation allowance (contra-asset account) Assume all temporary differences result in a deferred tax asset or liability and then determine if an exception applies Income Tax is key to remember. Maryland – Enacted new rate last year applicable to next year. My current taxes will be based on current rates and deferred taxes based on future rates enacted today. US - The president signs it and you are done. Mexico – Be careful because in other countries the president’s signature doesn’t necessarily cause an “enactment” there are other events that have to occur.
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FAS 109: The Balance Sheet Approach
Compute the current tax asset or liability (estimating the current year tax return) Same process as preparing the tax return Compute the deferred tax asset or liability on the difference between the book and tax basis of assets and liabilities and tax attributes and carryforwards Deferred tax is the future expected tax effect of temporary differences and carry forwards Adjust the general ledger accounts to computed balances Analyze the existing tax accounts, compute the total provision and adjust balances in all accounts to provision calculations Measurement is based upon enacted tax laws and rates Comprehensive liability approach considering future operations The tax rate used is the statutory tax rate for the period expected to turn. It has to be enacted, but based on enacted rates you do look to future tax rates. We have seen a lot of foreign rate changes in the past year for which this impacts registrants. 34
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Balance Sheet Approach to Tax Provision
Current Taxes Deferred Taxes Tax Provision Rec’vble Payable Asset Liability Current Deferred Beginning Ending …get the balance sheet correct and ….. Reiterate - FAS 109 is a balance sheet approach. Get away from the tax return P&L approach to a balance sheet approach. First get your current payable/receivable, then based on book/tax basis differences get your deferred items right and the tax expense/benefits falls out. …. the P&L falls out 35
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Tax Software Objectives
Streamline the tax provision process Strengthen controls and reporting Plan for changes in accounting regulations and ease their impact on your organization Reallocate resources to tax matters strategic to your business Integrate finance, provision, and compliance systems Improve tax risk management procedures
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FAS 109 Process Implementation/Process
While a provision software system is designed to provide better functionality, a company will still need to make sure of the following: Implementation Data Collection Process is efficient/complete Validate Data/Prior year data is input correctly System/report functions are designed specifically for the company Controls Company has process to identify and obtain necessary information that will be input into system. Current year data is input correctly. Failure to do this will result in a company that will continue to have difficulty with their provision process.
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Software Selection FAS109 software selection
While a majority of companies use Excel, there has been a large shift to Provision software systems. TaxStream is the leader in the provision software system market at approximately 20% of the market. Key Driver (besides Market Ownership) – Tax Return System
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IFRS Tax Update
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Agenda IFRS overview Overview of IFRS/US GAAP accounting differences
IFRS/FAS 109 differences
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IFRS Overview
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IFRS – Overview IFRS (International Financial Reporting Standards) is a set of established accounting standards promulgated by the London-based International Accounting Standards Board (IASB) that is gaining accelerated use on a worldwide basis Key characteristics of IFRS: Principals-based approach that places greater emphasis on interpretation and application of principles, with a particular focus on the spirit of the principle being applied The standards necessitate the assessment of the substance of transactions and an evaluation of whether the accounting presentation reflects the economic reality There is renewed focus on the need for professional judgment in arriving at accounting conclusions Greater use of fair value as a measurement basis placing emphasis on obtaining reliable measurements
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The SEC and FASB initiated a process that will likely culminate in the transition from US GAAP to IFRS Global Fortune 500 IFRS is quickly gaining worldwide acceptance as a global standard for financial reporting Today Used in over 100 countries and by approximately 40% of the Global Fortune 500 Required for listing companies across all EU countries, starting in 2005 Adoption date announced by large countries like Brazil, Canada, and India Tomorrow Expected that all major countries will have adopted IFRS to some extent by 2011 Convergence of Japan will be substantially completed Substantial majority of Global Fortune 500 will report under IFRS U.S. public companies will likely have the option of using either IFRS or US GAAP by 2011 As this graph illustrates, migration to IFRS is much more prominent than to US GAAP 43 43
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Regulatory Developments
Considerable movement towards mutual recognition of financial reporting frameworks between the US and the EU Recent SEC developments Elimination of US GAAP reconciliation for Foreign Private Issuers using IFRS effective 12/31/07 year ends Concept release allowing US companies a choice of IFRS is gathering support
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IFRS Hierarchy In absence of a Standard or Interpretation that specifically applies to a transactions management should use its judgment and consider the applicability of the following sources in descending order IASB Standards and Interpretations IASB Framework Other standard setting bodies with similar conceptual framework (e.g. U.S. GAAP)
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A “Principle-Based” Approach
No longer simply understanding the “rules” Will need to focus more on… The “substance” of transactions Evaluate whether the accounting presentation reflects the “economic reality” Renewed focus on use of professional judgment Comparability versus uniformity
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Differences between IFRS
and FAS 109
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IFRS Tax Literature IAS 12, Income Taxes
Originally effective 1 January 1998 Revised in 1999 and 2000 Amended by IFRS 2, Share-based payments To be amended further to reflect convergence issues SIC 21, Income Taxes – Recovery of Revalued Non-Depreciable Assets SIC 25, Income Taxes – Changes in the Tax Status of an Enterprise or its Shareholders There is significantly more guidance on accounting for income taxes under US GAAP than IFRS
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Tax Accounting Convergence Key Concepts
Approach between the two accounting standards is similar Comprehensive asset/liability approach Deferred tax provided on all temporary differences Measured at enacted tax rates Tax assets reduced to ‘more likely than not’ recoverable Many differences come from differences in underlying accounting – not tax accounting e.g. Share-based payments Some differences appear minor and only realised in careful reading of the applicable pronouncements
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Tax Accounting Convergence
Tax accounting convergence – latest news: The FASB is still grappling with a decision on the planned August exposure draft and the decision of whether to issue a revised SFAS 109 or an amended form of IAS 12. It also remains uncertain how FIN 48 will factor into the new guidance. Currently, it appears, FIN 48 will remain in US GAAP and the IASB plans to amend IAS 37 soon to provide rules regarding the disclosure of uncertainties relating to income tax.
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IFRS Uncertain Tax Positions
IFRS currently: IAS 37 requires accrual where liability is “probable” and “quantifiable” Interest and penalties are excluded from income tax expense IFRS may not go to a FIN 48 model… Wait and see mode until exposure draft is released
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Tax Accounting Convergence Enacted vs Substantively Enacted Tax Rates
Which tax rate? SFAS 109: Enacted tax rate IAS 12: Enacted or “substantively” enacted Substantively enacted would be the stage of passing law where further stages are administrative (eg in the UK, this would be passing of a bill in parliament rather than signing by the Queen) Convergence: Both boards have agreed that substantial enactment for operations in non-US jurisdictions but “enacted” for operations within the USA. IASB will clarify that “substantial enactment” means that future steps in the enactment process will not change the outcome
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Tax Accounting Convergence Intercompany Transfers of Assets
The sale of an asset between tax jurisdictions is a taxable event that establishes a new tax base for the asset in the buyer’s tax jurisdiction. The new tax base is deductible on the buyer’s tax return as the asset is sold outside the group or consumed. Difference IFRS Provide tax on temporary difference (i.e. at buyer’s tax rate) US GAAP follows ARB 51 Can apply to intra-group sales, transfers and distribution whereby tax basis of the asset changes as a result of the transfer Defer all tax paid by seller and reverse any deferred tax consequences Prohibits recognition of a deferred tax asset for tax base difference between the jurisdictions Result is that deferred taxes are recognised at seller’s tax rate on temporary difference before sale (as if sale had not occurred) Boards’ decision FASB has agreed to amend SFAS 109 to eliminate this exception.
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Tax Accounting Convergence Foreign Non-Monetary Assets and Liabilities
Difference US GAAP exempts deferred tax arising from retranslation of assets and liabilities from local currency to functional currency as a result of changes in exchange rates No exemption under IAS 12 Boards’ decision FASB will remove exemption
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Tax Accounting Convergence Definition of Tax Base
Difference No definition of tax base in US GAAP Dependent on the expected manner of recovery under IFRS Boards’ decision Both boards are proposing to adopt a new joint definition of tax base Tax base of an asset determined as amount deductible if asset were to be sold for carrying value at balance sheet date ‘Management intention’ principle to be removed
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Tax Accounting Convergence Balance Sheet Classifications
Difference IFRS DTAs not recognised unless ‘probable’ that they will be realized All deferred tax assets and liabilities classified as non-current under IAS 12 US GAAP Recognise all DTAs and record valuation allowance if more likely than not that DTA will not be recognised DTA/DTLs must be split between current and non-current Boards’ decision IASB will adopt SFAS109 reporting requirements and asset recognition approach IASB has agreed that “probable” means “more likely than not” and will add explanation to IAS 12 Considerations May require changes to process, software, and general ledger accounts
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Tax Accounting Convergence ‘Unremitted Earnings’
More correctly – Investments in subsidiaries, branches and associates, and interests in joint ventures… Differences Exemption under IAS 12 from recognizing deferred tax on temporary differences on unremitted earnings if parent can control timing of reversal and probable that difference will not reverse in foreseeable future SFAS109 prohibits recognition of a DTL for excess of financial reporting over tax base that is ‘permanent’ in nature Boards’ decision IASB to move to US GAAP wording for exemption
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Tax Accounting Convergence Changes to Disclosure Requirements
Disclosures required by one standard and not the other will be adopted by both, including: Separate disclosure in tax charge for adjustments in respect of prior year items (SFAS 109 will adopt) Disclosure of amounts and basis for allocation of DTA/DTLs between members of a group that files a consolidated tax return (IAS 12 will adopt) Disclosure of income tax consequences of payment of a dividend where income is taxed differently if distributed Additional new disclosures to be adopted by both, including: Disclosures relating to intercompany transfers of assets Considerations May require changes to process, software, and general ledger accounts
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Tax Accounting Convergence Initial Recognition Exemption
Difference IAS 12 prohibits recognition of deferred tax arising on initial acquisition of an asset or liability in certain circumstances Under IAS 12 no subsequent movements in these positions are recognised No equivalent under SFAS109 Boards’ decision IASB will eliminate exemption All assets fair valued on initial recognition and deferred tax recognized on differences between FV and tax base Resulting DTA/DTL included in calculation of purchase discount allowance
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Tax Accounting Convergence Intra-period Allocations / Backwards Tracing
Both IAS 12 and FAS 109 require tax on items taken to equity in the current year to be allocated to equity. However, standards differ on current year deferred tax related to an item taken to equity in an earlier period SFAS 109: Changes to DTAs/DTLs originally recorded in equity may be allocated to income from continuing operations subject to intraperiod tax allocation rules Changes to VA due to change in circumstance about realizability Changes in tax law/rate IAS 12: Any changes to a DTA/DTL originally recorded in equity are also recorded to equity except in exceptional circumstances. Convergence: IASB will amend IAS 12 to adopt the intraperiod allocation requirements similar to those contained in SFAS 109.
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Convergence Decisions - Summary US GAAP Changes
Intra-group transfers to buyer’s tax rate Measurement of deferred tax on translation of foreign non-monetary assets and liabilities Additional disclosure requirements Substantively enacted tax rates in foreign jurisdictions
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Convergence Decisions - Summary IFRS Changes
Adopt SFAS 109 approach to deferred tax assets Define probable as more likely than not Record valuation allowance when not realisable B/S classification – current vs non-current Define tax base – amount that would be realised on sale/disposition Delete initial recognition exemption for asset acquisition Exemptions from recognizing deferred tax on unremitted earnings Allocation of tax to P&L vs equity Additional disclosure requirements
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