Back to basics
Users are looking for decision-useful information on cash flows and risks related to income taxes. In theory, the recognized tax expense or benefit would paint a clear picture as to both the current and deferred (or future) obligations related to income taxes. However, given the complexity in today's model, that isn't always the result.
Framework for enhancements
In the past, we and others have suggested that the FASB and IASB reconsider income tax accounting in its entirety. However, several attempts to reform the model over the past decade were abandoned for
various reasons. As such, we believe meaningful progress to enhance the usefulness of income tax financial reporting can be achieved through targeted improvements. Specific cost-effective improvements will benefit users, preparers, auditors and regulators.
Our recommendations focus on topics that are broadly applicable across many companies and industries and that are highly complex. Our recommendations seek to enhance comparability and better reflect the economics of the transactions and, where possible, align U.S. accounting standards with international standards.
Drivers of complexity – exceptions
Today's model has a number of "exceptions" to its fundamental principles that foster complexity without necessarily providing decision-useful information. The exceptions have generally been the result of compromises or accommodations. In some instances, they were introduced through other accounting standard updates in an attempt to "bridge" differences with fundamental income tax accounting. The application of the exceptions, however, has increased due to an increase in the complexity and magnitude of transactions to which the exceptions apply.
To illustrate: Today's model provides an "exception" for certain intercompany transactions—specifically transfers of assets—whereby the tax consequences are not immediately reported. Tax paid by a U.S. parent on the sale of assets to an affiliate in a different tax jurisdiction, for instance, is not reported as current tax expense. Instead, the exception results in non-cash charges that are included in the effective tax rate over many years.
This, and many other exceptions like it, requires special tracking for financial reporting. In addition, policy choices when accounting for these exceptions also diminish comparability of financial results. Removing these exceptions would in many instances reduce complexity, improve comparability, and provide more clarity.
Drivers of complexity – mechanical rules and allocations
The current model includes prescriptive rules for the financial statement presentation of tax balances. An example is the rules for classifying total tax expense or benefit among the financial statement components such as continuing operations, discontinued operations, other comprehensive income, and equity. This process is known as intraperiod allocation. Often, the model results in components showing tax benefits or expenses that are counterintuitive. The increase in activity across the components, along with external factors such as frequently changing global tax rates, have caused the mechanical process of allocating taxes to become more difficult than ever.
The balance sheet classification of deferred taxes as current or noncurrent may not be reflective of the economics. The current model requires deferred taxes to be classified based on the underlying asset (e.g., fixed assets) or liability, as opposed to the expected reversal period in which cash taxes will be impacted.
In addition, a valuation allowance recorded against deferred tax assets is allocated on a pro rata basis as opposed to a specific identification method. This may, for example, result in an allocation of the valuation allowance to current deferred tax assets even though only long-term tax assets are impaired.
Our proposal
We believe targeted changes to the existing income tax standard would enhance clarity and comparability while reducing complexity. While there are several areas that could be targeted for improvement, we have focused on those that have broad impact, result in harmonization with international standards, and remove exceptions and mechanical rules that lead to complexity. Specifically, we highlight enhancements that can be made to the accounting for intercompany transactions, the allocation method for tax expense or benefits, and the balance sheet classification of tax assets and liabilities.
Refinements to the model
Intercompany exception: We believe the FASB was on the right path when it tentatively agreed to eliminate the exception for certain intercompany transactions nearly a decade ago. This exception causes significant complexity for preparers. We recommend that this exception be eliminated. Current and deferred taxes could instead be recorded in accordance with fundamental principles. Such change would increase comparability
and converge with international accounting standards.
Income statement presentation: Another potential quick-fix would be to eliminate the intraperiod allocation rules in favor of reporting a single income tax expense amount. This could be accompanied by additional disclosure, if necessary, to understand the incremental tax effect of items outside of continuing operations, such as discontinued operations. Alternatively, the model could be changed in a more limited fashion by removing the so-called "backwards tracing" restriction. In that way, changes in deferred tax balances, due for example to changes in tax rates, would simply be reported in the same component in which the tax effect originated.
Balance sheet presentation: Users and preparers would also benefit from permitting deferred taxes to be presented entirely as long-term assets or liabilities, with disclosure of the expected timing of the reversals. Alternatively, if the current/noncurrent model is retained, a simple improvement would be to allow the valuation allowance to be allocated specifically to the tax attribute to which it relates.
Enhanced clarity
Stakeholders are seeking information that helps them better understand a company's tax profile and structure both in the U.S. and globally, thereby allowing them to better assess the risks and benefits related to a company's global tax positions. Additional disclosures pertaining to a company's taxes in its major tax jurisdictions would help provide that improved understanding.
Companies are also facing growing pressure from stakeholders and regulators to provide more clarity with respect to their indefinitely reinvested foreign earnings. One potential solution to address these requests would be for the FASB to developa simplified disclosure framework that promotes consistency and provides users with relevant baseline information. Such disclosures might include a high level description of the company's plans with respect to their unremitted foreign earnings supplemented by information about the general magnitude of the potential tax impact if earnings were remitted to the parent. Considering the difficulty of precisely determining the incremental tax cost of repatriating earnings, an appropriate approach may be to permit disclosure of a range of the potential tax impact.
At the same time, we believe the existing guidance requiring companies to have documented specific plans for reinvestment is burdensome for preparers and auditors. We recommend clarification of the guidance in a more principles-based manner focusing on the company's ability and intent to indefinitely reinvest. This would better align U.S. GAAP with the international tax accounting standard.
In conclusion
We believe the time is right for taking steps to refine the current income tax accounting model. Targeted improvements will yield significant benefits for all stakeholders by reducing complexity and improving the alignment of income tax accounting with the underlying economics.
Such a project would be responsive to the findings of the recently completed post- implementation review and also consistent with the FASB's current initiative to simplify current accounting to reduce complexity.
What would be an example of additional complexity that arose resulting from an attempt to "bridge" income tax accounting with other accounting areas that have been changed?
A: One key area is the income tax accounting guidance related to stock options or similar awards.
The current model prohibits a deferred tax asset from being recognized for a net operating loss (NOL) carryforward attributable to certain so-called "windfall" tax deductions resulting from the settlement of stock compensation, even though the NOL is reported on the tax return and is expected to be used.
In addition, the "basic" accounting for certain tax effects from the settlement of stock compensation depends upon an off- balance sheet measure known as a "windfall pool." The pool is used to determine whether the write-off of previously recorded deferred tax assets is recorded in additional paid-in capital (APIC) or earnings. This asymmetry requires special tracking of the settlements and may result in disparate outcomes for the same economic transaction based solely on whether a company has built up a windfall pool.
One approach to improvement would be to record all such tax effects as income tax expense or benefit. Alternatively, the tax effects could be reported in APIC without regard to whether there is a "windfall pool." Either way, this will relieve a burdensome task by preparers, particularly those with large and recurring stock compensation programs, while providing clarity and comparability for users.
Access a PDF copy of the article on PwC.com.
To have a deeper discussion about our point of view on accounting for income taxes, please contact:
Brett Cohen
Partner
Phone: 973-236-7201
Email: brett.cohen@us.pwc.com
Beth Paul
US Strategic Thought Leader, Accounting Services Group
Phone: 973-236-7270
Email: elizabeth.paul@us.pwc.com