Deferred taxes in personal financial statements

CPA Journal, The, Mar 1999 by Nurnberg, Hugo

Under AICPA Statement of Position 82-1, Accounting and Financial Reporting for Personal Financial Statements, assets are reported at estimated current values and liabilities are reported at estimated current amounts. Additionally, a provision for estimated income taxes on differences between these reported amounts and tax bases of assets and liabilities is presented between liabilities and net worth. The estimated provision is computed as if the estimated current values of assets had been realized and the estimated current amounts of liabilities had been liquidated on the statement date. Changes in current values of assets, current amounts of liabilities, and the estimated provision are reported as unrealized increases and decreases in net worth in the statement of changes in net worth. A user of personal financial statements needs information on this $3 million deferred tax asset, together with the likelihood of realizing it as reflected by the size of the valuation allowance (zero to $3 million), to avoid underestimating the individual's net worth.

A shortcoming of SOP 82-1 is that this presentation of the estimated provision between liabilities and net worth is ambiguous. (A similarly ambiguous presentation was formerly given to deferred tax credits under APB Opinion No. 11.) I believe that the estimated provision is a deferred tax liability, and that FASB Statement 109, Accounting for Income Taxes, provides guidance in measuring and recognizing it.

FASB 109 Summary FASB 109 notes a critical assumption of financial accounting-that the reported amounts or book bases of assets and liabilities will be recovered and settled, respectively. With a few exceptions, discussed later, differences between tax and book bases of assets and liabilities are either taxable or deductible temporary differences.

Taxable temporary differences result in taxable amounts in future years when book bases of assets are recovered and liabilities are settled. Deferred tax liabilities represent deferred tax consequences of taxable temporary differences-future tax payments from future reversals of existing taxable temporary differences.

Deductible temporary differences result in deductible amounts in future years when book bases of assets are recovered and liabilities are settled. Deferred tax assets represent deferred tax consequences of deductible temporary differences and carryforwards-future tax benefits from future reversals of existing deductible temporary differences and future utilizations of existing carryforwards.

Deferred tax assets are reduced by a valuation allowance when, based on all available evidence, realization of some portion or all of the deferred tax benefits fails the "more likely than not" test. This means that there is a greater than 50% probability that realization will occur.

The beginning-of-year valuation allowance is adjusted when new information results in modifying judgments about the realization of deferred tax assets. The adjustment is recognized and disclosed in the period in which it occurs, usually as a component of income tax expense (or benefit) from continuing operations.

Throughout, FASB 109 seeks to report deferred tax assets and liabilities that are the best estimates of the future tax consequences of temporary differences. For this reason, the measurement and recognition of deferred tax assets and liabilities reflects currently enacted tax laws and rates, expected actions and elections, and anticipated tax-planning strategies. Additionally, deferred tax assets and liabilities are adjusted for changes in estimates and changes in tax laws and rates. FASB 109 is applicable to all taxable business entities, whether their assets and liabilities are reported at historical costs or current values.

Recognition and Measurement

In my opinion, the credit provision for estimated income taxes under SOP 82-1 is a deferred tax liability under FASB 109. But the recognition and measurement rules of SOP 82-1 differ from the recognition and measurement rules of FASB 109.

Under SOP 82-1, the estimated tax provision is computed as if the estimated current values of all nontax assets are realized and the estimated current amounts of all nontax liabilities are settled on the balance sheet date, using applicable tax laws and regulations, and considering recapture provisions and available carryovers. Implicitly, SOP 82-1 uses current tax laws and rates in effect at the balance sheet date and assumes near-term liquidation even if liquidation is not expected. Thus, taxable temporary differences are tax effected at short-term capital gains tax rates on investments not held longterm at the balance sheet date, even when it is expected that the investment will be held and sold long-term or held to the death of the owner and escape capital gains tax altogether.

In contrast, FASB 109 assumes an expected outcomes perspective. Under FASB 109, a deferred tax liability is computed using tax laws and rates currently enacted to apply to the future years when temporary differences reverse and the deferred tax liability is paid, i.e., the future years when nontax assets and liabilities are expected to be realized and settled, respectively. In this way, the deferred tax liability reflects the best estimate of the future tax consequences of taxable temporary differences. FASB 109 does not assume nearterm liquidation unless liquidation is expected.