IFRS: Income Tax

A Brief Review of IFRS Income Tax Exposure Draft, IAS12, and FAS 109

BY: M Chowdhury

 IFRS and US GAAP both use balance sheet approach to recognize differences in taxes due to differences in book value of the assets or liability and their tax base.  The IFRS standards are based on IAS 12 (Income Taxes) while the primary source of US GAAP is FAS 109 (Accounting for Income Taxes).  Although the IFRS and US GAAP share the same temporary difference approach, the two models differ when it comes to application.  Most of the divergences resulted from the treatment of certain exception items.  Some other differences resulted from the difference in the recognition and measurement of deferred tax assets and liabilities and also the allocation of tax to equity or other comprehensive income. The divergences create non compatible financial statements. 

 In March 2009 the IFRS issued exposure draft “Income Tax”.  The exposure draft, which proposes significant changes to IAS 12, is part of the convergence project between IFRS and FASB.  The exposure draft attempts to reduce the divergence between the US GAAP and IFRS by eliminating all exceptions and establishing a common approach to the recognition and measurement of tax assets and liabilities.  The board seeks public comments on the exposure draft by July 2009.

 Meanwhile, the FASB suspended its deliberations on the convergence of income tax project.  The board may take smaller project in the future to make FAS 109 more compatible to the IFRS.  

The following discussion is based on the March 2009 IFRS exposure draft.

 Balance sheet approach: 

The concept of recognizing deferred taxes due to the temporary difference in carrying value of the assets in the financial statements and their tax base is similar under IAS12 and FAS 109. 

 Observation: The exposure draft retains the balance sheet approach of recognizing deferred tax.

 Valuation allowance: 

A valuation allowance is required if the consumption of the deferred tax assets is not probable.  However, unlike the IAS 12 the exposure draft proposes a separate line for the valuation allowance. 

 Observation: The new proposal aligned with FAS 109.

 Definitions of tax basis:

The exposure draft changes the definition of the tax basis stated under IAS 12 to the existing practice under US GAAP.  Tax basis under FAS 109 generally implies the amount that would be recognized under the existing tax laws of a tax jurisdiction. The IASB proposes that tax basis be defined as the measurement under applicable substantively enacted tax laws of an asset, liability, or other item.  The ED also proposes an additional method for determining tax basis which is the amount of tax deductions that would be available if the entity recovered the carrying amount by selling the asset.  In another word the tax consequences results from the sales of the assets or settlement of the liability.  The purpose of this method is to address the multiple tax implications results from sale or the use of the asset. 

 The proposal essentially removes the management intentions or expectations about the recovery or settlement of an assets or liability under IAS 12.    

 Observation:  Although the IASB proposals align the definition of tax basis with US GAAP but the difference remains in the definition of tax law.  The IFRS requires the measurement of deferred tax using substantively enacted tax law while the US GAAP uses enacted law.   

 Definitions of temporary difference: 

IAS 12 defines temporary differences are the differences between the carrying amount of the assets or liabilities in the financial statements and their tax basis irrespective of whether these temporary differences have any impact on the taxable profit.  The exposure draft proposes that temporary differences be defined as the differences between the carrying amount of the assets or liabilities in the financial statements and their tax basis only if the entity expects that there will be an impact on the taxable profit when the carrying amount is settled or realized.

 Observation: The board proposal is consistent with the US GAAP.

 Tax credit and investment tax credit:

IAS 12 does not address the accounting treatment for tax credit or investment tax credit.  The IASB exposure draft defines tax credit as an amount which reduces the future taxes payable and investment tax credit is directly related to a depreciable asset purchase.

 Observation: The exposure draft proposes definition for tax credit or investment tax credit, which converges with US GAAP. 

 Tax rate for deferred tax:

The ED proposes to continue to use substantially enacted tax rate to measure deferred tax assets and liabilities.  The proposal is similar to the current requirements of IAS 12.  The FAS 109 requires the use of enacted tax rate expected to apply at the end of the reporting period to measure deferred taxes.  The board justifies its decision to use substantially enacted tax rate on the premise that in some jurisdictions there is a time lag of few months between the announcements of the new tax rate or law and the actual date of enactment.  According to IASB substantive enactment is achieved when any future steps in the enactment process will not change the outcome.  In the US this threshold is met when there is no threat from the presidential veto.

 Observation:  IASB provides additional clarity by defining the reason for the term substantially enacted tax rate. The broad definition  of enacted tax rate is intended to address the myriad tax laws in countries around the world.

 Classification of deferred tax assets and liabilities:

The current standard (IAS 1) requires that deferred tax be classified as current assets or liabilities regardless of the classification of the underlying assets or liabilities responsible for the deferred tax. 

 The ED requires that deferred tax assets or liabilities to be classified as current or non current based on the classification of the underlying assets or liabilities.

  Observation: The IASB proposal aligns with the classification required by FAS 109

 Alternative Minimum Tax: 

FAS 109 requires the use of AMT rate when the condition exists for such rate.  However, IAS 12 is silent on AMT.  The ED proposes to follow the FAS 109 requirements with regards to AMT.

 Intercompany transactions: 

The ED proposes to retain the current IAS 12 requirements regarding intercompany transactions. 

 FAS 109 requires that taxes on intercompany profits (on non consolidating tax returns) be deferred until the asset is sold to a third party.  Under IAS 12 the tax on the profits will be recognized immediately. 

 The ED proposes additional disclosures to alleviate any concerns or impression of earnings management.  The board proposes reconciliation between the opening and ending balance of the deferred tax assets and liabilities, for each type of temporary differences and each type of unused tax losses and credits.  

 Observation:  The IFRS position is more practical.

 Uncertain tax positions: 

IAS 12 does not address any uncertainty relating to the tax position taken by an entity in its tax return.

 The FIN 48 Accounting for Uncertainty in Income Taxes –an Interpretation of FASB Statement No. 109 provides guidance on the uncertain tax positions.  An entity should recognize the tax benefits in full if it is more likely than not that the tax authority will accept the tax positions.   FIN 48 requires entity to use a cumulative probability measurement approach in determining the threshold to recognize the tax benefits.

 In the exposure draft the board did not agree with the underlying concept of FIN 48 because it was not consistent with the approach taken in the amended IAS 37 which does not allow any probability based threshold to recognize benefits.  The board took the position that any uncertainty should be considered in the measurement of the deferred tax assets or liabilities by using probability weighted- average of all outcomes.   The probability based threshold is no longer necessary.  Additionally, the board proposes that entity should make additional disclosure regarding uncertain tax positions.

 Observation:  The removal of probability based threshold may require more thorough review of the tax positions companies have taken.

 Intraperiod tax allocation: 

Intraperiod allocation refers to allocation of tax expense and liability to various sub-classifications such as between continued and discontinued operation, comprehensive income and equity

 The board acknowledges the complexity associated with the application of IAS 12 and FAS 109.  In some situations backward tracing requirements of IAS 12 is appropriate but in other situations they are difficult and produce arbitrary results.  The board, after much deliberation, decided to adopt the allocation approach of FAS 109 which is more fully specified method than IASB 12.  But knowing the complexity with FAS 109 the board has kept open the IAS 12 methods for further comments and review.    

 The current IAS 12 uses a method called backward tracing to allocate the tax benefit or expense.  The model requires that tax benefits or expenses out side of continuing operation to be allocated to the same place where the pre tax item was initially recorded.   

 Observation: In principal the FAS 109 approach is similar to IAS 12 however the FAS 109 model prohibits backwards tracing.   Generally intraperiod tax allocation triggered by irregular or extra ordinary items, capital transactions, or prior period adjustments.  Income tax expense related to continued operation needs to be disclosed separately but the taxes related to extraordinary items or discontinued operation can be presented net of taxes.  Under FAS 109 income taxes are computed twice, once on the overall income from the current operation without taken into account any irregular item and second time the income tax is computed on all income including all irregular items. The difference between the two calculations belongs to the extraordinary item.

 

Source:

IASB exposure draft: Income Tax, March 2009

IASB 12: Income Taxes

FAS 109: Accounting for Income Taxes

IFRS AND US GAAP: PENSION ACCOUNTING

 

CHALLENGES, IMPLICATIONS, AND STRATEGIES

(mchowdhry12@yahoo.com)

 

The accounting for post retirement employee benefits is complex and poses many challenges under the US GAAP as well as the IFRS.  The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) continue to review the accounting standards pertains to pension accounting in order to improve clarity, provide additional guidance, and accelerate harmonization of both accounting standards.

 

In this study we review the similarities and differences between US GAAP and IAS 19 as it relates to post-employment benefits plans.  We will also examine the implications of the convergence to IFRS and suggests some conversion strategies.

 

The International Financial Reporting Standards (IFRS) is a set of accounting standards developed by the International Accounting Board (IASB). The European companies listed in European stock exchange converted to IFRS in 2005 as required by the European Union Accounting regulations.  Many companies outside the EU region has adopted or planning to adopt the IFRS.   

Japan, Canada, and India have decided to adopt IFRS standards by the year 2012.

 

In 2002 the FASB expressed their support for single accounting standards for financial reporting and pledged to work with IASB to make reporting standards compatible.  In August 2008 the SEC proposed road map to IFRS implementation and calls for companies to adopt IFRS by the first quarter of 2015.  One of the goals of the single standards is to provide comparability of financial statements with relevant peer groups.  Conversion to IFRS is a major undertaking which will impact various levels of operations and has the potential to add more volatility in earnings or balance sheet. 

 

While most of the IFRS accounting standards are similar in concepts to US GAAP but there remains some significant differences when it comes to application.  Unlike US GAAP, IFRS does not always provide extensive guidance and in some situations the IFRS applications require exercise of judgment.   Additionally the US GAAP is more rules based standards while the IFRS accounting standards are more principal based.

 

 Following items require careful analysis and transition strategy:

• Impact of first time adoption of IFRS
• Determine the first time adoption options allowed by IFRS
• Presentation of components of pension and post retirement plans
• Impact of the restriction in recognizing pension plan assets
• Determine approach in recognizing actuarial gains or losses
• Impact of changes in recognizing prior service cost
• Impact of elimination of smoothing (MRV)
• Impact of special event-curtailment and settlement
• Impact of implicit pension promises or informal practices

 

Recent development: In March 2008 IASB issued a discussion paper proposing amendments to the following:

• Elimination of the corridor approach
• Elimination of deferred recognition and smoothing of actuarial gains or losses and prior service costs.
• Risk free discount rate for valuing plan obligation
• Creation of new pension classification: Contribution based promises and defined benefits promises instead of defined benefit and defined contribution.  The term “plan” is replaced by “promises”.  Multiple promises will require multiple accounting.
• Return on plan assets will be recorded as one line item instead of two components: Expected returns and Actuarial gains/losses.

 

The IASB has not made any specific recommendation on how the transaction should be recorded and presented in the financial statements but made three recommendations and requested public comments.  The board hopes to issue final standards with the above proposed changes in 2011.

 

At the January 2009 meeting IASB decided that change in benefit obligation should be disaggregated into employment, financing, and remeasurement components. 

 

 

Subject: First time adoption of accounting standards

 

US GAAP	IFRS	Implications
Generally financial statements need to be presented in retrospectively.	First time adoption of IAS 19 requires retrospective restatement but company may elect exemption from retrospective statements.	Electing exemption may increase/decrease future earnings and impact the owner’s equity.

 

Observation:  The International Accounting Standard Board require retrospective application of all IFRS but it also allows certain exemption for first time adoption because of the costs and complexity involve with retrospective application.  However, the alternatives choices allowed by IFRS 1 may diminish the comparability of financial statements among peers if some companies choose retrospective restatement.

 

The impact to companies who are using US GAAP may not be as profound as companies using non US GAAP where actuarial gains or losses are treated as off balance sheet item.   Under US GAAP actuarial gains or losses are recorded in AOCI with corresponding entry to accrued or prepaid pension cost.  These gains or losses are subsequently amortized to pension expense.

 

Transition strategy: Electing the exemption from retrospective restatement will accelerate the transition by avoiding complexities and costs associated with retrospective restatement.  Company may still choose corridor method after the adoption.

 

 

Subject: Financial statement presentation:

 

US GAAP	IFRS	Implications
The pension plans annual benefit cost be recognized as single component in the earnings.	Components of annual benefit cost can be presented separately in the P&L.  For example service cost can be presented as part of operating expense and interest or return on assets can be part of the finance costs.	EBITA will increase under IFRS.

 

Observation: The election to presents pension cost by components enhances quality and transparency of the operating expense for the company.  Once again, the multiple choices allowed under IAS 19 diminish the comparability of financial statements.  Because some companies may elect to show the components of the pension cost and others may not.

 

Transition strategy: The election to report pension expense by components will increase company’s EBITA.  Therefore, company needs to review the impact on lenders covenant and communicate the findings to the lenders in a timely manner.

 

Subject: Recognition of pension asset (pre-paid)

 

US GAAP	IFRS	Implications
Pension asset can be recognized with out any limitations or restrictions.	There is a ceiling on defined benefit asset that can be recognized on the balance sheet.  The recognition of pension assets can not exceed the total of unrecognized prior service cost, actuarial gains and losses and the present value of benefits available for refunds or reduction of future contributions to the plan.	The IFRS approach may reduce the pre-paid pension assets.

 

Observation:  The IASB has issued amendment (May 2002) to prevent the counter intuitive effects which results from the interaction of corridor method (actuarial gains or losses) and the ceiling on the recognition of asset.  The purpose of the amendment is to prevent gains or losses being recognized solely for the recognition of prior service cost or actuarial gains or losses.

 

Transition strategy: IASB has recently issued an exposure draft to identify issues which may impair the clarity and reliability of financial statements.  One of the main items on the ED is to elimination of Corridor or SoRIE methods of recognizing actuarial gains or losses. The IASB recommends that actuarial gains or losses be recognized in the earnings immediately.  Company should prepare the impact of such changes on their financial statements.  The IASB expects to issue the final standards by 2011.

 

Subject: Actuarial gains or losses:

 

US GAAP	IFRS	Implications
Uses corridor approach to recognize gains and losses exceeding 10% of DBO or FMV of Assets	Same
Any systematic method that results in faster recognition of gains or losses can be used instead of the corridor approach.	Same
SoRIE method is not allowed.	Actuarial gains or losses can be recorded in statement of other recognized income (SoRIE method).
Requires gains or losses over the corridor and not expensed to be recorded in the equity section of balance sheet under AOCI and subsequently amortized out of AOCI to earnings.	Amortization or recycling is strictly prohibited.  Allows off balance sheet recognition of actuarial gains or losses.	Off balance sheet recognition may under or overstate pension obligation which will create balance sheet volatility.
Inactive plan- excess over corridor to be amortized over the average future life of the participants.	Inactive plan-actuarial gains or losses in excess of corridor to be recorded in earnings immediately.	Earnings volatility.

 

Observation:  IAS 19 allows three methods for recognizing actuarial gains and losses.  The multiple choices diminish the comparability of financial statements among peers, which is one of the goals of IFRS.

 

Transition strategy: In general electing to recognize the actuarial gains or losses in the equity upon transition (first time adoption) will ease the P&L impact but will add volatility to the balance sheet.  The equity may be adversely affected if the gains and losses are significant.  Since the US GAAP (FAS 158) already requires recognition of actuarial gains or losses in the equity, the IFRS conversion will have minimum impact on the owners’ equity of the financial statements prepared according to US GAAP. However, the pension expense will increase/decrease in the subsequent years because IFRS does not require entities to amortize actuarial gains or losses recorded in the statement of other recognized income (SoRIE).  Companies should carefully monitor any new development with regards to the discussion paper issued in March 2008.  

 

 Subject: Prior year service cost:

 

US GAAP	IFRS	Implications
Requires prior service cost to be recorded in the AOCI in the year of the adoption of plan amendment. Increase/decrease in benefits due to plan changes requires to be amortized over the future working life time of participants or average inactive life time.  A decrease in benefits should be offset against any prior increase before amortization.	Increase/decrease in benefits due to plan change requires to be fully expensed in the year of adoption if the employees are fully vested.  Non-vested portion of the increased benefits to be amortized into earnings over the vesting period.	Potential earnings volatility resulting from accelerated expensing or crediting of prior service cost.

 

Observation:  According to US GAAP prior service cost to be recognized in the other comprehensive income of the owners’ equity.  The method of recognition of non-vested benefits under US GAAP and IFRS is similar in concept but the amortization period of such benefits varies substantially under the two standards.  IAS 19 requires that increase/decrease in prior service cost pertains to fully vested employees be reflected in the earnings in the year of adoption of plan change.  The requirements will generate earnings and balance sheet volatility.

 

Transition strategy: Companies must determine the amount of prior service cost that is vested and non-vested.  The vested portion of the benefits should be recognized at the conversion date. Companies would be better off by electing the alternate approach allowed by IFRS at the first time adoption. Under the alternate approach (option 2) companies will recognize the unamortized PSC in the equity which will eliminate any impact on earnings The non-vested portion of the benefits can remain off balance sheet and be amortized after the adoption of IFRS over a period before the benefits become vested.  Recognition of the vested portion of prior service costs may increase the earnings volatility and the pension benefits obligation after the transition.  However, the off balance sheet recognition of non vested pension benefits may have a positive impact on the pension obligation.

 

Subject: Special event accounting: Curtailment

 

US GAAP	IFRS	Implications
Curtailment resulting gains recognized when the employee terminate or a plan suspension or amendment has been finalized.  Curtailment losses are recognized when it is probable and effects can be reasonably estimated.	Curtailment resulting gains or losses recognized in earnings when the curtailment occurs.  Curtailment deemed to occur when a plan amendment is contractually binding or an entity made a commitment.	Deferral of gain will be eliminated under IASB 19.

 

Observation:  There are significant differences between US GAAP and IFRS when it comes to the timing of the recognition of curtailment gains or losses.   FAS 88 requires that curtailment losses be recorded when it is probable and the impact can be estimated.  However, curtailment gains should be deferred and recognize only when the employee terminates employment with the company or if the gains results from plan amendment, the gains should be recognized after the adoption of the amendment. 

 

IAS 19 requires that any curtailment gains/losses be recognized immediately when the company has a binding contract or demonstrably committed to reduce the benefits.  Impact of the curtailment must be material in relation to overall financial statements.

 

  Transition strategy: Companies need to identify and prepare schedule of all curtailment gains or losses that has not been expensed.  Some companies may benefit by making the plan change prior to converting to IFRS.

 

Subject: Special event accounting: Settlement

 

US GAAP	IFRS	Implications
Recognition of gains or losses from settlement is not required if the settlement cost does not exceed the plan’s service cost and interest costs	Settlement accounting is not required if the settlement payments are paid out according to normal operating procedure.	The amount of gains or losses recognized in earnings may be different.

 

Observation:  IFRS and US GAAP require that gains or losses resulted from settlement should be recognized.  However, under US GAAP the calculation of gains and losses include the recognition of any unrecognized actuarial gains or losses and any remaining unrecognized transition asset.  The IFRS calculation includes the change in the DBO and fair value of plan assets plus the related share of previously unrecognized actuarial gains or losses and prior service cost.

 

Transition strategy:  The calculation of settlement gains or losses is different under the two standards.  Entities should evaluate the impact of the different calculation. 

 

 

Subject: Assets valuation

 

US GAAP	IFRS	Implications
Valuations of pension assets are fair value less any cost to sell.   But in order to determine the expected returns on plan assets smoothing of market related value is allowed.	Valuations of pension assets are at market value at the balance sheet date.  Does not allow smoothing of market value (MRV)	Expected returns may fluctuate.

 

Observation:  US GAAP permits the use of a calculated asset values (to spread market value up to 5 years) in determining expected returns on plan assets.  IFRS does not allow such approach and requires that FMV of assets be used in the measurement day.

 

Transition strategy:  Companies need to evaluate the impact of the change on plan assets or obligations.  A sudden increase in plan obligations may adversely affect the bank covenant.

 

 

Subject: Obligation valuation

US GAAP	IFRS	Implications
Benefit obligation include obligation or benefit increase written under existing contract and exclude any implicit promises or employer informal practice.	Benefit obligation include obligation or benefit increase written under existing contract but include any implicit promises or employer informal practice.	Increase in the benefit obligation for many flat dollar benefit plans.

 

Observation:  US GAAP does not require companies to recognize pension obligation beyond the written agreement or contract.  In instances where an employer has permitted a regular increase in future benefits each year may be construed as implicit promise to increase benefits.  IAS 19 requires that such unwritten promise should be included in valuing the future benefits. 

 

Transition strategy:  Companies should evaluate past practices related to benefit obligation increase.   If there is a pattern of giving increases which are not part of the written agreement and never been recognized under US GAAP may have to recognized under IFRS.

 

 

 

Sources:

1. IFRS: IAS 19 Employee Benefits

 

2. US GAAP: FASB statements number 87- Employers accounting for pensions, 88- Employers’ accounting for settlements and curtailments of defined benefit pension plans and for termination benefits, 106- employers’ accounting for post retirement benefits other than pensions, 132 Employers’ Disclosures about Pension and Other Postretirement Benefits  and 158 –Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans

 

3. Discussion Paper – Preliminary Views on Amendments to IAS 19 Employee Benefits

 

4. IFRS and US GAAP: Similarities and differences-PricewaterhouseCoopers