Goodwill and Effective Tax Rates History of Accounting for Income Taxes

Chapter 3 Digging Deeper

Contents:

| GOODWILL AND EFFECTIVE TAX RATES | HISTORY OF ACCOUNTING FOR INCOME TAXES|

GOODWILL AND EFFECTIVE TAX RATES

1. The disparate tax and book treatment of goodwill has long triggered significant tax rate effects for many companies. Before 1993, when a company acquired goodwill in an acquisition, the goodwill was not amortizable for tax purposes. However, for book purposes, companies were required to amortize the cost of acquired goodwill over a period not exceeding 40 years. For years prior to 1993, this difference in the treatment of goodwill for tax purposes (not deductible) and book purposes (deductible) created an unfavorable permanent difference that caused an increase in a company's reported effective tax rate.

Companies often chose the "pooling" method for business combinations to avoid creating any goodwill (i.e., under the pooling method the two companies' balance sheets were essentially combined at book value, and no goodwill was created). The pooling method no longer is available. Section 197, added in 1993, resolved this problem for goodwill acquired after 1993. Goodwill was deductible for tax purposes over 15 years and for book purposes over a period not to exceed 40 years. Thus, the goodwill deduction became a temporary difference and had no effect on the reported effective tax rate.

Recent changes to accounting methods for goodwill have again created potential book-tax difference issues. Goodwill no longer is subject to amortization. Instead, the new GAAP rules require an annual determination of whether the intangible has been impaired. If the intangible has suffered an impairment, a deduction is required, to reduce the intangible's book value. This accounting method change has produced a book-tax difference that potentially is permanent. That is, the goodwill is amortizable for tax purposes over 15 years under § 197 but will never produce book deductions unless an impairment occurs. However, this book-tax difference is treated as a temporary difference and does not affect the reported effective tax rate.

HISTORY OF ACCOUNTING FOR INCOME TAXES

2. Accounting for income taxes has a long and controversial history. The original pronouncement addressing accounting for income taxes was APB 11. APB 11 focused on the income statement rather than balance sheet accounts. The so-called "deferred method" under APB 11 simply produced a "deferred tax" amount that was the difference between the tax provision and the actual taxes paid for the current year. Consequently, the "deferred tax" amount on the balance sheet was simply the cumulative difference produced by the APB 11 calculations, and it bore little relationship with the underlying transactions or assets. However, note that the APB 11 method may produce the same results as the FAS 109 method in simple situations (for example, no valuation allowance or changes in enacted tax rates).

In 1987, FAS 96 replaced APB 11, with significant changes in the method used to produce the provision for income tax expense. FAS 96 was controversial and its implementation was delayed by the FASB several times. The terminology of "temporary differences" and "permanent differences" was adopted in FAS 96 (replacing the concept of "timing difference" in APB 11). FAS 96 also adopted the "balance sheet" approach, treating any book-tax difference in the basis of a company's assets and liabilities as generating a future tax impact (tax savings or tax cost). FAS 96 required a number of complex hypothetical tax calculations based on expected future reversal of temporary differences. However, the effect of future income and expense items could not be considered in these hypothetical calculations.

FAS 96 was quickly replaced with FAS 109 in 1992. FAS 109 continued with the balance sheet approach and the concept of "temporary" and "permanent" differences. FAS 109 did allow the consideration of expected future income and expenses in determining deferred tax assets and liabilities. It also created the concept of a valuation allowance, requiring a substantial amount of auditor judgment in determining the likelihood of deferred tax assets being realized in the future.