Copyright 2010 Gale Group, Inc.All Rights ReservedASAPCopyright 2010 A.M. Best Company, Inc. Best’s Review
May 1, 2010
Pg. 86(3) Vol. 111 No. 1 ISSN: 1527-5914
A taxing situation: how to account for deferred taxes; Regulatory/Law: Deferred Taxes
Deferred taxes have long been one of the most perplexing issues for chief executive officers to understand. Trying to decipher what, when and where to defer often becomes problematic when deferrals show up as assets on balance sheets.
This is the first part of a two-part series that will provide a historical overview of Statements of Statutory Accounting Principles No. 10, Income Taxes, better known as SSAP 10. It went into effect Jan.l, 2001, and is still wreaking havoc for many insurance companies. This article will also cover corresponding Generally Accepted Accounting Principles, or GAAP, literature identified as ASC 740 Income Taxes(formerly referred to as Financial Accounting Standard No. 109 Accounting for Income Taxes, or simply FAS 109). It will highlight some ofthe significant differences between the two methodologies and conclude with some current developments in the area.
Sooner or later, the CEO or chief financial officer of an insurance company is confronted with an issue concerning its income tax provision. Unfortunately, this tends to occur the day before the report needs to be issued–or worse, when an error in the tax provision is discovered by the auditor after the regulatory filing has been completed, resulting in an amendment. This typically results in an unfavorableadjustment to the company’s surplus.
Recently, a client was struggling financially and did not watch its provision calculations closely enough.
Since the client had generated a loss for the year on a book and tax basis, it recorded refundable income taxes on its annual statement. Unfortunately, the client had filed previously for refunds under carry-backs; did not have any taxes paid in from prior years to be refunded; and the calculation was not sent to us to review before filing.
The error was discovered several months later during the audit process, resulting in a reduction to surplus of more than $1 million andan amended annual statement filing. The large decrease in surplus did not help the company’s relationship with its regulators, which placed the already struggling company into default on their risk-based capital requirements.
In this particular case, the controller who made the mistake endedup leaving the company in embarrassment. The CFO took full responsibility for his failure to catch the error on review, but the damage had been done to the company and its reputation.
The board of directors is never pleased in such situations, and this creates anxiety for everyone involved. Terms such as SSAP 10, FAS 109, DTAs, DTLs, admissibility, FIN 48, temporary differences and current taxes are thrown around and offered as explanations. What makes the issues especially complicated for insurance companies is that firms often need to prepare their statements on a statutory basis of accounting as well as U.S. GAAP.
This means individuals responsible for the provision must not onlybe familiar with statutory accounting principles and U.S. GAAP, but they must also have a fundamental understanding of federal income taxrules and regulations–the main cause of issues encountered.
In order to understand SSAP 10, it is imperative to first recognize the fundamental principles of ASC 740, since SSAP 10 adopts ASC 740–with modifications for state taxes, the realization criteria for deferred tax assets and the recording impact of changes in its deferredtax balances.
ASC 740 Income Taxes
ASC 740, formerly referred to as FAS 109, was adopted in February 1992, and uses a balance-sheet approach to income taxes. The focus ison differences between U.S. GAAP and tax balances in its assets and liabilities, as opposed to an income tax approach. ASC 740 provides that the purpose of accounting for income taxes is to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in a company’s financial statements or tax returns.
The following basic principles found in ASC 740 are applied in accounting for income taxes at the date of the financial statements:
* A current tax liability or asset is recognized for the estimatedtaxes payable or refundable on tax returns for the current year.
* A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carry-forwards.
* The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated.
* The measurement of deferred tax assets is reduced by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
Temporary or timing differences arise when income or expense itemsare recorded on the books in periods different from the periods in which they are recognized as taxable income or expense in the tax return.
For example, if a company depreciates its fixed assets for U.S. GAAP purposes over a five-year period but takes advantage of accelerated depreciation for tax purposes, this would give rise to a timing difference. This difference in depreciation would impact taxable income (taxable income would be less than book income in the current period)and the tax basis of assets (book basis would be higher than the taxbasis).
Temporary differences are measured using a balance sheet approach whereby statutory and tax-basis balance sheets are compared. They ordinarily become taxable or deductible when the related asset is recovered or the related liability is settled. A deferred tax liability or asset denotes the increase or decrease, in taxes payable or refundable, in future years as a result of temporary differences and carry-forwards at the end of the current year.
A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years. For example, assume that a company purchases computer equipment for $100,000. On the books, the company capitalizes the $100,000 and depreciates it using astraight-line method over five years, giving rise to a $20,000 deduction per year. For tax purposes, the company elects to take advantageof Internal Revenue Code section 179 and expenses the full $100,000 in year one.
As a result, two things occur. First, on the current tax provision, the company’s taxable income is going to be $80,000 less than book income in this period. This is the difference between tax depreciation ($100,000) as compared to book depreciation ($20,000).
Second, a temporary difference is created between the book basis and the tax basis of property for which a company takes accelerated depreciation on its tax return because the company will have more taxable income in the future. At the end of this period, the book basis ofthe asset is $80,000 ($100,000 cost less depreciation of $20,000) and the tax basis of the asset is $0 ($100,000 cost less $100,000 section 179 depreciation) Because the tax deduction in the future will be less than the book depreciation, a deferred tax liability is recognized in the current year for the related taxes payable in future years.
A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carry-forwards. For example, a temporary difference is created between the reported amount of the unpaid losses and loss adjustment expenses reportedon the tax return versus the financial statements. For tax purposes,companies are required to discount the unpaid losses and loss adjustment expenses, giving yield to a greater tax deduction in the future.Payment of the losses and expenses will result in greater tax deductions in future years, and a deferred tax asset is recognized in the current year for the reduction in taxes payable in future years.
How They’re Different
There are numerous differences between ASC 740 and SSAP 10. The major dissimilarities are in how they treat state income taxes, valuation allowances and changes in deferred tax assets and liabilities.
According to SSAP 10, state income taxes are included as taxes, licenses and fees and there is no provision made for deferred state income taxes.
Comparatively, ASC 740 includes state income taxes as income taxesincurred and does provide for deferred state income taxes.
SSAP 10 does not reduce the deferred tax assets by a valuation allowance. Instead, a company must compute how much of the deferred tax asset is admitted. This approach is much more objective than requiredby ASC 740. Generally speaking, gross tax assets shall be admitted in an amount equal to the sum of (1) federal income taxes paid in prior years that can be recovered through loss carry-backs for existing temporary differences that reverse by the end of the subsequent calendar year; (2) the lesser of (a) the amount of gross deferred tax assets expected to be realized within one year of the balance sheet date, or (b) 10% of statutory capital and surplus as required to be shown on the statutory balance sheet of the entity for its most recently filed statement.
Conversely, U.S. GAAP requires that deferred tax assets be reducedby a valuation allowance if it is more likely than not that some portion, or all of the deferred tax assets, will not be realized.
Recently, some changes were made to SSAP 10, and SSAP 10R Income Taxes–Revised, A Temporary Replacement of SSAP No. 10, was adopted. These changes should provide some relief to insurance companies that have suffered a reduction in their surplus due to current economic conditions. Under SSAP 10R, the admissibility test is increased from 10%to 15% of adjusted surplus, and the admissibility test increases theloss carry-back allowance from one year to three. The changes will be effective for year-end Dec. 31, 2009, and for interim periods 2010,and will expire Dec. 31, 2010, unless additional changes are made.
Changes in deferred tax assets and deferred tax losses are recognized as a separate component of gains and losses in unassigned surplus. By comparison, U.S. GAAP requires that changes in deferred tax assets and deferred tax losses be included in income tax expense or benefit and are allocated to continuing operations, discontinued operations and extraordinary items.
* At Issue: Deciding what, when and where to defer can become problematic when deferrals show up as assets on balance sheets.
* What It Means: If deferred taxes are not handled properly, an insurance company may have to adjust its surplus.
* What Needs to Happen: In order to accurately ascribe deferred taxes, a CEO must ensure the company’s financial department understandsstatutory and GAAP accounting regulations.
Part 2 will discuss common mistakes that continue to be made and how companies should address these concerns. Below are just a few mistakes that are often seen. How to prevent these and more will be explained in Part 2.
Some common errors:
1. Booking refundable taxes when a company has a tax loss, but no taxes have been paid in to be refunded.
2. Confusing the tax provision with the deferred tax asset. For example, a client once booked a deferred tax asset as refundable taxes and as a deferred tax asset, resulting in double-dipping on the assets.
3. Forgetting to include net operating losses in the deferred tax assets calculation.
4. Incorrect treatment of non-admitted assets.
Contributor Paul Dougherty is partner-in-charge of the Insurance Tax Practice at Amper, Politziner & Mattia LLP. He can be reached at Dougherty@amper.com
May 20, 2010