Practical Lessons in Applying Accounting Standards: A Case Study in Applying Accounting Standards Carries Practical Lessons for Accountants
Pounder, Bruce, Strategic Finance
Recently I participated in an online discussion with colleagues about how U.S. Generally Accepted Accounting Principles (GAAP) should be applied to a specific real-world situation. We researched the issue and reached a conclusion that we believed to be correct. But we could have easily reached an incorrect conclusion if we hadn't done three particular things in the course of our research. In this month's column, I'll describe the situation we addressed, identify the three key things we did to arrive at our conclusion, and explain why each was critical to the correctness of our conclusion. The practical lessons you'll learn from this case study will help you correctly apply U.S. GAAP--or other accounting standards--to many other situations.
In the United States, accounting for income tax purposes differs significantly from financial accounting. Yet income taxes represent an economic reality that must be reflected in a company's financial accounting. Earlier this year, my colleagues and I sought to answer a question regarding the application of financial accounting standards--specifically, U.S. GAAP--to an actual situation involving corporate income taxes, which I'll now summarize.
A reporting entity, "Company X," prepares financial statements and files income tax returns on a calendar-year basis. During 2012, the company incurred research and development (R&D) costs for which no special treatment was required or allowed under enacted tax laws. At year-end, those costs were properly reflected in the company's estimate of its taxable income for 2012. For financial accounting purposes, the company estimated its liability for income taxes at year-end based on its estimated taxable income for the year.
In January 2013, a new tax law was enacted. The law, which was retroactively effective for 2012, allows Company X to claim a tax credit on its 2012 tax return for the R&D costs that it incurred in 2012. At the time the new law was enacted, the company hadn't filed its 2012 tax return nor had it issued its 2012 financial statements.
Company X intends to claim the tax credit on its 2012 tax return. As a result, the actual amount of the company's tax liability would be lower than the amount it had estimated at the end of 2012. The financial accounting question that arose from this situation was "Should the tax liability to be reported in Company X's 2012 financial statements reflect the tax credit or not?"
What first came to mind for my colleagues and me was the accounting concept of "subsequent events." Under U.S. GAAP, subsequent events are events that occur after the end of a fiscal year but before financial statements for that year are issued (or are available to be issued). In some cases, subsequent events provide the reporting entity with additional information about the existence and/or amounts of its assets and liabilities as of year-end. In such cases, U.S. GAAP generally requires the reporting entity to use that information in reporting its year-end assets and liabilities (see my April 2010 column, "The Benefit of Hindsight").
The main subsequent events provisions of U.S. GAAP are documented in Topic 855, Subsequent Events, of the Financial Accounting Standards Board's (FASB's) Accounting Standards Codification[R] (ASC). My colleagues and I perceived the retroactively effective tax law to be the kind of subsequent event that ASC Topic 855 would require Company X to consider when measuring its 2012 year-end tax liability. As such, it seemed correct to conclude that the tax liability to be reported in Company X's 2012 financial statements should reflect the new R&D tax credit because the company's reported liability would then match its actual liability more closely.
We had arrived at a simple, obvious answer to our question. But you may have heard an old saying often attributed to Mark Twain, Albert Einstein, and others: "For every problem there is always a solution that is simple, obvious, and wrong. …