Will Intangibles Trip You Up? Financial Restatements Due to Improper Accounting for Income Taxes Often Come from Mishandling Indefinite-Lived Intangibles Issues

By Adams, Mollie T.; Inger, Kerry K. et al. | Strategic Finance, November 2015 | Go to article overview

Will Intangibles Trip You Up? Financial Restatements Due to Improper Accounting for Income Taxes Often Come from Mishandling Indefinite-Lived Intangibles Issues


Adams, Mollie T., Inger, Kerry K., Meckfessel, Michele D., Strategic Finance


Amending a tax return might not put a CFO's job at risk, but having to restate financial statements too often because of tax-related issues might do it! Many companies have stumbled over the thorny tax issues surrounding indefinite-lived intangible assets--especially in situations involving business combinations-and have had to restate their financial statements. In a panel session at the 2014 annual meeting of the American Taxation Association, Stephanie Davis, tax vice president at Valero Energy Corporation, said that having to amend a tax return wouldn't put her job at risk, but a tax-related restatement of the financial statements would. With merger and acquisition activity on the rise in recent years, more CFOs may face these issues in the future.

Accounting for income taxes is one area that leads to a high percentage of total restatements. According to the Ernst & Young Technical Line paper, "Lessons Learned from Our Review of Restatements," accounting for income taxes was the largest cause for restating in a sample of 2011 restatements and was the second-largest cause in a sample of 2010 restatements. We examined restatements occurring between 2005 and 2010 related to accounting for income taxes and identified by Audit Analytics, a Sutton, Mass.-based independent research firm. Seventeen of the identified firms restated their financial statements due to two problems: (1) improper recording of deferred taxes related to indefinite-lived intangibles acquired in mergers and acquisitions and (2) mishandling of deferred tax assets and liabilities on indefinite-lived intangibles in determining the valuation allowance.

Companies--and their CFOs--engaging in mergers and acquisitions need to be familiar with the associated tax accounting implications if they want to avoid similar restatements. To help navigate these issues, we'll take a close look at accounting for income taxes related to indefinite-lived intangible assets in the context of business combinations, as well as the determination of the valuation allowance.

UNDERSTANDING THE PROBLEM

Because the restatements occur as a result of mergers and acquisitions, let's briefly review the area of business combinations and its consequences in accounting for income taxes. Remember that the federal tax law rules for business combinations are complex, and this overview isn't meant to be a comprehensive discussion of those rules.

Mergers and acquisitions take one of two general forms: a stock acquisition or an asset acquisition. Depending on the structure of the merger and the consideration paid to the target's shareholders, the business combination is either a tax-free reorganization or a taxable transaction.

Internal Revenue Code (IRC) [section]368, "Definitions Relating to Corporate Reorganizations," and Treasury Regulation 1.368 contain the tax-free reorganization rules that exempt six specific corporate combinations from taxable gain recognition at the time of the reorganization. Four of them (Types A, B, C, and E) affect the accounting for income taxes with indefinite-lived intangibles.

In Type A or B reorganizations-which are nontaxable business combinations under IRC [section]368(a)(1)(A) and IRC [section]368(a)(1)(B), respectively-the acquiring company assumes the carryover (historical) basis of the acquired company's assets and liabilities. When a taxable stock acquisition occurs without election of IRC [section]338, "Certain stock purchases treated as asset acquisitions," the purchaser receives the target's stock with a tax basis "stepped up" to fair market value, but the assets retain their carryover basis. In taxable asset acquisitions and taxable stock acquisitions with a [section]338 election, the acquiring company is allowed a "stepped up" basis of all assets and liabilities to fair market value.

IRC [section]1060, "Special allocation rules for certain asset acquisitions," orders the allocation of purchase price based on seven asset classes. …

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