Summary

This Financial Reporting Alert serves as a reminder that upon an entity’s adoption of Statement 141(R),    ¹ any subsequent changes to the entity’s acquired uncertain tax positions and valuation allowances associated with acquired deferred tax assets will no longer be applied to goodwill, regardless of the acquisition date of the associated business combination. Rather, such changes will typically be recognized as an adjustment to income tax expense. This Alert also highlights other changes to income tax accounting resulting from the issuance of Statement 141(R).

Background

Statement 141(R) is applied prospectively to business combinations in which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. However, the transition guidance of Statement 141(R) does not only affect business combinations consummated after the Statement’s effective date; it changes subsequent accounting for certain income tax items regardless of the related business combination date.

Before Statement 141(R), any changes in an acquired entity’s uncertain tax positions and reversals of valuation allowances associated with acquired deferred tax assets generally would be applied to goodwill, regardless of whether such changes occurred during the allocation period or after it. In contrast, Statement 141(R) requires any adjustments to an acquired entity’s uncertain tax positions, or valuation allowances associated with acquired deferred tax assets that occur after the measurement period, to be recorded pursuant to Interpretation 48    ² and Statement 109.    ³ Accordingly, any changes after the measurement period will generally be reflected in income tax expense. The transition provisions of Statement 141(R) clarify that this new requirement applies to all tax uncertainties and valuation allowances recognized as a result of a business combination, including those that arose in business combinations consummated before Statement 141(R)’s effective date.

 Acquired Uncertain Tax Positions

Under Issue 93-7,  ⁴ any changes in an acquired entity’s uncertain tax position balances were generally recognized as adjustments to goodwill. Statement 141(R) nullified Issue 93-7 and states that income tax uncertainties acquired in a business combination should be accounted for in accordance with Interpretation 48. Statement 141(R) also amended Interpretation 48 to add paragraph 12B, which states:  

The effect of a change to an acquired tax position, or those that arise as a result of the acquisition, shall be recognized as follows: 

a.      Changes within the measurement period that result from new information about facts and circumstances that existed as of the acquisition date shall be recognized through a corresponding adjustment to goodwill.  However, once goodwill is reduced to zero, the remaining portion of that adjustment shall be recognized as a gain on a bargain purchase in accordance with paragraphs 36–38 of Statement 141(R).

b.      All other changes in acquired income tax positions shall be accounted for in accordance with this Interpretation. 

Therefore, if an acquired entity’s unrecognized tax benefit for a tax position is adjusted during the measurement period because of new information about facts and circumstances that existed as of the acquisition date, goodwill should be adjusted. However, even during the measurement period, if the adjustment to the acquired entity’s unrecognized tax benefit is the result of an identifiable event that occurred after the business combination’s acquisition date, then the adjustment is generally recorded to income tax expense. Note that Interpretation 48 states that judgments may be changed only after the evaluation of new information — not on the basis of a new evaluation or new interpretation of information that was available in previous financial reporting periods. After the measurement period, all changes in the acquired entity’s unrecognized tax benefit will be recorded pursuant to the guidance in Interpretation 48.

Paragraph 12B of Interpretation 48 is effective for all business combinations (regardless of when the business combination was consummated) on or after the effective date of Statement 141(R).

Example 1

On January 15, 2005, Company X acquired 100 percent of Company Y. As part of the purchase accounting, X recognized a liability associated with an unrecognized tax benefit. On December 31, 2006, X increased the liability as a result of new information to reflect a change in its best estimate of the ultimate settlement with the taxing authority. In accordance with Issue 93-7, X recorded this adjustment as an increase to goodwill. After it adopts Statement 141(R), X will be required to record any additional adjustments to the liability as a component of income tax expense. 

Example 2

Company X purchases 100 percent of Company Y on February 15, 2007, and the transaction is accounted for under Statement 141. Company X has recorded an unrecognized tax benefit of $100 related to Y’s state tax nexus issues. Company X has a calendar year-end and will adopt Statement 141(R) on January 1, 2009. On March 15, 2009, X concludes, on the basis of new information, that Y’s $100 unrecognized tax benefit is no longer needed. Following the transitional provisions of Statement 141(R), X will reverse the liability for the unrecognized tax benefit and credit income tax expense.  

 Acquired Deferred Tax Asset Valuation Allowances 

Under paragraph 30 of Statement 109, an acquired entity’s deferred tax assets, or operating loss carryforwards that were not initially realizable as of the acquisition date (partial or full valuation allowance against the acquired entity’s deferred tax assets), but are considered realizable after the acquisition date, were generally applied to goodwill.  Statement 141(R) amended Statement 109 to add paragraph 30A, which states:

The effect of a change in a valuation allowance for an acquired entity’s deferred tax asset shall be recognized as follows: 

a.      Changes within the measurement period [footnote 8a] that result from new information about facts and circumstances that existed at the acquisition date shall be recognized through a corresponding adjustment to goodwill. However, once goodwill is reduced to zero, an acquirer shall recognize any additional decrease in the valuation allowance as a bargain purchase in accordance with paragraph 36–38 of Statement 141(R).

b.      All other changes shall be reported as a reduction or increase to income tax expense (or a direct adjustment to contributed capital as required by paragraph 26).

[Footnote 8a states that] the measurement period in the context of a business combination is described in paragraphs 51–56 of Statement 141(R). 

Therefore, subsequent changes in an acquired entity’s deferred tax asset valuation allowance that were established as of the business combination’s acquisition date would generally be recorded to income tax expense unless such adjustments occurred in the measurement period and related to information about facts and circumstances that existed as of the acquisition date. If the adjustment occurred during the measurement period and relates to new information about facts and circumstances that existed as of the acquisition date, the adjustment would be recorded to goodwill.

When an entity adopts Statement 141(R), paragraph 30A is effective for business combinations regardless of when they were consummated. 

Example

On July 15, 2006, Company X acquired 100 percent of Company Y. As part of the purchase accounting, X established a full valuation allowance on Y’s deferred tax asset for net operating losses (NOLs) of $100. On September 30, 2007, X determined that $40 of Y’s NOLs will be realizable and reversed its valuation allowance with a corresponding entry to goodwill in accordance with paragraph 30 of Statement 109. Company X has a calendar year-end and will adopt Statement 141(R) on January 1, 2009. On June 15, 2009, X concludes that, under Statement 109, Y’s remaining $60 NOL deferred tax asset is realizable and the valuation allowance is no longer necessary. Following the transitional provisions of Statement 141(R), X will reverse its remaining $60 valuation allowance and record a corresponding credit to income tax expense.

Other Income Tax Accounting Changes

Statement 141(R) amends Statement 109 concerning (1) recognition of a deferred tax asset for the excess of tax deductible goodwill over goodwill for financial reporting and (2) reversals of acquirer’s valuation allowance on its deferred tax assets resulting from a business combination. Under Statement 141(R), the recognition of a deferred tax asset for tax deductible goodwill in excess of financial reporting goodwill is no longer prohibited. That is, all deferred tax assets for tax deductible goodwill from business combinations after the adoption of Statement 141 (R) will be recorded as of the acquisition date. For excess tax deductible goodwill from business combinations accounted for under Statement 141, paragraphs 262 and 263 of Statement 109 (pre-Statement 141(R) amendments) still apply. That is, goodwill will continue to be adjusted as the tax deductible goodwill (“second component”) is realized on the tax return.

The guidance in paragraph 266 of Statement 109 (pre-Statement 141(R) amendments) on acquirers’ valuation allowances stated that in some circumstances, reversals of an acquirer’s valuation allowance that resulted from the business combination would be included in the business combination accounting. Statement 141(R) amends paragraph 266 and clarifies that reversals of acquirers’ valuation allowances are not part of the business combination accounting.

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  1   FASB Statement No. 141(R), Business Combinations.

  2   FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes.

  3   FASB Statement No. 109, Accounting for Income Taxes.

  4   EITF Issue No. 93-7, “Uncertainties Related to Income Taxes in a Purchase Business Combination.”

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