GLG News by Thomas Klein, CPA

Implications: Depending upon management's classification of a security (i.e., either "trading" or "available for sale"), a charge may or may not appear on the income statement in the same period as the write-down on the balance sheet. If the security is classified as a trading security, the charge on the income statement will occur in the same period as the write-down.  However, if the security is classified as available for sale, the charge bypasses the income statement and is taken directly to stockholders equity.  If the value of the security does not recover prior to its liquidation, the charge typically is taken in the year of liquidation. The potential charge for write-downs related to available for sale securities can be quantified by looking at the statement of stockholders equity, particularly other comprehensive income.

Analysis: Citigroup and Merrill Lynch, as well as numerous other companies, have taken massive write-downs on their security holdings.  Depending upon management's classification of a security (i.e., either "trading" or "available for sale"), a charge may or may not appear on the income statement in the same period as the write-down on the balance sheet. If the security is classified as a trading security, the charge on the income statement will occur in the same period as the write-down.  However, if the security is classified as available for sale, the charge bypasses the income statement and is taken directly to stockholders equity.  If the value of the security does not recover prior to its liquidation, the charge typically is taken in the year of liquidation.The potential charge for write-downs related to available for sale securities can be quantified by looking at the statement of stockholders equity, particularly other comprehensive income.

Implications: Investors fled General Motors following the release of its Q3 results.  The reported loss for the quarter was $38.96 billion of which 99% of the loss ($38.6 billion) resulted from the write-down of deferred tax assets.  Have investors overreacted to the noncash charge or is the decline in market value justified?

Analysis: At the close of Q3, GM management determined that deferred tax assets (i.e., the after tax value of NOLs, tax credits, etc.) reflected on the Company's balance sheet were overstated based upon the accounting guidelines for deferred tax assets ("DTAs").  Apparently, management determined that it is no longer "more-likely-than-not" that the Company will realize the benefits of $38.6 billion in tax attributes (e.g., NOLs, tax credits) in the future.

The more-likely-than-not threshold under Financial Accounting Standard 109 is defined to be "more than 50%".  For example, management may have concluded, as of Q2, that there was a 55% probability of realizing these tax attributes in the future.  However, as of Q3, the probability may have slipped to 45% with respect to $38.6 billion of tax attributes.  The reduction in the probability of future realization likely resulted from the Company's consistent history of losses in recent periods.  In other words, NOL carryforwards and tax credits only have value to the extent that the Company becomes profitable in the tax jurisdictions in which those tax attributes reside.  If it is not more-likely-than-not that this will occur before those tax attributes expire, the assets must be taken off the balance sheet through the recording of a valuation allowance (and thus a corresponding charge to earnings).
 
Interested parties should realize that if circumstances change such that it once again becomes more-likely-than-not that the attributes will be realized in the future, some or all of the $38.6 billion will once again be reflected on the balance sheet with a corresponding tax benefit reflected on the income statement.  The bottom line is that the "more-likely-than-not" test is an all or nothing test in that no deferred tax asset can be recorded on the balance sheet if the probability of future realization is less-likely-than-not (e.g., 45%) while the entire asset can be recognized if the probability of future realization is more-likely-than-not (e.g., 55%).

Implications: The FASB received over 400 letters representing more than 1,000 companies’ concerns about implementation issues related to FASB Interpretation #48 (FIN 48).  The vast majority of the letters requested a deferral of the effective date of the new Interpretation; fiscal years beginning after December 15, 2006 (i.e., the quarter ending December 31, 2007 for calendar year companies).  The FASB voted overwhelmingly not to defer the effective date.  This means that most companies' financial statement will be affected beginning Q1 of 2007.

Analysis: Despite the protests of hundreds of companies, the FASB refused to defer the effective date (generally, Q1 of 2007) of FASB Interpretation #48 (FIN 48).  The Interpretation requires companies to identify and quantify all of their "uncertain tax positions" and accrue liabilities accordingly.  The Interpretation will affect earnings as well as the balance sheet presentation.

Uncertain tax positions exist because of certain ambiguities in the tax code. Generally, a taxpayer must only have a "realistic possibility" of prevailing in a tax matter in order to avoid the imposition of penalties. Therefore, taxpayers often take aggressive tax positions in their tax return filings. Some companies are less aggressive and others are more aggressive; this is often driven by management's tolerance for uncertainty and the nature of a company's business activities.

Beginning in 2007, all public companies will have to comply with the provisions of FIN 48. FIN 48 will generally result in the recording of more liabilities for uncertain tax positions than its predecessor, Financial Accounting Standard ("FAS") 5. Initially, companies will be required to increase their liabilities for existing uncertain tax positions with a corresponding adjustment to retained earnings (as of January 1, 2007 for most companies). Thereafter, companies will be required to make adjustments to their liabilities for uncertain tax positions (both increases and decreases) and these adjustments may impact earnings, depending upon the nature of the tax position. Some companies will see an increase in the volatility of the their effective tax rates (ETR) while others will not. Generally, the more aggressive the company (with regard to tax positions), the more volatility it will experience in its ETR.

Not only will some companies experience more volatility in their ETRs, they will also experience an overall increase in their provision for taxes (i.e., income tax expense). This is likely for two reasons: First, companies that have been historically aggressive in their tax positions may decide to become somewhat less aggressive in their tax positions given the new accounting treatment for these positions; Second, the additional footnote disclosures required under FIN 48 may result in taxing authorities (e.g., the IRS) having greater success in detecting aggressive tax strategies.

Though not effective until Q-1 of 2007, SEC Staff Accounting Bulletin ("SAB") 74 requires companies to disclose the effects of FIN 48 in their 2006 K-1s (available in early March of 2007 for most companies). Therefore, the amount of the additional liability to be recorded in Q-1 of 2007 resulting from the transition from FAS 5 to FIN 48 should be disclosed (i.e., quantified in the tax footnote) in the 2006 K-1s.

Implications: FASB Interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes, is scheduled to become effective for a company's first quarter beginning after December 15, 2006 (i.e., the quarter ended 3/31/07 for calendar year companies).  The FASB announced today that it will consider deferring the effective date by one year when it meets on January 17, 2007.  The possible delay was likely prompted by numerous concerns that have been expressed to the FASB by hundreds of companies.  Implementation of FIN 48 will impact most companies' balance sheets, earnings and cash flows.

Analysis: Due to numerous concerns expressed by hundreds of companies, the FASB announced that it will consider deferring the effective date of FIN 48 by one year.  Adoption of the new interpretation would have had an immediate impact on most companies' balance sheets; in some cases, a material impact. Thereafter, earnings would have likely been impacted as well.  In addition to the balance sheet and statement of earnings impact, companies would also be required to provide far more information regarding its tax strategies in its income tax footnote disclosures.  This could lead to more effective auditing by the taxing authorities.

The FASB will likely consider whether companies have had adequate time to identify all of their uncertain tax positions.  This can be a very extensive process for any company, let alone for conglomerates and multinational companies.  In addition to identifying the positions, companies also need to quantify the appropriate amount of the additional liability for each uncertain tax position.  Concerns have also been expressed about the transparency of the footnote disclosures and their impact on future income tax audits.  The FASB has already indicated that the principal of full disclosure trumps these concerns.  So, it is likely that he FASB will focus on the former concern (i.e., time constraints).

The following is a recap of the interpretation in its current state:

Uncertain tax positions exist because of certain ambiguities in the tax code. Generally, a taxpayer must only have a "realistic possibility" of prevailing in a tax matter in order to avoid the imposition of penalties. Therefore, taxpayers often take aggressive tax positions in their tax return filings. Some companies are less aggressive and others are more aggressive; this is often driven by management's tolerance for uncertainty and the nature of a company's business activities.

Beginning in 2007, all public companies will have to comply with the provisions of FIN 48. FIN 48 will generally result in the recording of more liabilities for uncertain tax positions than its predecessor, Financial Accounting Standard ("FAS") 5. Initially, companies will be required to increase their liabilities for existing uncertain tax positions with a corresponding adjustment to retained earnings (as of January 1, 2007 for most companies). Thereafter, companies will be required to make adjustments to their liabilities for uncertain tax positions (both increases and decreases) and these adjustments may impact earnings, depending upon the nature of the tax position. Some companies will see an increase in the volatility of the their effective tax rates (ETR) while others will not. Generally, the more aggressive the company (with regard to tax positions), the more volatility it will experience in its ETR.

Not only will some companies experience more volatility in their ETRs, they will also experience an overall increase in their provision for taxes (i.e., income tax expense). This is likely for two reasons: First, companies that have been historically aggressive in their tax positions may decide to become somewhat less aggressive in their tax positions given the new accounting treatment for these positions; Second, the additional footnote disclosures required under FIN 48 may result in taxing authorities (e.g., the IRS) having greater success in detecting aggressive tax strategies.

Though not effective until Q-1 of 2007, SEC Staff Accounting Bulletin ("SAB") 74 requires companies to disclose the effects of FIN 48 in their 2006 K-1s (available in early March of 2007 for most companies). Therefore, the amount of the additional liability to be recorded in Q-1 of 2007 resulting from the transition from FAS 5 to FIN 48 should be disclosed (i.e., quantified in the tax footnote) in the 2006 K-1s.

Implications: FASB Interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes, becomes effective in a company's first quarter beginning after December 15, 2006 (i.e., the quarter ended 3/31/07 for calendar year companies).  Adoption of the new interpretation will have an immediate impact on most companies balance sheets; in some cases, a material impact.  Thereafter, earnings will likely be impacted as well.  The long-term impact on earnings is still unknown.  Companies that are less aggressive from a tax perspective will see less of an impact on earnings; those that have been more aggressive will likely see a greater impact on earnings (i.e., a reduction in earnings).  In addition to the balance sheet and statement of earnings impact, companies will also have to provide far more information regarding its tax strategies in its income tax footnote.

Analysis: Uncertain tax positions exist because of certain ambiguities in the tax code.  Generally, a taxpayer must only have a "realistic possibility" of prevailing in a tax matter in order to avoid the imposition of penalties.  Therefore, taxpayers often take aggressive tax positions in their tax return filings.  Some companies are less aggressive and others are more aggressive; this is often driven by management's tolerance for uncertainty and the nature of a company's business activities.

Beginning in 2007, all public companies will have to comply with the provisions of FIN 48.  FIN 48 will generally result in the recording of more liabilities for uncertain tax positions than its predecessor, Financial Accounting Standard ("FAS") 5.  Initially, companies will be required to increase their liabilities for existing uncertain tax positions with a corresponding adjustment to retained earnings (as of January 1, 2007 for most companies).  Thereafter, companies will be required to make adjustments to their liabilities for uncertain tax positions (both increases and decreases) and these adjustments may impact earnings, depending upon the nature of the tax position.  Some companies will see an increase in the volatility of the their effective tax rates (ETR) while others will not.  Generally, the more aggressive the company (with regard to tax positions), the more volatility it will experience in its ETR.

Not only will some companies experience more volatility in their ETRs, they will also experience an overall increase in their provision for taxes (i.e., income tax expense).  This is likely for two reasons: First, companies that have been historically aggressive in their tax positions may decide to become somewhat less aggressive in their tax positions given the new accounting treatment for these positions; Second, the additional footnote disclosures required under FIN 48 may result in taxing authorities (e.g., the IRS) having greater success in detecting aggressive tax strategies.

Though not effective until Q-1 of 2007, SEC Staff Accounting Bulletin ("SAB") 74 requires companies to disclose the effects of FIN 48 in their 2006 K-1s (available in early March of 2007 for most companies).  Therefore, the amount of the additional liability to be recorded in Q-1 of 2007 resulting from the transition from FAS 5 to FIN 48 should be disclosed (i.e., quantified in the tax footnote) in the 2006 K-1s.

Implications: Restatement charges for option backdating were initially perceived to be a largely noncash adjustment to earnings.  However, it is becoming apparent that the backdating may result in very significant tax liabilities, with a material impact on a company's cash flows.

Analysis: When companies backdate option grants to a lower exercise price, the result is often a larger taxable gain to the employee upon the exercise of the option.  In the case of "nonqualified stock options", the company receives a corresponding tax deduction for compensation expense.  Therefore, as a result of the backdating, the company has overstated its tax deduction.

There are other examples where a company has likely overstated its tax deductions as a result of the backdating.  For example, the tax code limits the tax deduction for nonperformance based compensation paid to certain highly compensated officers to $1,000,000.  To the extent that, as a result of the backdating, the options were "in the money" on the grant date, the compensation would no longer be considered performance based compensation and would be subject to the $1,000,000 limit.  Thus, to the extent that the employee already had nonperformance based compensation in excess of $1,000,000 (which is very likely), the company's tax deduction for the stock option compensation expense would be overstated.

There are other examples which represent situations where the company would have understated its payroll withholding tax obligations.  For example, "Incentive Stock Options" (i.e., qualified options), if backdated, would lose their preferential tax treatment and result in additional payroll tax liabilities to the company.

These are but three examples illustrating the potential for the imposition of large tax, interest and penalty assessments.  In addition to the adverse tax consequences faced by the company, the employees will also face additional tax liabilities.  To the extent that those employees were not responsible for the backdating, will the company have an obligation to make those employees whole (i.e., reimburse them for their incremental tax costs)?  This, of course, would further add to the company's outflow of cash.