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WILL INTANGIBLES TRIP YOU UP? - Strategic Finance
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WILL INTANGIBLES TRIP YOU UP?
BY MOLLIE T. ADAMS, CPA; KERRY K. INGER, CPA; AND MICHELE D. MECKFESSEL, CPA
October 30, 2015
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mending 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.
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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 secondlargest 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
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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) §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 §368(a)(1)(A) and
IRC §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
§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 §338 election, the acquiring company is allowed a
“stepped up” basis of all assets and liabilities to fair market value.
IRC §1060, “Special allocation rules for certain asset acquisitions,” orders the allocation of purchase price
based on seven asset classes. is allocation requires distributing the purchase price to the five classes of
tangible assets, with the remainder distributed to intangibles. Intangible assets acquired in taxable asset
acquisitions and taxable stock acquisitions with a §338 election would be considered intangible assets
under IRC §197, “Amortization of goodwill and certain other intangibles.” ese assets include many of
those considered to be indefinite-lived intangible assets for financial accounting purposes, including
goodwill, trademarks, and franchises.
For taxable asset acquisitions and taxable stock acquisitions with a §338 election, §197 intangibles are
amortized over a 15-year period regardless of their useful life, including goodwill. But when a company
acquires these same intangibles in a nontaxable transaction or a taxable stock acquisition without a §338
election, they aren’t amortizable under IRC §197.
VALUING INDEFINITE­LIVED INTANGIBLES
All business combinations under U.S. Generally Accepted Accounting Principles (GAAP) are required to
use acquisition accounting whether they involve a stock acquisition or an asset acquisition. Under
acquisition accounting, all identifiable assets acquired in a business combination (including intangibles
other than goodwill) would be recorded at their fair values on the date of acquisition under FASB
Accounting Standards Codification® (ASC) paragraph 805-20-30-1.
When a company acquires goodwill in a business acquisition, the company initially measures it as the
excess of the consideration paid over the fair value of the net identifiable assets on the date of acquisition.
A publicly traded company holding goodwill doesn’t amortize it (see ASC paragraph 350-20-25-1) but
instead periodically impairment tests it (see ASC paragraph 350-20-35-1). Privately held companies
holding goodwill can elect to amortize it over a period not to exceed 10 years (under ASC paragraph 35020-35-63). Other indefinite-lived intangible assets aren’t amortized for financial statement purposes (see
ASC paragraph 350-30-35-1) but rather are periodically impairment tested (see ASC paragraphs 350-3035-15 through 350-30-35-17), regardless of the type of entity that’s holding the asset.
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At the time of the acquisition, a company must recognize deferred tax assets and liabilities related to the
acquired assets and liabilities and also recognize any related valuation allowance (see ASC paragraph 805740-25-2). In addition, a deferred tax asset or liability related to any difference between the book and tax
basis of indefinite-lived intangibles, other than goodwill, must be recorded at the time of acquisition—
regardless of whether the assets are tax deductible or not (see ASC paragraph 805-740-25-3).
In general, book and tax basis shouldn’t differ in transactions in which a “step-up” basis is taken for tax
purposes (taxable asset acquisitions and taxable stock acquisitions with a §338 election), because the
assets would be recorded at fair value for both book and tax purposes and wouldn’t initially generate
deferred tax assets or liabilities. For transactions in which the assets have carryover basis for tax purposes
(nontaxable transactions and taxable stock acquisitions without a §338 election), a deferred tax liability
related to any excess book over tax basis—or a deferred tax asset related to any tax over book basis—would
be recorded at the time of acquisition. A company must include these deferred tax assets and liabilities in
the calculation of goodwill for financial statement purposes.
A deferred tax liability would also be recorded for subsequent amortization deducted on acquired
indefinite-lived intangible assets that fall under IRC §197 (that is, assets acquired in a taxable asset
acquisition or a taxable stock acquisition with a §338 election). e deferred tax liability would remain on
the books until the asset becomes impaired and is written down. At that time, the deferred tax liability
would be decreased or removed from the books, depending on the amount of the impairment.
e subsequent accounting is more complicated for indefinite-lived intangible assets that aren’t tax
deductible—that is, assets acquired in a nontaxable transaction or a taxable stock acquisition without a
§338 election.
For nondeductible indefinite-lived intangible assets, a deferred tax asset or liability will be recorded for
the difference between the book basis and the tax basis of the asset. If impairment occurs for financial
accounting purposes, the deferred tax asset or liability will be adjusted to reflect the updated difference
between book basis and tax basis.
HOW TO HANDLE GOODWILL
e initial accounting for income taxes related to goodwill differs on whether the goodwill is tax
deductible or not and whether the tax basis exceeds the book basis or vice versa.
No deferred taxes are recorded when nondeductible goodwill is acquired. A permanent difference results
when the goodwill is impaired (if held by a publicly traded company) or amortized (if held by a privately
held company) for book purposes. e company must split tax-deductible goodwill into two components
(see ASC paragraphs 805-740-25-8 and 805-740-25-9). Component 1 goodwill is the amount of goodwill
that has the same book basis and tax basis. For Component 1 goodwill, publicly traded companies would
record a deferred tax liability when the tax deduction is taken and then reverse it when the goodwill is
impaired for book purposes. Private companies would record a deferred tax asset for the excess of book
amortization over tax amortization for the first 10 years and then reverse it over the next five years.
Component 2 goodwill relates to the difference between book and tax basis. If the Component 2 goodwill
is an excess of book goodwill over tax goodwill, the company doesn’t record any deferred taxes, and the
subsequent impairment or amortization for book purposes will result in a permanent difference. If the
Component 2 goodwill is an excess of tax over book goodwill, the company must record a deferred tax
asset at the time of acquisition, which is then reversed as the company takes tax deductions. Recording the
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deferred tax asset at the time of acquisition will create an iterative (circular) calculation of book goodwill
because the creation of the deferred tax asset will reduce the amount of goodwill recorded for book
purposes.
Table 1 summarizes the implications of accounting for taxes, and Tables 2 and 3 show examples of proper
acquisition accounting.
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VALUATION ALLOWANCE ISSUES
If it’s more likely than not that the tax benefit won’t be fully recognized, then deferred tax assets should be
reduced to net realizable value by a valuation allowance (see ASC subparagraph 740-10-30-5(e)). Future
realization of a tax benefit from a deferred tax asset depends on sufficient future taxable income of the
appropriate character. Future realization of a tax benefit from a deferred tax asset requires sufficient future
taxable income to be offset by the future deduction. Additionally, the future taxable income must be of the
appropriate type (i.e., character) to be able to utilize the deduction.
It’s important that companies consider the reversal patterns of temporary differences in assessing the
need for a valuation allowance, including the particular year in which the temporary differences result in
taxable or deductible amounts. e reversal pattern shows the year in which the temporary differences
will reverse when assessing the need for a valuation allowance (see ASC paragraphs 740-10-55-18 and
740-10-55-19). e reversal pattern associated with an indefinite-lived intangible asset is unknown
because reversal is contingent upon a future event. For example, a deferred tax liability associated with
goodwill won’t reverse unless the goodwill is impaired. Existing deferred tax liabilities associated with
indefinite-lived intangibles shouldn’t be considered a source of future taxable income in determining the
necessary valuation allowance because the timing of the reversal is uncertain. If a company uses deferred
tax liabilities associated with indefinite-lived intangibles as a source of future taxable income, it results in
an understatement of the valuation allowance and an overstatement of net income.
AVOIDING RESTATEMENTS
When engaging in mergers and acquisitions, the CFO must consider the tax accounting implications
associated with indefinite-lived intangibles to avoid having to restate financial statements. e
classification as a stock or asset transaction and whether the transaction is tax-free or taxable determines
the tax accounting implications. In general, taxable asset acquisitions and stock acquisitions with a §338
election don’t initially result in recording deferred taxes on indefinite-lived intangibles because the basis is
“stepped up” to fair value for book and tax purposes. A deferred tax liability is recorded as amortization,
deducted under IRC §197, and will be reversed upon impairment of the indefinite-lived intangible assets
for book purposes. In contrast, tax-free transactions and taxable stock acquisitions without a §338
election require recording the deferred taxes on indefinite-lived intangibles at the time of the transaction
because the basis is “stepped up” to fair value only for book purposes.
If indefinite-lived intangibles are present, the CFO must carefully consider the determination of the
valuation allowance. Specifically, the deferred tax liability associated with indefinite-lived intangibles
should not be considered as a source of future taxable income when determining the appropriate
valuation allowance since the timing of the reversal is unknown because it’s dependent upon the
impairment of indefinite-lived intangible assets for book purposes.
Mollie T. Adams, CPA, Ph.D., is an assistant professor of accounting
and MSA Program Coordinator at Bradley University. You can reach
her at mtadams@bradley.edu. https://sfmagazine.com/post-entry/october-2015-will-intangibles-trip-you-up/
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Kerry K. Inger, CPA, Ph.D., is an assistant professor at the School
of Accountancy, Raymond J. Harbert College of Business, Auburn
University. Kerry is also an IMA Member­at­Large. You can reach
her at inger@auburn.edu.
Michele D. Meckfessel, CPA, Ph.D., is an assistant professor of
accounting at the University of Missouri­St. Louis and a member of
IMA’s St. Louis Chapter. You can reach her at
meckfesselm@umsl.edu.
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