Income Taxes and Purchase Accounting

1. Income Taxes and Purchase Accounting • FAS 109 governs Income Tax Accounting Under GAAP • Generally requires Deferred Income Taxes on Temporary Differences. Temporary differences are defined as differences between the Tax Basis and Book Basis of Assets and Liabilities • Purchase accounting may result in temporary differences.

2. Purchase Accounting-NARUC • For regulatory purposes, original cost of Plant in Service and Accumulated Depreciation previously recorded on books of acquired entity are recorded on books of purchaser at same amount • Difference between purchase price and original cost is recorded as Plant Acquisition Adjustment (PAA)

3. Plant Acquisition Adjustment • PAA is evaluated in rate proceedings and may or may not be included in rate base. • Amortization of PAA is evaluated in rate proceedings and may or may not represent a recoverable cost. • Usually depends on statutes or whether utility can demonstrate ratepayer benefits of purchase.

4. Purchase Accounting--GAAP • FAS 141 requires the purchase method. Prior to FAS 141, companies were permitted to use the pooling of interests method as well, depending on whether certain provisions of APB 16 were met. • Under FAS 141, purchased assets and liabilities acquired are recorded at fair value. • Normally, current assets and liabilities are already recorded at fair value, so much of valuation effort is for non-current amounts (such as PP&E).

5. Purchase Accounting--GAAP • Regulatory Assets and Regulatory Liabilities would generally be included as acquired amounts at their recorded value. • Fair value is a subjective determination and normally may require appraisers or financial modeling.

6. Purchase Accounting--GAAP • For GAAP, difference between purchase price and fair value of assets net of liabilities acquired represents intangible assets (or liability). • Intangibles should be analyzed to identify specific intangible assets (i.e., franchises, customer lists, patents, etc.). • If a difference still exists, goodwill results.

7. Purchase Accounting--GAAP • Identifiable intangibles (apart from goodwill) are generally amortized. • Goodwill is not amortized for financial statement purposes, but is subject to an annual impairment test. • The annual impairment test compares the fair value of the future net cash flows of the acquired enterprise to determine if such cash flows will cover the recorded goodwill.

8. Purchase Accounting—GAAP/Regulatory • Future cash flows of a regulated utility, under traditional ratemaking, can be projected based on return on and recovery of plant, and recovery of operating expenses. • Generally, regulated plant assets are not “fair valued” like enterprises in general would fair value plant assets. This is because regulated cash flows are limited to those generated in the regulatory process (“recovery of” and “return on”). In effect, book value (original cost) equals book value for a regulated utility.

9. Purchase Accounting-GAAP/Regulatory • If the excess purchase price is permitted in the regulatory process as a Plant Acquisition Adjustment, it will be amortized (generally over the life of the related plant). • If the excess purchase price is not permitted in the regulatory process, for financial statement purposes, it becomes goodwill and is not amortized.

10. Purchase Accounting-GAAP/Regulatory • GAAP requires deferred income taxes on all temporary differences. • Deferred income taxes on the temporary differences of the acquired entity should be recorded in the purchase.

11. Purchase Accounting-Tax Considerations • For income tax purposes, excess purchase price is analyzed and attributed, if possible to various intangibles (i.e., customer lists). • Identified intangibles are deductible over an appropriate amortization period. • Generally, the balance represents deductible goodwill, which is amortized for income tax purposes over 15 years.

12. Purchase Accounting—Goodwill Issue • Situation: Goodwill (not PAA) not amortized for books, amortized for tax • FAS 141 and FAS 142, require the entity to recognize deferred income taxes that are associated with these assets, in accordance with FAS 109. As a result, deferred tax liabilities related to goodwill and indefinite-lived intangible assets will not reverse (be settled) until some indefinite future period. The reversal of these temporary differences will occur only when the assets either become impaired, are disposed of, or, in the case of indefinite-lived intangible assets, are reclassified as an amortizable intangible asset. Nonetheless, deferred taxes are required on this difference.

13. Purchase Accounting—Goodwill Issue (Continued) • If the acquired entity does not have the required deferred income taxes recorded, the difference will affect goodwill.

14. Purchase Accounting-Transaction Costs • Transaction Costs • May be deductible for tax • Considered as purchase price under FAS 141 • Alternative accounting • Method 1 • Establish a deferred income tax liability for the tax effect of the transaction cost • Method 2 (PwC preferable method) • Treat the tax benefit of the deductible transaction costs as reduction of goodwill

15. Issues • Book basis vs. Tax Basis will be different, especially for PAA, Goodwill and other intangibles. • If PAA is not permitted for regulatory purposes, any related tax effects should be recorded below the line. Same with other temporary differences. Tax effects should be handled consistent with regulatory treatment. • GAAP presentation may not = Regulatory presentation. Regulatory USOA’s generally do not have an account for “Goodwill.”

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