Accounting for Income Taxes: Core Principles

Accounting for income taxes is the method companies use to report taxes on their financial statements under U.S. Generally Accepted Accounting Principles (GAAP). The guidance for this is in Accounting Standards Codification (ASC) 740, which aims to match the tax effects of business activities with the period the income was earned.

This specialized accounting is necessary because financial reporting rules differ from the Internal Revenue Code. These differences mean a company’s reported income is often not the same as its taxable income. ASC 740 provides a framework to account for these discrepancies.

Core Concepts of Income Tax Accounting

Income tax accounting is based on the difference between “book income” and “taxable income.” Book income, or pretax financial income, is calculated according to GAAP for public income statements. Taxable income is calculated using the Internal Revenue Code (IRC) and determines a company’s actual tax payment.

The two income figures differ because GAAP is designed for investor transparency, while the IRC is designed to raise revenue and influence economic behavior. This leads to two types of distinctions between book and tax income: permanent and temporary differences.

Permanent differences are revenue or expense items recognized for either book or tax purposes, but not both, and they will never reverse. For example, interest from municipal bonds is included in book income but is exempt from federal tax. Other examples include non-deductible fines and penalties and certain limits on meal and entertainment expenses.

Temporary differences are timing discrepancies in when revenue or expenses are recognized for book versus tax purposes. These differences originate in one period and are expected to reverse in the future. For instance, a company might use straight-line depreciation for its financial statements but an accelerated method for its tax return. These temporary differences create deferred taxes.

Calculating the Current and Deferred Tax Provision

The total income tax expense on a company’s income statement has two parts: current tax expense and deferred tax expense. The calculation begins with pretax book income and adjusts for differences between accounting and tax rules.

Current Tax Expense

The current tax expense is the income tax a company owes for the current period, based on its tax return. To determine taxable income, a company adjusts its book income by subtracting non-taxable revenues and adding back non-deductible expenses. This taxable income is then multiplied by the applicable statutory tax rate, which is 21% for most U.S. corporations.

Deferred Tax Liabilities (DTLs)

A deferred tax liability (DTL) arises from taxable temporary differences. These occur when revenue is recognized in book income before it is taxed, or when a tax deduction is taken before the expense is recognized for book purposes. This results in a lower current tax payment but creates an obligation to pay more tax in the future when the difference reverses. To calculate the DTL, the cumulative temporary difference is multiplied by the enacted future tax rate.

Deferred Tax Assets (DTAs)

A deferred tax asset (DTA) results from deductible temporary differences and tax loss carryforwards. These happen when an expense is recognized for book purposes before it is tax-deductible, or when revenue is taxed before it is recognized in book income. This leads to a company paying more tax currently, creating a future tax benefit. A significant source of DTAs is a Net Operating Loss (NOL), which can be carried forward to offset future taxable income, though the deduction is limited to 80% of taxable income in the year of use.

Total Income Tax Provision

The total income tax provision on the income statement is the sum of the current tax expense and the deferred tax provision. The deferred tax provision is the net change in the company’s DTA and DTL balances from the beginning to the end of the period. An increase in a DTL or a decrease in a DTA results in a deferred tax expense, while a decrease in a DTL or an increase in a DTA creates a deferred tax benefit.

The Valuation Allowance for Deferred Tax Assets

After calculating its deferred tax assets (DTAs), a company must assess if it can use them. A valuation allowance is an account that reduces DTAs on the balance sheet to an amount that is “more likely than not” to be realized, which is a probability threshold of over 50%. If it is more likely than not that some or all of the DTA will expire unused, a valuation allowance must be recorded.

This assessment requires evaluating all available positive and negative evidence. A history of recent losses is strong negative evidence. To support the conclusion that a DTA is realizable, a company must identify sufficient future taxable income from specific sources.

Sources of Future Taxable Income

ASC 740 outlines four potential sources of future taxable income a company must consider to justify realizing its DTAs.

• Future reversals of existing taxable temporary differences, which create deferred tax liabilities (DTLs). Since DTLs result in future taxable income, they can be a reliable source to support the realization of DTAs.
• Future taxable income from operations, excluding reversing temporary differences. This requires management to develop reliable forecasts of future profitability.
• Taxable income in prior years to which losses can be carried back. Tax law changes have eliminated this option for most net operating losses, so this source is now rarely available.
• Tax-planning strategies, which are specific actions management could and would take to generate taxable income. An example is selling an appreciated asset to generate a capital gain to absorb capital loss carryforwards.

Accounting for Uncertain Tax Positions

Companies often take positions on tax returns where the law is unclear, creating uncertain tax positions (UTPs). ASC 740 provides a two-step process for accounting for these positions.

The first step is recognition. A company can only recognize a tax position’s benefit if it is “more likely than not” to be sustained on its technical merits, meaning a greater than 50% chance of success if examined by a tax authority. If this threshold is not met, no benefit can be recorded.

If the recognition threshold is met, the second step is measurement. The company must measure the benefit as the largest amount of tax benefit that is cumulatively greater than 50% likely of being realized upon settlement. For example, if there is a 40% chance of realizing a full $100 benefit and a 30% chance of realizing $80, the company would recognize an $80 benefit, as that is the largest amount with a cumulative probability over 50% (40% + 30% = 70%). The difference between the benefit claimed on the tax return and the amount recognized is recorded as a liability.

Financial Statement Presentation and Disclosure

The final step is presenting the results on the financial statements and providing detailed disclosures in the footnotes, as governed by ASC 740. Recent updates, such as ASU 2023-09, have increased the required level of detail.

Income Statement Presentation

On the income statement, the total income tax expense appears as a single line item, “Provision for income taxes.” This amount is subtracted from pretax income to arrive at net income and includes both current and deferred tax expenses or benefits.

Balance Sheet Presentation

On the balance sheet, deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are classified as non-current. Companies must net their DTAs and DTLs within each tax-paying jurisdiction, resulting in either a net non-current DTA or a net non-current DTL for each jurisdiction.

Required Footnote Disclosures

The footnotes provide details that supplement the financial statements. ASC 740 requires several disclosures, including:

• The significant components of income tax expense, broken down into current and deferred portions for federal, state, and foreign taxes.
• The tax effects of major temporary differences and carryforwards that comprise the DTA and DTL balances.
• A rate reconciliation that explains the difference between the company’s effective tax rate and the statutory federal income tax rate of 21%.
• Information about any valuation allowance, including the total amount and any significant changes during the year.
• A tabular reconciliation of the beginning and ending balances of the liability for unrecognized tax benefits for public companies.