ASC 740-10: Accounting for Income Taxes

Accounting Standards Codification (ASC) 740 provides the U.S. Generally Accepted Accounting Principles (U.S. GAAP) for how companies must account for and report the effects of income taxes. This standard applies to all entities subject to income taxes that prepare financial statements under U.S. GAAP, ensuring reports provide a clear picture of a company’s tax-related assets and liabilities.

The primary objective of ASC 740 is to recognize two components. The first is the current tax provision, which is the amount of taxes a company expects to pay or receive as a refund for the current year. The second is the recognition of deferred tax assets and liabilities, which represent the future tax consequences of events already recognized in financial statements, ensuring tax effects are accounted for in the proper period.

Calculating the Current Tax Provision

Determining the current income tax provision begins with a company’s pretax book income from its income statement. This book income is rarely the same as the taxable income reported to tax authorities like the Internal Revenue Service (IRS) because the rules for financial and tax accounting are not always aligned. To arrive at taxable income, a company must make specific adjustments to its pretax book income.

These adjustments fall into two categories: permanent and temporary differences. Permanent differences are revenue or expense items recognized for book purposes but never for tax purposes, or vice versa. Common examples include tax-exempt municipal bond interest and non-deductible entertainment expenses or certain fines. These items permanently affect a company’s effective tax rate.

After accounting for permanent differences, the company adjusts for temporary differences. These are book-tax differences that will reverse over time, and while their primary impact is on deferred taxes, they must be factored into the current calculation. Once all adjustments are made, the resulting figure is the current taxable income, which is multiplied by the enacted statutory tax rate to determine the current income tax expense.

Accounting for Deferred Taxes

Deferred taxes arise from temporary differences between financial and tax accounting. A temporary difference is the variance between an asset or liability’s carrying amount in the financial statements (book basis) and its value for tax purposes (tax basis). These differences signify that certain items will be included in taxable income in a different period than they are recognized in financial income.

A Deferred Tax Liability (DTL) represents income tax payable in a future period. DTLs are created when an item results in lower taxable income now but higher taxable income later. A common example relates to depreciation, where a company uses an accelerated method for tax purposes while using the straight-line method for financial reporting. This creates a temporary difference that leads to higher tax payments in the future.

A Deferred Tax Asset (DTA) represents a future tax benefit. DTAs arise when an item causes higher taxable income now but is expected to generate a tax deduction later. For instance, a company may record an expense for a warranty reserve on its books, but tax law only permits a deduction when the warranty cost is paid. Net Operating Loss (NOL) carryforwards for losses arising in recent years are another source of DTAs and can be carried forward indefinitely, though the annual deduction is limited to 80% of that year’s taxable income.

Both DTAs and DTLs are calculated by multiplying the temporary difference by the enacted tax rate expected to be in effect when the difference reverses. The deferred tax amounts are not discounted to their present value.

The Valuation Allowance Assessment

After calculating its deferred tax assets (DTAs), a company must assess their realizability. ASC 740 requires a valuation allowance if it is “more likely than not” that some portion or all of its DTAs will not be realized. The “more likely than not” standard means there is a greater than 50% chance that the future tax benefits will go unused. This allowance is a contra-asset that reduces the DTA value on the balance sheet to the amount expected to be realized.

To make this judgment, companies must evaluate all available positive and negative evidence, considering four sources of future taxable income. The first and most objective source is the future reversal of existing taxable temporary differences, also known as deferred tax liabilities (DTLs). When a DTL reverses, it creates taxable income that can be offset by DTAs.

A second source is future taxable income from core operations. This involves projecting future profits, which is subjective and requires strong evidence, especially if a company has a recent history of losses. A cumulative loss over a three-year period is considered significant negative evidence that is difficult to overcome.

The third source is taxable income in prior carryback years. The utility of this source is limited in the U.S. because the Tax Cuts and Jobs Act of 2017 largely eliminated NOL carrybacks, with narrow exceptions for certain businesses. The final source involves implementing specific tax-planning strategies. For a strategy to be considered, it must be prudent, feasible, and something management would realistically implement to prevent a DTA from expiring unused.

Recognizing Uncertain Tax Positions

Companies often take tax positions on their returns with some uncertainty about whether they will be sustained if challenged by a tax authority. ASC 740 provides specific guidance for accounting for these uncertain tax positions (UTPs).

The process involves two steps. The first is recognition, where a company determines if it is “more likely than not” that the tax position would be sustained upon examination, based on its technical merits. This assessment assumes the authority has full knowledge of all relevant information. If this greater-than-50% likelihood threshold is not met, no benefit can be recognized.

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. This requires the company to consider a range of possible outcomes and their associated probabilities.

For example, a company takes a $100 tax deduction that is a UTP and assesses a 40% chance of sustaining the full $100 and a 30% chance of sustaining $60. The cumulative probability of realizing at least $60 is 70% (40% + 30%). Since this is the first level to cross the 50% threshold, the company would recognize a tax benefit of $60. The remaining $40 is recorded as a liability for unrecognized tax benefits.

Financial Statement Presentation and Disclosure

The final step under ASC 740 is presenting and disclosing the results of the income tax accounting process in the company’s financial statements. The standard prescribes how these amounts should be reported on the balance sheet and income statement, and what information must be detailed in the footnotes.

On the balance sheet, all deferred tax assets and liabilities are classified as noncurrent. A company nets its DTAs and DTLs within a tax-paying jurisdiction to report either a single net noncurrent asset or liability. Current taxes payable or receivable are reported separately as a current liability or asset.

The income statement presents the total income tax expense or benefit for the period on a single line. This provision is composed of the current tax expense (tax payable for the year) and the deferred tax expense (the net change in deferred tax assets and liabilities). This presentation separates the cash taxes owed for the year from tax effects related to future periods.

The footnotes provide supporting details for investors. Disclosures include:

• A breakdown of the significant components of the company’s net deferred tax assets and liabilities, showing amounts for items like NOLs and depreciation.
• The total valuation allowance recorded against DTAs and a reconciliation of any changes in that allowance during the year.
• A tax rate reconciliation that explains the difference between the statutory federal income tax rate and the company’s effective tax rate.
• A disclosure of income taxes paid, disaggregated by federal, state, and foreign jurisdictions.
• A tabular reconciliation of the beginning and ending balances of the liability for unrecognized tax benefits.