FASB ASC 740-10: An Overview of Income Tax Accounting

The Financial Accounting Standards Board (FASB) provides guidance for how companies report income tax effects under U.S. Generally Accepted Accounting Principles (GAAP) in its Accounting Standards Codification (ASC) Topic 740-10. This standard governs how an organization reflects federal, state, local, and foreign income-based taxes on its financial statements.

ASC 740-10 requires a company to recognize taxes payable for the current year and to recognize deferred tax assets and liabilities. These deferred items represent the future tax impact of transactions already recorded, ensuring financial reports show the full tax consequences of a company’s activities.

The Core Objective of Income Tax Accounting

ASC 740-10 uses the “asset and liability method,” which treats the future tax effects of a company’s activities as assets and liabilities on the balance sheet. This approach focuses on the differences between the book values of assets and liabilities on the financial statements and their corresponding tax bases. An underlying assumption is that the reported values of assets and liabilities will eventually be recovered or settled.

This balance sheet-focused approach ensures the income statement reflects the tax effects of transactions in the same period they are recognized for financial reporting. This provides a more comprehensive view of a company’s financial health by acknowledging future tax obligations or benefits.

Calculating Current and Deferred Taxes

A company’s total income tax expense begins with the current portion, which is determined by applying enacted tax rates to the company’s taxable income for the period. Taxable income is calculated according to the rules of the relevant tax authorities, like the Internal Revenue Service (IRS), and often differs from the pre-tax income on financial statements.

The deferred tax calculation arises from temporary differences, which occur when there is a difference between the book value of an asset or liability and its tax basis. These differences are temporary because they reverse over time, resulting in either taxable or deductible amounts in future years. For example, a company might use accelerated depreciation for tax returns while using a straight-line method for its financial statements, creating a temporary difference.

Another example is a warranty reserve, which is expensed for book purposes when a sale is made but is not deductible for tax purposes until the company pays a claim. In contrast, permanent differences affect either book income or taxable income, but not both, and will never reverse. Examples include tax-exempt interest income from municipal bonds or certain meal expenses that are only partially deductible for tax purposes. Permanent differences do not give rise to deferred tax assets or liabilities.

A company calculates its deferred tax liability (DTL) by multiplying its total taxable temporary differences by the enacted future tax rate expected to apply when those differences reverse. A deferred tax asset (DTA) is calculated by multiplying total deductible temporary differences and any tax loss carryforwards by the applicable future tax rate.

The Valuation Allowance Against Deferred Tax Assets

After calculating its deferred tax assets (DTAs), a company must assess if it can realize their value. A DTA represents a future tax benefit, so ASC 740-10 requires a company to establish a valuation allowance to reduce a DTA to the amount that is “more-likely-than-not” to be realized. This means there must be a greater than 50% likelihood that the company will use the tax benefit.

To make this assessment, management considers all available positive and negative evidence. The standard outlines four sources of future taxable income to realize a DTA, with the most objective being the future reversal of existing taxable temporary differences. Another source is projected future taxable income, exclusive of reversing temporary differences.

A company can also look to taxable income in prior years if carryback is permitted under tax law. The final source involves tax-planning strategies, which are actions management could take to generate sufficient taxable income to realize the DTAs. These strategies must be prudent, feasible, and something the company would realistically implement.

The evaluation requires weighing evidence such as a history of recent losses against factors like existing profitable contracts. If management concludes it is more likely than not that some portion of the DTA will not be realized, a valuation allowance must be recorded, which increases the company’s income tax expense.

Accounting for Uncertain Tax Positions

ASC 740-10 provides guidance for tax positions where the outcome is uncertain. An uncertain tax position (UTP) is a stance a company takes on a tax return that could be challenged by a tax authority like the IRS. This could involve how income is allocated, the deductibility of an expense, or a decision not to file a tax return in a jurisdiction.

The accounting for UTPs follows a two-step process. First, for recognition, a company can only recognize the benefit of a tax position if it is “more-likely-than-not” (a greater than 50% probability) that the position would be sustained on its technical merits if challenged.

If the recognition threshold is met, the company proceeds to measurement. The company must record the largest amount of tax benefit that has a cumulatively greater than 50% likelihood of being realized upon settlement with the tax authority. Any portion of the benefit that does not meet this measurement criterion is recorded as a liability for unrecognized tax benefits.

Financial Statement Presentation and Disclosure

Proper presentation of income tax amounts in the financial statements is required. On the balance sheet, all deferred tax assets and liabilities are classified as noncurrent. Companies must present a net deferred tax asset or liability, determined by netting all DTA and DTL balances within a particular tax-paying jurisdiction.

On the income statement, the total income tax expense or benefit is shown as a single line item before net income. This line item is composed of both the current and deferred tax expense.

The footnotes to the financial statements must provide detail to help users understand the company’s tax position. Disclosures include a breakdown of the components of the company’s deferred tax assets and liabilities and a reconciliation of the balance of unrecognized tax benefits.

Public companies must provide a detailed rate reconciliation, breaking down the difference between the statutory federal rate and the effective tax rate into specific categories, including:

• State and local taxes
• Foreign tax effects
• The effect of changes in tax laws
• Tax credits
• Changes in valuation allowances
• Changes in unrecognized tax benefits

All entities are also required to disclose income taxes paid, disaggregated by federal, state, and foreign jurisdictions.