What Is ASC 740? The Standard for Accounting for Income Tax
Understand the principles of ASC 740, the GAAP standard for income tax accounting, and how it reconciles book income with tax law on financial statements.
The guidance for how companies handle income taxes in their financial records is the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) 740, “Income Taxes.” This standard under U.S. Generally Accepted Accounting Principles (GAAP) dictates how businesses account for and report the financial effects of income taxes. The objective of ASC 740 is to recognize the amount of taxes payable for the current year and to account for any future tax assets or liabilities from the company’s operations.
The Two Parts of the Tax Provision
Under ASC 740, the total income tax expense a company records has two main pieces. The first is the current tax expense, which represents the actual amount of income taxes the company calculates and expects to pay to federal, state, and foreign tax authorities for the current operating period. This figure is based on the taxable income reported on the company’s tax returns for that year, applying the currently enacted tax laws and rates.
The second piece is the deferred tax expense or benefit. This component does not relate to a cash tax payment in the current year but instead reflects the change in the company’s deferred tax assets and liabilities on its balance sheet from the beginning to the end of the period. It accounts for the future tax effects of transactions that have already been recognized in the financial statements.
The Concept of Deferred Taxes
Deferred taxes are a core concept in ASC 740 and arise from “temporary differences” between a company’s income for accounting purposes (book income) and its income for tax purposes. These differences occur when a revenue or expense item is recorded in one period for the financial statements and a different period for the tax return, creating a short-term mismatch that must be accounted for. These temporary differences result in either deferred tax liabilities (DTLs) or deferred tax assets (DTAs). A DTL represents a future tax payment, such as when a company uses accelerated depreciation for tax purposes but straight-line for its books. A DTA represents a future tax saving, like when a company accrues a warranty expense on its books before it can be deducted for tax purposes.
Reporting on Financial Statements
The total income tax expense, which is the combination of the current and deferred tax expenses, is reported on the income statement. It is shown as a final expense line item that reduces the company’s income before tax to arrive at its net income for the period.
The cumulative balances of a company’s deferred tax assets and deferred tax liabilities are reported on the balance sheet. These items are classified as noncurrent assets and noncurrent liabilities. Companies must disclose the total amounts of both DTAs and DTLs in the notes to their financial statements.
In late 2023, the FASB issued an update that enhances the disclosure requirements for income taxes. For public companies, these rules are effective for annual periods beginning after December 15, 2024, and require more detailed information in the notes to their financial statements. This includes a more thorough breakdown of their effective tax rate and the actual income taxes paid. For all other entities, these new disclosure requirements will become effective one year later.