ASC 740, Income Taxes, provides recognition, initial measurement, subsequent measurement, presentation and disclosure guidance for income taxes in the financial statements. Its primary objective is to show the after-tax financial position of a company in its balance sheet. To do this, it requires that the asset and liability method be applied, which focuses on the balance sheet rather than the income statement.
While ASC 740 only covers the accounting for taxes based on income, it does have a fairly wide scope. It applies to all entities with activities that are subject to income taxes, including domestic and foreign entities as well as not-for-profit entities. In addition, certain aspects of ASC 740, such as those related to uncertainty in income taxes, even apply to entities that are not subject to income tax!
In a company’s financial statements you may find numerous line items related to income taxes, including current tax payable or receivable, deferred tax assets, deferred tax liabilities, valuation allowance, current tax expense or benefit, deferred tax expense or benefit, and total income tax expense or benefit. All of these items are interrelated and stem from the following equation:
As you can see from the equation, total income tax expense (or benefit) presented in a company’s income statement is comprised of two key components, current tax and deferred tax. However, it is important to note that income tax expense or benefit is really the residual amount after applying the asset/liability method and calculating the balance sheet amounts of both current and deferred tax.
Current income taxes
Interestingly, ASC 740 spends little time talking about the calculation of current income taxes, with the exception of special considerations such as the accounting for uncertainty in income taxes which impacts current taxes. That is because most of the accounting for current taxes is left to the tax code, which is just fine because current taxes payable (or receivable) and the resulting current income tax expense (or benefit) is predominately “the amount owed to the government for the year” which comes from the current income tax provision that is based on the tax code.
The current tax provision, which again is largely based on the income tax return can be further broken down as follows:
Permanent differences and temporary differences, both of which arise due to differences between the accounting rules and the tax code reconcile GAAP income to taxable income.
Permanent differences are items that enter into pretax financial income, but never into taxable income – or – items that enter into taxable income but never into pretax financial income. Almost all of these differences arise directly from the tax code. An example in the United States is entertainment expenses, which are shown as an expense on a company’s income statement but are not deductible for tax purposes.
Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the financial statements. Unlike permanent differences, these differences will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled, respectively. Another way to describe temporary differences would be “timing differences." They are the result of items that are accounted for in the financial statements now but won’t be included in the tax return until later, or vice versa. Temporary differences also impact the deferred tax provision which is further described below.
Other items impact the calculation of current taxes as well, such as uncertain tax positions.
Our course Income Taxes: Overview of ASC 740 provides an overview of ASC 740 by walking through the income tax provision.
Deferred income taxes
The definition of a temporary difference is outlined in the previous section. Temporary differences, once multiplied by the appropriate tax rate, give rise to deferred taxes. Deductible temporary differences result in deferred tax assets and taxable temporary differences result in deferred tax liabilities. But why? Remember, temporary differences give rise to taxable or deductible amounts in future years. Since U.S. GAAP requires the accrual method of accounting, these items must be reflected in the financial statements in the current period, thus giving rise to deferred taxes.
Deferred income tax expense or benefit is based on the change in deferred tax assets and liabilities from the beginning of the period to the end of the period as follows:
Identifying the change in deferred taxes involves application of the guidance in ASC 740 which follows the basic asset/liability method principle. The steps to account for deferred taxes can be summarized as follows:
As you can see from the steps, accounting for deferred taxes focuses primarily on the balance sheet. In step 1, the GAAP amounts of all assets and liabilities are compared to their respective tax bases, which are based on the tax code. Any resulting differences are considered temporary differences unless an exception applies. ASC 740 has certain limited exceptions to the recognition of deferred taxes. While there are only a few, they are important to understand and often have strict application criteria.
In step 2, any differences identified in step 1 are separated based on whether they give rise to future taxable amounts or future deductible amounts. Sometimes this is an easy determination, but often times it is not intuitive. Our course Income Taxes: Deferred Tax and Valuation Allowance provides practical guidance on how to do this along with numerous examples.
Step 3 might sound straightforward, but there are a few things to consider. To calculate deferred taxes, ASC 740 requires companies to use the enacted tax rate that is expected to apply to taxable income in the periods in which the deferred tax item(s) are expected to reverse. In addition, graduated tax rates (if applicable) and other provisions of tax law (e.g. different rates for different types of income) must be considered when determining the appropriate rate to apply. The impact of any changes in enacted tax rates in subsequent years are recognized by adjusting deferred taxes with the offset recognized in the income statement.
Step 4 often requires the most judgment. Deferred tax assets must be reduced by a valuation allowance if it is more likely than not, based on all available evidence, that some portion or all of the deferred tax assets will not be realized. The valuation allowance must be sufficient to reduce the deferred tax assets to the amount that is more likely than not to be realized. What evidence? How do we know if a deferred tax asset can be realized? In order to realize a deferred tax asset, there must be future taxable income. This future taxable income must be of the appropriate character and available in the period in which the deferred tax assets are expected to reverse. ASC 740 provides four possible sources of taxable income:
- Taxable income in prior carryback year(s) if carryback is permitted under the tax law
- Future reversals of existing taxable temporary differences (i.e., deferred tax liabilities)
- Future taxable income exclusive of reversing temporary differences and carryforwards
- Tax-planning strategies
All available evidence, both positive and negative, must be considered when determining whether a valuation allowance is needed. More weight should be place on objective evidence rather than subjective evidence. The first two sources provide fairly objective evidence because they primarily relate to matters that have already occurred. The second two sources are considered subjective because they depend primarily on the occurrence or nonoccurrence of a future event. This is why considerable judgment is often involved when assessing the need for and amount of a valuation allowance.
The valuation allowance is not a “set it and forget it” amount. Changes in circumstances that cause a change in judgment about the realizability of a deferred tax asset in future years must be accounted for by adjusting the valuation allowance accordingly.
Our course Income Taxes: Deferred Tax and Valuation Allowance provides a deep dive into the stepped methodology for accounting for deferred taxes.
Uncertainty in income taxes
Uncertainty in income taxes arises because tax law is often subject to interpretation and may relate to the nature, validity, amount, or timing of a tax position. Therefore, it may be uncertain whether a tax position taken (or to be taken) on a tax return, and therefore reflected in the financial statements, will be sustained upon audit by the taxing authorities. The resulting uncertainty leads to questions about whether tax positions taken, or to be taken, on tax returns should be reflected in the financial statements before they are resolved with the taxing authorities. ASC 740 provides specific guidance on how to account for uncertainty in income taxes:
- Focuses on how transactions will be treated under the tax law and whether positions taken on tax returns should be reflected in financial statements
- Applies to all tax positions accounted for under ASC 740
- Provides guidance on recognition, measurement, derecognition, interest & penalties, presentation and disclosure
This is another area of income tax accounting that involves significant judgment. In addition, the accounting guidance is quite extensive. Our course Income Taxes: Uncertainty in Income Taxes explores the identification of, and accounting for, uncertainty in income taxes using the guidance in ASC 740.
ASC 740 provides guidance on several other issues including presentation, disclosure, interim period considerations, and the intraperiod tax allocation. Overall presentation is fairly straightforward. Deferred taxes must be presented as non-current in the balance sheet and can be offset and presented as a single amount if they arise in the same tax paying component of an entity in the same tax jurisdiction. ASC 740 also includes numerous disclosure requirements.
There are specific requirements in ASC 740 on the “intraperiod tax allocation." This guidance requires a step by step approach whereby income tax expense or benefit is allocated among continuing operations, discontinued operations, other comprehensive income, and equity. There are lots of rules and exceptions related to this allocation and it is arguably the most complex area of income tax accounting.
Accounting Differences: ASC 740 vs. IAS 12
The good news is that ASC 740 and IAS 12 have similar objectives and basic principles. They are actually quite similar overall. However, there are some differences.
The key differences are:
A separate valuation allowance is recognized to reduce deferred tax assets to the amount that is more-likely-than-not to be realized.
Deferred tax assets are recognized to the extent that it is probable they will be realized (i.e. a net approach).
Current and deferred taxes are measured based on tax rates that are enacted at the reporting date.
Current and deferred taxes are measured based on tax rates that are enacted or substantively enacted at the reporting date.
An exception to recognition of deferred taxes exists related to intra-entity transfers of inventory that result in a step-up in tax basis.
No such exception exists.
Both GAAPs include an exception to deferred tax recognition related to investments in subsidiaries, foreign corporate joint ventures and equity method investees if certain requirements are met, however the specific application criteria are different.
Changes in deferred tax items that were initially recognized outside of the P&L (e.g. OCI) are generally recognized in the P&L.
Changes in deferred tax items that were initially recognized outside of the P&L (e.g. OCI) are also recognized outside of the P&L.
For tax positions that are more likely than not to be sustained, the recognition of that tax position is based on the largest amount of tax benefit that is more likely than not of being realized.
For tax positions that the tax authority is unlikely to accept (or to accept in full), the effect of the tax uncertainty is reflected in measuring current or deferred tax by using either the most likely amount or the expected value method.
The differences noted above are not the only differences between ASC 740 and IAS 12. For more comprehensive coverage of differences between the two, refer to the thought leadership provided by the Big 4 accounting firms. See the Accounting Resources section below for links.
Join the Revolution with GAAP Dynamics!
GAAP Dynamics training courses are designed to help leading accounting firms and multinational companies move beyond the training status quo. Our courses are continually updated and new courses are constantly being added, so check back often! Below are a few of our course related to income taxes.
Income Taxes: Overview of ASC 740 - This course provides an overview of ASC 740 by walking through the income tax provision and discussing presentation and disclosure requirements.
Income Taxes: Deferred Tax and Valuation Allowance - In this course you will dive into a stepped methodology for accounting for deferred taxes. After you learn about each step, you will complete a case study applying what you learned.
Income Taxes: Uncertainty in Income Taxes - This course explores the identification of, and accounting for, uncertainty in income taxes using the guidance in ASC 740.
There are numerous resources available on accounting for income taxes under both ASC 740 and IAS 12. To save you time searching, we have compiled a list of resources below to assist you in your research and quest to master lease accounting.
Resources from GAAP Dynamics:
We have written several blogs on a variety of specific income tax accounting topics which are listed below. Click on the links to view the full blog post.
Accounting for Income Taxes under ASC 740: An Overview
Accounting for income taxes under ASC 740, it’s a topic most non-tax accountants try to avoid…we’ll help you break it down!
Accounting for Income Taxes under ASC 740: Deferred Taxes
Accounting for income taxes under ASC 740 is a difficult topic to grasp. This post explores accounting for deferred taxes and the valuation allowance.
Example: Accounting for Uncertain Tax Positions (ASC 740)
What is an uncertain tax position and how do you account for them under U.S. GAAP? This post summarizes the accounting for uncertain tax positions under ASC 740 using a quick worked example
Our Favorite Resources for Accounting for Income Taxes (ASC 740)
Accounting for Income Taxes under ASC 740 is always a challenge, but this collection of our favorite resources will make it a tad easier!
The Guidance is Clear: Uncertain Tax Positions and IFRS (IFRIC 23)
Uncertainty in income tax treatments is not a new topic. But the guidance under IAS 12 has not been certain, until now, thanks to IFRIC 23.
Impact of COVID-19 on Accounting for Income Taxes under ASC 740
The COVID-19 pandemic has required numerous accounting and financial reporting considerations, including the accounting for income taxes under ASC 740.
Taxes and The New Lease Accounting Standard (ASC 842)
Entities are getting ready to implement ASC 842, but how are tax accounts and returns impacted? This post explores the tax impacts of the new lease accounting standard.
Taxes and the New Revenue Recognition Standard (ASC 606)
Entities getting ready to implement the new revenue recognition standard (ASC 606). But how are tax accounts and returns impacted by this change?
Get Out of the Pool: Changes to ASC 718 Are Making Companies Billions!
A worked example of how changes to ASC 718, specifically elimination of the APIC pool, are making companies like Google and Facebook billions.
Indefinite Reversal Criteria of ASC 740 (APB 23): A Worked Example
How should entities apply the indefinite reversal criteria within ASC 740-30 (the APB 23 exception) in practice? This worked example shows how.
What Readers of the Financial Statements Need to Know About the TCJA!
The accounting for the Tax Cuts and Jobs Act (TCJA) is done, but as a reader of financial statements, can you recognize changes due to the 21% rate?
Resources from the FASB and IASB:
- ASC 740, Income Taxes – This link will take you to the authoritative guidance (professional subscription required)
- FASB Technical Agenda – There are often FASB projects related to income taxes. Use this link to see what is on the horizon.
- IAS 12, Income Taxes – This link will take you to the landing page for IAS 12. A professional subscription is required to access the full standard with all applicable appendices.
- IFRIC 23 Uncertainty over Income Tax Treatments – This link will take you to the landing page for IAS 12. A professional subscription is required to access the full standard.
- International Accounting Standards Work Plan – There are often IASB projects related to income taxes. Use this link to see what is on the horizon.
Resources from Accounting Firms:
The Big 4 accounting firms have informative, in-depth guides on accounting for income taxes. To save you time and effort in your research, we have linked to them below.
- PWC’s Income Taxes Guide
- KPMG’s Handbook: Accounting for Income Taxes
- EY’s Financial Reporting Developments (A Comprehensive Guide): Income Taxes
- Deloitte’s A Roadmap to Accounting for Income Taxes
- Deloitte’s IAS 12 – Income Taxes summary
- Deloitte’s IFRIC 23 – Uncertainty over Income Tax Treatments summary
- PWC’s Manual of Accounting – IFRS (subscription required)
- KPMG’s Insights into IFRS (subscription required)
- Deloitte’s iGAAP: International IFRS (subscription required)
- KPMG’s IFRS Compared to U.S. GAAP