Accounting for income taxes. Although my parents may always think every CPA prepares tax returns, we know the truth. There are an awful lot of accountants and auditors in this world who spend a majority of their time avoiding the subject of income taxes! Why? It’s complicated. But as one of those people who used to avoid it, I’m here to tell you: it’s the complexities that make it so interesting…in fact, it is now one of my favorite topics to teach in the classroom!
If you’re one of those people who thinks they could use a refresher on ASC Topic 740 but haven’t made it out to see one of our live sessions yet, you’re in luck! Our three-part series on accounting for income taxes was just released on The Revolution, our new online learning platform! So, join me, and let’s take a quick tour of accounting for income taxes, starting with a general overview.
Income Taxes: Overview of ASC Topic 740
The Basics
U.S. GAAP, specifically ASC Topic 740, Income Taxes, requires income taxes to be accounted for by the asset/liability method. The asset and liability method places emphasis on the valuation of current and deferred tax assets and liabilities. The amount of income tax expense recognized for a period is the amount of income taxes currently payable or refundable, plus or minus the change in aggregate deferred tax assets and liabilities. Under this method, which focuses on the balance sheet, the amount of deferred income tax expense is determined by changes to deferred tax assets and liabilities.
We all know the general formula for the income tax provision: current tax expense or benefit + deferred tax expense or benefit = total income tax expense or benefit as reported in the financial statements. Let’s take a look at each of these components:
- Current tax expense or benefit. This is the amount of income taxes payable or receivable for the current year as determined by applying the provisions of tax law to taxable income or loss for the year. Remember, taxable income is different from financial income…it’s what the company actually owes the government(s). Generally speaking, the equation to calculate current income tax expense or benefit is as follows:
Pretax financial income (this is what shows up in the company’s financial statements)
+/- Permanent differences (these are items recognized for book purpose, but never for tax purposes…or vice versa)
+/- Temporary differences (these are differences between amounts reported for tax purposes and those reported for book purposes)
x Enacted tax rate
Current income tax expense
- Deferred tax expense or benefit. After the “amount owed to the government” (current tax payable) is calculated we must then determine whether any other income taxes have to be recognized for financial reporting purposes. This depends on whether there are any temporary differences between the amounts reported for tax purposes and those reported for book purposes.
A temporary difference is the difference between the asset or liability provided on the tax return (tax basis) and its carrying (book) amount in the financial statements. This difference will result in a taxable or deductible amount in the future. For example, consider a product warranty liability. For book purposes, a company would record a liability related to a product warranty. However, that liability would not be recognized for tax purposes (i.e. a “zero tax basis”), because the expense related to the product warranty would not be deductible on the income tax return until it was paid. Therefore, the expense and associated liability are recognized for financial reporting purposes before they are recognized for tax purposes. Since GAAP is based on the accrual method of accounting, an asset or liability should be recognized for these differences that have future tax consequences.
Deferred tax expense or benefit generally represents the change in the sum of the deferred tax assets, net of any valuation allowance, and deferred tax liabilities during the year.
Companies first need to calculate their current income taxes payable or receivable, then figure out their deferred tax assets and liabilities. The calculation of deferred tax assets and liabilities should be based on enacted tax law, not future expectations/assumptions. Finally, deferred tax assets (like any other asset) need to be assessed for recoverability. Any amounts not deemed to be recoverable should be written off through expense. The current income tax payable or receivable is recorded with the offset to the P&L (current tax expense). Deferred tax assets and liabilities are normally recorded with the offsetting entry to the P&L (deferred tax expense).
Introduction to the Course
This interactive and engaging eLearning course, which is eligible for 1.0 CPE, walks you through the key principles of ASC Topic 740. In this course, you’ll learn:
- How to apply the asset and liability method, which focuses on the differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting
- The scope of ASC 740 and what types of taxes are included
- The income tax provision equation and how it is calculated
- How to identify temporary and permanent differences and how they impact the deferred tax accounts and tax rates
- The exceptions to deferred taxes
- The required disclosures related to income taxes
Income Taxes: Deferred Taxes and Valuation Allowance
We discussed the idea of calculating deferred tax expense in the overview section above. Generally speaking, temporary differences can be divided into future taxable amounts and future deductible amounts. Future taxable amounts increase taxable income and result in deferred tax liabilities for financial reporting purposes; future deductible amounts decrease taxable income and result in deferred tax assets for financial reporting purposes. Deferred tax expense or benefit generally represents the change in the sum of the deferred tax assets, net of any valuation allowance, and deferred tax liabilities during the year.
In this module, you'll dive into a five-step methodology for accounting for deferred taxes. After you learn about each step, you'll walk through a case study, so you can apply what you have just learned!
Income Taxes: Uncertainty in Income Taxes
Is tax law black and white? No, definitely not! In fact, we wrote a blog on the subject not too long ago. There’s lots of gray area in tax law causing companies to take positions that may, or may not, be sustained if reviewed by taxing authorities. This uncertainty in income taxes has an impact on the financial statements as well as the tax return. ASC 740, Income Taxes, provides guidance on how to account for this uncertainty in the financial statements.
In this module, you’ll explore the identification of, and accounting for, uncertainty in income taxes using the guidance in ASC 740.
We’ll explore identifying and calculating the impact of deferred taxes in the next blog post. In the meantime, if you’re ready to dive into accounting for income taxes, you can check out the entire collection of income tax courses here!
Disclaimer
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.
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