Accounting for Income Taxes under ASC 740: An Overview

Posted on January 22, 2019 by Vicky Hale, CPA | Tags: ASC 740, Deferred taxes,

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! This post provides an overview of accounting for income taxes under ASC 740. For more information on the accounting for income taxes, check out our Income Taxes Topic Page.

If you’re one of those people who thinks they could use a refresher on ASC 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 is available on the GAAP Dynamics Learning Library! So, join me, and let’s take a quick tour of accounting for income taxes, starting with a general overview.

Accounting for income taxes: Overview of ASC 740

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.

Graphic showing the components of a U.S. GAAP income tax provision. Current income tax expense plus deferred income tax expense equals the total income tax expense (or benefit) for the year.

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 income tax expense or benefit

Current income tax expense or benefit 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 income tax expense or benefit

After the “amount owed to the government” (current income 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.

Graphic showing how to determine whether a temporary difference gives rise to future taxable or future deductible amounts. Future taxable amounts give rise to deferred tax liabilities, while future deductible amounts give rise to deferred tax assets.

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).

We cover this and much more in our Income Taxes: Overview of ASC 740 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

Accounting for income taxes: Deferred tax 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 as shown in the image below.

Graphic showing the calculation and components of a deferred income tax provision under ASC 740.

Need to take a deeper dive in the deferred income taxes? Well, you’re in luck! Check out our Income Taxes: Deferred Tax and Valuation Allowance course. In this CPE-eligible, eLearning course (1.5 CPE), we walkthrough a five-step methodology that you can use when accounting for deferred taxes in accordance with ASC 740. After discussing each step, we dive into the concept of a valuation allowance, which is needed if it is more likely than not that an entity cannot utilize its deferred tax assets. This online course concludes with a comprehensive case study so you can apply what you’ve just learned.

Accounting for income taxes: Uncertainty in income Taxes

Is tax law black and white? No, definitely not! 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 provides guidance on how to account for this uncertainty in the U.S. GAAP financial statements. We’ve summarized this guidance in an eight-step process below depicted in the image below.

Eight-step process for determining and accounting for uncertainty in income taxes.

Check out our Income Taxes: Uncertainty in Income Taxes eLearning course to help you with the identification of, and accounting for, uncertainty in income taxes using the guidance in ASC 740.

Closing thoughts

In summary, accounting for income taxes scares a lot of CPAs. Don’t be scared. Be prepared! You can start by enrolling in our ASC 740: Accounting for Income Taxes course collection (3 courses; 4.5 CPE).

We hope that this blog aids your understanding of accounting for income taxes in accordance with U.S. GAAP. If you get tripped up, we’re always here to help!

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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.