Basic recognition threshold

A more-likely-than-not recognition criterion is applied to a tax position before and separate from the measurement of a tax position. This means that an entity initially recognizes the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination.

The term more likely than not means

• a likelihood of more than 50%;
• the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any;
• the determination should consider the facts, circumstances, and information available at the reporting date; and
• the level of evidence that is necessary and appropriate to support an entity’s assessment of the technical merits of a tax position is a matter of judgment that depends on all available information.

A change in facts after the reporting date but before the financial statements are issued or are available to be issued is recognized in the period in which the change in facts occurs. An entity shall recognize the benefit of a tax position when it is effectively settled.

Temporary differences

Income taxes currently payable for a particular year usually include the tax consequences of most events that are recognized in the financial statements for that year. However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenues, expenses, gains, and losses, differences arise between

1. the amount of taxable income and pretax financial income for a year, and
2. the tax bases of assets or liabilities and their reported amounts in financial statements.

A difference between the tax basis of an asset or a liability and its reported amount in the statement of financial position will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. Examples include the following:

1. Revenues or gains that are taxable after they are recognized in financial income
2. Expenses or losses that are deductible after they are recognized in financial income
3. Revenues or gains that are taxable before they are recognized in financial income
4. Expenses or losses that are deductible before they are recognized in financial income
5. A reduction in the tax basis of depreciable assets because of tax credits
6. Investment tax credits accounted for by the deferral method
7. An increase in the tax basis of assets because of indexing whenever the local currency is the functional currency
8. Business combinations and combinations accounted for by NFPs

Basis differences that are not temporary differences

Certain basis differences may not result in taxable or deductible amounts in future years when the related asset or liability for financial reporting is recovered or settled and, therefore, may not be temporary differences for which a deferred tax liability or asset is recognized.

Tax-to-tax differences are not temporary differences. An example of a tax-to-tax difference is an excess of the parent entity’s tax basis of the stock of an acquired entity over the tax basis of the net assets of the acquired entity.

Basic requirements

The following basic requirements are applied to the measurement of current and deferred income taxes at the date of the financial statements:

1. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated.
2. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.

Total income tax expense (or benefit) for the year is the sum of deferred tax expense (or benefit) and income taxes currently payable or refundable.

Deferred tax expense (or benefit)

Deferred tax expense (or benefit) is the change during the year in an entity’s deferred tax liabilities and assets.

Deferred taxes should be determined separately for each taxpaying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction. That determination includes the following procedures:

1. Identify the types and amounts of existing temporary differences and the nature and amount of each type of operating loss and tax credit carryforward and the remaining length of the carryforward period.
2. Measure the total deferred tax liability for taxable temporary differences using the applicable tax rate.
3. Measure the total deferred tax asset for deductible temporary differences and operating loss carryforwards using the applicable tax rate.
4. Measure deferred tax assets for each type of tax credit carryforward.
5. Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized. The valuation allowance shall be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.

Balance sheet classification of deferred tax assets and liabilities

Deferred tax assets and liabilities should be classified as noncurrent for financial reporting purposes, and are offset against each other providing the deferred tax liabilities and assets did not arise from different taxpaying components of a company or from different tax jurisdictions. If they did, then these deferred tax liabilities and assets would be presented separately and not offset against each other.

Applicable tax rate

The applicable tax rate is the regular U.S. tax rate for the year in which the deferred tax liability is expected to be settled or the asset recovered. In the absence of enacted changes in future tax rates, this rate is simply the current rate. However, enacted changes in future tax rates must be given consideration. If the enacted tax law allows for different tax rates on different types of taxable income, this should be considered (for example, ordinary income and capital gains). This approach is frequently described as the liability method of measuring the deferred tax amount.

A single flat tax rate (for example, the maximum marginal rate) may be used for companies for which graduated rates are not a significant factor. If graduated rates are a significant factor, deferred tax liabilities or deferred tax assets should be measured using average graduated tax rates.

The applicable tax rate in jurisdictions other than the United States requires consideration of any alternative tax system that exists and its interaction with the regular tax system. Alternative minimum tax rates are not considered in the calculation of deferred tax amounts. However, an alternative minimum tax credit carryforward is treated as a deferred tax asset just like any other tax credit carryforward.

The tax asset realized through carryback of future losses to a current or prior period is measured using tax laws and rates for current or prior years (that is, the year for which the refund is expected to be realized based upon carryback provisions of the tax law).

Knowledge check

3. How are deferred tax assets and liabilities presented in the balance sheet?
   1. Deferred tax assets are presented separately from deferred tax liabilities and classified as noncurrent.
   2. Deferred tax assets and deferred tax liabilities are presented separately and classified as current.
   3. Deferred tax assets and deferred tax liabilities are offset against each other and classified as noncurrent, providing they did not arise from different taxpaying components of a company or from different tax jurisdictions.
   4. Deferred tax assets and deferred tax liabilities are offset against each other, and classified as current, providing they did not arise from different taxpaying components of a company or from different tax jurisdictions.
4. When determining the deferred tax asset or liability, what tax rate should be used?
   1. The current year’s tax rate.
   2. The regular tax rate for the year in which the deferred tax liability is expected to be settled or the asset recovered.
   3. The forecasted rate for the year in which the deferred tax liability is expected to be settled or the asset recovered.
   4. The tax rate in effect when the deferred tax asset or liability was initially reported.

Allocation to continuing operations

The amount of income tax expense or benefit allocated to continuing operations may include multiple components. The tax effect of pretax income or loss from current year continuing operations is always one component of the amount allocated to continuing operations.

The tax effect of pretax income or loss from continuing operations generally should be determined by a computation that does not consider the tax effects of items that are not included in continuing operations. The exception to that incremental approach is that all items be considered in determining the amount of tax benefit that results from a loss from continuing operations and that shall be allocated to continuing operations. This modification of the incremental approach is consistent with consideration of the tax consequences of taxable income expected in future years based on realizability of deferred tax assets.

Allocation to other than continuing operations

The tax effects of the following items are charged or credited directly to related components of shareholders’ equity:

• Adjustments to the opening balance of retained earnings for certain changes in accounting principles or a correction of an error
• Gains and losses included in comprehensive income but excluded from net income (for example, translation adjustments or unrealized gains and losses of available-for-sale securities)
• An increase or decrease in contributed capital (for example, deductible expenditures reported as a reduction of the proceeds from issuing capital stock)
• Expenses for employee stock options that are recognized differently for financial reporting and tax purposes
• Dividends that are paid on unallocated shares held by an employee stock ownership plan and that are charged to retained earnings
• Deductible temporary differences and carryforwards that existed at the date of a quasi-reorganization
• All changes in the tax bases of assets and liabilities caused by transactions among or with shareholders shall be included in equity, including the effect of valuation allowances initially required upon recognition of any related deferred tax assets.

FASB ASC 740 requires consideration of the tax consequences of all items to determine the amount of tax benefit that results from a loss from continuing operations and that should be allocated to continuing operations.

The allocation of tax expense (benefit) to items other than continuing operations is accomplished as follows:

• One item other than continuing operations — Allocation is made to continuing operations first, and the amount of expense or benefit remaining is allocated to the other item.
• Two or more items other than continuing operations — The amount remaining after allocation to continuing operations should be allocated among the other items in proportion to their individual effects on income tax expense or benefit for the year. The sum of the separately calculated amounts may not equal the total amount left after allocation to continuing operations. When this occurs, the following procedures are used to allocate the remaining amount to these other items:
  • The effect on income tax expense or benefit is determined for the total loss for all net loss items.
  • The tax benefit determined previously is apportioned ratably to each loss item.
  • The amount that remains, that is, the difference between (1) the amount allocated to all items other than continuing operations and (2) the amount allocated to all net loss items, is determined.
  • The tax expense determined in the preceding item is apportioned ratably to each net gain item.

The consolidated amount of current and deferred tax expense for a group that files a consolidated tax return should be allocated among the members of the group when those members issue separate financial statements. The method selected should be systematic and rational.

• A method that allocates current and deferred taxes to each member of the group as if it were a separate taxpayer meets those criteria.
• Examples of methods that are not allowable include methods that allocate
  • only current taxes payable to a member of a group that has taxable temporary differences,
  • deferred taxes to a member of the group using a method fundamentally different from the asset and liability method in FASB ASC 740, and
  • no current or deferred tax expense to a member of the group that has taxable income because the consolidated group has no current or deferred tax expense.

Knowledge check

5. Under FASB ASC 740, which item should have the tax effect charged or credited directly to related components of shareholders’ equity?
   1. Switches from accelerated to straight-line depreciation.
   2. Change in tax status of an item from taxable to nontaxable.
   3. A decrease in contributed capital such as deductible expenditures reported as a reduction of the proceeds from issuing capital stock.
   4. Deductible temporary differences and carryforwards that existed prior to the date of a quasi-reorganization.