ASC 740-10, Overall, which provides most of the guidance on accounting and reporting for income taxes
ASC 740-20, Intraperiod Tax Allocation, which provides guidance on the process of allocating income tax benefits or expenses to different components of comprehensive income
ASC 740-30, Other Considerations or Special Areas, which provides guidance for specific limited exceptions related to investments in subsidiaries and corporate joint ventures arising from undistributed earnings or other causes.

Scope and Scope Exceptions

The term “tax position” is used in ASC 740-10 to refer to each judgment that management makes on an income tax return that has been or will be filed that affects the measurement of current or deferred income tax assets and liabilities at the date of each interim or year-end statement of financial position. Tax positions include:

Deductions claimed
Deferrals of current income tax to one or more future periods
Income tax credits applied
Characterization as capital gain versus ordinary income
Whether or not to report income on an income tax return
Whether or not to file an income tax return in a particular jurisdiction.

The effects of a tax position can result in a permanent reduction of income taxes payable or deferral of the payment of income taxes to a future year. The taking of a tax position can also affect management's estimate of the valuation allowance sufficient to reflect its estimate of the amount of deferred income tax assets that are realizable.

ASC 740-10 applies to income taxes accounted for in accordance with ASC 740, and thus does not apply directly or by analogy to other taxes, such as real estate, personal property, sales, excise, or use taxes. The scope of ASC 740-10 includes any entity potentially subject to income taxes, including:

Nonprofit organizations
Flow-through entities (e.g., partnerships, limited liability companies, and S corporations)
Entities whose income tax liabilities are subject to 100% credit for dividends paid such as real estate investment trusts (REITs) and registered investment companies.

Overview

Reporting entities are required to file income tax returns and pay income taxes in the domestic (federal, state, and local) and foreign jurisdictions in which they do business. GAAP require that financial statements be prepared on an accrual basis and that, consequently, the reporting entity is required to accrue a liability for income taxes owed or expected to be owed with respect to income tax returns filed or to be filed for all applicable tax years and in all applicable jurisdictions.

A longstanding debate has involved the controversial recognition of benefits (or reduced obligations) related to income tax positions that are uncertain or aggressive and which, if challenged, have a more-than-slight likelihood of not being sustained, resulting in the need to pay additional income taxes, often with interest and—sometimes—penalties added. Preparers have objected to presenting income tax obligations for such positions, often on the not-unreasonable theory that to do so would provide taxing authorities with a “road map” to the challengeable income tax positions taken by the reporting entity. With the issuance of FIN 48, Accounting for Uncertainty in Income Taxes, uncertain income tax positions were to become subject to formal recognition and measurement criteria, as well as to extended disclosure requirements under GAAP. The guidance is incorporated in ASC 740 and is explained and illustrated in detail in this chapter.

The computation of taxable income for the purpose of filing federal, state, and local income tax returns differs from the computation of net income under GAAP for a variety of reasons. In some instances, referred to as temporary differences, the timing of income or expense recognition varies. In other instances, referred to as permanent differences, income or expense recognized for income tax purposes is never recognized under GAAP, or vice versa. An objective under GAAP is to recognize the income tax effects of transactions in the period that those transactions occur. Consequently, deferred income tax benefits and obligations frequently arise in financial statements.

The basic principle is that the deferred income tax effects of all temporary differences (which are defined in terms of differential bases in assets and liabilities under income tax and GAAP accounting) are to be formally recognized. To the extent that deferred income tax assets are of doubtful realizability—are not “more likely than not to be realized”—a valuation allowance is provided, analogous to the allowance for uncollectible receivables.

The process of interperiod income tax allocation, which gives rise to deferred income tax assets and liabilities, is required under GAAP. As with many accounting measurements, the prescribed methodology has varied depending upon whether the primary objective was accuracy of the statement of financial position or of the income statement.

Under ASC 740, purchase price allocations made pursuant to purchase-method business combinations under ASC 805, Business Combinations (and recognized values pursuant to acquisition-method business combinations under its replacement standard, ASC 805) are made gross of income tax effects, and any associated income tax benefit or obligation is recognized separately.

Postcombination changes in valuation allowances for an acquired entity's deferred income tax assets no longer automatically reduce recorded goodwill and intangibles. The accounting depends upon whether the changes occur during or after the expiration of the measurement period.

If the change occurs during the prescribed measurement period, not to exceed one year from the acquisition date, it is first applied to adjust goodwill until goodwill is eliminated, with any excess adjustment remaining being recorded as a gain from a bargain purchase. If the change occurs subsequent to the measurement period, it is recognized in the period of change as a component of income tax expense or benefit, or, in the case of certain specified exceptions, as a direct adjustment to contributed capital. Notably, the transition provisions of ASC 805 require this treatment to be applied prospectively after the effective date of the standard, even with respect to acquisitions that were originally recorded under the predecessor standard.

The income tax effects of net operating loss or tax credit carryforwards are treated as deferred income tax assets just like any other deferred income tax benefit.

With its statement of financial position orientation, ASC 740 requires that the amounts presented be based on the amounts expected to be realized, or obligations expected to be liquidated. Use of an average effective income tax rate convention is permitted. The effects of all changes in the deferred income tax assets and liabilities flow through the income tax provision in the income statement; consequently, income tax expense is normally not directly calculable based on pretax accounting income in other than the simplest situations.

Discounting of deferred income taxes has never been permitted under GAAP, even though the ultimate realization and liquidation of deferred income tax assets and liabilities is often expected to occur far in the future. The inability to predict accurately the timing of the realization of deferred income tax benefits or the payment of deferred income tax payments makes discounting very difficult to accomplish.

DEFINITIONS OF TERMS

Alternative Minimum Tax. A tax that results from the use of an alternate determination of a corporation's federal income tax liability under provisions of the U.S. Internal Revenue Code.

Carrybacks. Deductions or credits that cannot be utilized on the tax return during a year that may be carried back to reduce taxable income or taxes payable in a prior year. An operating loss carryback is an excess of tax deductions over gross income in a year; a tax credit carryback is the amount by which tax credits available for utilization exceed statutory limitations. Different tax jurisdictions have different rules about whether excess deductions or credits may be carried back and the length of the carryback period.

Carryforwards. Deductions or credits that cannot be utilized on the tax return during a year that may be carried forward to reduce taxable income or taxes payable in a future year. An operating loss carryforward is an excess of tax deductions over gross income in a year; a tax credit carryforward is the amount by which tax credits available for utilization exceed statutory limitations. Different tax jurisdictions have different rules about whether excess deductions or credits may be carried forward and the length of the carryforward period. The terms carryforward, operating loss carryforward, and tax credit carryforward refer to the amounts of those items, if any, reported in the tax return for the current year.

Conduit bond obligor. The party on behalf of whom a state or local government agency raises funds by issuing bonds (commonly referred to as municipal bonds, industrial revenue bonds, or private activity bonds). Interest on the bonds typically is exempt from federal income tax to the investor, and in order to qualify for this exemption, the proceeds from the bond must be used by the conduit bond obligor for purposes permitted under the federal income tax code. If the proceeds from the bonds are used to provide funding to multiple parties that participate in a pool (a pooled conduit debt security), all of the individual conduit bond obligors that participate are considered individually to be conduit bond obligors.

Conduit debt securities. Certain limited-obligation revenue bonds, certificates of participation, or similar debt instruments issued by a state or local governmental entity (issuer) for the purpose of providing financing for a specific third party (the conduit bond obligor) that is not a part of the issuer's reporting entity. Even though these securities bear the issuer's name, the issuer often has no obligation with respect to the debt other than as provided in a lease or loan agreement with the conduit bond obligor on whose behalf the securities are issued. The conduit bond obligor is responsible for making or funding all principal and interest payments when due and is also responsible for future financial reporting requirements with respect to the securities.

Current Tax Expense (or Benefit). The amount of income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year.

Deductible Temporary Difference. Temporary differences that result in deductible amounts in future years when the related asset or liability is recovered or settled, respectively.

Deferred Tax Asset. The deferred tax consequences attributable to deductible temporary differences and carryforwards. A deferred tax asset is measured using the applicable enacted tax rate and provisions of the enacted tax law. A deferred tax asset is reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized.

Deferred Tax Consequences. The future effects on income taxes as measured by the applicable enacted tax rate and provisions of the enacted tax law resulting from temporary differences and carryforwards at the end of the current year.

Deferred Tax Expense (or Benefit). The change during the year in an entity's deferred tax liabilities and assets. For deferred tax liabilities and assets acquired in a purchase business combination during the year, it is the change since the combination date. Income tax expense (or benefit) for the year is allocated among continuing operations, discontinued operations, extraordinary items, and items charged or credited directly to shareholders' equity.

Deferred Tax Liability. The deferred tax consequences attributable to taxable temporary differences. A deferred tax liability is measured using the applicable enacted tax rate and provisions of the enacted tax law.

Effective settlement. A conclusion, reached by applying criteria specified in ASC 740-10-25, that a taxing authority has in effect made its final determination with respect to the portion of a tax position, if any, that it will accept, and that management considers the possibility of further examination or reexamination of any aspect of the position to be remote.

Future deductible temporary difference. The difference between the GAAP carrying amount and income tax basis of an asset or liability that will reverse in the future and result in future income tax deductions; these give rise to deferred income tax assets.

Future taxable temporary difference. Temporary differences that result in future taxable amounts, which give rise to deferred income tax liabilities.

Gains and Losses Included in Comprehensive Income but Excluded from Net Income. Gains and losses included in comprehensive income but excluded from net income include certain changes in fair values of investments in marketable equity securities classified as noncurrent assets, certain changes in fair values of investments in industries having specialized accounting practices for marketable securities, adjustments related to pension liabilities or assets recognized within other comprehensive income, and foreign currency translation adjustments. Future changes to generally accepted accounting principles (GAAP) may change what is included in this category.

Highly certain income tax position. An income tax position that, based on clear and unambiguous tax law, rulings, regulations and interpretations, has a remote likelihood of being disallowed by the applicable taxing jurisdiction examining it with full possession of all relevant facts.

Income Tax Expense (or Benefit). The sum of current tax expense (or benefit) and deferred tax expense (or benefit).

Income tax position. Each judgment that management makes on an income tax return that has been or will be filed that affects the measurement of current or deferred income tax assets and liabilities at an interim or year-end date. The effects of taking an income tax position can result in a permanent reduction of income taxes payable or deferral of the payment of income taxes to a future year. The taking of an income tax position can also affect management's estimate of the valuation allowance sufficient to reflect the amount of deferred income tax assets that it believes will be realizable.

Interperiod tax allocation. The process of apportioning income tax expense among reporting periods without regard to the timing of the actual cash payments for income taxes. The objective is to reflect fully the income tax consequences of all economic events reported in current or prior financial statements and, in particular, to report the expected future income tax effects of the reversals of temporary differences existing at the reporting date.

Intraperiod tax allocation. The process of apportioning income tax expense applicable to a given period between income before extraordinary items and those items required to be shown net of tax such as extraordinary items, discontinued operations, and prior period adjustments.

Nexus. Nexus represents the types and extent of business activity that must be present before a state can impose an income tax on an entity. If an entity has nexus in a particular state, that entity is required to pay and collect/remit taxes in that state. In general, nexus is applied for income tax purposes if an entity derives income from sources within the state, owns or leases property in the state, employs personnel in the state in activities that exceed “mere solicitation,” or owns property located in the state. The amount of activity or connection that is necessary to create nexus is defined by each individual state's statute or case law and/or regulation, and thus is not uniform from state to state.

Nonpublic enterprise. An entity (1) whose debt or equity securities are not traded in a public market and (2) is not a conduit bond obligor for conduit debt securities traded in a public market. For the purpose of this definition, a public market can be a domestic or foreign exchange or over-the-counter market, even if the securities are only quoted locally or regionally. It is important to note that GAAP does not contain uniform definitions of public or nonpublic enterprises. Thus, the use of this terminology must be evaluated in the context of the specific standard in which it is used.

Operating loss carryback or carryforward. The excess of income tax deductions over taxable income. To the extent that this results in a carryforward, the income tax effect is included in the reporting entity's deferred income tax asset.

Ordinary income or loss (used in interim accounting for income taxes). In GAAP this term is defined differently than it is for income tax purposes. For GAAP purposes, ordinary income or loss is computed as pretax income (loss) from continuing operations less: (1) extraordinary items, (2) discontinued operations, (3) cumulative effects of changes in accounting principle, and (4) significant unusual or infrequently occurring items.

Permanent differences. Differences between pretax accounting income and taxable income as a result of the treatment accorded certain transactions by the income tax laws and regulations that differ from the accounting treatment. Permanent differences will not reverse in subsequent periods.

Pretax accounting income. Income or loss for the accounting period as determined in accordance with GAAP without regard to the income tax expense for the period.

Public enterprise. An entity (1) whose debt or equity securities are traded in a public market, (2) that is a conduit bond obligor for conduit debt securities traded in a public market, or (3) whose financial statements are filed with a regulatory agency in preparation for the sale of any class of securities. For the purpose of this definition, a public market can be a domestic or foreign exchange or over-the-counter market, even if the securities are only quoted locally or regionally. GAAP does not contain uniform definitions of public or nonpublic enterprises. Thus, the use of this terminology must be evaluated in the context of the specific standard in which it is used.

Tax (or Benefit). Tax (or benefit) is the total income tax expense (or benefit), including the provision (or benefit) for income taxes both currently payable and deferred.

Tax consequences. The effects on income taxes—current or deferred—of an event.

Tax credits. Reductions in income tax liability as a result of certain expenditures accorded special treatment under the Internal Revenue Code. Examples of such credits include: the Investment Tax Credit, investment in certain depreciable property; the Jobs Credit, payment of wages to targeted groups; the Research and Development Credit, an increase in qualifying R&D expenditures; and others.

Tax Position. A position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. A tax position can result in a permanent reduction of income taxes payable, a deferral of income taxes otherwise currently payable to future years, or a change in the expected realizability of deferred tax assets. The term tax position also encompasses, but is not limited to:

A decision not to file a tax return
An allocation or a shift of income between jurisdictions
The characterization of income or a decision to exclude reporting taxable income in a tax return
A decision to classify a transaction, entity, or other position in a tax return as tax exempt
An entity's status, including its status as a pass-through entity or a tax-exempt not-for-profit entity.

Taxable income. The difference between the taxable revenue and deductible expenses as defined by the Internal Revenue Code for a tax period without regard to special deductions (e.g., net operating loss or contribution carrybacks and carryforwards).

Taxable Temporary differences. Temporary differences that result in taxable amounts in future years when the related asset is recovered or the related liability is settled.

Tax-Planning Strategy. An action (including elections for tax purposes) that meets certain criteria (see paragraph 740-10-30-19) and that would be implemented to realize a tax benefit for an operating loss or tax credit carryforward before it expires. Tax-planning strategies are considered when assessing the need for and amount of a valuation allowance for deferred tax assets.

Unrecognized income tax benefits. The portion of income tax benefits claimed on income tax returns filed or to be filed for which, in management's judgment, realization would not be more than 50% probable should the income tax position be examined by the applicable taxing authority possessing all relevant information.

Unrelated business income. Income earned from a regularly carried-on trade or business that is not substantially related to the charitable, educational, or other purpose that is the basis of an organization's exemption from income taxes. This income subjects the otherwise tax-exempt organization to an entity-level unrelated business income tax (UBIT).

Valuation allowance. The contra asset that is to be reflected to the extent that, in management's judgment, it is “more likely than not” that the deferred income tax asset will not be realized.

CONCEPTS, RULES, AND EXAMPLES

Evolution of Accounting for Income Taxes

The differences in the timing of recognition of certain expenses and revenues for income tax reporting purposes versus the timing under GAAP had always been a subject for debates in the accounting profession. The initial debate was over the fundamental principle of whether or not income tax effects of timing difference should be recognized in the financial statements. At one extreme were those who believed that only the amount of income tax currently owed (as shown on the income tax return for the period) should be reported as periodic income tax expense, on the grounds that potential changes in tax law and the vagaries of the entity's future financial performance would make any projection to future periods speculative. This was the “no allocation” or “flow-through” position. At the other extreme were those who held that the matching principle demanded that reported periodic income tax expense be mechanically related to pretax accounting income, regardless of the amount of income taxes actually currently payable. This was the “comprehensive allocation” argument. The debate was settled in the late 1960s: comprehensive income tax allocation became GAAP.

The other key debate was over the measurement strategy to be applied to interperiod income tax allocation. When, in the 1960s and 1970s, accounting theory placed paramount importance on the income statement, with much less interest in the statement of financial position, the method of choice was the “deferred method,” which invoked the matching principle. The annual income tax provision (consisting of current and deferred portions) was calculated so that it would bear the expected relationship to pretax accounting income; any excess or deficiency of the income tax provision over income taxes payable was recorded as an adjustment to the deferred income tax amounts reflected on the statement of financial position. This practice, when applied, resulted in a net deferred income tax debit (subject to some limitations on asset realization) or a net deferred income tax credit, which did not necessarily mean that an asset or liability, as defined under GAAP, actually existed for that reported amount.

By the late 1970s, accounting theory made the financial reporting priority the statement of financial position. Primary emphasis was placed on the measurement of assets and liabilities—which, under CON 6's definitions, clearly would not include certain deferred income tax benefits or obligations as these were then measured. To compute deferred income taxes consistent with this orientation requires use of the “liability method.” This essentially ascertains, as of each date for which a statement of financial position is presented, the amount of future income tax benefits or obligations that are associated with the reporting entity's assets and liabilities existing at that time. Any adjustments necessary to increase or decrease deferred income taxes to the computed balance, plus or minus the amount of income taxes owed currently, determines the periodic income tax expense or benefit to be reported in the income statement. Put another way, income tax expense is the residual result of several other computations oriented to measurement in the statement of financial position.

ASC 740 required that all deferred income tax assets are given full recognition, whether arising from deductible temporary differences or from net operating loss or tax credit carryforwards.

Under ASC 740 it is necessary to assess whether the deferred income tax asset is realizable. Testing for realization is accomplished by means of a “more-likely-than-not” criterion that indicates whether an allowance is needed to offset some or all of the recorded deferred income tax asset. While the determination of the amount of the allowance may make use of the scheduling of future expected reversals, other methods may also be employed.

In summary, interperiod income tax allocation under GAAP is currently based on the liability method, using comprehensive allocation. While this basic principle may be straightforward, there are a number of computational complexities to be addressed. These will be presented in the remainder of this chapter.

An example of application of the liability method of deferred income tax accounting follows.

Simplified example of interperiod income tax allocation using the liability method

Caitlyn International has no permanent differences in years 2012 through 2014 (these are discussed later in this chapter). The company has only two amounts on its statement of financial position with temporary differences between their income tax and financial reporting bases, property and equipment; and prepaid rent. No consideration is given to the classification of the deferred income tax amounts (i.e., current or long-term) as it is not considered necessary for purposes of this example.

Details of Caitlyn's temporary differences are as follows:

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Property and equipment future taxable temporary difference

On January 1, 2012, Caitlyn International purchased $400,000 of property and equipment with a 10-year estimated useful life which, under its normal accounting policy, it depreciates using the straight-line method. For income tax purposes, these assets qualify as 5-year personal property under the General Depreciation System (GDS), and consequently, income tax depreciation is computed using the Modified Accelerated Cost Recovery System (MACRS) which is equivalent to double-declining balance depreciation with a half-year assumed for the year placed in service and changing to straight-line depreciation when advantageous to the taxpayer. In addition, as permitted by IRC Section 179, Caitlyn elected to deduct $100,000 of these costs in the year placed in service. By making this election, for the purpose of computing income tax cost recovery, Caitlyn is required to reduce the depreciable basis of the eligible assets by the amount of Section 179 deduction taken during the tax year.

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The computation of deferred income taxes is as follows:

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Note from the computations that, under the liability method, deferred income tax expense or benefit is the amount necessary to adjust the statement of financial position to the computed balance. No attempt is made to correlate the amount of deferred income tax expense or benefit to pretax accounting income or loss. Nor is it necessary to track the amount of each temporary difference that originates or reverses during the year.

ASC 740 in Greater Detail

While the liability method is conceptually straightforward, in practice there are a number of complexities to be addressed. Income tax accounting remains one of the more difficult areas of accounting practice. In the following pages, these measurement and reporting issues will be discussed in greater detail:

Temporary and permanent differences
Treatment of net operating loss carryforwards
Measurement of deferred income tax assets and liabilities
Considering whether a valuation allowance is needed
The effect of tax law changes on previously recorded deferred income tax assets and liabilities
The effect of a change in the tax status of the reporting entity from taxable to non-taxable or vice versa on previously recognized deferred income tax assets and liabilities
The effect of accounting changes for income tax purposes
Income tax effects of dividends paid on shares held by Employee Stock Ownership Plans (ESOP)
The income tax effects of business combinations at and after acquisition date
Intercorporate income tax allocation
Separate financial statements of subsidiaries or investees
Asset acquisitions
Intraperiod income tax allocation
Classification in the statement of financial position
Disclosures
Interim reporting.

Detailed examples of deferred income tax accounting under ASC 740 are presented throughout the following discussion of these issues.

Temporary and Permanent Differences

Deferred income taxes are provided for all temporary differences, but not for permanent differences. Thus, it is important to be able to distinguish between the two.

Temporary differences.

While many typical business transactions are accounted for identically for income tax and financial reporting purposes, there are many others subject to different income tax and accounting treatments, often leading to their being reported in different periods in financial statements than they are reported on income tax returns. The term “timing differences,” used under prior GAAP, has been superseded by the broader term “temporary differences” under current rules. Under income statement-oriented GAAP, timing differences were said to originate in one period and to reverse in a later period. These involved such common items as alternative depreciation methods, deferred compensation plans, percentage-of-completion accounting for long-term construction contracts, and cash basis versus accrual basis accounting.

The more comprehensive concept of temporary differences, consistent with modern GAAP, includes all differences between the income tax basis and the financial reporting carrying value of assets and liabilities, if the reversal of those differences will result in taxable or deductible amounts in future years. Temporary differences include all the items formerly defined as timing differences, and other additional items.

Temporary differences under ASC 740 that were defined as timing differences under prior GAAP can be categorized as follows:

Revenue recognized for financial reporting purposes before being recognized for income tax purposes. Revenue accounted for by the installment method for income tax purposes, but fully reflected in current GAAP income; certain construction-related revenue recognized using the completed-contract method for income tax purposes, but recognized using the percentage-of-completion method for financial reporting purposes; earnings from investees recognized using the equity method for accounting purposes but taxed only when later distributed as dividends to the investor. These are future taxable temporary differences because future periods' taxable income will exceed GAAP income as the differences reverse; thus they give rise to deferred income tax liabilities.

Revenue recognized for income tax purposes prior to recognition in the financial statements. Certain taxable revenue received in advance, such as prepaid rental income and service contract revenue not recognized in the financial statements until later periods. These are future deductible temporary differences, because the costs of future performance will be deductible in the future years when incurred without being reduced by the amount of revenue deferred for GAAP purposes. Consequently, the income tax benefit to be realized in future years from deducting those future costs is a deferred income tax asset.

Expenses deductible for income tax purposes prior to recognition in the financial statements. Accelerated depreciation methods or shorter statutory useful lives used for income tax purposes, while straight-line depreciation or longer useful economic lives are used for financial reporting; amortization of goodwill and nonamortizable intangible assets over a 15-year life for income tax purposes while not amortizing them for financial reporting purposes unless they are impaired. Upon reversal in the future, the effect would be to increase taxable income without a corresponding increase in GAAP income. Therefore, these items are future taxable temporary differences, and give rise to deferred income tax liabilities.

Expenses recognized in the financial statements prior to becoming deductible for income tax purposes. Certain estimated expenses, such as warranty costs, as well as such contingent losses as accruals of litigation expenses, are not tax deductible until the obligation becomes fixed. In those future periods, those expenses will give rise to deductions on the reporting entity's income tax return. Thus, these are future deductible temporary differences that give rise to deferred income tax assets.

In addition to these familiar and well-understood categories of timing differences, temporary differences include a number of other categories that also involve differences between the income tax and financial reporting bases of assets or liabilities. These include:

Reductions in tax-deductible asset bases arising in connection with tax credits. Under the provisions of the 1982 income tax act, taxpayers were permitted a choice of either full ACRS depreciation coupled with a reduced investment tax credit, or a full investment tax credit coupled with reduced depreciation allowances. If the taxpayer chose the latter option, the asset basis was reduced for tax depreciation, but was still fully depreciable for financial reporting purposes. Accordingly, this type of election is accounted for as a future taxable temporary difference, which gives rise to a deferred income tax liability.

Increases in the income tax bases of assets resulting from the indexing of asset costs for the effects of inflation. Occasionally proposed but never enacted, enacting such a provision to income tax law would allow taxpaying entities to finance the replacement of depreciable assets through depreciation based on current costs, as computed by the application of indices to the historical costs of the assets being remeasured. This reevaluation of asset costs would give rise to future taxable temporary differences that would be associated with deferred income tax liabilities since, upon the eventual sale of the asset, the taxable gain would exceed the gain recognized for financial reporting purposes resulting in the payment of additional tax in the year of sale.

Certain business combinations accounted for by the purchase method or the acquisition method. Under certain circumstances, the amounts assignable to assets or liabilities acquired in business combinations will differ from their income tax bases. Such differences may be either taxable or deductible in the future and, accordingly, may give rise to deferred income tax liabilities or assets. These differences are explicitly recognized by the reporting of deferred income taxes in the consolidated financial statements of the acquiring entity. Note that these differences are no longer allocable to the financial reporting bases of the underlying assets or liabilities themselves, as was the case under the old net of tax method.

A financial reporting situation in which deferred income taxes may or may not be appropriate would include life insurance (such as key person insurance) under which the reporting entity is the beneficiary. Since proceeds of life insurance are not subject to income tax under present law, the excess of cash surrender values over the sum of premiums paid will not be a temporary difference under the provisions of ASC 740, if the intention is to hold the policy until death benefits are received. On the other hand, if the entity intends to cash in (surrender) the policy at some point prior to the death of the insured (i.e., it is holding the insurance contract as an investment), which would be a taxable event, then the excess surrender value is in fact a temporary difference, and deferred income taxes are to be provided thereon.

Temporary differences from share-based compensation arrangements.

ASC 718-50 contains intricate rules with respect to accounting for the income tax effects of different types of share-based compensation awards.

The complexity of applying the income tax provisions contained in ASC 718-50 is exacerbated by the complex statutes and regulations that apply under the US Internal Revenue Code (IRC). The American Job Creation Act of 2004 added IRC §409A, which contains complicated provisions regarding the timing of taxability of specified amounts deferred under nonqualified deferred compensation plans. In general, amounts deferred under specified types of nonqualified plans are currently includable in gross income to the extent the benefits are not subject to a substantial risk of forfeiture unless certain requirements are met. An incentive stock option (ISO or statutory option governed by IRC §422) is not subject to §409A; however, certain nonqualified stock option (NQSO or nonstatutory) plans are subject to these requirements.

Differences between the accounting rules and the income tax laws can result in situations where the cumulative amount of compensation cost recognized for financial reporting purposes will differ from the cumulative amount of compensation deductions recognized for income tax purposes. Under current income tax law applicable to certain NQSO awards, an employer recognizes an income tax deduction for the intrinsic value of the option on the date that the employee exercises the option. The intrinsic value is computed as the difference between the option's exercise price and the market price of the stock on the date of exercise. Under ASC 718-50 this type of equity award is recognized at the fair value of the options at grant date with compensation cost recognized over the requisite service period. Consequently, during the period from grant date until the end of the requisite service period, the reporting entity is recognizing compensation cost in its financial statements with no corresponding income tax deduction. Because the award described above is accounted for as equity (and not as a liability), the credit that offsets the debit to compensation cost is to additional paid-in capital. This results in a future deductible temporary difference between the carrying amounts of additional paid-in capital for financial reporting and income tax purposes, thus giving rise to a deferred income tax asset and corresponding deferred income tax benefit.

At exercise, to the extent that the income tax deduction based on intrinsic value exceeds the cumulative compensation cost recognized for financial reporting purposes, the income tax effect (the effective income tax rate multiplied by the cumulative difference) is credited to additional paid-in capital rather than being reflected in the income statement as a deferred income tax benefit.

The IRC provides employers the ability to obtain a current income tax deduction for payments of dividends (or dividend equivalents) to employees that hold nonvested shares, share units, or share options that are classified under ASC 718-50 as equity. Under this scenario, the payment of the dividends is charged to retained earnings under ASC 718-50, irrespective of the fact that the employer/reporting entity obtains a tax deduction for the payment as taxable compensation. The income tax benefit realized from deducting these payments is to be recorded as an increase to additional paid-in capital and, as explained in the discussion of ASC 718-50 in the chapter on ASC 718, included in the pool of excess tax benefits available to absorb tax deficiencies on share-based payment awards.

Temporary differences arising from convertible debt with a beneficial conversion feature.

Issuers of debt securities sometimes structure the instruments to include a nondetachable conversion feature. If the terms of the conversion feature are “in-the-money” at the date of issuance, the feature is referred to as a “beneficial conversion feature.” Beneficial conversion features are accounted for separately from the host instrument under ASC 470-20.

The separate accounting results in an allocation to additional paid-in capital of a portion of the proceeds received from issuance of the instrument that represents the intrinsic value of the conversion feature calculated at the commitment date, as defined. The intrinsic value is the difference between the conversion price and the fair value of the instruments into which the security is convertible multiplied by the number of shares into which the security is convertible. The convertible security is recorded at its par value (assuming there is no discount or premium on issuance). A discount is recognized to offset the portion of the instrument that is allocated to additional paid-in capital. The discount is accreted from the issuance date to the stated redemption date of the convertible instrument or through the earliest conversion date if the instrument does not include a stated redemption date.

For US income tax purposes, the proceeds are recorded entirely as debt and represent the income tax basis of the debt security, thus creating a temporary difference between the basis of the debt for financial reporting and income tax reporting purposes.

ASC 740-10-55 specifies that the income tax effect associated with this temporary difference is to be recorded as an adjustment to additional paid-in-capital. It would not be reported, as are most other such income tax effects, as a deferred income tax asset or liability in the statement of financial position.

Other common temporary differences include:

Accounting for investments. Use of the equity method for financial reporting while using the cost method for income tax purposes.

Accrued contingent liabilities. These cannot be deducted for income tax purposes until the liability becomes fixed and determinable.

Cash basis versus accrual basis. Use of the cash method of accounting for income tax purposes and the accrual method for financial reporting.

Charitable contributions that exceed the statutory deductibility limitation. These can be carried over to future years for income tax purposes.

Deferred compensation. Under GAAP, the present value of deferred compensation agreements must be accrued and charged to expense over the employee's remaining employment period, but for income tax purposes these costs are not deductible until actually paid.

Depreciation. A temporary difference will occur unless the modified ACRS method is used for financial reporting over estimated useful lives that are the same as the IRS-prescribed recovery periods. This is only permissible for GAAP if the recovery periods are substantially identical to the estimated useful lives.

Estimated costs (e.g., warranty expense). Estimates or provisions of this nature are not included in the determination of taxable income until the period in which the costs are actually incurred.

Goodwill. For US federal income tax purposes, amortization over fifteen years is mandatory. Amortization of goodwill is no longer permitted under GAAP, but periodic write-downs for impairment may occur, with any remainder of goodwill being expensed when the reporting unit to which it pertains is ultimately disposed of.

Income received in advance (e.g., prepaid rent). Income of this nature is includable in taxable income in the period in which it is received, while for financial reporting purposes, it is considered a liability until the revenue is earned.

Installment sale method. Use of the installment sale method for income tax purposes generally results in a temporary difference because that method is generally not permitted to be used in accordance with GAAP.

Long-term construction contracts. A temporary difference will arise if different methods (e.g., completed-contract or percentage-of-completion) are used for GAAP and income tax purposes.

Mandatory change from the cash method to the accrual method. Generally one-fourth of this adjustment is recognized for income tax purposes each year.

Net capital loss. C corporation capital losses are recognized currently for financial reporting purposes but are carried forward to be offset against future capital gains for income tax purposes.

Organization costs. GAAP requires organization costs to be treated as expenses as incurred. For income tax purposes, organization costs are recorded as assets and amortized over a 60-month period. Also see the following section, “Permanent differences.”

Uniform cost capitalization (UNICAP). Income tax accounting rules require manufacturers and certain wholesalers to capitalize as inventory costs certain costs that, under GAAP, are considered administrative costs that are not allocable to inventory.

Permanent differences.

Permanent differences are book-tax differences in asset or liability bases that will never reverse and therefore, affect income taxes currently payable but do not give rise to deferred income taxes.

Common permanent differences include:

Club dues. Dues assessed by business, social, athletic, luncheon, sporting, airline and hotel clubs are not deductible for federal income tax purposes.

Dividends received deduction. Depending on the percentage interest of the payer owned by the recipient, a percentage of the dividends received by a corporation are nontaxable. Different rules apply to subsidiaries.

Goodwill—nondeductible. If, in a particular taxing jurisdiction, goodwill amortization is not deductible, that goodwill is considered a permanent difference and does not give rise to deferred income taxes.

Lease inclusion amounts. Lessees of automobiles whose fair value the IRS deems to qualify as a luxury automobile are required to limit their lease deduction by adding to taxable income an amount determined by reference to a table prescribed annually in a revenue procedure.

Meals and entertainment. A percentage (currently 50%) of business meals and entertainment costs are not deductible for federal income tax purposes.

Municipal interest income. A 100% exclusion is permitted for investment in qualified municipal securities. Note that the capital gains applicable to sales of these securities are taxable.

Officer's life insurance premiums and proceeds. Premiums paid for an officer's life insurance policy under which the company is the beneficiary are not deductible for income tax purposes, nor are any death proceeds taxable.

Organization and start-up costs. GAAP requires organization and start-up costs to be treated as expenses as incurred. Certain organization and start-up costs are not allowed amortization under the tax code. The most clearly defined are those expenditures relating to the cost of raising capital. Also see the prior section, “Temporary differences. . . .”

Penalties and fines. Any penalty or fine arising as a result of violation of the law is not allowed as an income tax deduction. This includes a wide range of items including parking tickets, environmental fines, and penalties assessed by the US Internal Revenue Service.

Percentage depletion. The excess of percentage depletion over cost depletion is allowable as a deduction for income tax purposes.

Wages and salaries eligible for jobs credit. The portion of wages and salaries used in computing the jobs credit is not allowed as a deduction for income tax purposes.

Treatment of Net Operating Loss Carryforwards

The recognition and measurement of the income tax effects of net operating loss carryforwards under ASC 740 differ materially from how this was dealt with under earlier standards. Historically, it had been presumed that net operating losses would generally not be realizable; accordingly, the income tax effects of carryforwards were not recognized in the financial statements until the future period in which the benefits were realized for income tax purposes. That is, the provision for income taxes in the loss year only reflected the benefit derived, if any, from carrying back the net operating loss to prior years to obtain a refund. Any excess net operating loss available to offset future years' taxable income was not recognized until actually realized. Consequently, the statement of financial position would not display a deferred income tax asset relating to the net operating loss carryforward. This treatment was justified in order to report the entity's assets at amounts that did not exceed their estimated net realizable value. (Only in exceptional cases, when realization of the benefits was deemed to be assured beyond a reasonable doubt, was recognition in the loss period permitted.)

With the imposition of ASC 740, all temporary differences and carryforwards have been conferred identical status, and their income tax effects are to be given full recognition on the statement of financial position. Specifically, the income tax effects of net operating loss carryforwards are equivalent to the income tax effects of future deductible temporary differences, and the once important distinction between the two has been eliminated. The deferred income tax effects of net operating losses are computed and recorded, but as is the case for all other deferred income tax assets, the need for a valuation allowance must also be assessed (as discussed below). The income tax effects of income tax credit carryforwards (e.g., general business credits, alternative minimum tax credits) are used to increase deferred income tax assets dollar-for-dollar versus being treated in the same manner as future deductible temporary differences, as illustrated in the following example.

Example—Net operating loss carryforwards and income tax credit carryforwards

Casey Corporation has the following future deductible temporary differences and available carryforwards at December 31, 2012:

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Note the net operating loss is multiplied by the income tax rate to compute its effect on the deferred income tax asset since it is available to reduce future years' taxable income. In contrast, the general business credit carryforward is not multiplied by the income tax rate since it is available to be used to offset future years' income tax.

The reporting of the current income tax benefit of carrying back net operating losses was also changed by the current standard. ASC 740 provides that the income tax benefits of net operating loss carrybacks and carryforwards, with limited exceptions (discussed below), are to be reported in the same manner as the source of either income or loss in the current year. As used in the standard, the phrase “in the same manner” refers to the classification of the income tax benefit in the income statement (i.e., as income taxes on income from continuing operations, discontinued operations, extraordinary items, etc.) or as the income tax effect of gains included in other comprehensive income but excluded from net income on the income statement. The income tax benefits are not reported in the same manner as the source of the net operating loss carryforward or income taxes paid in a prior year, or as the source of the expected future taxable income that will permit the realization of the carryforward.

For example, if the income tax benefit of a loss that arose in a prior year in connection with an extraordinary item is first given recognition in the current year, the benefit would be allocated to income taxes on income from continuing operations if the benefit offsets income taxes on income from continuing operations in the current year. The expression “first given recognition” means that the net deferred income tax asset, after deducting the valuation allowance, reflects the income tax effect of the loss carryforward for the first time.

Under ASC 740, the gross deferred income tax asset will always reflect all future deductible temporary differences and net operating loss carryforwards in the periods they arise. Thus, first given recognition means that the valuation allowance is eliminated for the first time. If it offsets income taxes on extraordinary income in the current year, then the benefits would be reported in extraordinary items. As another example, the tax benefit arising from the entity's loss from continuing operations in the current year would be allocated to continuing operations, regardless of whether it might be realized as a carryback against income taxes paid on extraordinary items in prior years. The income tax benefit would also be allocated to continuing operations in cases where it is anticipated that the benefit will be realized through the reduction of income taxes to be due on extraordinary gains in future years. (See the “Intraperiod Income Tax Allocation” section later in this chapter.)

Thus, the general rule is that the reporting of income tax effects of net operating losses are driven by the source of the tax benefits in the current period. There are only two exceptions to the foregoing rule. The first exception relates to existing future deductible temporary differences and net operating loss carryforwards that arise in connection with business combinations and for which income tax benefits are first recognized. This exception will be discussed below (see income tax effects of business combinations). As in the preceding paragraph, first recognized means that a valuation allowance (as discussed more fully later in this chapter) provided previously is being eliminated for the first time.

The second exception to the aforementioned general rule is that certain income tax benefits allocable to stockholders' equity are not to be reflected in the income statement. Specifically, income tax benefits arising in connection with contributed capital, employee stock options, dividends paid on unallocated ESOP shares, or temporary differences existing at the date of a quasi reorganization are reported as accumulated other comprehensive income in the stockholders' equity section of the statement of financial position and are not included in the income statement.

Certain transactions among stockholders that occur outside the company can affect the status of deferred income taxes. The most commonly encountered of these is the change in ownership of more than 50% of the company's stock, which limits or eliminates the company's ability to utilize net operating loss carryforwards, and accordingly requires the reversal of deferred income tax assets previously recognized under ASC 740. Changes in deferred income taxes caused by transactions among stockholders are to be included in current period income tax expense in the income statement, since these are analogous to changes in expectations resulting from other external events (e.g., changes in enacted income tax rates). However, the income tax effects of changes in the income tax bases of assets or liabilities caused by transactions among stockholders would be included in equity, not in the income statement, although subsequent period changes in the valuation account, if any, would be reflected in income (ASC 740-20-45).

Measurement of Deferred Income Tax Assets and Liabilities

Scheduling of the reversal years of temporary differences.

Under ASC 740 there is no need to forecast (or “schedule”) the future years in which temporary differences are expected to reverse except in the most exceptional circumstances. To eliminate the burden, it was necessary to endorse the use of the expected average (i.e., effective) income tax rate to measure the deferred income tax assets and liabilities and to forgo a more precise measure of marginal tax effects. Scheduling is now encountered primarily (1) when income tax rate changes are to be phased in over multiple years, and (2) in order to determine the classification (current or noncurrent) of a deferred income tax asset arising from a net operating loss carryforward or income tax credit carryforward or to determine whether such a carryforward might expire unused for the purpose of determining the amount of valuation allowance needed (as discussed in the following section of this chapter).

Determining the appropriate income tax rate.

Currently, C corporations with taxable income between $335,000 and $10,000,000 are taxed at an expected income tax rate equal to the 34% marginal rate, since the effect of the surtax exemption has fully phased out at that level, effectively resulting in a flat tax. Thus, the computation of deferred federal income taxes for these entities is accomplished simply by applying the 34% top marginal rate to all temporary differences and net operating loss carryforwards outstanding at the date of the statement of financial position. This technique is applied to future taxable temporary differences (producing deferred income tax liabilities), and to future deductible temporary differences and net operating loss carryforwards (giving rise to deferred income tax assets). The deferred income tax assets computed must still be evaluated for realizability; some, or all, of the projected income tax benefits may fail the “more-likely-than-not” test and consequently may need to be offset by a valuation allowance.

On the other hand, reporting entities that have historically been taxed at an effective federal income tax rate lower than the top marginal rate compute their federal deferred income tax assets and liabilities by using their expected future effective income tax rates. Consistent with the goal of simplifying the process of calculating deferred income taxes, reporting entities are permitted to apply a single, long-term expected income tax rate, without attempting to differentiate among the years when temporary difference reversals are expected to occur. In any event, the inherent imprecision of forecasting future income levels and the patterns of temporary difference reversals makes it unlikely that a more sophisticated computational effort would produce better financial statements. Therefore, absent such factors as the phasing in of new income tax rates, it is not necessary to consider whether the reporting entity's effective income tax rate will vary from year to year.

The effective income tax rate convention obviates the need to predict the impact of the alternative minimum tax (AMT) on future years. In determining an entity's deferred income taxes, the number of computations may be as few as one.

Computing deferred income taxes.

The procedure to compute the gross deferred income tax provision (i.e., before addressing the possible need for a valuation allowance) is as follows:

Identify all temporary differences existing as of the reporting date. This process is simplified if the reporting entity maintains both GAAP and income tax statements of financial position for comparison purposes.
Segregate the temporary differences into future taxable differences and future deductible differences. This step is necessary because a valuation allowance may be required to be provided to offset the income tax effects of the future deductible temporary differences and carryforwards, but not the income tax effects of the future taxable temporary differences.
Accumulate information about available net operating loss and tax credit carryforwards as well as their expiration dates or other types of limitations, if any.
Measure the income tax effect of aggregate future taxable temporary differences by separately applying the appropriate expected income tax rates (federal plus any state, local, and foreign rates that are applicable under the circumstances). Ensure that consideration is given in making these computations to the federal income tax deductibility of income taxes payable to other jurisdictions.
Similarly, measure the income tax effects of future deductible temporary differences, including net operating loss carryforwards.

ASC 740 prescribes that separate computations be made for each taxing jurisdiction. In many cases, this level of complexity is not needed and a single, combined effective income tax rate can be used. However, in assessing the need for valuation allowances, it is necessary to consider the entity's ability to absorb deferred income tax benefits against income tax liabilities. Inasmuch as benefits from one tax jurisdiction will not reduce income taxes payable to another tax jurisdiction, separate calculations will be needed in these situations. Also, for purposes of presentation in the statement of financial position (discussed below), offsetting of deferred income tax assets and liabilities is only permissible within the same jurisdiction.

Separate computations are made for each taxpaying component of the primary reporting entity: if a parent company and its subsidiaries are consolidated for financial reporting purposes but file separate income tax returns, the reporting entity comprises a number of components, and the income tax benefits of any one will be unavailable to reduce the income tax obligations of the others.

The principles set forth above are illustrated by the following example.

Computation of deferred income tax liability and asset—Basic example

Assume that Humfeld Company has a total of $28,000 of future taxable temporary differences and a total of $8,000 of future deductible temporary differences. There are no available operating loss or tax credit carryforwards. Taxable income is $230,000 and the income tax rate is a flat (i.e., not graduated) 34% for the current year and not anticipated to change in the future. Also assume that there were no deferred income tax liabilities or assets in prior years.

Current income tax expense and income taxes currently payable are computed as taxable income times the current rate ($230,000 × 34% = $78,200). The deferred income tax asset is computed as $2,720, representing 34% of future deductible temporary differences of $8,000. The deferred income tax liability of $9,520 is calculated as 34% of future taxable temporary differences of $28,000. The deferred income tax expense of $6,800 is the net of the deferred income tax liability of $9,520 and the deferred income tax asset of $2,720.

The journal entry to record the required amounts is:

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In 2011, Humfeld Company has taxable income of $411,000, aggregate future taxable and future deductible temporary differences are $75,000 and $36,000 respectively, and the income tax rate remains a flat 34%.

Current income tax expense and income taxes currently payable are each $139,740 ($411,000 × 34%).

Deferred amounts are calculated as follows:

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Because the increase in the liability in 2012 is larger (by $6,460) than the increase in the asset for that year, the result is a deferred income tax expense for 2012.

The Valuation Allowance for Deferred Income Tax Assets Expected to Be Unrealizable

ASC 740 requires that all deferred income tax assets be given full recognition, subject to the possible provision of an allowance when it is determined that this asset is unlikely to be realized. This approach (providing full recognition on a gross basis, but also providing for a valuation allowance to reduce the recorded asset to the expected realizable amount) conveys the greatest amount of useful information to the users of the financial statements.

In dealing with the question of measurement of the valuation account, FASB could well have been guided by ASC 450, which established the standard for recognizing contingent obligations incurred and impairments of assets. Under ASC 450, the threshold for recognition of impairment would have been that the impairment was deemed to be “probable” of realization. FASB rejected the notion of applying that standard to this measurement situation, and instead developed a new measure, the “more-likely-than-not” criterion.

Under this provision of ASC 740, a valuation allowance is to be provided for that fraction of the computed year-end balances of the deferred income tax assets for which it has been determined that it is more likely than not that the reported asset amount will not be realized. As used in this context, “more likely than not” represents a probability of just over 50%. Since it is widely agreed that the term probable, as used in ASC 450, denotes a much higher probability (perhaps 85% to 90%), the threshold for reflecting an impairment of deferred income tax assets is much lower than the threshold for other assets (i.e., in most cases, the likelihood of a valuation allowance being required is greater than, say, the likelihood that a long-lived asset is impaired).

If a higher threshold had been set (such as ASC 450's “probable”), great diversity could have developed in practice as to the amount of valuation allowances offsetting deferred income tax assets, which would not have been consistent with the goal of comparability of financial statements over time and across entities.

Establishment of a valuation allowance

Assume that Couch Corporation has a future deductible temporary difference of $60,000 at December 31, 2012. The tax rate is a flat 34%. Based on available evidence, management of Couch Corporation concludes that it is more likely than not that all sources will not result in future taxable income sufficient to realize an income tax benefit of more than $15,000 (25% of the future deductible temporary difference). Also assume that there were no deferred income tax assets in previous years and that prior years' taxable income was inconsequential.

At 12/31/12 Couch Corporation records a deferred income tax asset in the amount of $20,400 ($60,000 × 34%) and a valuation allowance of $15,300 (34% of the $45,000 difference between the $60,000 of future deductible temporary differences and the $15,000 of future taxable income expected to absorb the future tax deduction arising from the reversal of the temporary difference).

The journal entry at 12/31/12 is

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The deferred income tax benefit of $5,100 represents that portion of the deferred income tax asset (25%) that, more likely than not, is realizable.

Assume that at the end of 2013, Couch Corporation's future deductible temporary difference has decreased to $50,000 and that Couch now has a net operating loss carryforward of $42,000. The total of the net operating loss carryforward ($42,000) plus the amount of the future deductible temporary difference ($50,000) is $92,000. A deferred income tax asset of $31,280 ($92,000 × 34%) is recognized at the end of 2013. Also assume that management of Couch Corporation concludes that it is more likely than not that $25,000 of the tax asset will not be realized. Thus, a valuation allowance in that amount is required, and the balance in the allowance account of $15,300 must be increased by $9,700 ($25,000 − $15,300).

The journal entry at 12/31/13 is

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The deferred income tax asset is debited $10,880 to increase it from $20,400 at the end of 2012 to its required balance of $31,280 at the end of 2013. The deferred income tax benefit of $1,180 represents the net of the $10,880 increase in the deferred income tax asset and the $9,700 increase in the valuation allowance.

While the meaning of the “more likely than not” criterion is clear (more than 50%), the practical difficulty of assessing whether or not this subjective threshold test is met in a given situation remains. A number of positive and negative factors need to be evaluated in reaching a conclusion as to the necessity of a valuation allowance. Positive factors (those suggesting that an allowance is not necessary) include:

Evidence of sufficient future taxable income, exclusive of reversing temporary differences and carryforwards, to realize the benefit of the deferred income tax asset
Evidence of sufficient future taxable income arising from the reversals of existing future taxable temporary differences (deferred income tax liabilities) to realize the benefit of the deferred income tax asset
Evidence of sufficient taxable income in prior year(s) available for realization of a net operating loss carryback under existing statutory limitations
Evidence of the existence of prudent, feasible tax planning strategies under management control that, if implemented, would permit the realization of the deferred income tax asset
An excess of appreciated asset values over their tax bases, in an amount sufficient to realize the deferred income tax asset
A strong earnings history exclusive of the loss creating the deferred tax asset.

While the foregoing may suggest that the reporting entity will be able to realize the benefits of the future deductible temporary differences outstanding as of the date of the statement of financial position, certain negative factors must also be considered in determining whether a valuation allowance needs to be established against deferred income tax assets. These factors include:

A cumulative recent history of losses
A history of operating losses, or of net operating loss or tax credit carryforwards that have expired unused
Losses that are anticipated in the near future years, despite a history of profitable operations.

Thus, the process of evaluating whether a valuation allowance is needed involves the weighing of both positive and negative factors to determine whether, based on the preponderance of available evidence, it is more likely than not that the deferred income tax assets will be realized.

Example of applying the more-likely-than-not criterion to a deferred income tax asset

Assume the following facts:

Foy Corporation reports on a calendar year, and it commenced operations and began applying ASC 740 in 2006.
As of December 31, 2012, it has future taxable temporary differences of $85,000 relating to income earned on equity-method investments; future deductible temporary differences of $12,000 relating to deferred compensation arrangements; a net operating loss carryforward (which arose in 2009) of $40,000; and a capital loss carryforward of $10,000 (which arose in 2012).
Foy's expected effective income tax rate for future years is 34% for both ordinary income and net long-term capital gains. Capital losses cannot be offset against ordinary income.

The first steps are to compute the deferred income tax asset and/or liability without consideration of the possible need for a valuation allowance.

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The next step is to consider the need for a valuation allowance to partially or completely offset the deferred income tax asset, based on a “more likely than not” assessment of the asset's realizability. Foy management must evaluate both positive and negative evidence to determine the need for a valuation allowance, if any. Assume that management identifies the following factors that may affect this need:

Before the net operating loss deduction, Foy reported taxable income of $5,000 in 2012. Management believes that taxable income in future years, apart from net operating loss deductions, should continue at approximately the same level experienced in 2012.
The future taxable temporary differences are not expected to reverse in the foreseeable future as the equity method investee is not expected to incur losses or pay dividends to Foy.
The capital loss arose in connection with a securities transaction of a type that is unlikely to recur. The company does not generally engage in activities that have the potential to result in capital gains or losses.
Management estimates that certain productive assets have a fair value exceeding their respective income tax bases by about $30,000. The entire gain, if realized for income tax purposes, would result in recapture of depreciation previously taken. Since the current plans call for a substantial upgrading of the company's plant assets, management feels it could easily accelerate those actions in order to realize taxable gains, should it be desirable to do so for income tax planning purposes.

Based on the foregoing information, Foy Corporation management concludes that a $3,400 valuation allowance is required. The reasoning is as follows:

There will be some taxable operating income generated in future years ($5,000 annually, based on the earnings experienced in 2012), which will absorb a modest portion of the reversal of the deductible temporary difference ($12,000) and net operating loss carryforward ($40,000) existing at year-end 2012.
More importantly, the feasible tax planning strategy of accelerating the taxable gain relating to appreciated assets ($30,000) would certainly be sufficient, in conjunction with operating income over several years, to permit Foy to fully realize the income tax benefits of the future deductible temporary difference and net operating loss carryover.
However, since capital losses can only be carried forward for five years, are only usable to offset future capital gains, and Foy management is unable to project future realization of capital gains, it is more likely than not that the associated tax benefit accrued ($3,400) will not be realized, and thus a valuation allowance must be recorded.

Based on this analysis, an allowance for unrealizable deferred income tax benefits in the amount of $3,400 is established by a charge against the current (2012) income tax provision.

Among the foregoing positive and negative factors to be considered, perhaps the most difficult to fully grasp is that of available income tax planning strategies. Since ASC 740 requires that all available evidence be assessed to determine the need for a valuation allowance, the matter of the cost of implementing those strategies is irrelevant. In fact, there is no limitation regarding strategies that may involve significant costs of implementation, although in computing the amount of valuation allowance needed, any costs of implementation must be netted against the benefits to be derived.

For example, if a gross deferred income tax asset of $50,000 is recorded, and certain strategies have been identified by management that would protect realization of the future deductible item associated with the computed income tax benefit at an implementation cost of $10,000, then the net amount of income tax benefit, which is more likely than not to be realizable, would not be $50,000. Rather, it may be only $43,400, which is the gross benefit less the after-tax cost of implementation, assuming a 34% tax rate {$50,000 − [$10,000 × (1 − .34)]}. Accordingly, a valuation allowance of $6,600 is established in this example.

Impact of a qualifying tax strategy

Assume that Kruse Company has a $180,000 net operating loss carryforward as of 12/31/12, scheduled to expire at the end of the following year. Future taxable temporary differences of $240,000 exist that are expected to reverse in approximately equal amounts of $80,000 in 2013, 2014, and 2015. Kruse Company estimates that taxable income for 2013 (exclusive of the reversal of existing temporary differences and the operating loss carryforward) will be $20,000. Kruse Company expects to implement a qualifying income tax planning strategy that will accelerate the total of $240,000 of taxable temporary differences to 2013. Expenses to implement the strategy are estimated to approximate $30,000. The tax rate is 34%.

In the absence of the income tax planning strategy, $100,000 of the net operating loss carryforward could be realized in 2013 based on estimated taxable income of $20,000 plus $80,000 of the reversal of future taxable temporary differences. Thus, $80,000 would expire unused at the end of 2013 and the net amount of the deferred income tax asset at 12/31/12 would be recognized as $34,000, computed as $61,200 ($180,000 × 34%) minus the valuation allowance of $27,200 ($80,000 × 34%).

However, by implementing the income tax planning strategy, the deferred income tax asset is calculated as follows:

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The gross deferred income tax asset thus can be recorded at the full benefit amount of $61,200 ($180,000 × 34%). However, a valuation allowance is required for $19,800, representing the net-of-tax effect of the $30,000 in anticipated expenses related to implementation of the strategy. The net deferred income tax asset at 12/31/11 is $41,400 ($61,200 − $19,800). Kruse Company will also recognize a deferred income tax liability of $81,600 at the end of 2012 (34% of the taxable temporary differences of $240,000).

The adequacy of the valuation allowance must be assessed at the date of each statement of financial position. Adjustments to the amount of the valuation allowance are recorded by a charge against, or a credit to, current earnings, via the current period income tax expense or benefit. Thus, even if the gross amount of future deductible temporary differences has remained constant during a year, income tax expense for that year might be increased or decreased as a consequence of reassessing the adequacy of the valuation allowance at year-end. It is important that these two computational steps be separately addressed: First, the computation of the gross deferred income tax assets (the product of the expected effective income tax rate and the total amount of future deductible temporary differences) must be made; then the amount of the valuation allowance to be provided to offset the deferred income tax asset must be assessed (using the criteria set forth above). Although changes in both the deferred income tax asset and valuation allowance affect current period income tax expense, the processes of measuring these two amounts are distinct. Furthermore, ASC 740 requires disclosure of both the gross deferred income tax asset (and also the gross deferred income tax liability) and the change in the valuation allowance for the year. These disclosure requirements underline the need to separately measure these items without offsetting.

Accounting for Uncertainty in Income Taxes

Background.

Seldom in the history of US standard setting has there been a particular standard or interpretation as universally reviled by client management, financial statement preparers, and auditors as FIN 48, Accounting for Uncertainty in Income Taxes (ASC 740-10).

The process of filing income tax returns requires management, in consultation with its tax advisors, to make judgments regarding how it will apply intricate and often ambiguous laws, regulations, administrative rulings, and court precedents. If and when the income tax returns are audited by the taxing authority, sometimes years after they are filed, these judgments may be questioned or disallowed in their entirety or in part. As a result, management must make assumptions regarding the likelihood of success in defending its judgments in the event of audit in determining the accounting entries necessary to accurately reflect income taxes currently payable and/or refundable.

The primary driver behind the perceived need for this standard is the notion that, in general, irrespective of the method being used to recognize and measure these assets and/or liabilities, management of reporting entities historically have not used a high degree of rigor in their determination. Consequently, especially in the case of public companies, where earnings per share are viewed as an important measure of performance, the estimation of the allowance for income taxes payable was sometimes viewed as a management tool to either improve reported earnings by reducing the allowance or to build up excess liabilities (sometimes referred to as “cookie-jar reserves”) that, when needed in future periods, could be reduced in order to achieve the desired result of greater earnings.

Often, management would try to justify not recording a liability in excess of the amounts acknowledged by the as-filed tax returns. They would assert that in order to properly apply ASC 450 to the reporting entity's income tax liability, one of the factors that they believed should be a legitimate consideration is examination risk and the probability that the entity's income tax returns will be examined by the relevant taxing jurisdiction. Proponents of this approach often take it a step further and factor into the analysis management's beliefs regarding whether the examiner will be curious enough (and knowledgeable enough) to thoroughly examine the company's positions and require the company to provide a high level of detailed support for those positions.

Initial recognition and measurement.

ASC 740-10 uses a two-step approach to recognition and measurement.

Initial recognition—Management is to evaluate each tax position as to whether, based on the position's technical merits, it is “more likely than not” that the position would be sustained upon examination by the taxing authority. In making this evaluation, management is required to assume that the tax position will be examined by the taxing authority and that the taxing authority will be provided with all relevant facts and will have full knowledge of all relevant information. Thus, management is prohibited from asserting that a position will be sustained because of a low likelihood that the reporting entity's income tax returns will be examined.

The term “more likely than not,” consistent with its use in ASC 740-10, means that there is a probability of more than 50% that the tax position would be sustained upon examination. A judgment of more likely than not represents a positive assertion by management that the reporting entity is entitled to the economic benefits provided by the tax position it is taking. The term “upon examination” includes resolution of appeals or litigation processes, if any, necessary to settle the matter.

This is a new threshold condition for recognition. Unlike the “more likely than not” criterion in ASC 740-10-45, which governs the recognition of a valuation allowance to offset all or a portion of deferred income tax assets that have already been fully recognized, this establishes a requirement for whether to give any accounting recognition to the income tax effects of questionable tax positions being taken. Failing to meet this threshold test means that, for example, an income tax deduction being claimed would not be accompanied by recognition of a reduction of income tax expense in a GAAP-basis financial statement, and thus that an income tax liability would be required to be reported for the entire tax benefit claimed on the income tax return, notwithstanding management's assertion that a deduction claimed on its income tax return was valid.

Positions must be evaluated independently of each other without offset or aggregation. A “unit of account” approach can be taken in this evaluation if it is based on the manner in which management prepares and supports its income tax return and is consistent with the approach that the taxing authority would reasonably be expected to use in conducting an examination.

In considering the technical merits of its tax positions, management is to consider the applicability of the various sources of tax authority (enacted legislation, legislative intent, regulations, rulings, and case law) to the facts and circumstances. Management may also take into account, if applicable, any administrative practices and precedents that are widely understood with respect to the manner that the taxing authority deals specifically with the reporting entity or other similar taxpayers.

Initial measurement—If a tax position meets the initial recognition threshold, it is then measured to determine the amount to recognize in the financial statements. The following considerations apply to the measurement process:

Consider if the position is based on clear and unambiguous tax law. If so, and management has a high level of confidence in the technical merits of the position, the position qualifies as a “highly certain tax position” and, consequently, the full benefit would be recognized in the financial statements. Stated in the language of FIN 48, the measurement of the maximum amount of income tax benefit that is more than 50% likely to be realized is 100% of the benefit claimed.

NOTE: Management may deem the amount of a tax position to be highly certain of being sustained but may not be highly certain as to the timing of the benefit. For example, in deciding whether to record a cost as an expense of the period in which it is incurred or to capitalize it, management may be highly certain that the cost will be deductible in some period but not be highly certain as to whether the proper period to deduct it is in the current period or ratably over multiple future periods. Under these circumstances, management would be required to measure the maximum amount that it believed was more than 50% likely of being sustained in the period that the cost is incurred.
If it is not highly certain that the full benefit of a position would be sustained in the year claimed, then the amount to be recognized for the tax position is measured as management's best estimate of the maximum benefit that is more than 50% likely of being realized upon effective settlement with a taxing authority possessing full knowledge of all relevant information. Management is to consider the amounts and probabilities of various settlement outcomes based on the facts, circumstances, and information available at the date of the statement of financial position. As stated above, management must assume that the taxing authority will conduct an examination and may not consider the likelihood of this not occurring in this measurement process.

As explained above, measurement under ASC 740-10 can be a fairly complex process. It requires that management consider the amounts and probabilities of various effective settlement outcomes. The amount of the income tax benefit to be given financial statement recognition is the largest (i.e., most favorable) estimated outcome that is more than 50% probable, as illustrated in the following example.

Example of the two-step initial recognition and measurement process

Menkin Manufacturing planned to claim a $10,000 credit for increasing research activities (R&D credit) on its 2012 corporate income tax return. In consultation with its tax advisor, management believes that a portion of the credit is at risk because of ambiguity regarding the technical merits of the decision to classify certain costs as qualifying to be included in the computation of the credit. Management does believe, however, that it is “more likely than not” that the reporting entity will qualify for all or a portion of the R&D credit, and thus recognition will have to be limited to only a portion of the amount it will be claiming on its income tax return.

Since the credit meets the more-likely-than-not threshold for initial recognition, management must measure the amount to be recognized. It has estimated the range of possible outcomes (i.e., of credit allowed) and related likelihoods as follows:

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The largest outcome above that has a more than 50% cumulative probability of being realized is $7,500, which management has estimated as having a cumulative probability of 65%. Therefore, management would recognize only $7,500 of this tax position in the reporting entity's financial statements. This would result in Menkin Manufacturing reflecting a liability for unrecognized income tax benefits in the amount of $2,500 on its statement of financial position as of December 31, 2012.

Note, in the foregoing example, that while the income tax return will claim an R&D credit for the full $10,000, GAAP-basis financial statements will only reflect a credit of $7,500, and thus will report an accrued tax liability of $2,500 pertaining to the credit taken but not likely to be allowed upon examination. The recognition of this liability has created significant controversy in the business community, as the liability along with the disclosures required by FIN 48 and discussed later in this chapter arguably provide a “road map” for taxing authorities to use in identifying positions that can be easily challenged. Nonetheless, FIN 48 complies with the GAAP imperative of reporting the entity's assets and liabilities on an appropriate measurement basis. GAAP financial reporting, in other words, is not a tool to be used by management to avoid recording the accounting consequences of the tactical decisions it makes regarding the tax positions it takes.

The following diagram illustrates the application of the recognition and measurement criteria:

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Interest.

If the relevant taxing jurisdiction requires interest to be paid on income tax underpayments, the reporting entity is to recognize interest expense in the first period that interest would begin to accrue under that jurisdiction's relevant tax law. Interest is to be computed using the following formula:

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Thus, if a tax position taken by the reporting entity fails the “more likely than not” recognition test, the presumption is that the position would not be sustained and that the entire tax benefit and associated interest (and penalties, if applicable) are to be recognized as a liability on the statement of financial position. Since interest is a period cost for the use of borrowed funds, it must be accrued until the taxing authorities reject the tax position and formally impose the demand for back taxes and interest, or the statute of limitations for the position lapses.

Penalties.

If upon disallowance on examination, a position would subject the taxpayer to penalty, the reporting entity is to recognize an expense for that penalty in the period it claims or expects to claim the position in its income tax return. That is, the penalty must be accrued as the tax position becomes formalized in a tax filing. An exception is permitted if the positions taken that would be subject to penalty are under the minimum threshold that the jurisdiction uses to assess the penalty. If management later changes its assessment of whether the minimum threshold has been exceeded in a subsequent period, the penalty is to be recognized as an expense in that period.

Subsequent recognition, derecognition, and measurement.

Judgments regarding initial recognition and measurement are not to be changed based on a reevaluation or reinterpretation of information that was available or should have been available in previous reporting periods. Only if new information becomes available can a new judgment be made. Management's new judgment is to consider the facts, circumstances, and information available at that time. Final certainty is not necessary for this purpose; that is, the position does not have to be subject to final settlement, court ruling, or full resolution to be remeasured.

For tax positions taken by management that do not meet the initial recognition criterion, the benefit becomes recognizable in the first interim period that the position meets any one of the following three conditions:

The tax position meets the recognition criterion, and thus its probability of realization is deemed to be more than 50%.
The statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired.
The tax position is effectively settled through examination, negotiation, or litigation.

In determining whether the condition of “effective settlement” has occurred, FSP FIN 48-1 provides that management is to evaluate whether all of the following conditions have been met:

The taxing authority has completed its examination procedures, including all levels of appeal and administrative reviews that are required by that authority for the specific tax position.
Management does not intend to appeal or litigate any aspect of the position included in the completed examination.
The possibility of the taxing authority examining or reexamining any aspect of the tax position is remote, considering:
1. The authority's policy on reopening closed examinations,
2. The specific facts and circumstances of the tax position, and
3. The authority has full knowledge of all relevant information that might cause it to reopen an examination that had been previously closed.

When a taxing authority conducts an examination of a tax year, it may not choose to examine a particular tax position taken by management. Nevertheless, upon completion of the examination and all levels of appeal and review, management is permitted to consider that position effectively settled for that tax year. Management is not permitted, however, to consider that tax position or a tax position similar to it to be settled for any other open periods that were not subject to examination, nor is management permitted to use the “effectively settled” criteria for a tax position as a basis for changing its assessment of the technical merits of any tax position taken in other periods.

Tax positions recognized in previous periods that no longer meet the more-likely-than-not criterion are to be reversed (“derecognized,” in FASB terminology) in the first period in which that criterion is no longer met. Importantly, it is not permitted that this objective be accomplished through the use of a valuation account or allowance to offset the recorded benefit; rather, it must be recorded as a direct reversal of the previously recorded benefit.

The accounting to record a change in judgment depends on whether the amount subject to change had been previously recognized in a prior annual period or in a prior interim period of the same fiscal year.

According to FIN 48, the effects of changes in tax positions taken in prior annual periods (including related interest and penalties, if any) are to be recognized as a “discrete item” in earnings in the period of change. Although the term “discrete item” is not defined or explained, the intent is for the change to be reported and disclosed in the same manner as the effects of a change in the enacted tax rate. This entails charging or crediting income from continuing operations for the period of change. Presumably, this would not require a separate line item on the face of the income statement (which would give disproportionate attention to the item), but would require separate disclosure in the notes to the financial statements as a significant component of income tax expense attributable to continuing operations, as specified in AsC 740.

Changes occurring in interim periods are accounted for differently. A change in judgment that applies to a tax position taken in a previous interim period of the current fiscal year is considered an integral part of the annual reporting period. Consequently, the effects of the change are recognized prospectively, through an adjustment to the estimated annual effective tax rate, in accordance with ASC 270 and ASC 740-270.

Classification.

Tax liabilities resulting from applying ASC 740-10 are current tax obligations. They are not to be classified as deferred income tax liabilities unless they are recognized as the result of a future taxable temporary difference created by a tax position that meets the more-likely-than-not criterion.

For reporting entities that present a classified statement of financial position, the customary classification rules apply; the portion of income tax obligations recognized that are not deferred income tax liabilities under ASC 740 are classified based on management's judgment regarding whether it anticipates the payment of cash within one year or within the reporting entity's next operating cycle, if it exceeds one year. (Deferred income tax assets and liabilities are classified using the same classification as the assets or liabilities to which they relate or, if they do not relate to specific assets or liabilities, based on the year in which the temporary difference is expected to reverse.) The liability for unrecognized income tax benefits (or reduction in amounts refundable) is not permitted to be combined or netted with deferred income tax assets or liabilities.

FIN 48 provides management policy elections with respect to how it accounts for interest and penalties that are required to be accrued on the liability for unrecognized income tax positions:

Management is to elect which of these alternative accounting policies the reporting entity will follow, and then to disclose and consistently apply that policy.

Applicability to business combinations.

ASC 805 clarifies that an acquirer is to apply its provisions to income tax positions taken by the acquiree prior to the date of the business combination. Thus, the provisions of ASC 740-10 apply to the determination of the income tax bases used to compute deferred income tax assets and liabilities as well as amounts of income taxes currently payable to or refundable from taxing authorities.

If a change occurs that affects a preexisting income tax position that was assumed as a part of the acquisition or an income tax position that arose as a result of the acquisition, the change is to be recognized as follows:

Changes occurring during the measurement period (as defined in ASC 805) that result from new information regarding facts and circumstances that existed on the acquisition date are recognized as an adjustment to goodwill. Should goodwill be reduced to zero, however, the remaining portion of the adjustment is to be recognized as a gain arising from a bargain purchase, in accordance with ASC 805. That standard requires recognition of such gains as part of net income and does not permit characterization as an extraordinary gain, as had been the case with the predecessor standard.
All other changes relating to acquired income tax positions are to be accounted for in the same manner as prescribed for other income tax positions.

The Effect of Tax Law Changes on Previously Recorded Deferred Income Tax Assets and Liabilities

General rules.

The balance-sheet-oriented measurement approach of ASC 740 makes it necessary to reevaluate the deferred income tax asset and liability balances at each year-end. If changes to income tax rates or other provisions of the income tax law (e.g., deductibility of items) are enacted, the effect of these changes must be recognized so that the deferred income tax assets and liabilities are fairly presented on the statement of financial position. Any offsetting adjustments are made through the current period's income tax expense or benefit on the income statement; that is, current income tax expense or benefit reflects the income tax effect of current transactions and the revision of previously provided income tax effects for transactions which have yet to reverse.

When income tax rates are revised, this may impact not only the unreversed effects of items that were originally reported in the continuing operations section of the income statement, but also the unreversed effects of items first presented as discontinued operations, extraordinary items, or in other income statement captions. Furthermore, the impact of changes in income tax rates on the accumulated balance of deferred income tax assets or liabilities that arose through charges or credits to other comprehensive income (under ASC 220) is included in income tax expense associated with continuing operations.

For example, if an entity has unrealized gains on holding available-for-sale securities at a time when relevant income tax rates (presumably, the capital gains rates) are lowered, the reduction in the deferred income tax liability associated with these unrealized gains will reduce current period income tax expense associated with continuing operations, despite the fact that the income tax provision was originally reported in other comprehensive income (not net income) and in the equity section of the statement of financial position as accumulated other comprehensive income.

Enactment occurring during an interim period.

When income tax law changes occur during an interim reporting period, the effects are to be reported in the interim period in which enactment occurs. The effects of the changes are included in continuing operations, whatever the source of the temporary differences being impacted. For example, if in the first fiscal quarter of a year an entity accrued a loss relating to discontinued operations, which is not tax deductible until realized, the income tax effect would be shown in the discontinued operations section of the income statement for that quarter. If income tax rates are changed in the third quarter of the same year, the deferred income tax asset recognized in connection with the loss from discontinued operations would then need to be adjusted upward or downward, based on the difference between the newly enacted income tax rates and the previously effective income tax rates. The income statement effect of this adjustment is included with income tax expense pertaining to income from continuing operations in the third quarter.

Changes in a valuation allowance for an acquired entity's deferred income tax asset.

ASC 805 specifies that the acquirer is to recognize changes in a valuation allowance for an acquiree's deferred income tax asset as follows:

Changes within the measurement period (defined in ASC 805-10-25) resulting from new information regarding facts and circumstances that existed at the acquisition date are to be recognized through an adjustment to goodwill. Should goodwill be reduced to zero, however, the acquirer is to recognize any additional decrease in the valuation allowance as a gain from a bargain purchase in the period of adjustment. The gain is not permitted to be characterized as an extraordinary gain.
Changes related to elimination of valuation allowances with respect to initial recognition of the following items are afforded special accounting treatment directly affecting equity, rather than current net income:
1. Temporary differences where the deferred income tax effect is recognized by directly charging or crediting contributed capital (e.g., amounts incurred as stock issuance costs that are treated as deductible expenses for income tax purposes but are accounted for as a reduction of proceeds from the issuance of the stock for financial reporting purposes)
2. Specified temporary differences between GAAP and income tax accounting that give rise to deferred income tax assets attributable to equity-classified employee stock options are treated as additional paid-in capital under ASC 718-50
3. Temporary differences with respect to dividends paid on unallocated shares held by an ESOP that are charged to retained earnings
4. Temporary differences associated with quasi reorganizations (with limited exceptions) that resulted in the deferred income tax benefit directly increasing contributed capital
All other changes in the valuation allowance are to be recognized as either an increase to or reduction of income tax expense.

Leveraged leases.

When a change in the income tax law is enacted, all components of a leveraged lease must be recalculated from the inception of the lease based upon the revised after-tax cash flows resulting from the change. Differences from the original computation are included in income in the year in which the tax law changes are enacted (ASC 840-30-S35). In making these revised computations, assumptions are to incorporate expectations regarding the effect, if any, of the alternative minimum tax (ASC 740-10-25).

The US Internal Revenue Service (IRS) may challenge the timing of the lessor's income tax deductions related to certain types of leveraged lease transactions.¹ Upon eventual settlement with the IRS regarding these matters, the economics of the lease may be significantly less favorable from the standpoint of the lessor than they were at inception because the originally projected economic benefits resulted heavily from the ability to obtain income tax deductions for accelerated tax depreciation and interest expense that, early in the lease term, would typically exceed the rental income generated by the lease.

ASC 840-30-35 provides that reporting entities whose income tax positions frequently vary between the alternative minimum tax (AMT) and regular tax are not required to annually recalculate the net investment in the lease unless there is an indication that the original assumptions about the leveraged lease's anticipated total after-tax net income were no longer valid.

Another factor to consider in the determination of the after-tax cash flows attributable to leveraged lease transactions is the application of ASC 740-10. As discussed earlier in this chapter, the lessor is required to assess whether it is more likely than not (i.e., there is a greater than 50% probability) that the income tax positions it takes or plans to take relative to the transaction would be sustained upon examination by the applicable taxing authorities. If the income tax positions do not meet that recognition threshold, the income tax benefits associated with taking those positions would be excluded from the leveraged lease calculations and, in fact, would give rise to a liability for unrecognized income tax benefits as well as an accrual for any applicable interest and penalties for all open tax years that are within the statute of limitations. This could obviously have a significant impact on the computed rate of return on the investment attributable to the years in which the net investment is positive.

If, however, the income tax positions meet the recognition threshold, then they are subject to measurement to determine the maximum amount that is more than 50% probable of being sustained upon examination. The difference between the income tax position taken or planned to be taken on the income tax return (the “as-filed” benefit) and the amount of the benefit measured using the more-than-50% computation, along with any associated penalties and interest, is recorded as a liability for unrecognized income tax benefits.

The only situation in which this liability, penalties, and interest would not be applicable would be if the tax positions were assessed to be highly certain tax positions, as defined in ASC 740-10. Under those circumstances, the entire income tax benefit associated with the lease would be recognized, and of course no interest or penalties would be recognized.

Computation of a deferred income tax asset with a change in rates

Assume Campione Company has $80,000 of future deductible temporary differences at the end of 2012, which are expected to result in income tax deductions of approximately $40,000 each on income tax returns for 2013–2014. Enacted tax rates were 50% for years 2009–2012, and are 40% for 2013 and thereafter.

The deferred income tax asset is computed at 12/31/12 under each of the following independent assumptions:

If Campione Company expects to offset the future deductible temporary differences against taxable income in years 2013-2014, the deferred income tax asset is $32,000 ($80,000 × 40%).
If Campione Company expects to realize an income tax benefit for the future deductible temporary differences by carrying back a loss to pre-2013 tax years to obtain a refund of income taxes previously paid at the higher 50% rate, the deferred income tax asset is $40,000 ($80,000 × 50%).

Assume that Campione Company expects, at the end of 2012, to realize a deferred income tax asset of $32,000 (the first scenario above). Also assume that income taxes payable in each of the years 2009-2011 were $8,000 (or 50% of taxable income of $16,000 in each year). Realization of $24,000 (3 years × $8,000 per year) of the $32,000 deferred income tax asset is assured through carryback refunds even if no taxable income is earned in years 2013-2014. Whether a valuation allowance for the remaining $8,000 is needed depends on Campione Company's assessment of the levels of future taxable income.

The foregoing estimate of the certain tax benefit, based on a loss carryback to periods of higher tax rates than are statutorily in effect for future periods, should only be utilized when future losses (for income tax purposes) are expected. This restriction applies since the benefit thus recognized (net of any valuation allowance) exceeds benefits that would be available in future periods, when tax rates will be lower.

Reporting the Effect of Tax Status Changes

The reporting of changes in an entity's income tax status is entirely analogous to the reporting of newly enacted income tax rate changes. Such adjustments typically arise from a change from (or to) taxable status to (or from) “flow through” or nontaxable status. When a previously taxable C corporation elects to become a flow-through entity (an S corporation), the stockholders become personally liable for income taxes on the company's earnings. This liability occurs whether the earnings are distributed to them or not, similar to the taxation of partnerships and limited liability companies.

When the income tax status change becomes effective, the effect of any consequent adjustments to deferred income tax assets and liabilities is reported in current income tax expense. This is always included in the income tax provision relating to continuing operations.

Under ASC 740, deferred income taxes are to be eliminated by reversal through current period income tax expense. Thus, if an entity with a net deferred income tax liability elects S corporation status, it will report an income tax benefit in the continuing operations section of its current income statement.

Similarly, if an S corporation elects to convert to a C corporation, the effect is to assume a net income tax benefit or obligation for unreversed temporary differences existing at the date the change becomes effective. Accordingly, the financial statements for the period in which the change becomes effective will include the effects of the event in current income tax expense. For example, if the entity has unreversed future taxable temporary differences at the date its income tax status change became effective, it reports income tax expense for that period. Conversely, if it had unreversed future deductible temporary differences, a deferred income tax asset (subject to the effects of any valuation allowance necessitated by applying the more-likely-than-not criterion) would be recorded, with a corresponding credit to the current period's income tax expense or benefit in the income statement.

Any entity eliminating an existing deferred income tax asset or liability, or recording an initial deferred income tax asset or liability, must fully explain the nature of the events that transpired to cause this adjustment. This is disclosed in the notes to the financial statements for the reporting period.

S corporation elections may be made prospectively at any time during the year preceding the tax year in which the election is intended to be effective and retroactively up to the 16th day of the 3rd month of the tax year in which the election is intended to be effective. The IRS normally informs the electing corporation of whether or not its election has been accepted within 60 days of filing. In practice, however, the IRS seldom denies a timely filed election, and such elections are considered essentially automatic. Consequently, if a reporting entity files an election before the end of its current fiscal year to be effective at the start of the following year, it is logical that the income tax effects would be reported in current year income. For example, an election by a C corporation to become an S corporation that is filed in December 2012, to be effective at the beginning of the company's next fiscal year, January 1, 2013, would give rise to the elimination of the deferred income tax assets and liabilities at the date of filing, the effect of which would be reported in the 2012 financial statements. No deferred income tax assets or liabilities would appear on the December 31, 2012 statement of financial position, and income tax expense or benefit for 2012 would include the effects of the reversals of deferred income tax assets and liabilities that had been previously recognized.

There are two situations that could result in an S corporation continuing to recognize deferred income taxes. The first situation arises when the S corporation operates in one or more states that impose state income taxes on the S corporation in an amount that is material to the financial statements. In this situation, the S corporation should compute and recognize deferred state income tax assets and liabilities in the same manner that a C corporation recognizes them for federal income taxes.

The second situation is referred to as “built-in gains tax.” Under current income tax law, a C corporation electing to become an S corporation may have built-in gains, which could result in a future corporate income tax liability, under defined circumstances. In such cases the reporting entity, even though it has become an S corporation, will continue to report a deferred income tax liability related to this built-in gain.

Reporting the Effect of Accounting Changes for Income Tax Purposes

Occasionally an entity will initiate or be required to adopt changes in accounting that affect income tax reporting, but which will not impact financial statement reporting. Past examples have included the change to the direct write-off method of bad debt recognition (mandated by a change in the income tax law, while the GAAP requirement to recognize an allowance for uncollectible accounts receivable continued in effect for financial reporting); and the adoption of uniform capitalization for valuing inventory for income tax purposes, while continuing to currently expense certain administrative costs not inventoriable under GAAP for financial reporting.

Generally, these mandated changes involve two distinct types of temporary differences. The first of these changes is the onetime, catch-up adjustment which either immediately or over a prescribed time period impacts the income tax basis of the asset or liability in question (net receivables or inventory, in the examples above), and which then reverses as these assets or liabilities are later realized or settled and are eliminated from the statement of financial position. The second change is the ongoing differential in the amount of newly acquired assets or incurred liabilities recognized for income tax and financial reporting purposes; these differences also eventually reverse, when the inventory is ultimately sold or the receivables are ultimately collected. This second type of change is the normal temporary difference that has already been discussed. It is the first type of change that differs from those previously discussed in this chapter, and that will now be illustrated.

Example of adjustment for prospective catch-up adjustment due to change in tax accounting

Blakey Corporation has, at December 31, 2012, accrued interest of $80,000 on its long-term debt. Also assume that expected future taxes will be at a 34% rate and that, effective January 1, 2013, the income tax law is revised to eliminate deductions for accrued but unpaid interest with existing accruals to be taken into income ratably over four years (referred to in tax vernacular as “a four-year spread”). A statement of financial position of Blakey Corporation prepared on January 1, 2013, would report

A deferred income tax asset in the amount of $27,200 (i.e., $80,000 × 34%, which is the income tax effect of future deductions that Blakey will be entitled to take over the succeeding four years for the amount of interest that had been accrued and unpaid at the effective date of the tax law change, taken when specific receivables are written off and bad debts are incurred for income tax purposes);
A current income tax liability of $6,800 (one-fourth of the income tax obligation); and a noncurrent income tax liability of $20,400 (three-fourths of the tax income obligation).

The deferred income tax asset is not deemed to be identified with the liability, accrued interest (if it were, it would all be reported as a current asset), but rather with the future specific tax benefits expected to be realized from recognizing 25% of the accrual as a deduction in each of the next four years. Accordingly, the deferred income tax asset is categorized as current and noncurrent according to Blakey Corporation's best estimate of the timing of those future income tax benefits.

Income Tax Effects of Dividends Paid on Shares Held by Employee Stock Ownership Plans

ASC 740 affects the accounting for certain employee stock ownership plan (ESOP) transactions. Under ASC 718-40, dividends paid on unallocated shares are not considered to be dividends for financial reporting purposes. If used to pay down ESOP debt, these dividends are reported as reductions of debt or of accrued interest; if paid to plan participants, such dividends are reported as compensation cost. GAAP requires that the income tax benefits arising from dividends paid on unallocated shares be consistent with the reporting of those dividends. Thus, if the dividends were included in compensation cost, the tax benefit would be included in the income tax provision associated with continuing operations.

Dividends paid on allocated shares are treated as normal dividends for financial reporting purposes. However, per ASC 718-40, any income tax benefits resulting from these dividend payments are also to be credited to income tax expense reported in continuing operations. In FASB's view, income tax deductible dividends for other than unallocated ESOP-held shares represent an exemption from income tax of an equivalent amount of the payor's earnings. For that reason, it concluded that the income tax effects be reported in continuing operations.

FASB's decision regarding the presentation of the income tax effects of ESOP and other stock compensation plans are fully analogous. Given that both types of plans sometimes result in income tax deductions for amounts not recognized as compensation expense under GAAP, it was determined that the resulting income tax benefits be accounted for consistently.

Deferred Income Tax Effects of Changes in the Fair Value of Debt and Marketable Equity Securities

Unrealized gains or losses on holdings of marketable securities are not recognized for income tax purposes until realized through a sale. Thus, the gains or losses that are included in the financial statements (either in the income statement or in other comprehensive income) are temporary differences under ASC 740-10-25-18, et seq. The income tax effects of all temporary differences are recognized in the financial statements as deferred income tax assets or deferred income tax liabilities, with an additional requirement that an allowance be provided for deferred income tax assets that MLTN will not be realized. Accordingly, adjustments to the carrying value of debt or equity investments included in either the trading or available-for-sale portfolios for changes in fair value will give rise to deferred income taxes, as will any recognition of “other-than-temporary” declines in the value of debt securities being held to maturity.

For gains or losses recognized in connection with holdings of investments classified as trading, since the fair value changes are recognized in net income currently, the deferred income tax effects of those changes will also be presented in the income statement.

Example of deferred income taxes on investments in debt and marketable equity securities

Odessa Corp. purchased Zeta Company bonds for the purpose of short-term speculation, at a cost of $100,000. At year-end, the bonds had a fair value of $75,000. Odessa has a 40% effective income tax rate. The entries to record the fair value adjustment and the related income tax effect are

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On the other hand, if the investment in Zeta Company bonds had been classified (at the date of acquisition, or subsequently if the intentions had been revised) as available-for-sale, the adjustment to fair value would have been reported in other comprehensive income, and not included in net income. Accordingly, the income tax effect of the adjustment would also have been included in other comprehensive income. The entries would have been as follows:

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Finally, if the investment in Zeta Company bonds had been made with the intention and ability to hold to maturity, recognition of the decline in value would have depended upon whether it was judged to be temporary or other than temporary in nature. If the former, no recognition would be given to the decline, and hence there would be no deferred income tax effect either. If deemed to be other than temporary, the investment would need to be written down, with the loss included in net income. Accordingly, the income tax effect would also be reported in the income statement. The entries would be as follows:

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An other-than-temporary decline in value in securities available for sale would also have been recognized in net income (not merely in other comprehensive income), and accordingly the income tax effect of that loss would have been reported in net income.

As with all other transactions or events giving rise to deferred income tax assets, an evaluation must be made as to whether the entity would be MLTN to ultimately realize the income tax benefit so recorded. To the extent that it was concluded that some or all of the deferred income tax asset would not be realized, an allowance would be recorded, with the offset being either to the current income tax provision (if the income tax effect of the timing difference was reported in net income) or to OCI (if the income tax effect had been reported there).

Deferred income taxes will also be recorded in connection with unrealized gains recognized due to changes in the fair value of debt or equity investments. Deferred income tax liabilities will be reported in the statement of financial position, and the corresponding income tax provision will be reported in the income statement (for fair value gains arising from holdings of securities in the trading portfolio) or in other comprehensive income (for fair value changes relative to available-for-sale investments).

Other guidance on accounting for investments.

A number of specialized issues arising in connection with short-term (or other) investments are addressed in the following paragraphs.

Business Combinations

This explanation and illustration of how to apply income tax accounting rules to business combinations, by necessity, must be divided into separate and distinct sections, since business combinations are subject to different recognition and measurement rules depending on when the transaction occurred.

Each time FASB has issued standards making major changes to these rules, it has not required reporting entities to retrospectively restate business combinations accounted for under the superseded standards. Thus, a reporting entity that has entered into numerous business combinations over an extended period of time may be applying a plethora of accounting standards to the various subsidiaries it consolidates in its financial statements.

Purchase-method accounting under ASC 805.

Accounting for the income tax effects of business combinations reported as purchases under ASC 805 is one of the more complex aspects of interperiod income tax accounting. The principal complexity relates to the recognition, at the date of the purchase, of the deferred income tax effects of the differences between the income tax and financial reporting bases of the assets and liabilities acquired. Further difficulties arise in connection with the recognition of goodwill or the treatment of negative goodwill from “bargain purchases.” In some instances, the reporting entity expects that the ultimate income tax allocation will differ from the initial one (such as when the taxpayer anticipates disallowance by the taxing authorities of an allocation made to identifiable intangibles), and this creates yet another complex accounting matter to be dealt with.

Under ASC 805, purchase price is allocated on a “gross of tax effects” basis, with separate recognition of the deferred income tax assets and obligations.

Under US federal income tax laws and regulations, business combinations can be either taxable or nontaxable in nature. ASC 740 is applicable to differences between the income tax and financial reporting bases of assets acquired and liabilities assumed in both taxable and nontaxable business combinations.

In a taxable business combination, the total purchase price is allocated to assets and liabilities for both income tax and financial reporting purposes, although under some circumstances these allocations may differ.

In a nontaxable business combination, the predecessor entity's income tax bases for the various assets and liabilities are carried forward for income tax purposes, while for financial reporting purposes the purchase price is allocated to the assets and liabilities acquired. Thus, both taxable and nontaxable business combinations will result in significant differences between the income tax and financial reporting bases of the net assets acquired.

Acquisition-date accounting using the purchase method under ASC 805. ASC 740 requires that the income tax effects of the income tax and GAAP basis differences of all assets and liabilities generally be presented as deferred income tax assets and liabilities as of the acquisition date. In general, this “grossing up” of the statement of financial position is a straightforward matter.

Goodwill. Goodwill arises when a portion of the price paid in a business combination accounted for as a purchase cannot be allocated to identifiable assets, including intangibles. This excess cost is deemed to relate to the unidentifiable intangible asset known as goodwill that is, in practice, associated with the acquired entity's excess earning power.

Historically, goodwill had been subject to mandatory amortization for purposes of GAAP financial reporting over an estimated useful life that was not to exceed 40 years. As part of the Omnibus Budget Reconciliation Act of 1993 (OBRA), goodwill became deductible (IRC §197) for federal income tax purposes, with a mandatory fifteen-year straight-line amortization period.

In 2001, the FASB issued new business combinations and goodwill accounting requirements (ASC 805 and ASC 350), mandating that goodwill no longer be amortized for financial reporting purposes, but rather be subject to periodic impairment testing. Thus, the relationship of GAAP and income tax accounting for goodwill has varied considerably over the years.

Under ASC 805 and ASC 350, the pre-1993 situation was effectively reversed. Goodwill was now amortizable for federal income tax purposes but was no longer amortizable for financial reporting purposes. Goodwill could potentially be charged to GAAP expense sporadically, since it must be regularly tested for impairment and to the extent impaired it must be written down or written off immediately.

Thus income tax/GAAP differences under ASC 805 and ASC 350 were deemed temporary differences for which deferred income taxes were recognized for financial reporting under GAAP.

Since, per ASC 740, temporary differences are those arising from differences between the income tax and financial reporting bases of assets and liabilities, deferred income taxes are to be recognized and measured for goodwill. In general, deductible income taxes amortization of goodwill will create a deferred income tax liability in the financial statements, analogous to that arising from the use of accelerated income tax depreciation. If GAAP goodwill is subsequently reduced to reflect impairment, a portion of the deferred income tax liability will be reversed. Some part of the deferred income tax liability will remain on the statement of financial position until the goodwill is ultimately eliminated either through full impairment or when the reporting unit is disposed of or ceases operations.

Example of computation of deferred income taxes and goodwill resulting from a nontaxable purchase business combination

Coustan Tacks and Sole Industries Inc. (CTS) acquired substantially all of the assets of Sylvan Shoe Works Inc. (SSW) on January 2, 2010. Following are the facts and assumptions relative to the business combination, the two companies, and the income tax rules that apply:

The income tax rate is a flat 34%.
The acquisition cost is $500,000.
The fair values of the assets acquired total $750,000.
The income tax bases of the assets acquired total $600,000.
The fair value and income tax bases of the liabilities assumed by CTS in the purchase are $250,000.
The difference between the income tax basis and fair values of the assets acquired, $150,000, consists of future taxable temporary differences of $200,000 and future deductible temporary differences of $50,000.
There is no doubt as to the realizability of the future deductible temporary differences in this case.

Based on these facts, the GAAP allocation of the purchase price is as follows:

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Negative goodwill. In some purchase business combination situations, “negative goodwill” results from what are often referred to as bargain purchases. These are situations in which the fair value of the net identifiable assets acquired exceeds the purchase price. Under ASC 805 and ASC 350, this excess is first allocated on a pro rata basis to all acquired assets other than cash and cash equivalents, trade receivables, inventory, financial instruments that are required to be carried on the statement of financial position at fair value, assets to be disposed of by sale, and deferred income tax assets. This will tend to affect the carrying value of long-lived, mostly depreciable, assets, which will reduce future depreciation charges over the respective lives of those assets. Any excess negative goodwill would then be immediately recognized as an extraordinary gain, as distinct from the earlier requirement that this negative goodwill be amortized over up to forty years.

For income tax purposes, negative goodwill is handled in a manner similar to that under GAAP—the cost bases of nonmonetary long-lived assets are proportionally reduced, and any excess is immediately taxable. Thus, a temporary difference probably did not arise from the accounting treatment applied to negative goodwill for income tax and GAAP purposes. In the past, temporary differences arose from the differential treatments (immediate taxability versus amortization for financial reporting), creating deferred income tax assets in many instances.

The accounting for a taxable purchase business combination is similar to that for a non-taxable one. However, unlike the previous example, in which there were numerous assets with different income tax and financial reporting bases, there are likely to be only a few differences in the case of taxable purchases. In practice, the accountant, with assistance from a valuation specialist, is tasked with analyzing the amount allocated to goodwill for income tax purposes to ensure that due care was taken in identifying acquired intangibles that are recognizable for financial reporting purposes separately from goodwill.

Exception for permanent basis differences. US income tax law contains provisions that allow a parent company that owns a majority interest in a domestic subsidiary to avoid future taxation of the excess of the basis of its investment for financial reporting purposes over its basis in the investment for income tax reporting purposes. For example, if the parent's interest in the subsidiary is 80% or more, the parent is permitted to elect to compute the taxable gain or loss on a liquidation of the subsidiary using the income tax basis of the subsidiary's net assets rather than by reference to the parent company's own income tax basis of its investment in the subsidiary's stock (IRC §332). Another variant is a tax-free statutory merger or consolidation (IRC §368). ASC 740 specifies that deferred income tax assets are only recognized if it is apparent that the temporary difference will reverse in the “foreseeable future.”

In-process research and development. To the extent that a portion of the purchase price of a business combination was allocated to in-process research and development, ASC 805 and ASC 350 continued the previous practice of immediately expensing these assets upon their acquisition.

Per ASC 805, the acquirer is required to recognize all tangible and intangible research and development assets acquired in a business combination. For further details, see the section entitled “Acquisition method accounting under ASC 805 and ASC 810-10-65” later in this chapter.

Subsequent accounting. One of the attributes that distinguishes ASC 740 from its predecessors is that net deferred income tax benefits are now fully recognized, subject to the possible need for a valuation allowance. This requirement has a major impact on the accounting for business combinations.

In the example presented above, all future deductible temporary differences were assumed to be fully realizable, and therefore the deferred income tax benefits associated with those temporary differences were recorded as of the acquisition date, with no need for an offsetting valuation allowance. However, in other situations, there may be substantial doubt concerning realizability (i.e., it may be considered more likely than not that the future benefits are unrealizable) and accordingly a valuation allowance would be recognized at the date of the purchase business combination. In such an instance, the allocation of the purchase price would reflect this fact, which would result in the allocation of a greater share of the purchase cost to goodwill than would otherwise be the case. Under current GAAP goodwill cannot be amortized for financial reporting purposes, and the difference in accounting for goodwill under GAAP and income tax reporting rules will add to the deferred income tax implications of the business combination.

If, at a date subsequent to the business combination transaction, it is determined that the valuation allowance must be reduced or eliminated, ASC 740 stipulates that the effect of this reduction is applied first to eliminate any goodwill recorded in connection with that business combination. Once goodwill has been reduced to zero, the excess is applied to eliminate any noncurrent identifiable intangible assets acquired in that business combination, and any further excess is reflected in the current period income tax expense or benefit. Thus, in this situation the general rule that changes in the allowance are mated to debits or credits in current period income tax expense from continuing operations is not followed.

The transition provisions of ASC 805 relative to income taxes substantially changed the accounting described in the previous paragraph. Under ASC 805, changes in the valuation allowance for acquired deferred income taxes are to be recognized as an adjustment to income tax expense or, in the case of certain items (employee stock options, dividends on unallocated ESOP shares, and certain quasi reorganizations) as an adjustment to contributed capital.

Example of subsequent realization of a deferred income tax asset in a purchase business combination

Assume that Michael Company (acquirer) acquired Reba Enterprises (acquiree) on January 2, 2012, for $2,000,000 in cash. There was no goodwill recognized in the transaction. The income tax basis of the net assets was $6,000,000 (i.e., future deductible temporary differences equal $4,000,000).

Income tax and GAAP bases at acquisition date, 1/2/2012

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The $4,000,000 of accrued warranty costs (which are not deductible for income tax purposes until actually paid) are expected to reverse as follows: 2012—$1,500,000; 2013—$1,000,000; After 2013—$1,500,000.

The current and expected future income tax rate is a flat 34% and the law restricts use of the acquiree's future deductible temporary differences and carryforwards to its own future taxable income. The acquiree has incurred tax losses in the past three years and 2012 is also expected to result in a tax loss. Thus, Michael Company management concludes that a valuation allowance for the full amount of the deferred income tax asset is required. However, at the end of 2013, Michael Company, due to improved results, decides that a valuation allowance is no longer necessary.

At the date of acquisition, the deferred income tax asset was recorded at $1,360,000 ($4,000,000 × 34%) but with a corresponding valuation allowance for the same amount. At the end of 2012, the deferred income tax asset is $850,000 computed as 34% of $2,500,000 ($4,000,000 original warranty liability − $1,500,000 reversal in 2012), again with a corresponding valuation allowance. At the end of 2013, the deferred income tax asset is $510,000 computed as 34% of $1,500,000 ($4,000,000 original warranty liability − the 2012 reversal of $1,500,000 and the 2013 reversal of $1,000,000).

At the end of 2013, when management determines that a valuation allowance is no longer necessary, elimination of the valuation allowance results in a deferred income tax benefit or in a reduction of deferred income tax expense.

The foregoing facts are summarized as follows:

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Thus, the journal entries related to deferred income taxes are:

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Note that, in the previous example, had goodwill arisen in the acquisition, the accounting would differ based on whether the change in assessment of the valuation allowance occurred before or after the effective date of Financial Accounting Standard (FAS) 141(R).

Pre-FAS 141(R)—	In the postacquisition period in which the tax benefit is realized, (1) the elimination of the valuation allowance is applied to reduce any goodwill recognized in connection with the acquisition, (2) if the goodwill is reduced to zero, any remaining benefit is used to reduce other noncurrent intangible assets included in the acquisition, and (3) if any benefit remains after (1) and (2), it is recognized as a reduction in income tax expense (or an increase in income tax benefit).
Post-FAS 141(R)—	If the change occurs during the measurement period and results from new information that bears on facts and circumstances that existed on the acquisition date, the change is recognized by adjusting goodwill. If goodwill is reduced to zero, any excess is recorded currently as a gain from a bargain purchase. Such gains, under FAS 141(R), are no longer characterized as extraordinary.
	If the change does not occur during the measurement period, it is reported as a reduction of income tax expense or, if related to dividends on unallocated ESOP shares, employee stock options, or certain quasi reorganizations, as a direct adjustment to contributed capital.

Under ASC 740, the income tax benefits of net operating losses are not distinguished from those arising from future deductible temporary differences. Accordingly, the treatments set forth above for pre- and post-FAS 141(R) are applied here as well. If the benefits are recognized for the first time at a date after the acquisition pre-FAS 141(R) (by reducing or eliminating the valuation allowance), then goodwill arising from the business combination is eliminated, other purchased noncurrent intangibles are reduced to zero, and current income tax expense is reduced. Negative goodwill is neither created nor increased in such circumstances, however.

If, however, the recognition of the benefits occurs after the effective date of FAS 141(R), the benefits do not reduce any assets recorded as a part of the acquisition and, instead, reduce current income tax expense or contributed capital as previously described.

Precisely the same approach is employed in connection with income tax credit carryforwards (e.g., investment credit, jobs credit, research and development credit, etc.) that may have existed at the date of the business combination, but that may not have been recognized due to doubtful realizability. While previously the treatments accorded net operating loss and income tax credit carryforwards were dissimilar, under ASC 740 they are identical.

In some instances, entities having unrecognized income tax benefits of net operating loss or income tax credits arising in connection with a purchase business combination may generate other similar income tax benefits after the date of the acquisition. A question in such a circumstance relates to whether a FIFO convention should be adopted to guide the recognition of these benefits. While in some instances income tax law may determine the order in which the benefits are actually realized, in other cases the law may not do so. ASC 740 provides that in those latter situations, the benefits realized are to be apportioned, for financial reporting purposes, between pre- and postacquisition income tax benefits. The former are accounted for as above, and the latter reported as reductions of current period income tax expense, consistent with the general rules of ASC 740.

In a period that a subsidiary first meets the criteria in ASC 360 for its operations to be classified as discontinued operations, it becomes apparent that differences between the financial reporting basis and income tax basis of the subsidiary's assets and liabilities will reverse in the foreseeable future. Thus, the parent is to recognize deferred income taxes on the temporary difference between the income tax and financial reporting bases in that period (ASC 740-30-25).

Acquisition-method accounting under ASC 805 and ASC 810-10-65.

In general, these standards retain the gross-up approach from ASC 740, whereby deferred income tax assets and liabilities are recorded independently of the acquired assets or assumed liabilities that gave rise to them.

Postcombination changes in a valuation allowance for deferred tax assets of the acquired entity are to be recognized as follows:

Changes during the measurement period—If a change in the valuation allowance during the measurement period results from new information regarding facts and circumstances existing at the acquisition date, the change is to be recognized as an adjustment to goodwill. If goodwill is reduced to zero by the change, any remaining decrease in the valuation allowance is handled in the same manner as negative goodwill in a bargain purchase; that is, the excess is recorded as a gain.
All other changes—All other changes in the valuation allowance are to be reflected as an increase or decrease in income tax expense in the period of the change or, with respect to the following items, as a charge or credit to the relevant component of equity:
1. Changes related to tax-deductible costs such as stock issuance costs or debt issuance costs that give rise to temporary GAAP basis/tax basis differences in equity.
2. Changes related to temporary differences related to employee stock options are to be accounted for in accordance with ASC 718-740. Accounting for share-based compensation is discussed in the chapter on ASC 718.
3. Dividends paid on unallocated shares held by an ESOP that are charged to retained earnings.
4. Changes that affect deductible temporary differences and carryforwards that existed at the date of certain quasi reorganizations that qualify, under ASC 852-20, to be reported as a direct addition to contributed capital upon recognition of the tax benefits in years subsequent to the quasi reorganization.

Assessment of postcombination realizability of deferred income tax assets. Some tax jurisdictions permit the acquirer to obtain future income tax benefits in postcombination tax years from utilizing deductible temporary differences or carryforwards of its own or of the acquiree.

If the newly consolidated enterprise expects to file a consolidated income tax return, the acquirer may, upon evaluation of the sufficiency of its valuation allowance, determine that the allowance should change. For example, future taxable income generated by the acquiree may allow the consolidated “taxpayer” to utilize net operating loss carryforwards of the acquirer whose future utilization would have otherwise been doubtful. If this were allowable under the tax law of a jurisdiction, the acquirer is to reduce the valuation allowance accordingly. The reduction of the valuation allowance is not, however, accounted for as part of the accounting for the business combination under the acquisition method. Instead, it is recognized as an income tax benefit as a component of income from continuing operations (or credited directly to equity under the specified circumstances discussed previously).

Goodwill. As previously discussed in the context of prior business combinations standards, few areas of income tax accounting are as complex as the treatment of differences between tax and GAAP goodwill.

The carrying value of goodwill for GAAP and income tax purposes will frequently differ. Examples of reasons for these differences include such items as

Example items resulting in tax goodwill in excess of GAAP goodwill:

The acquirer and acquiree do not fully analyze the nature of the separately identifiable intangible assets included in the acquisition, since all intangible assets, including goodwill, are amortized for US federal income tax purposes using the same 15-year statutory life. Upon review for GAAP purposes, certain intangibles are identified that meet the legal/contractual criterion or the separability criterion and are reclassified from goodwill for GAAP purposes.
Application of ASC 805 results in recognition of GAAP assets that are not recognized for income tax purposes, such as indemnification assets or in-process research and development assets. As a result, the residual value allocated to goodwill for GAAP purposes is less than goodwill recognized for income tax purposes.
Postacquisition impairment write-downs of GAAP goodwill are not deductible for income tax purposes.

Example items resulting in GAAP goodwill in excess of tax goodwill:

Application of ASC 805 results in recognition of GAAP liabilities that are not recognized for income tax purposes, such as preacquisition contingencies or contingent consideration. GAAP recognition of these liabilities reduces the aggregate assigned values with respect to the business combination and increases the residual goodwill recognized for GAAP purposes without affecting the goodwill recognized for income tax purposes.
Over the US federal 15-year statutory life over which goodwill is amortized, the income tax basis of goodwill is reduced annually, whereas for GAAP purposes, the carrying value of goodwill is not reduced unless it is impaired.

ASC 740 expressly prohibits recognition of a temporary difference or deferred income taxes with respect to goodwill that, in particular taxing jurisdiction, is not deductible.

ASC 740 prescribes a two-component approach to analyzing differences between GAAP and tax-deductible goodwill to determine whether they give rise to a temporary difference and the related deferred income taxes thereon.

Component 1. For the purposes of this analysis, the first component of goodwill is the lesser of the amount of goodwill recognized for GAAP purposes or the amount of tax-deductible goodwill recognized for income tax purposes in the particular jurisdiction being analyzed. Obviously, at acquisition, Component 1 goodwill will be the same for GAAP and income tax purposes. However, differences in this component of goodwill that arise in subsequent periods give rise to temporary differences for which deferred income tax assets or liabilities are to be recognized.

Component 2. The second component is the excess of the larger goodwill amount that was not allocated to Component 1. In other words, if GAAP goodwill exceeds tax-deductible goodwill, Component 2 would be that excess amount; if tax-deductible goodwill exceeds GAAP goodwill, Component 2 would be that excess amount.

The deferred income tax treatment afforded differences between GAAP goodwill and tax goodwill varies depending on which basis exceeds the other, as illustrated in the following table.

Recognition of Deferred Income Taxes for GAAP/Tax Differences in Goodwill

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Example of deferred income taxes where tax-deductible goodwill exceeds GAAP goodwill

On January 2, 2012, Butler Soccer Supply (BSS) acquired Spector Sod and Turf (SST) in a taxable acquisition. $14,000 of income tax goodwill was allocable for GAAP purposes to an indefinite-lived intangible asset at acquisition thus causing a difference between the goodwill amounts recognized for purposes of GAAP and income tax reporting.

The effective income tax rate for this jurisdiction expected to apply in all applicable periods is a flat 34%.

The acquisition-date allocations resulted in goodwill being recognized for GAAP and income tax purposes as follows:

1. Tax-deductible goodwill recognized for income tax purposes	$65,000
2. Goodwill recognized for GAAP purposes	51,000
3. Excess of tax-deductible goodwill over GAAP goodwill	$14,000

Based on the above, the “components” of goodwill are comprised of:

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As previously discussed, at the acquisition date, Component 1 of goodwill will be the same for tax and GAAP purposes. In future periods, however, as income tax deductions are taken for goodwill amortization, these amounts will differ and that difference will give rise to temporary differences necessitating the recognition of deferred income taxes.

The Component 2 tax-deductible goodwill exceeds GAAP goodwill, representing a future deductible temporary difference that requires recognition of a deferred income tax asset at the acquisition date. Application of this principle, however, can produce computational complexity. In theory, recognition of a deferred income tax asset in connection with recording a business combination results in a reduction of GAAP goodwill, since the entry to record the deferred income tax asset would be recorded by debiting the deferred income tax asset and crediting goodwill. That hypothetical credit to goodwill would reduce the difference computed above between GAAP goodwill and tax goodwill and, in circular fashion, would affect the computation of the deferred income tax asset. To avoid this circularity, ASC 740 requires the following computational method to determine the amount to recognize as a deferred asset:

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Substituting the known amounts per example

The entry to record the acquisition-date deferred income tax asset is as follows:

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To record acquisition-date deferred income tax asset arising from future deductible temporary difference due to excess of the tax basis of deductible goodwill over the carrying amount of goodwill for financial reporting purposes.

To prove the accuracy of the computations, the deferred income tax asset is computed as follows:

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On its consolidated income tax return for the year ended December 31, 2011, BSS deducted amortization of goodwill computed as follows:

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Assuming that no goodwill impairment was recognized for financial reporting purposes for 2012 and that no valuation allowance was needed to reduce the deferred income tax asset to the amount that is more likely than not realizable, the goodwill temporary difference between income tax basis and GAAP carrying amount at 12/31/2012 is:

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The computation above is easily proven by multiplying the effective tax rate of 34% by the $4,333 change in the future deductible temporary difference, yielding the $1,473 tax effect recorded in the entry.

It is important to note that, on the 2012 consolidated income tax return of BSS and Subsidiary, there will be a deduction for goodwill amortization that will reduce income taxes currently payable that would be recorded as follows, assuming the income tax effects of all other income tax positions have been already recorded:

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Obviously the effects of the two entries offset each other and result in reducing the deferred income tax asset that existed at acquisition date as the income tax benefits are being realized on currently filed income tax returns.

As a practical matter, it would be a rare situation for an acquirer to have gathered all of the information necessary to establish the appropriate values to record the acquisition in time to issue timely financial statements when due. For this reason, ASC 805 provides for a measurement period during which provisional amounts initially recognized for the transaction are subject to retrospective adjustment. Any such adjustments are to reflect additional information that the acquirer obtains after the acquisition date that was not previously available. For the additional information to be relevant for this purpose, it must provide new information regarding facts and circumstances that existed as of the acquisition date that, if known at the time, would have resulted in different measurements of the amounts recognized as of that date.

In addition to causing revisions to previous measurements, the new information may also result in the recognition of additional assets or liabilities that had not been initially identified or recorded when the provisional entries were made to record the combination. The measurement period ends when management of the acquirer obtains the information it needs to make the final determinations (or determines that such information is not available); however, in no case may the measurement period exceed one year from the acquisition date.

Increases and/or decreases in the provisional amounts during the measurement period are reflected as adjustments to goodwill. These adjustments are made retrospectively as if they had been recorded on the acquisition date. Consequently, information for prior periods that is presented for comparative purposes is to be revised to reflect the adjustments and their effect on other measurements such as depreciation, amortization, and, of course, deferred income taxes.

Subsequent to the measurement period, the only changes that are permitted to the accounting for the business combination are restatements to correct errors in accordance with ASC 250.

Effect of deferred income tax liabilities arising from goodwill on analysis of the need for a valuation allowance with respect to deferred income tax assets. In the US, under current federal income tax law, goodwill is amortized over a statutory 15-year life using the straight-line method. The following example illustrates the status of the GAAP tax difference at the end of that 15-year period, assuming no impairment charges are recorded for GAAP.

Example of effect of income tax goodwill amortization on deferred income taxes

On January 2, 2012, Melanie Artist Supply, Inc. (MAS) acquired Larry's Paint-by-Number, Inc. (LPBN) in a taxable acquisition. The difference between tax goodwill and GAAP goodwill was as follows (using the same assumptions from the previous “Butler Soccer Supply” example):

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Based on the application of the formulaic approach used in the previous example, GAAP goodwill was adjusted as follows at the acquisition date:

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Assuming that there are no impairment charges incurred for GAAP purposes, and income tax amortization is deducted straight-line in each of the 15 succeeding years ($65,000 ÷ 15 years = $4,333 per year) the following summarizes the tax and GAAP balances immediately succeeding the final tax amortization deduction:

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Note that by the end of the 15-year tax amortization period, the acquisition-date deferred income tax asset had fully reversed and had, in fact, become a deferred income tax liability.

In the preceding example, the deferred income tax liability relates to the GAAP carrying value of goodwill that is not amortizable for financial reporting purposes and has an indefinite life. Absent an outright sale or liquidation of the reporting unit, management would be unable to estimate whether the goodwill might give rise to future taxable income prior to the expiration of the statutory net operating loss carryforward period which, under current US income tax law, is 20 years after the tax year in which the net operating loss was generated. This same lack of predictability would also apply, for example, to deferred income tax liabilities associated with identifiable, indefinite-life intangibles.

When such a situation arises and management is assessing the realizability of deferred income tax assets to determine the need for a valuation allowance, it would normally not be appropriate to consider the reversal of these types of future taxable temporary differences in assessing whether, in the future, the taxpayer will, more likely than not, be able to generate sufficient taxable income to permit it to obtain the tax benefits associated with its deferred income tax assets. This potentially results in the consolidated reporting entity requiring a full valuation allowance with respect to its deferred income tax assets. If, however, a particular tax jurisdiction were to permit an indefinite carryforward period for a net operating loss, management would be permitted to consider future reversal of the deferred income tax liability in assessing the need for a valuation allowance.

Negative goodwill and bargain purchases. The chapter on ASC 805 discusses in detail the concept of a “bargain purchase” in which the aggregate of the values assigned to the identifiable assets acquired and liabilities assumed exceed the consideration transferred by the acquirer and the noncontrolling interest in the acquiree (if any). This situation can occur when the transaction is a forced sale where the seller is acting under duress—if, for example, the seller is at risk because of a personal guarantee of acquiree indebtedness or needs immediate liquidity due to maturing personal debt.

In applying the formulaic approach illustrated in the preceding example, the amount of goodwill recognized for financial reporting purposes may not be sufficient to absorb the adjustment for the amount computed as a deferred income tax asset. When this is the case, the computational approach requires modification, as illustrated in the following example.

Example of deferred income taxes where tax-deductible goodwill exceeds GAAP goodwill and adjustment results in gain from a bargain purchase

On January 2, 2012, Novak Condiments Inc. (NI) acquired Jacobson Pickle Corp. (JP) in a taxable acquisition. The effective income tax rate for this jurisdiction expected to apply in all applicable periods is a flat 34%.

The acquisition-date allocations resulted in goodwill being recognized for GAAP and income tax purposes as follows:

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Based on the above, the “components” of goodwill comprise:

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Application of the previously illustrated formula yields the following results:

DTA =	Deferred tax asset
TR =	Tax rate expressed as a percentage
PTD =	Preliminary temporary difference representing the excess of tax goodwill over GAAP goodwill before giving effect to the income tax benefit associated with goodwill
DTA =	[TR ÷ (100% − TR)] × PTD

Substituting the known amounts per example:

The deferred tax asset (DTA) computed of $103,000 exceeds the GAAP carrying value initially assigned to goodwill of $51,000. If the DTA were recorded without adjustment, it would result in the elimination of the $51,000 of GAAP goodwill and the recognition of an income tax benefit of $52,000. This would not result in the deferred income tax asset being computed at the rate at which it is expected to be realized when the temporary difference reverses.

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To properly compute the deferred tax adjustment in this case, the formula needs to be modified as follows:

The original formula was

The formula is modified in order to use the limit imposed by the carrying value of the GAAP-basis goodwill to solve for the PTD, as follows:

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Using substitution, the adjustment to GAAP goodwill for the deferred income tax asset is computed/proven as follows:

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The last step is to compute the gain from bargain purchase that arises as a result of recording the remaining deferred income tax asset.

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The entry to record the remainder of the deferred income tax asset and the gain from bargain purchase is as follows:

To record the acquisition-date deferred income tax asset attributable to a gain from bargain purchase.

To prove the accuracy of the computations, the deferred income tax asset is computed as follows:

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In-process research and development assets. ASC 805 requires the acquirer to recognize all tangible and intangible R&D assets acquired in a business combination at the acquisition date without immediately writing them off to expense. This treatment is afforded these assets even if they have no alternative future use. Accounting subsequent to initial recognition is to be accomplished as follows:

Tangible R&D assets are to be accounted for based on their nature (e.g., fixed assets to be held and used, inventory, supplies, etc.).
Intangible R&D assets are to be classified as indefinite-lived intangibles until the related R&D project is either completed or abandoned.
Upon completion or abandonment of the R&D project to which the assets relate, management of the consolidated reporting entity is to determine the estimated remaining useful life of the assets, if any, and amortize their carrying value over that period.
As is the case for other long-lived assets, temporarily idled intangible assets are not to be accounted for as abandoned.
During the period of time that the assets are considered to be indefinite-lived, they are subject to the same impairment testing rules that apply to other indefinite-lived intangibles.

If income tax law in an applicable taxing jurisdiction requires acquired R&D assets to be written off (deducted) or recognized at an amount that differs from the foregoing GAAP requirements, then the recognition of these assets for financial reporting purposes will result in a future taxable temporary difference and the related deferred income tax liability would be recognized.

Tax Allocation for Business Investments

There are two basic methods for accounting for investments in the common stock of other corporations: (1) the fair value method as set forth in ASC 320, and (2) the equity method, as prescribed by ASC 323. The cost method, previously employed for intercorporate investments lacking the attribute of “significant influence” by the investor, is no longer appropriate, except for the exceedingly rare situation when fair value information is absolutely unavailable. If the cost method is used, however, there will be no deferred income tax consequence, since this conforms to the method prescribed for income tax reporting.

The fair value method is used in instances where the investor is not considered to have significant influence over the investee. The ownership threshold generally used to denote significant influence is 20% of ownership; this level of ownership is not considered an absolute (ASC 323-10-15), but it will be used to identify the break between application of the fair value and equity methods in the illustrations that follow. In practice, the 20% ownership interest defines the point at which there is a rebuttable presumption that the investor has significant influence, and it is often noted that publicly held companies will establish investment ownership percentages very slightly over or under 20%, presumably to support their desires and decisions to use, or not use, the equity method of accounting for those investments.

Under both the cost and fair value methods, ordinary income is recognized as dividends received by the investor, and capital gains (losses) are recognized upon the disposal of the investment. For income tax purposes, no provision is made during the holding period for the allocable undistributed earnings of the investee. There is no deferred income tax computation necessary when using the cost method, because there is no temporary difference.

The equity method is generally required whenever an investor owns 20% or more of an investee or has significant influence over the investee's operations with a lower ownership percentage. Under the equity method, the investment is recorded at cost and subsequently increased by the allocable portion of the investee's net income. The investor's share of the investee's net income is then included in the investor's pretax accounting income. Dividend payments are not included in pretax accounting income but instead are considered to be a reduction in the carrying amount of the investment. For income tax purposes, however, dividends received are the only revenue realized by the investor. As a result, the investor must recognize deferred income tax expense on the undistributed net income of the investee that will be taxed in the future. The current effective GAAP in this area consists of ASC 740-30 and ASC 740. These standards are discussed below.

GAAP distinguishes between an investee and a subsidiary and prescribes different accounting treatments for each. An investee is considered to be a corporation whose stock is owned by an investor that holds between 20% and 50% of the outstanding stock. An investee situation occurs when the investor has significant influence but not control over the corporation invested in. A subsidiary, on the other hand, exists when more than 50% of the stock of a corporation is owned by another. This results in a presumption that the investor has direct control over the corporation invested in. ASC 740-30 governs accounting for the income tax effects of owning subsidiaries.

Undistributed earnings of a subsidiary.

These accounting requirements are set forth in ASC 740-30. While the timing of distribution of a subsidiary's net income to its parent may be uncertain, it will eventually occur, whether by means of dividends, or via the disposal of the entity and realization of capital gains. Accordingly, deferred income taxes must be provided, but the amount will be dependent upon the anticipated means of realization, which of course may change over time.

The magnitude of the income tax effects to be provided depends upon specific application of the income tax laws and management intent. If the law provides a mechanism under which the parent can recover its investment tax-free, deferred income taxes are not provided. For example, under §332 of the IRC, a parent corporation can liquidate an 80%-or-more-owned subsidiary without recognizing gain or loss for income tax purposes. Also, under IRC §368, a parent can effect a statutory merger or consolidation with its 80%-or-more-owned subsidiary, under which no taxable gain or loss would be recognized.

In other cases, the minimization or avoidance of income taxes can be achieved only if the parent company owns a stipulated share of the subsidiary's stock. A parent owning less than this threshold level of its subsidiary may express its intent to utilize a tax planning strategy to acquire the necessary additional shares to realize this benefit. In evaluating this strategy, the cost of acquiring the additional shares must be considered, and the benefits to be recognized (i.e., a reduced deferred income tax liability) must be offset by the cost of implementing the strategy as discussed earlier in this chapter.

A distinction exists in the application of ASC 740-30 between differences in income tax and financial reporting basis that are considered “inside basis differences” versus “outside basis differences,” and this is clarified by ASC 830-740-25. Certain countries' income tax laws allow periodic revaluation of long-lived assets to reflect the effects of inflation with the offsetting credit recorded as equity for income tax purposes. Because this is an internal adjustment that does not result from a transaction with third parties, the additional basis is referred to as “inside basis.” ASC 830-740-25 indicates that the ASC 740-30 indefinite reversal criteria only apply to “outside basis differences,” and not to “inside basis differences” arising in connection with ownership of foreign subsidiaries. Therefore, a deferred income tax liability is to be provided on the amount of the increased inside basis.

Certain foreign countries tax corporate income at rates that differ depending on whether the income is distributed as dividends or retained by the corporation. Upon subsequent distribution of the accumulated earnings, the taxpayer receives a tax credit or refund for the difference between the two rates. In the consolidated financial statements of a parent company, the future income tax credit and the deferred income tax effects related to dividends that will be paid in the future are recognized based on the distributed rate if the parent provided for deferred income taxes because it did not invoke the indefinite reversal criteria of ASC 740-30. If the parent did not provide for deferred income taxes as a result of applying the ASC 740-30 criterion, the undistributed rate is to be used (ASC 740-10-25). The treatment of the tax credit in the separate financial statements of the foreign company is discussed later in this chapter in the section titled “Separate Financial Statements of Subsidiaries or Investees.”

Undistributed earnings of an investee.

When an entity has an equity method investee, it is presumed to be able to exercise significant influence, but lack control. Because the ability to indefinitely postpone income taxes on the investee's net income would be absent in such a case, in contrast to the parent-subsidiary situation above, GAAP requires full interperiod income tax allocation for the effects of undistributed investee net income. The facts and circumstances involved in each situation, however, will be the final determinant of whether this temporary difference is assumed to be a future dividend or a capital gain for purposes of computing the deferred income tax effect.

Example of income tax effects from investee company

To illustrate the application of these concepts, assume Investor Company owns 30% of the outstanding common stock of Investee Company and 70% of the outstanding common stock of Subsidiary company. Additional data for Subsidiary and Investee companies for the year 2011 are as follows:

The following sections illustrate how the foregoing data are used to recognize the income tax effects of the stated events.

The pretax accounting income of Investor Company will include its equity in Investee Company net income equal to $15,000 ($50,000 × 30%). Investor's taxable income, on the other hand, will include dividend income of $6,000 ($20,000 × 30%), reduced by a deduction of 80% of the $6,000, or $4,800. This 80% dividends received deduction is a permanent difference between pretax accounting income and taxable income and is allowed for dividends received from domestic corporations in which the taxpaying corporation's ownership is less than 80% but at least 20%. A lower dividends-received deduction of 70% is permitted when the ownership is less than 20%, and a 100% deduction is provided for dividends received from domestic corporations in which the ownership is 80% to 100%.

In this example, a temporary difference results from Investor's equity ($9,000) in Investee's undistributed income of $30,000 (= $50,000 net income less $20,000 dividends). The amount of the deferred income tax credit in 2011 depends upon the expectations of Investor Company regarding the manner in which the $9,000 of undistributed income will be realized. If the expectation of receipt is via dividends, then the temporary difference is 20% (the net taxable portion, after the dividends received deduction) of $9,000, or $1,800, and the deferred income tax liability associated with this temporary difference in 2012 is the expected effective income tax rate times $1,800. However, if the expectation is that receipt will be through future sale of the investment, then the temporary difference is the full $9,000 and the deferred income tax liability is the current corporate capital gains rate times the $9,000.

The entries below illustrate these alternatives. An assumed tax rate of 34% is used for ordinary income, while a rate of 20% is used for capital gains. It is also assumed that there are no pre-2012 temporary differences to consider. Note that the amounts in the entries below relate only to Investee Company's incremental impact upon Investor Company's income tax assets and liabilities.

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Example of income tax effects from subsidiary

The pretax accounting income of Investor Company will also include equity in Subsidiary income of $70,000 (70% × $100,000). This $70,000 will be included in consolidated pretax income in Investor's consolidated financial statements. For income tax purposes, Investor and Subsidiary cannot file a consolidated income tax return because the minimum level of control (i.e., 80%) is not present. Consequently, the taxable income of Investor will include dividend income of $42,000 (70% × $60,000), and there will be an 80% dividends received deduction of $33,600. The temporary difference discussed in ASC 740-30 results from Investor's 70% equity ($28,000) in Subsidiary's undistributed earnings of $40,000. The amount of the deferred income tax liability in 2011 depends upon the expectations of Investor Company as to the manner in which this $28,000 of undistributed income will be received. The same expectations can exist as previously discussed for Investor's equity in Investee's undistributed earnings (i.e., through future dividend distributions or capital gains).

The entries below illustrate these alternatives. A marginal tax rate of 34% is assumed for dividend income, and a rate of 20% applies to capital gains. It is also assumed that there are no pre-2012 temporary differences to consider. The amounts in the entries below relate only to Subsidiary Company's incremental impact upon Investor Company's income tax assets and liabilities.

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If a company owns 80% or more of the voting stock of a subsidiary and consolidates the subsidiary for both financial reporting and income tax purposes, then no temporary differences exist between consolidated pretax income and taxable income. If, in the circumstances noted above, consolidated financial statements are prepared but a consolidated income tax return is not, IRC §243 allows the Investor to take a 100% dividends received deduction. Accordingly, the temporary difference between consolidated pretax income and taxable income is zero if the Investor assumes the undistributed income will be realized in dividends.

Summary of Temporary Differences of Investees and Subsidiaries

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Separate Financial Statements of Subsidiaries or Investees

Push-down accounting.

ASC 805-50 addressed a number of issues concerning whether the use of a step-up in the income tax basis of an acquired entity, as permitted by the 1982 tax law, mandated the use of push-down accounting, and the necessary allocation of the income tax provision between parent and subsidiaries if a step-up was not elected. Push-down accounting is not required for non-SEC registrants. In addition, if the acquiree continues to report its net assets on their historical basis, three alternative methods of allocating consolidated income tax expense or benefit are acceptable: (1) allocation to the acquiree on the preacquisition basis; (2) crediting the income tax benefit of basis step-up to the acquiree's stockholders' equity upon realization; and (3) crediting the income tax benefit to the income of the acquirer when realized as a permanent difference.

Tax credits related to dividend payments.

Some taxing jurisdictions have differing income tax rates that are applied to taxable income based on whether that income is distributed to investors or retained in the business. For example, Germany taxes undistributed profits at a 45% rate and distributed profits at a 30% rate. When previously undistributed profits are distributed, the taxpayer earns an income tax credit for the differential between the two rates. ASC 740-10-30 specifies that the accounting for the income tax credit in the separate financial statements of the reporting entity paying the dividend is a reduction of income tax expense in the period that the credit is included in its income tax return. During the period of time that the earnings remain undistributed, the rate applied to the temporary difference in computing deferred income taxes is the rate applicable to the undistributed profits (45% in this example).

Asset Acquisitions

ASC 740 established the principle that the income tax effects of temporary differences related to purchase business combinations are to be “grossed up.”

ASC 740-10-25 now provides that in situations where an acquiring entity makes an asset acquisition:

When management recognizes a reduction in the reporting entity's valuation allowance that directly results from the asset acquisition, the reduction is not to enter into the accounting for the asset acquisition. The acquiring entity is to reduce the valuation allowance and either recognize the reduction:
1. As an income tax benefit or
2. As a credit to contributed capital if related to items such as employee stock options, dividends on unallocated ESOP shares, or certain quasi reorganizations.
Any income tax uncertainties existing at the date of acquisition are to be accounted for in accordance with FIN 48.

These specific amendments are to be applied to all asset acquisitions irrespective of when they occurred.

Intraperiod Income Tax Allocation

ASC 740 predominantly deals with the requirements of interperiod income tax allocation (i.e., deferred income tax accounting), but its scope also includes intraperiod income tax allocation. This relates to the matching of various categories of comprehensive income or expense (continuing operations, extraordinary items, corrections of errors, prior period adjustments, etc.) with the income tax effects of those items, as presented in the income (or other financial) statement. The general principle is that the income statement presentation of the effects of income taxes should be the same as items to which the income taxes relate; and in this regard, ASC 740 did not change prior practice. A “with and without” approach is prescribed as the mechanism by which the marginal, or incremental income tax effects of items other than those arising from continuing operations are to be measured. However, under ASC 740 there are some significant departures from past practice, as described in the following paragraphs.

Under prior GAAP, the “with and without” technique was applied in a step-by-step fashion proceeding down the face of the income statement. For example, an entity having continuing operations, discontinued operations, and extraordinary items would calculate income tax expense as follows: (1) Income tax would be computed separately for the aggregate results and for continuing operations. The difference between the two amounts would be allocated to the total of discontinued operations and extraordinary items. (2) Income tax expense would be computed on discontinued operations. The residual amount (i.e., the difference between income tax on discontinued operations and the income tax on the total of discontinued operations and extraordinary items) would then be allocated to extraordinary items. Thus, the amount of income tax expense allocated to any given classification in the statement of income (and the other financial statements, if relevant) was partially a function of the location in which the item was traditionally presented in the income and retained earnings statements.

ASC 740 adopted an incremental calculation of income tax expense to be allocated to classifications other than continuing operations. However, rather than applying successive allocations on the “with and without” basis to determine income tax expense or benefit applicable to each succeeding income statement caption, the income tax effects of all items other than continuing operations are allocated pro rata. That is, once income tax expense or benefit allocable to continuing operations is determined, the residual income tax expense or benefit is apportioned to all the other classifications (discontinued operations, et al.) in the ratios that those other items bear, on a pretax basis, to the total of all such items. Furthermore, income tax expense or benefit on income from continuing operations includes not only income taxes on the income earned from continuing operations, as expected, but also the following items:

The impact of changes in income tax laws and rates, which includes the effects of such changes on items that were previously reflected directly in stockholders' equity (accumulated other comprehensive income), as described more fully below.
The impact of changes in the entity's taxable status.
Changes in estimates about whether the income tax benefits of future deductible temporary differences or net operating loss or tax credit carryforwards are more likely than not to be realizable (i.e., an adjustment to the valuation allowance for such items).
The income tax effects of tax-deductible dividends paid to stockholders, as discussed elsewhere in this chapter.

Under ASC 740, stockholders' equity is charged or credited directly with the initial income tax effects of items that are reported in stockholders' equity without being presented on the income statement. These items include the following:

Corrections of the effects of accounting errors of previous periods.
Gains and losses that are defined under GAAP as being part of comprehensive income but are not reported in the income statement, such as foreign currency translation adjustments under ASC 830, and the fair value adjustments applicable to available-for-sale portfolios of debt and marketable equity securities held as investments. As per ASC 220, the income tax effects of these types of items will be reported in the same financial statement where other comprehensive income items are reported. These items may be reported either in a stand-alone statement of comprehensive income, or a combined statement of income and other comprehensive income, or in an expanded version of the statement of changes in stockholders' equity.
Taxable or deductible increases or decreases in contributed capital, such as offering costs reported under GAAP as reductions of the proceeds of a capital stock offering, but which are either immediately deductible or amortizable for income tax purposes.
Increases in the income tax bases of assets acquired in a taxable business combination accounted for as a pooling of interests under GAAP, if an income tax benefit is recognized at the date of the business combination (i.e., if the income tax effects of existing future deductible temporary differences are not fully offset by a valuation allowance at that date).
Expenses incurred in connection with stock issued under provisions of compensatory stock option plans, which are recognized for income tax purposes but are reported for accounting purposes in stockholders' equity.
Dividends that are paid on unallocated shares held in an ESOP, and that are charged against retained earnings.
Deductible temporary differences and net operating loss and tax credit carryforwards that existed at the date of a quasi reorganization.

The effects of income tax rate or other income tax law changes on items for which the income tax effects were originally reported directly in stockholders' equity are reported in continuing operations, if they occur in any period after the original event. For example, assume the reporting entity recognized a deferred income tax asset related to an employee stock option program amounting to $34,000 in 2012, based on the estimated future income tax deduction it would receive at the then-current and anticipated future income tax rate of 34%. If the statutory income tax rate is reduced to 25% in 2013 before the temporary difference reverses, the adjustment to the deferred income tax asset ($34,000 − $25,000 = $9,000) is reported in income tax expense or benefit applicable to income from continuing operations in 2013.

Comprehensive example of the intraperiod income tax allocation process

Assume $50,000 in future deductible temporary differences at 12/31/12; these differences remain unchanged during the current year, 2013.

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Income tax rates are: 15% on the first $100,000 of taxable income; 20% on the next $100,000; 25% on the next $100,000; 30% thereafter.

Expected future effective income tax rates were 20% at December 31, 2012, but are judged to be 28% at December 31, 2013.

Retained earnings at December 31, 2012, were $650,000.

Intraperiod tax allocation proceeds as follows:

Step 1 —	Income tax on total taxable income of $320,000 ($400,000 − $120,000 + $60,000 − $20,000) is $61,000 computed as follows:
Step 2 —	Income tax on income from continuing operations of $400,000 is $85,000, net of tax credit computed as follows.
Step 3 —	The $24,000 difference is allocated pro rata to discontinued operations, extraordinary gain, and correction of the error in prior year depreciation as follows:
Step 4 —	The adjustment of the deferred income tax asset, amounting to a $4,000 increase due to an effective tax rate estimate change [$50,000 × (.28 − .20)] is allocated to continuing operations, regardless of the source of the temporary difference. A summary combined statement of income and retained earnings for 2013 is presented below.

This example does not include items that will, under provisions of ASC 220, be reported in other comprehensive income.

The income tax effect of a retroactive change in tax rates on current and deferred income tax assets and liabilities is to be determined at the enactment date, using temporary differences and currently taxable income computed as of the date of enactment. The cumulative income tax effect is included in income from continuing operations. Furthermore, the income tax effect of items not included in income from continuing operations (e.g., from discontinued operations) that arose during the current fiscal year and prior to enactment is measured based on the enacted income tax rate at the time the transaction was recognized for financial reporting purposes; the income tax effect of a retroactive change in rates on current or deferred income tax assets or liabilities related to those items is nevertheless included in income from continuing operations (ASC 740-10-45).

Classification in the Statement of Financial Position

Deferred income taxes.

A reporting entity that presents a classified statement of financial position will classify its deferred income tax liabilities and assets as either current or noncurrent consistent with the classification of the related asset or liability. A deferred income tax asset or liability that is not related to an asset or liability for financial reporting purposes, such as the deferred income tax consequences related to a net operating loss carryforward or income tax credit carryforward, is classified based on the expected reversal or utilization date. These classifications must be made for each separate tax-paying component within each taxing jurisdiction.

Within each of the separate components, the current asset and liability are offset and presented as a single amount, with similar treatment for the noncurrent items. Understandably, offsetting is not permitted for different tax-paying components or for different tax jurisdictions. Thus, a statement of financial position may present current and noncurrent deferred income tax assets, along with current and noncurrent deferred income tax liabilities, under certain circumstances.

If the enterprise has recorded a valuation allowance, it must prorate the allowance between current and noncurrent according to the relative size of the gross deferred income tax asset in each classification.

Payment to retain fiscal year.

S corporations and partnerships are permitted to elect tax fiscal years other than a calendar year (IRC §444). If the election is made, however, the electing entity is required to make a payment to the Internal Revenue Service in an amount that approximates the income tax that the stockholders (or partners) would have paid on the income for the period between the fiscal year-end elected and the end of the calendar year. This payment, which is not a tax, is recomputed and adjusted annually and is fully refundable to the electing entity in the future upon liquidation, conversion to a calendar tax year-end or a decline in its taxable income to zero. This “required payment” should be accounted for as an asset, analogous to a deposit (ASC 740-10-55).

Disclosure

ASC 740 is one of a handful of standards that differentiates between public and nonpublic enterprises with respect to the nature and extent of required disclosures. The Appendix, “Disclosure Checklist for Commercial Businesses,” has a list of the interim and year-end disclosures related to income taxes.

Accounting for Income Taxes in Interim Period

Basic rules.

The appropriate perspective for interim period reporting is to view the interim period as an integral part of the year, rather than as a discrete period. This objective is usually achieved by projecting income for the full annual period, computing the income tax thereon, and applying the “effective rate” to the interim period income or loss, with quarterly (or monthly) revisions to the expected annual results and the income tax effects thereof, as necessary.

While the Board chose to not comprehensively address interim reporting when it deliberated ASC 740, there were certain clear contradictions between ASC 270 and the principles of ASC 740, which the Board did address. As discussed in more detail below, these issues were (1) recognizing the income tax benefits of interim losses based on expected net income of later interim or annual periods, (2) reporting the benefits of net operating loss carryforwards in interim periods, and (3) reporting the effects of income tax law changes in interim periods. Other matters requiring interpretation, which were left to the user to address without official guidance, included the classification of deferred income tax assets and liabilities on interim statements of financial position and allocation of interim period income tax provisions between current and deferred income tax expense.

The annual computation of income tax expense is based upon the current income taxes payable or refundable as indicated on the income tax return, plus or minus the adjustment necessary to adjust the deferred income tax asset and liability to the proper balances as of the date of the statement of financial position (including consideration of the need for a valuation allowance, as previously discussed). The computation of interim period income tax expense should be consistent with this asset and liability method.

ASC 740-270 introduced some unfortunate terminology that, although confusing, nevertheless must be understood in the context of interim tax computations. The term “ordinary income” as used in ASC 740-270 is not the same as that term is used in the income tax law to distinguish capital gains, for example, from operating income and deductions. The ASC 740-270 definition of “ordinary income” is, formulaically:

Pretax income or loss from continuing operations

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This “ordinary income” is used as the denominator in calculating an effective income tax rate to be used to compute income tax expense currently payable for the interim period. Note that pretax income is not adjusted for the effects of permanent or temporary differences.

Below is a relatively simple example that illustrates these basic principles.

Basic example of interim period accounting for income taxes

Boffa, Inc. estimates that pretax accounting income for the full fiscal year ending June 30, 2012, will be $400,000. Boffa does not expect to have any of the items that would adjust its “ordinary income” as defined above either at year-end or during any of its interim quarters. The company expects that it will incur $60,000 of meals and entertainment expenses, of which 50% are nondeductible under the current tax law the annual premium on an officer's life insurance policy is $12,000; and dividend income (from a less than 20% ownership interest) is expected to be $100,000. The company recognized income of $75,000 in the first quarter of the year. The deferred income tax liability arises solely in connection with property and equipment temporary differences; these differences totaled $150,000 at the beginning of the year and are projected to equal $280,000 at year-end after taking into account expected acquisitions and disposals for the remainder of the fiscal year. The graduated statutory income tax rate schedule is provided below. Boffa management used a future expected effective income tax rate of 34% to compute the beginning deferred income tax liability and does not anticipate changing that percentage at the end of the fiscal year. The change in the future taxable temporary difference during the first quarter is $30,000.

Boffa must first calculate its estimated effective income tax rate for the year. This rate is computed using all of the tax planning alternatives available to the company (e.g., tax credits, foreign rates, capital gains rates, etc.).

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Computation of the first quarter current income tax expense:

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Computation of the first quarter deferred income tax expense (same method as year-end).

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Finally, the entry necessary to record the income tax expense at the end of the first quarter is as follows:

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In the second quarter, Boffa, Inc. revises its estimate of income for the full fiscal year. It now anticipates only $210,000 of pretax accounting income (“ordinary income”), including only $75,000 of dividend income, because of dramatic changes in the national economy. Other permanent differences are still expected to total $42,000.

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The actual “ordinary income” for the second quarter was $22,000, and the change in the temporary difference was only an additional $10,000. Income tax expense for the second quarter is computed as follows:

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Under ASC 270, and also under the general principle that changes in estimate are reported prospectively (as stipulated by ASC 250), the results of prior quarters are not restated for changes in the estimated effective annual tax rate. Given the current and deferred income tax expense that was recognized in the first quarter, shown above, the following entry is required to record the income taxes as of the end of the second quarter:

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The foregoing illustrates the basic problems encountered in applying GAAP to interim reporting. In the following paragraphs, we discuss some of the items requiring modifications to the approach described in the previous example.

Net operating losses in interim periods.

ASC 740-270 sets forth the appropriate accounting when losses are incurred in interim periods or when net operating loss carryforward benefits are realized during an interim reporting period.

Carryforward from prior years. The interim accounting for the utilization of a net operating loss carryforward is reflected in one of two ways.

If the income tax benefit of the net operating loss is expected to be realized as a result of current year “ordinary income,” that income tax benefit is included as an adjustment to the effective annual tax rate computation illustrated above.
If the income tax benefit of the net operating loss is not expected to be realized as described in item 1, the benefit is allocated first to reduce year-to-date income tax expense from continuing operations to zero with any excess allocated to other sources of income that would provide the means to utilize the net operating loss (e.g., extraordinary items, discontinued operations, etc.).

When a valuation allowance is reduced or eliminated because of a revised judgment, the previously unrecognized income tax benefit is included in the income tax expense or benefit of the interim period in which the judgment is revised. An increase in the valuation allowance resulting from a revised judgment would cause a catch-up adjustment to be included in the current interim period's income tax expense from continuing operations. In either situation, the effect of the change in judgment is not prorated to future interim periods by means of the effective tax rate estimate.

Example of interim-period valuation allowance adjustments due to revised judgment

Camino Corporation has a previously unrecognized $50,000 net operating loss carryforward—that is, Camino had previously established a full valuation allowance for the deferred income tax asset arising from the net operating loss and thus had not previously recognized any deferred income tax benefit associated with the net operating loss; a flat 40% tax rate for current and future periods is assumed. Income for the full year (before net operating loss) is projected to be $80,000, consequently, the management of Camino has revised its judgment as to the future realizability of the net operating loss. In the first quarter Camino will report a pretax loss of $10,000.

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Accordingly, in the income statement for the first fiscal quarter, the pretax operating loss of $10,000 will give rise to an income tax benefit of $10,000 × 40% = $4,000.

In addition, an income tax benefit of $20,000 ($50,000 net operating loss × 40%) is recognized, and is included in the current quarter's income tax benefit relating to continuing operations. Thus, the total income tax benefit for the first fiscal quarter will be $24,000 ($4,000 + $20,000).

If Camino's second quarter results in pretax operating income of $30,000, and the expectation for the full year remains unchanged (i.e., operating income of $80,000), the second quarter income tax expense is $12,000 ($30,000 × 40%).

The income tax provision for the fiscal first half-year will be a benefit of $12,000, as follows:

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The foregoing example assumes that during the first quarter Camino's judgment changed as to the full realizability of the previously unrecognized benefit of the $50,000 loss carryforward. Were this not the case, however, the benefit would have been recognized only as actual tax liabilities were incurred (through current period income) in amounts sufficient to offset the net operating loss benefit.

Example of recognizing net operating loss carryforward benefit as actual liabilities are incurred

To illustrate this latter situation, assume the same facts about net income for the first two quarters, and assume now that Camino's judgment about the realizability of the prior period net operating loss does not change. Tax provisions for the first quarter and first half are as follows:

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Notice that recognition of an income tax benefit of $4,000 in the first quarter is based on the expectation of at least a breakeven full year's results. That is, the benefit of the first quarter's loss was deemed more likely than not. Otherwise, no income tax benefit would have been reported in the first quarter.

Estimated loss for the year. When the full year is expected to be profitable, it is irrelevant that one or more interim periods result in a loss, and the expected effective rate for the full year is used to record interim period income tax expense and benefits, as illustrated above. However, when the full year is expected to produce a loss, the computation of the effective annual income tax benefit rate must logically take into account the extent to which a net deferred income tax asset (i.e., the asset less any related valuation allowance) will be recognized at year-end. For the first set of examples, below, assume that the realization of income tax benefits related to net operating loss carryforwards are not entirely more likely than not. That is, the full benefits will be recognized as deferred income tax assets, but those assets will be offset partially or completely by the valuation allowance.

For each of the following examples we will assume that the Gibby Corporation is anticipating a loss of $150,000 for the fiscal year. The Company's general ledger currently reflects a deferred income tax liability of $30,000; all of the liability will reverse during the fifteen-year carryforward period. Assume future income taxes will be at a 40% rate.

Example 1

Assume that the company can carry back the entire $150,000 net operating loss to the preceding three years. The income tax potentially refundable by the carryback would (remember this is only an estimate until year-end) amount to $48,000 (an assumed amount). The effective rate is then 32% ($48,000/150,000).

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Note that both the income tax expense (2nd quarter) and benefit are computed using the estimated annual effective rate. This rate is applied to the year-to-date numbers just as in the previous examples, with any adjustment being made and realized in the current reporting period. This treatment is appropriate because the accrual of income tax benefits in the first, third and fourth quarters is consistent with the effective rate estimated at the beginning of the year, in contrast to those circumstances in which a change in estimate is made in a quarter relating to the realizability of income tax benefits not previously provided (or benefits for which full or partial valuation allowances were required).

Example 2

In this case assume that Gibby Corporation can carry back only $50,000 of the loss and that the remainder must be carried forward. Realization of future taxable income to fully utilize the net operating loss is not deemed to be more likely than not. The estimated carryback of $50,000 would generate an income tax refund of $12,000 (again assumed). The company is assumed to be in the 40% tax bracket (a flat rate is used to simplify the example). Although the benefit of the net operating loss carryforward is recognized, a valuation allowance must be provided to the extent that it is more likely than not that the benefit will not be realized. In this example, management has concluded that only 25% of the gross benefit will be realized in future years. Accordingly, a valuation allowance of $30,000 must be established, leaving a net of $10,000 as an estimated realizable income tax benefit related to the carryforward of the projected loss.

Considered in conjunction with the carryback refund of $12,000, the company will obtain a $22,000 income tax benefit relating to the projected current year loss, for an effective income tax benefit rate of 14.7%. The calculation of the estimated annual effective rate is as follows:

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In the foregoing, the income tax expense (benefit) is computed by multiplying the year-to-date income or loss by the estimated annual effective rate, and then subtracting the amount of tax expense or benefit already provided in prior interim periods. It makes no difference if the current period indicates an income or a loss, assuming of course that the full-year estimated results are not being revised. However, if the cumulative loss for the interim periods to date exceeds the projected loss for the full year upon which the effective income tax benefit rate had been based, then no further tax benefits can be recorded, as is illustrated above in the benefit for the third quarter.

The foregoing examples cover most of the situations encountered in practice. The reader is referred to ASC 740-270-55 for additional examples.

Operating loss occurring during an interim period. An instance may occur in which the company expects net income for the year and incurs a net loss during one of the reporting periods. In this situation, the estimated annual effective rate, which was calculated based upon the expected net income figure, is applied to the year-to-date income or loss to arrive at year-to-date income tax expense. The amount previously provided is subtracted from the year-to-date expense to arrive at the expense for the current reporting period. If the current period operations resulted in a loss, then the period will reflect an income tax benefit.

Income tax provision applicable to interim period nonoperating items

Unusual, infrequent, or extraordinary items. The financial statement presentation of these items and their related income tax effects are prescribed by ASC 740. Extraordinary items and discontinued operations are to be shown net of their related income tax effects. Unusual or infrequently occurring items are separately disclosed as a component of pretax income, and the income tax expense or benefit is included in the income tax expense from continuing operations. Presenting these items net of tax is strictly prohibited so the reader does not mistake them for extraordinary items.

The interim treatment accorded these items does not differ from the fiscal year-end reporting required by GAAP. However, according to ASC 270, these items are not to be included in the computation of the estimated effective annual income tax rate. The opinion also requires that these items be recognized in the interim period in which they occur rather than being prorated equally throughout the year. Examples of the treatment prescribed by the opinion follow later in this section.

Recognition of the income tax effects of a loss due to any of the aforementioned situations is permitted if the benefits are expected to be realized during the year, or if they will be recognizable as a deferred income tax asset at year-end under the provisions of ASC 740.

If a situation arises where realization is not more likely than not in the period of occurrence but becomes assured in a subsequent period in the same fiscal year, the previously unrecognized income tax benefit is reported in income from continuing operations until it reduces the income tax expense to zero, with any excess reported in those other categories of income (e.g., discontinued operations) which provided a means of realization of the tax benefit.

The following examples illustrate the treatment required for reporting unusual, infrequently occurring, and extraordinary items. Again, these items are not to be used in calculating the estimated annual tax rate. For income statement presentation, the income tax expense or benefit relating to unusual or infrequently occurring items is to be included with ordinary income from continuing operations. Extraordinary items are shown net of their applicable tax provision.

The following data apply to the next two examples:

Irwin Industries expects fiscal year ending June 30, 2012 income to be $96,000 and net permanent differences to reduce taxable income by $25,500.
Irwin Industries also incurred a $30,000 extraordinary loss in the second quarter of the year.

Example 1

In this case, assume that the loss can be carried back to prior periods and, therefore, the realization of any income tax benefit is assured. Based on the information given earlier, the estimated annual effective income tax rate can be calculated as follows:

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No adjustment in the estimated annual effective rate is required when the extraordinary, unusual, or infrequent item occurs. The income tax (benefit) applicable to the item is computed using the estimated fiscal year ordinary income and an analysis of the incremental impact of the extraordinary item. The method illustrated below is applicable when the company anticipates operating income for the year. When a loss is anticipated but realization of benefits of net operating loss carryforwards is not more likely than not, the company computes its estimated annual effective rate based on the amount of tax to be refunded from prior years. The income tax (benefit) applicable to the extraordinary, unusual, or infrequent item is then the decrease (increase) in the refund to be received.

Computation of the income tax applicable to the extraordinary, unusual, or infrequent item is as follows:

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Example 2

Again, assume that Irwin Industries estimates net income of $96,000 for the year with permanent differences of $25,500 which reduce taxable income. The extraordinary loss of $30,000 cannot be carried back and the ability to carry it forward is not more likely than not. Because no net deferred income tax assets exist, the only way that the loss can be deemed to be realizable is to the extent that current year ordinary income offsets the effect of the loss. As a result, realization of the loss is assured only as, and to the extent that, there is ordinary income for the year.

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Discontinued operations in interim periods. Discontinued operations, according to ASC 270, are included as significant, unusual, or extraordinary items. Therefore, the computations described for unusual, infrequent, or extraordinary items will also apply to the income (loss) from the discontinued component of the entity, including any provisions for operating gains (losses) subsequent to the measurement date.

If the decision to dispose of operations occurs in any interim period other than the first interim period, the operating income (loss) applicable to the discontinued component has already been used in computing the estimated annual effective tax rate. Therefore, a recomputation of the total tax is not required. However, the total tax is to be divided into two components.

That tax applicable to ordinary income (loss)
That tax applicable to the income (loss) from the discontinued component.

This division is accomplished as follows: a revised estimated annual effective rate is calculated for the income (loss) from ordinary operations. This recomputation is then applied to the ordinary income (loss) from the preceding periods. The total income tax applicable to the discontinued component is then composed of two items.

The difference between the total income tax originally computed and the income tax recomputed on remaining ordinary income
The income tax computed on unusual, infrequent, or extraordinary items as described above.

Example

Rochelle Corporation anticipates net income of $150,000 during the fiscal year. The net permanent differences for the year will be $10,000. The company also anticipates income tax credits of $10,000 during the fiscal year. For purposes of this example, we will assume a flat statutory rate of 50%. The estimated annual effective rate is then calculated as follows:

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In the third quarter, Rochelle made the decision to dispose of Division X. During the third quarter, the company earned a total of $60,000. Upon reclassification of Division X's property and equipment to “held-for-sale” on its statement of financial position, the company expects to incur a onetime charge to income of $75,000 and estimates that current year divisional operating losses subsequent to the disposal decision will be $20,000, all of which will be incurred in the third quarter. The company estimates revised ordinary income in the fourth quarter to be $35,000. The two components of pretax accounting income (discontinued operations and revised ordinary income) are shown below.

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Rochelle must now recompute the estimated annual income tax rate. Assume that all the permanent differences are related to the revised continuing operations. However, $3,300 of the tax credits were applicable to machinery used in Division X. Because of the discontinuance of operations, the credit on this machinery would not be allowed. Any recapture of prior period credits must be used as a reduction in the income tax benefit from either operations or the loss on disposal. Assume that the company must recapture $2,000 of the $3,300 investment tax credit that is related to Division X.

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The next step is to then apply the revised rate to the quarterly income from continuing operations as illustrated below.

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The tax benefit applicable to the operating loss from discontinued operations and the loss from the asset reclassification and remeasurement must now be calculated. The first two quarters are calculated on a differential basis as shown below.

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The only calculation remaining applies to the third quarter tax benefit pertaining to the operating loss and the loss on reclassification of the assets of the discontinued component. The calculation of this amount is made based on the revised estimate of annual ordinary income both including and excluding the effects of the Division X losses. This is shown below.

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The following income statement shows the proper financial statement presentation of these discontinued operations. The notes to the statement indicate which items are to be included in the calculation of the annual estimated rate.

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¹ The transactions that the IRS has reportedly challenged are commonly referred to as lease in–lease out (LILO) and sale in–lease out (SILO) transactions.

² Note that in certain circumstances, the formulaic approach illustrated will need to be modified or another computational method substituted. Among these circumstances are situations where (1) the reversal of the temporary differences may be realized for income tax purposes in periods with increasing or decreasing tax rates or (2) where future reversal may be treated as different types of taxable or deductible items (e.g., capital gain vs. ordinary income). In addition, if the acquirer's evaluation of the realizability of a deferred income tax asset necessitates establishing a valuation allowance for all or part of a deferred income tax asset, there may be little, if any effect of deferred income taxes on the amount of goodwill recognized, and a trial-and-error method of computation may need to be utilized to determine the amount of the deferred income tax asset to recognize.

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Table of Contents for 44 ASC 740 INCOME TAXES

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44 ASC 740 INCOME TAXES

PERSPECTIVE AND ISSUES

Subtopics

Scope and Scope Exceptions

Overview

DEFINITIONS OF TERMS

CONCEPTS, RULES, AND EXAMPLES

Evolution of Accounting for Income Taxes

ASC 740 in Greater Detail

Temporary and Permanent Differences

Temporary differences.

Temporary differences from share-based compensation arrangements.

Temporary differences arising from convertible debt with a beneficial conversion feature.

Permanent differences.

Treatment of Net Operating Loss Carryforwards

Measurement of Deferred Income Tax Assets and Liabilities

Scheduling of the reversal years of temporary differences.

Determining the appropriate income tax rate.

Computing deferred income taxes.

The Valuation Allowance for Deferred Income Tax Assets Expected to Be Unrealizable

Accounting for Uncertainty in Income Taxes

Background.

Initial recognition and measurement.

Interest.

Penalties.

Subsequent recognition, derecognition, and measurement.

Classification.

Applicability to business combinations.

The Effect of Tax Law Changes on Previously Recorded Deferred Income Tax Assets and Liabilities

General rules.

Enactment occurring during an interim period.

Changes in a valuation allowance for an acquired entity's deferred income tax asset.

Leveraged leases.

Reporting the Effect of Tax Status Changes

Reporting the Effect of Accounting Changes for Income Tax Purposes

Income Tax Effects of Dividends Paid on Shares Held by Employee Stock Ownership Plans

Deferred Income Tax Effects of Changes in the Fair Value of Debt and Marketable Equity Securities

Other guidance on accounting for investments.

Business Combinations

Purchase-method accounting under ASC 805.

Acquisition-method accounting under ASC 805 and ASC 810-10-65.

Tax Allocation for Business Investments

Undistributed earnings of a subsidiary.

Undistributed earnings of an investee.

Separate Financial Statements of Subsidiaries or Investees

Push-down accounting.

Tax credits related to dividend payments.

Asset Acquisitions

Intraperiod Income Tax Allocation

Classification in the Statement of Financial Position

Deferred income taxes.

Payment to retain fiscal year.

Disclosure

Accounting for Income Taxes in Interim Period

Basic rules.

Net operating losses in interim periods.

Income tax provision applicable to interim period nonoperating items

Table of Contents for
44 ASC 740 INCOME TAXES