The tax provision for a given year as computed under
ASC 740 represents not only the amounts currently due, but also the change in the cumulative future tax consequences of items that have been reported for financial reporting purposes in one year and taxable income purposes in another year (i.e., deferred tax). Under
ASC 740, the current and deferred tax amounts are computed separately, and the sum of the two equals the total provision. The total tax expense is meant to match the components of pretax income with their related tax effects in the same year, regardless of when the amounts are actually reported on a tax return. Therefore, it is necessary to determine which filing positions a reporting entity would take based on information available at the time the provision is calculated.
In
ASC 740, the computation of the tax provision focuses on the balance sheet. A temporary difference is created when an item has been treated differently for financial reporting purposes and for tax purposes in the same period, and when it is expected to reverse in a future period and create a tax consequence. The tax effect of these differences, referred to as deferred taxes, should be accounted for in the intervening periods. A deferred tax asset or liability is computed based on the difference between the book basis for financial reporting purposes and the tax basis of the asset or liability.
This asset and liability method, required by
ASC 740, measures the deferred tax liability or asset that is implicit in the balance sheet; it is assumed that assets will be realized, and liabilities will be settled at their carrying amounts. If the carrying amounts of assets and liabilities differ from their tax bases, implicit future tax effects will result from reversals of the book-and tax-basis differences.
The basic
ASC 740 model is applied through the completion of the following five steps:
Step 1: Identify temporary differences. There are two categories of temporary differences: (1) taxable temporary differences that will generate future tax (i.e., deferred tax liabilities) and (2) deductible temporary differences that will reduce future tax (i.e., deferred tax assets). Temporary differences are most commonly identified and quantified by (1) preparing a tax balance sheet and comparing it with the financial statement balance sheet and (2) reviewing the reconciliation of book income with taxable income.
Step 2: Identify tax loss carryforwards and tax credits. A reporting entity may have US federal, state and local, and foreign tax loss carryforwards and certain tax credits. Tax loss carryforwards typically include net operating losses (NOLs) and capital losses, which, depending on the relevant jurisdiction’s applicable tax law, may be carried back to prior periods and/or forward to future periods to offset taxable income. Tax credits may include research and development credit (R&D credit), foreign tax credits, the US federal corporate alternative minimum tax credit (CAMT credit), investment tax credits, and other tax credits. Tax credits generally provide a “dollar-for-dollar” benefit against taxes payable.
Step 3: Determine the tax rate to apply to temporary differences and loss carryforwards. The applicable tax rate is the rate, based on enacted tax law, that will be in effect in the period in which temporary differences reverse or are settled.
TX 4.3 discusses several factors that should be considered in determining the applicable rate.
Step 4: Calculate deferred tax assets and liabilities. For gross temporary differences and tax loss carryforwards, this entails multiplying the gross balance by the applicable tax rate. Tax credits generally provide a “dollar-for-dollar” benefit and therefore are already tax-effected.
Step 5: Evaluate the need for a valuation allowance. Under
ASC 740, deferred tax assets resulting from deductible temporary differences, loss carryforwards, and tax credit carryforwards must be recorded, and then subjected to a test for realizability. A valuation allowance must be established for deferred tax assets if it is “more-likely-than-not” that they will not be realized.
TX 5 discusses the valuation allowance assessment in detail.