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5.8 Scheduling future taxable income
Publication date: 31 Dec 2023
us Income taxes guide
Scheduling future taxable income, if carried to its full extent, involves extensive number-crunching. At the extreme, it would be tantamount to estimating what the tax return would look like for each future year in which temporary differences reverse.
When is scheduling future taxable income necessary? The simple answer is: when it matters. Scheduling is important when the assessment of the appropriate valuation allowance or the applicable tax rate could vary materially depending on relatively minor shifts in the timing of taxable income. For example, scheduling will generally have to be considered in the following situations:
- The realization of the deferred tax asset is dependent upon future reversals of existing taxable temporary differences. In other words, there is a deferred tax asset, but the likelihood of future taxable income from sources other than reversing taxable differences does not provide sufficient assurance of realization to avoid a valuation allowance. ASC 740 requires that projections of future taxable income must consider all years that may provide a source of taxable income for the realization of deferred tax assets. The entity must determine to what extent reversals of taxable temporary differences ensure realization through offsetting. This situation could occur not only when future prospects are marginal or worse, but also in jurisdictions where carryback and carryforward periods are relatively limited, future results are expected to be erratic, or there is a limitation on the use of certain tax attributes. For example, certain states limit the amount of NOL available in any one period. Another example is when a jurisdiction limits interest deductions in any one period (e.g., the 163(j) interest limitation in the United States).
- A change in the tax rate is enacted but will not take effect until a future year. The entity must determine the amount of temporary differences for which the current tax rates are applicable and the amount of temporary differences for which the rates enacted for the future will be applicable. Refer to TX 7 for guidance on changes in tax rates.
Example TX 5-16 discusses the realizability considerations when there are certain income limitations and various sources of income being assessed.
EXAMPLE TX 5-16
Evaluating the realizability of deferred tax assets including interest expense carryforwards
Evaluating the realizability of deferred tax assets including interest expense carryforwards
Company A is assessing the realizability of its deferred tax assets as of December 31, 20X1 for a particular jurisdiction. Company A has the ability to reliably forecast its results but due to the magnitude of its interest expense ($800 per year), the company generates a pretax loss of $200 per year. It has no permanent differences.
Company A has a net operating loss of $800 that does not expire and is not subject to any taxable income limitations when used. Its other tax attribute relates to interest expense that is not currently deductible. The interest carryforward of $300 does not expire. Interest expense deductions each year are limited to 30% of Adjusted Taxable Income (ATI), which for this jurisdiction equates to taxable income before interest deductions. Company A expects to continue to generate new interest carryforwards each year for the foreseeable future. Neither the net operating losses nor the interest carryforward can be carried back.
Company A also has a taxable temporary difference of $300 related to a finite-lived intangible asset that has book basis but no tax basis. The taxable temporary difference will reverse in equal amounts over the next three years as the intangible asset is amortized. Company A also has a taxable temporary difference of $400 related to goodwill, which will not reverse until the business is sold or the goodwill is impaired.
Company A has not identified any prudent and feasible tax-planning strategies.
How should Company A assess whether it needs a valuation allowance?
Analysis
Company A has two potential sources of future taxable income to consider—reversals of existing taxable temporary differences and forecasts of future taxable income (exclusive of reversing temporary differences and carryforwards). ASC 740-10-30-18 states, “[t]o the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered. Consideration of each source is required, however, to determine the amount of the valuation allowance that is recognized for deferred tax assets.”
Company A’s taxable temporary differences are not sufficient to realize all of its tax attributes. Therefore, it must consider whether it can forecast future taxable income. Although it is expecting to continue to generate a pretax loss, Company A can reliably forecast future taxable income (after taking into account the interest deduction limitation) as shown in the chart below. Therefore, Company A can reliably forecast future taxable income and should consider it as a source of taxable income.
Forecast |
||||
20X1 |
20X2 |
20X3 |
20X4 |
|
Taxable income: |
||||
Pretax loss |
(200) |
(200) |
(200) |
|
Reversal of taxable temporary difference on intangibles |
100 |
100 |
100 |
|
Add back: Interest expense |
800 |
800 |
800 |
|
Adjusted taxable income (ATI) |
700 |
700 |
700 |
|
Interest deduction (limited to 30% of ATI) |
(210) |
(210) |
(210) |
|
Taxable income |
490 |
490 |
490 |
|
NOL utilization |
(490) |
(310) |
0 |
|
Ending deferred tax balances (gross): |
||||
NOL carryforward |
800 |
310 |
0 |
0 |
Interest carryforward |
300 |
890 |
1,480 |
2,070 |
Total deductible temporary differences and carryforwards |
1,100 |
1,200 |
1,480 |
2,070 |
Taxable temporary difference - Intangibles |
(300) |
(200) |
(100) |
0 |
Taxable temporary difference - Goodwill |
(400) |
(400) |
(400) |
(400) |
Net deferred tax asset (gross) |
400 |
600 |
980 |
1,670 |
NOL realizable (from utilization above) |
(800) |
|||
Interest carryforward realizable (30% of DTL on Goodwill) |
(120) |
|||
Valuation allowance needed ($300 interest carryforward less $120 of future taxable income from goodwill temporary difference) |
180 |
|||
Company A concludes that it needs a valuation allowance of $180 (gross). Of its $1,100 in deductible temporary differences and carryforwards at December 31, 20X1, $920 (all of the NOL and $120 of the interest carryforward) is realizable. The remainder ($180) of the interest carryforward requires a valuation allowance.
Even though Company A will continue to generate additional interest carryforwards as evident in the forecast based on Company A’s existing operating and financial structure, the existing taxable temporary difference for goodwill is available as a source of income for the interest carryforward (since both are indefinite-lived), albeit limited by the 30% taxable income limitation for the interest carryforward under the tax law. Consistent with ASC 740-10-30-18, this source of income cannot be ignored. If the facts were different and Company A could not reliably forecast future taxable income, then only the taxable temporary differences from goodwill and intangibles would serve as a source of realization for the tax attributes. Company A would have to schedule the reversal of its taxable temporary difference for intangibles to determine how much realization it provides for the NOL and interest carryforward annually. Once that scheduling was done, Company A would then determine how much realization the taxable temporary difference for goodwill would provide for each DTA. The potential origination of additional interest carryforwards would not be considered in this fact pattern. Origination of new temporary differences is only considered if a company can forecast future taxable income.
5.8.1 General approach to scheduling
There are two basic approaches to the scheduling exercise. The approach used depends on whether a company can rely on forecasted taxable income.
Company cannot reliably forecast taxable income
If a company cannot reliably forecast taxable income, items considered in the scheduling exercise include only reversals of temporary differences, actual carryback availability, and available strategies. This approach does not consider future originating differences and is typically used when a company is not able to rely on projections of future taxable income. Therefore, the precision of the scheduling of reversals becomes critical. This approach also requires consideration of the extent to which carryback availability provides assurance of realization.
An abbreviation of this approach — a scheduling of reversals of temporary differences only — also could be used to determine the amount of reversals that will occur before and after an enacted future rate change when taxable income is expected in each future year.
Company is able to reliably forecast future taxable income
This approach is the same as the first approach, except that it considers estimated future taxable income (including future originating differences). When it is not clear whether all deductible differences and carryforwards will be used, this approach can be used to estimate the amount that will expire unused. It may also be employed to determine the applicable rate when enacted future rate changes and carrybacks from future years exist.
While the following discussion is in the context of full-scale scheduling and detailed deferred tax computations, reasonable approaches to aggregate temporary differences may be sufficient in many cases. For example, when there is a loss carryforward that expires in 10 years, the question may be the amount of reversals that will occur during the remainder of the carryforward period, and year-by-year scheduling will be unnecessary.
Example TX 5-17 demonstrates a high-level scheduling exercise for determining whether future taxable income including reversals supports the realization of a company’s deferred tax assets.
EXAMPLE TX 5-17
Example of scheduling resulting in an unused deduction
Example of scheduling resulting in an unused deduction
At the end of 20X0, Company A has taxable temporary differences related to property of $5,000, which will reverse at a rate of $500 per year over the next 10 years. Company A also has deductible temporary differences related to OPEB of $5,000, which reverse at the rate of $250 per year over the next 20 years. Expected taxable income, excluding the reversals of temporary differences, is $100 per year. There are no available tax-planning strategies or existing carryforwards, and any NOLs generated can be carried forward for 10 years.
Does Company A need to record a valuation allowance?
Analysis
As indicated in the following scheduling exercise, after considering the 10-year carryforward period of the losses created after the first 10 years, and $100 of taxable income expected in years 21 through 30, $500 of the deductible temporary difference originally related to the OPEB deductions would not offset any taxable income. Since there are no available tax-planning strategies and no remaining source of future taxable income, a valuation allowance for $500 representing the deductible temporary differences that will reverse in years 11 through 20 without a source of income should be recorded. If the facts were changed such that any losses created could be carried forward indefinitely, then no valuation allowance would be required since there is available taxable income excluding the reversals of temporary differences.
Years 1 through 10 |
Years 11 through 20 |
Years 21 through 30 |
|
Deductible temporary difference reversals |
$(250) |
$(250) |
$— |
Taxable temporary difference reversals |
500 |
— |
— |
Expected future taxable income other than reversals |
100 |
100 |
100 |
Expected taxable income/(loss) per year |
350 |
(150) |
100 |
× 10 yrs. |
× 10 yrs. |
× 10 yrs. |
|
3,500 |
(1,500) |
1,000 |
|
Carryforward from years 11 through 20 to years 21 through 30 |
— |
1,000 |
(1,000) |
$3,500 |
$(500) |
$— |
The $500 of unused deductions consists of $50 in each of years 11 through 20.
This example suggests a level of precision in estimates of future taxable income on a year-by-year basis. Even if estimates are made for distant future years on a year-by-year basis, such forecasts are inherently imprecise. However, when it is necessary to estimate the deductible differences or carryforwards that will not be used, an overall estimate would follow the approach illustrated.
5.8.2 Patterns of temporary difference reversals
Scheduling temporary differences can be extremely technical. For each class of temporary differences, the pattern of reversal must be determined. ASC 740-10-55-15 through ASC 740-10-55-22 acknowledges that in many cases, there is more than one logical approach. It further notes that the consideration of reversal patterns is relevant primarily in assessing the need for a valuation allowance. Judgment is critical in that assessment, and attempts at precision in predicting future taxable income other than reversals, would be pointless. The guiding concepts in determining reversal patterns are discussed in ASC 740-10-55-13 through ASC 740-10-55-14.
The particular years in which temporary differences result in taxable or deductible amounts are generally determined by the timing of the recovery of the related asset or settlement of the related liability. The tax law determines whether future reversals of temporary differences will result in taxable and deductible amounts that offset each other in future years.
In addition, ASC 740-10-55-15 through ASC 740-10-55-22 provides some ground rules:
- The methods used for determining reversal patterns should be systematic and logical.
- Minimizing complexity is an appropriate consideration in selecting a method.
- The same method should be used for all temporary differences within a particular category of temporary differences for a particular tax jurisdiction.
- The same method for a particular category in a particular tax jurisdiction should be used consistently from year to year.
“Category” is not defined in the guidance but two examples are cited: (1) liabilities for deferred compensation and (2) investments in direct financing and sales-type leases. Different methods may be used for different categories of temporary differences. If the same temporary difference exists in two tax jurisdictions (e.g., US federal and a state tax jurisdiction), the same method should be used for that temporary difference in both tax jurisdictions. See ASC 740-10-55-22.
A change in method is a change in accounting principle subject to the guidance in ASC 250, Accounting Changes and Error Corrections. Such a change, if material in its effects, would have to be justified as a change to a preferable method, and an SEC registrant would be required to obtain a preferability letter from its independent auditors.
The remaining sections discuss scheduling concepts related to common types of temporary differences, though they do not cover all possible types of temporary differences.
5.8.2.1 Scheduling depreciable and amortizable assets
Only reversals of temporary differences that exist at the balance sheet date would be scheduled. As indicated in ASC 740-10-55-14, the future originations and their reversals would be part of future taxable income, but would not be considered as part of the scheduling exercise for reversing differences. Example TX 5-18 illustrates scheduling the reversal of temporary differences related to depreciable assets.
EXAMPLE TX 5-18
Scheduling reversals of temporary differences—depreciable assets
Scheduling reversals of temporary differences—depreciable assets
At December 31, 20X0, Company A has a $12,000 taxable temporary difference related to a depreciable asset with a future pattern of depreciation expense as follows:
Basis difference at Jan. 1 |
Book depreciation |
Tax depreciation |
Difference |
|
20X1 |
($12,000) |
$2,400 |
$5,000 |
($2,600) |
20X2 |
(14,600) |
2,400 |
5,000 |
(2,600) |
20X3 |
(17,200) |
2,400 |
2,000 |
400 |
20X4–20Y0 ($2,400 book depreciation each year) |
(16,800) |
16,800 |
— |
16,800 |
Total |
$— |
$24,000 |
$12,000 |
$12,000 |
Under ASC 740, the $12,000 temporary difference would be deemed to reverse as follows:
20X1 |
20X2 |
20X3 |
20X4–20X7 ($2,400 each year) |
20X8 |
|
Depreciable asset |
— |
— |
$400 |
$9,600 |
$2,000 |
How should the reversal of the temporary difference be considered in the scheduling exercise?
Analysis
The origination of the additional $5,200 temporary difference in 20X1 and 20X2 and its reversal in 20X8 through 20Y0 would not be considered to be part of the reversal of the temporary difference existing at the balance sheet date. They would instead be considered as part of future taxable income other than reversals.
We believe that the following methods of categorizing temporary differences for determining reversal patterns may be used:
- Asset-by-asset approach
- Asset category (e.g., buildings)
- Total property, plant, and equipment category
To the extent certain assets within a particular category are indefinite-lived assets for financial reporting purposes (e.g., land, goodwill, indefinite-lived intangibles), we believe that as a general rule when assessing the need for a valuation allowance, those assets should be isolated and the reversal of taxable temporary differences associated with them not scheduled. For example, in assessing the need for a valuation allowance, a taxable temporary difference associated with land that there is no present plan to dispose of should not be offset against deductible temporary differences associated with depreciable plant and equipment. Refer to TX 5.5.1 for further guidance on “naked credits.”
Nonamortizable tax intangibles (other than goodwill)
In business combinations in which the tax basis of the acquired entity’s assets and liabilities is stepped up, tax basis may have been assigned to identifiable intangible assets other than goodwill. In some taxing jurisdictions, the intangibles may not be amortizable for tax purposes, even though they may be for book purposes. In these circumstances, the laws of the particular taxing jurisdiction would need to be considered to assess whether the recovery of the tax basis of the intangibles is allowed other than through a disposition or liquidation of the entire business—for example, whether the tax basis can be recovered by disposition or abandonment of just the intangible asset. If the basis can be recovered, entities should consider the appropriate tax rate to apply to gains and losses resulting from the relevant disposal options.
While these assets may seem similar to goodwill, they are different in their nature and do not represent a residual. In future periods, book amortization will give rise to a temporary difference for the excess tax basis, and a deferred tax asset will be recognized for the deductible temporary difference. While there may be no plans for sale or disposition of the intangibles, and it would not be expected to occur (if at all) before some distant future year, under the ASC 740 comprehensive allocation system, reversal of the temporary difference would be assumed. The question is whether a valuation allowance must be established.
To the extent that a loss on the sale of the intangible asset is expected, the company needs to consider whether there will be sufficient future taxable income of appropriate character available to realize the loss.
5.8.2.2 Scheduling assets or liabilities measured at present value
Many assets and liabilities are measured at present value for book purposes. This broad grouping includes many financial instruments (e.g., loans receivable and long-term debt), leases that are capitalized by the lessee or recorded as receivables by the lessor, most accruals for individual deferred compensation contracts, and OPEB obligations. We believe there are two basic approaches for scheduling the reversal of temporary differences related to assets and liabilities that are measured at present value: the loan amortization method and the present value method.
With respect to an asset or liability measured at present value, the aggregate future cash payments will exceed the principal balance at the balance sheet date, and the difference between the two scheduling methods involves the portion of future cash payments expected in each future year that is deemed to recover or settle the principal balance at the balance sheet date.
The two approaches are termed the loan amortization method and the present value method. Under the loan amortization method, future payments are considered to apply first to accrued interest, with the balance applied to principal. The application to principal would cause the reversal of the basis difference. Under this method, when payments are level, annual reversals will increase each year. This model mirrors the model used generally in financial statements in accounting for assets and liabilities measured at present value (i.e., the reversal amount for each future year will be the amount by which the recorded asset or liability is expected to be reduced in that year). The recorded asset (liability) may be expected to increase in a future year if the payments receivable (payable) in that year will be less than the interest income (expense) expected to accrue. Therefore, no reversal would be deemed to occur in that year.
The present value method assigns to each reversal year the present value at the balance sheet date of the payment to be made in that year. When payments are level, annual reversals will decrease each year. The present value method can be viewed as considering each required future payment as a separate zero-coupon asset or liability, with all interest accruing unpaid from the balance sheet date to the payment date. In contrast, the loan amortization method (and the financial statement model) emphasizes that the series of payments constitutes a single contract.
The results of the loan amortization method and the present value method are illustrated in Example TX 5-19.
EXAMPLE TX 5-19
Scheduling reversals of temporary differences—assets and liabilities measured at present value
Scheduling reversals of temporary differences—assets and liabilities measured at present value
On December 31, 20X1, Company X records an asset in the amount of $614,457. This amount represents the present value, using a 10% interest rate, of 10 payments due of $100,000 on December 31 of each of the next 10 years.
How would the reversal patterns differ under the loan amortization method vs. the present value method?
Analysis
The reversal for 20X2 under the loan amortization method would be based on the allocation of the 20X2 payment ($100,000) first to interest ($61,446) ($614,457 × 10%) and the remainder to principal ($38,554). A similar allocation would be made for each subsequent year.
In contrast, under the present value method, the reversal assigned to 20X2 would be the present value at December 31, 20X1 of the payment to be made on December 31, 20X2, which is calculated to be $90,909. A similar calculation would be made for each subsequent year using a present value formula (not shown in this example).
The reversal patterns under the two methods would be as follows:
Year |
Loan amortization |
Present value |
|
20X2 |
$38,554 |
$90,909 |
|
20X3 |
42,410 |
82,645 |
|
20X4 |
46,651 |
75,131 |
|
20X5 |
51,316 |
68,302 |
|
20X6 |
56,447 |
62,092 |
|
20X7 |
62,092 |
56,447 |
|
20X8 |
68,302 |
51,316 |
|
20X9 |
75,131 |
46,651 |
|
20Y0 |
82,645 |
42,410 |
|
20Y1 |
90,909 |
38,554 |
|
Total |
$614,457 |
$614,457 |
Note that when the asset or liability requires a series of level payments from the balance sheet date until liquidation, the reversal pattern derived under the loan amortization method is the exact reverse of that derived under the present value method.
It generally will be easier to apply the loan amortization method because the reversal amounts are usually consistent with the financial statement amounts. Accordingly, the amounts may be readily available, and the reversals deemed to occur in future years for a particular asset or liability may not change from year to year. Application of the present value method, by contrast, may require computations to be made solely to determine the reversals. Further, the reversal deemed to occur in any specific future year for any particular asset or liability will change from year to year. This occurs because, as the period between the balance sheet date and the future year decreases, the discount to present value also decreases, and the reversal deemed to occur in that future year increases.
While both may be acceptable, whichever method is selected must be used consistently.
Financial instruments
Scheduling reversals of temporary differences associated with financial instruments varies depending on how the financial instrument is valued for book and tax purposes.
Carried at amortized cost for both book and tax
The selected method—loan amortization or present value, discussed in TX 5.8.2.2—is applied separately to the book basis and to the tax basis of the financial instrument. Application to book basis would use the interest rate embedded in the book accounting, and application to tax basis would use the interest rate implicit in the tax accounting. In effect, the reversal of the temporary difference at the balance sheet date that is deemed to occur in each future year is the difference between the recovery in that year under the selected method of the book basis and of the tax basis.
In general, the reversal pattern under the loan amortization method would track the change in the temporary difference, assuming neither the book nor the tax balance increases during any year. However, for a loan receivable with a tax basis equal to the principal amount, a lower book basis, and the entire principal due at maturity, the amortization method would schedule the reversal of the entire temporary difference in the year of maturity since it is only in that year that recovery of (reduction in) the tax basis occurs. The amount of the temporary difference would change each year and, accordingly, the amount of the reversal deemed to occur in the year of maturity also would change in each year’s deferred tax calculations.
We believe that it also would be an acceptable application of the loan amortization method under ASC 740 to consider the reversals of the temporary difference at the balance sheet date to occur as the book basis is accreted to the principal amount and the temporary difference is correspondingly reduced. Under this approach, the expected future book interest income in excess of taxable interest income in each future year would be deemed to result in a tax deduction in that year. Even though actual tax deductions are not expected to occur in this pattern, the pattern would reflect the book income expected to be recognized without being reported as taxable income.
There are situations (e.g., marketable bonds) when the discount or premium for tax purposes is amortized on a straight-line basis or is not amortized at all. We believe that it would be reasonable in such cases to consider the temporary difference to reverse in the pattern in which the discount or premium is expected to be reduced for book purposes.
ASC 310, Receivables, requires amortization of certain net fees or costs (i.e., those related to revolving lines of credit) on a straight-line basis. Assuming that the net fees or costs were taxable (deductible) on loan origination, we believe it would be appropriate to schedule deductions (taxable income) based on expected book amortization.
Carried at amortized cost for book and fair value for tax
Debt securities that are held-to-maturity and carried at amortized cost under ASC 320, Investments–Debt Securities, but marked to market for tax, have a temporary difference reversal pattern that may be problematic. Because the security is classified as held-to-maturity, the premium or discount for tax purposes will be presumed to disappear over the remaining life of the instrument, but it will not amortize in any systematic pattern. Rather, the market value/tax basis will change as a result of the shortening of the period to maturity, changes in market interest rates, and changes in the issuer’s credit standing. For purposes of determining the reversal pattern, we believe it is reasonable to assume that market interest rates and the issuer’s credit standing will remain unchanged to maturity. The reversal pattern would be determined as though tax reporting in the future were to be based on amortized cost using the balance-sheet-date tax basis as amortized cost at that date. The reversal in each future year would be determined as the difference between the recovery of book basis and the recovery of tax basis assigned to that year under the method (loan amortization or present value) elected for the category of temporary differences in which the security is included.
Carried at fair value for book and amortized cost for tax
When a security is carried at market under ASC 320, but at cost or amortized cost for tax purposes, the reversal pattern will depend on management’s intentions and expectations. For example, we believe that it would not be prudent to anticipate changes in market prices in determining reversal patterns. Accordingly, the timing of the reversal of the balance-sheet-date unrealized appreciation or depreciation of a debt security should correspond to the period in which management intends to sell the security, and should be consistent with the operating plans of the entity.
On the other hand, when a debt security is classified as available-for-sale, but management has no particular expectation that it will be sold prior to maturity, the best approach may be to assume that the security will be held to maturity and that market interest rates and the issuer’s credit standing will remain unchanged. The reversal pattern then would be determined as if the security were to be carried at amortized cost in the future for book purposes using the balance-sheet-date market value as amortized cost at that date. The reversal in each future year would be determined as the difference between the recovery of book basis and the recovery of tax basis assigned to that year under the method (loan amortization or present value) elected for the category of temporary differences in which the security is included.
A company may expect to sell a debt security within the next few years but considerably in advance of its scheduled maturity. In this situation, we believe it is reasonable for the reversal pattern to mirror the pattern suggested for a debt security for which there is no particular expectation for sale; the balance of the temporary difference reversal should be assigned to the year in which sale is expected.
Leases
When a lessor records its investment in leased property as a sales-type or direct-financing lease, the book asset is measured at present value, and the accounting is similar to that for a loan receivable. The lessor accrues interest on its investment and applies lease payments to reduce it. An operating lease results in the recognition of lease income on a straight-line basis, while the underlying leased asset remains on the lessor’s balance sheet and continues to depreciate. If the agreement qualifies as a lease for tax purposes, the lessor owns a depreciable asset and depreciates the tax basis as permitted by the tax law.
Under ASC 842, a lessee that records a right-of-use asset and lease obligation will amortize the asset over the lease term (or shorter useful life) in its financial statements. The liability is measured at present value, and the lessee accrues interest on the recorded obligation and applies lease payments to reduce it. However, if the agreement is a lease for tax purposes, the lessee is entitled to tax deductions for the full amount of its lease payments.
The accounting described in the preceding paragraphs for both the lessor and lessee is the result of a single transaction, a lease. However, both have two temporary differences. The lessor in a direct-financing or sales-type lease has an investment in the lease (an asset measured at present value) for book purposes with no tax basis, and a separate temporary difference related to the property recorded for tax purposes with no book basis. The lessee has both a right-of-use asset and a lease liability for book purposes, each with a tax basis of zero.
It is important to track the two temporary differences separately for purposes of disclosure and due to a potential impact on valuation allowance assessments. A lessor would include in its deferred tax assets the amount related to the tax basis of its depreciable property. In its deferred tax liabilities, the lessor would include the amount related to taxable income to be reported on collection of its lease payments, which are deemed to be the recovery of its investment in the leased property. The lessee would include in deferred tax assets the amount for the future deductions for lease payments, which are deemed to reduce the lease liability. In its deferred tax liabilities, the lessee would include the amount for future taxable income equal to the amortization of its right-of-use asset. In terms of disclosure, as discussed in FSP 16.3, gross deferred tax assets and gross deferred tax liabilities must be disclosed.
The other reason to track the two temporary differences separately is to understand how the reversal pattern of the temporary differences impacts future taxable income, which could impact the measurement of valuation allowances.
Deferred compensation
For deferred compensation contracts with individual employees other than pensions and OPEBs, the accrued liability may represent the present value at the balance sheet date of stipulated payments scheduled to commence upon an employee’s retirement. Under the present value method, reversals are deemed to occur equal to the present value of payments to be made in each future year.
The loan amortization method assumes that any benefit payment applies first to interest accrued after the balance sheet date, including the interest from the balance sheet date to the retirement date, as well as the interest accruing between the retirement and payment dates. Under this approach, only a portion of payments due in the later payment years relates to the liability accrued at the balance sheet date.
In some cases, the present value at retirement of expected deferred compensation payments is accrued by straight-line charges over the period to retirement. Under ASC 715, Compensation—Retirement Benefits, the present value of the deferred compensation payments must be fully accrued at the “full eligibility date,” which may precede the retirement date. For simplicity, this discussion assumes those dates are the same.
Even when the accrual of the liability prior to the retirement date is not interest-adjusted, in concept the liability is measured at present value. This is why it is appropriate to apply either the loan amortization method or the present value method to expected actual future payments to determine the reversal pattern of the liability that will be accrued at the retirement date. Those reversals would be deemed to relate to the accrued liability at the balance sheet date based on the ratio of the accrued liability to the expected liability at the retirement date.
When payments will be made for the remaining life of the employee rather than for a stipulated period, the actuarial assumption used in providing the accrual also should be used in estimating the timing of the payments. The method of payment (lump sum versus annuity), as well as early or late retirement options, may be at the employee’s election. Absent any data on likely employee options that are expected to be selected, management judgment will be required.
Pensions
Accounting for pensions under ASC 715 can give rise to a number of temporary differences. In general, there will be no pension asset or liability for tax purposes. Deductions are generally available for qualified arrangements when cash contributions are made. The pension asset or liability for financial reporting thus will constitute a temporary difference.
Because the accounting model for pensions estimates future benefit payments and discounts them to present values, at first it might seem appropriate to consider any pension an asset or liability to be measured at present value for purposes of determining reversal patterns. Further, the ASC 715 model for OPEBs is based on the model for pensions, and we consider the recorded OPEB obligation to be a liability measured at present value as discussed above. However, because pension obligations typically are funded in advance to some extent, the US federal tax code provides for a tax deduction at the time of the funding, not at the time of the future benefit payment. As such, we do not believe the use of the loan amortization method or the present value method is appropriate under ASC 740 for pension-related deferred tax balances. Contrast this with OPEBs, where the US Federal tax code provides for a tax deduction upon direct payment to the individual (as it is unfunded). Because of the timing of OPEB tax deductions, we believe that use of the loan amortization or present value methods would be appropriate.
We believe that it is appropriate to base the reversal of a pension asset or liability on estimates of how and when the recorded asset or liability actually will be reduced. If it is expected that there will be increases in the recorded asset or liability before reductions occur, those would be ignored. The first reductions anticipated would be deemed to apply to the asset or liability existing at the balance sheet date. This approach is similar to that for depreciable assets, when increases in the temporary difference are ignored and reversals are applied on a FIFO basis. Predictions of future events will be very important in estimating the pension reversal pattern.
There may be circumstances in which it would be difficult to estimate when reduction of the pension temporary difference will occur with any level of precision. The FASB provided a pragmatic approach, which might be reasonable depending on the entity’s circumstances. Under this approach, the temporary difference is deemed to reverse pro rata over the average remaining service life of employees expected to receive benefits under the plan. If all or almost all participants are inactive, the temporary difference is deemed to reverse pro rata over their average remaining life expectancy.
If the circumstances are such that a prepaid pension asset is not expected to reverse for the foreseeable future, the associated deferred tax liability should be treated similar to other “naked credits.” Therefore, the taxable temporary difference should not be considered a source of taxable income to support realization of deferred tax assets that have a scheduled reversal pattern or attributes that are otherwise subject to expiration. See TX 5.5.1 for further discussion of naked credits.
5.8.2.3 Scheduling deferred revenue or income
The existence of deferred revenue indicates that a future sacrifice will be required in order to earn the revenue, and that sacrifice is measured by the amount of the deferred revenue. For purposes of considering its reversal pattern, consider the deferred revenue a liability that will be settled by a deductible cash payment in the period recognized.
5.8.2.4 Scheduling sale-leasebacks
The gain on a sale-leaseback is a type of deferred income. It is not uncommon for capital gains tax to be incurred on sales of real estate. Any benefit of a lower capital gains rate would be reflected in the current tax provision, and the deferred gain would be a deductible temporary difference. The deferred gain is deemed to reverse as ordinary deductions occur (i.e., the excess of future ordinary deductions for lease payments over future book expense, whether rent in an operating lease or depreciation in a capital lease).
5.8.2.5 Scheduling reserves for bad debts and loan losses
For specific reserves for bad debts, reversal will occur in the future year when the receivable is expected to be charged off. However, when an allowance for loss on a loan is based on present value measurements under ASC 310, the increase in the present value may be recognized with the passage of time. If so, this would indicate that the pattern of reversal of deductible temporary differences would be determined as discussed for financial instruments in TX 5.8.2.2 (i.e., using the loan amortization or present value method).
Unallocated reserves cannot be associated with an individual loan or trade receivable. Estimates of reversals should be based on management’s best estimate of when receivables or loans outstanding at the balance sheet date will result in actual charge-offs for tax purposes. For financial institutions to assume the sale or exchange of loans (to generate deductions), the loans would have to be carried at the lower of cost or market value. The carrying amount would consider the loan-loss reserves to the extent that they have been provided to cover losses on sales or swaps.
5.8.2.6 Scheduling contract accounting
The percentage-of-completion method typically will be used for both book and tax purposes in accounting for contracts. However, the tax law measures completion of a contract on the basis of a cost-to-cost analysis and incorporates a number of accounting conventions, which may result in significant differences from the method employed for financial reporting. This temporary difference may originate over several periods and reverse over several periods. Reversals would be determined by estimating all future book and tax amounts. The accumulated differences at the balance sheet date would reverse in the first years in which the differences run in the opposite direction.
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