1.3 Objectives of ASC 740
ASC 740-10
10-1 There are two primary
objectives related to accounting for income taxes:
- To recognize the amount of taxes payable or refundable for the current year
- To recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns.
As it relates to the second objective, some
events do not have tax consequences. Certain revenues are
exempt from taxation and certain expenses are not
deductible. In some tax jurisdictions, for example, interest
earned on certain municipal obligations is not taxable and
fines are not deductible.
10-2 Ideally, the second objective
might be stated more specifically to recognize the expected
future tax consequences of events that have been recognized
in the financial statements or tax returns. However, that
objective is realistically constrained because:
- The tax payment or refund that results from a particular tax return is a joint result of all the items included in that return.
- Taxes that will be paid or refunded in future years are the joint result of events of the current or prior years and events of future years.
- Information available about the future is limited. As a result, attribution of taxes to individual items and events is arbitrary and, except in the simplest situations, requires estimates and approximations.
10-3 Conceptually, a deferred tax
liability or asset represents the increase or decrease in
taxes payable or refundable in future years as a result of
temporary differences and carryforwards at the end of the
current year. That concept is an incremental concept. A
literal application of that concept would result in
measurement of the incremental tax effect as the difference
between the following two measurements:
- The amount of taxes that will be payable or refundable in future years inclusive of reversing temporary differences and carryforwards
- The amount of taxes that would be payable or refundable in future years exclusive of reversing temporary differences and carryforwards.
However, in light of the constraints
identified in the preceding paragraph, in computing the
amount of deferred tax liabilities and assets, the objective
is to measure a deferred tax liability or asset using the
enacted tax rate(s) expected to apply to taxable income in
the periods in which the deferred tax liability or asset is
expected to be settled or realized.
As noted in ASC 740-10-10-1, an entity’s overall objectives in
accounting for income taxes under ASC 740 are to (1) “recognize the amount of taxes
payable or refundable for the current year” (i.e., current tax expense or
benefit) and (2) “recognize deferred tax liabilities and assets for the
future tax consequences of events that have been recognized in an entity’s financial
statements or tax returns” (resulting in deferred tax expense or benefit). An
entity's total tax expense is generally the sum of these two components1 and can be expressed as the following formula:
To understand and apply ASC 740, management and practitioners must
be aware of these objectives, which are discussed in more detail in the next
sections.
1.3.1 Understanding “Events That Have Been Recognized in an Entity’s Financial Statements or Tax Returns”
Despite the significant differences in form between financial
statements and an income tax return, an entity is able to use the information on
which its income tax return preparation was based to develop a set of tax basis
financial statements that would look very similar to a set of financial
statements prepared for financial reporting purposes. The accounting for income
taxes is most easily understood if one first assumes that the income tax return
is used to create a set of tax basis financial statements that is similar in
form to a set of financial statements prepared for financial reporting purposes.
ASC 740-10-20 defines an event as a “happening of consequence to an entity.” An
event has an ASC 740 accounting consequence if it results in recognition in (1)
the entity’s U.S. GAAP financial statements for a period, (2) the entity’s tax
basis financial statements for a period, or (3) both.
1.3.2 Understanding “the Amount of Taxes Payable or Refundable for the Current Year”
An entity calculates the amount of income taxes payable or refundable for the
current year by completing its income tax return(s) for the year. That process
will result in the determination of an amount of income tax owed to a taxing
authority or, in some circumstances, an amount of a refund due to the entity
from the taxing authority. A current income tax payable or refundable is
recorded for such amounts with an offset to current income tax expense in the
income statement.
1.3.2.1 Permanent Differences
When an event is permanently recognized in a different
manner or amount in U.S. GAAP financial statements than it is in tax basis
financial statements, a permanent difference between pretax net income and
taxable income arises. A common example of such an event in the United
States is the recognition of certain portions of meals and entertainment
expenses that are not deductible for tax purposes. Another common example is
interest income that is not taxable (i.e., tax-exempt interest). Certain tax
credits (whether used in the current period or carried forward to reduce
income taxes otherwise owed in a future period), which reduce the amount of
tax owed but do not affect the amount of income before tax for U.S. GAAP
purposes, may also create permanent differences when the expenses incurred
for U.S. GAAP purposes are disallowed for tax purposes because the credit is
claimed.
Under ASC 740, entities inherently take into account the
income tax effects of permanent differences other than those created by tax
credit carryforwards by recognizing current income tax expense corresponding
with “the amount of taxes payable or refundable for the current year.” In
other words, such permanent differences will affect the amount of the income
tax payable or refundable and corresponding current tax expense or benefit
for the period. These permanent differences will also affect the income tax
rate the entity appears to be paying on its U.S. GAAP pretax income (i.e.,
the entity’s effective tax rate [ETR]). For example, if a cash expenditure
results in an expense for financial reporting purposes but does not
represent an expense for income tax purposes (i.e., because it is
permanently disallowed), the entity’s overall ETR for financial reporting
purposes will be higher than its statutory rate. For this reason, permanent
differences are often described as having a “rate impact” under ASC 740.
Permanent differences do not give rise to DTAs and DTLs. For additional
examples of common permanent differences and a discussion of the related
accounting, see Section
3.2.
1.3.3 Understanding “Deferred Tax Liabilities and Assets” and “Future Tax Consequences”
DTAs and DTLs (1) represent the future tax consequences of
certain events that have been recognized differently for financial reporting and
tax purposes and (2) result from two primary sources: temporary differences and
attributes.
1.3.3.1 Temporary Differences
A temporary difference represents the difference between (1)
the tax basis of an asset or liability, determined under tax law and in
accordance with the recognition and measurement guidance discussed in
Chapter 4, and (2) its reported
amount in the financial statements that will result in taxable or deductible
amounts in future years when such amount is recovered or settled,
respectively. Often, a temporary difference arises when an event is
ultimately accounted for in the same manner and amount for U.S. GAAP and tax
purposes but in different periods. For example, a temporary
difference may arise as a result of the rate at which an asset is
depreciated under U.S. GAAP as compared with its depreciation rate for tax
purposes. When an event is recognized in either the U.S. GAAP or tax basis
financial statements, a temporary difference may arise between pretax net
income reported for financial reporting purposes and taxable income reported
for income tax purposes. Temporary differences will generate additional
taxable income or loss when the related amount in the U.S. GAAP basis
financial statements is recovered (asset) or settled (liability).
Example 1-1
Entity X acquires a fixed asset with
cash of $100 and capitalizes the expenditure for
both financial reporting and income tax purposes.
For income tax purposes, X depreciates the fixed
asset entirely in one year; however, it depreciates
it over five years for financial reporting purposes.
After one year, the asset will have a carrying
amount or “basis” of $0 for income tax purposes but
will have a carrying amount of $80 for financial
reporting purposes. This $80 basis difference is
temporary because ultimately the entire $100 will be
recognized as an expense for both financial
reporting and income tax purposes. Since the $100
expense will be recognized in different periods, a
difference exists between the tax basis and the
amount of such basis reported in the financial
statements. That basis difference gives rise to a
temporary difference.
ASC 740-10-25-20 identifies a number of additional types of
events that could create a temporary difference. Such events and temporary
differences are discussed in more detail in Section 3.3.
1.3.3.1.1 Future Tax Consequences of Temporary Differences
ASC 740 requires an entity to use a balance sheet
approach to recognize the future tax consequences of temporary
differences. For an entity to accomplish this, it is critical for it to
understand that an inherent assumption in U.S. GAAP is that the
financial statement carrying amounts of assets and liabilities will be
recovered and settled, respectively. In other words, when applying the
income tax accounting guidance in ASC 740, an entity assumes that the
financial statement carrying amount of assets will convert to cash and
the financial statement carrying amount of liabilities will be settled
through disbursement of cash. An entity then determines whether such
future receipt or use of cash will result in an increase or decrease to
taxable income. To understand the significance of this assumption,
management and practitioners must also be acquainted with the concepts
of “financial statement carrying amount” and “tax basis.”
The initial carrying amount or basis for both financial
reporting purposes and income tax purposes can generally be
thought of as the amount of consideration paid to acquire an asset or
the amount of consideration received upon incurring a liability. For
example, the initial carrying amount or basis in a fixed asset for both
financial reporting and income tax purposes is typically the amount of
cash paid to acquire it. Similarly, the carrying amount or basis of a
note payable is usually the amount of cash received upon the note’s
issuance. The initial carrying amount is subsequently adjusted for
appreciation, accretion, depreciation, amortization, or impairment (as
permitted or required under financial reporting and income tax reporting
rules). That is, the carrying amount for financial reporting purposes
and for income tax purposes is the amount at which the asset or
liability is reported in the U.S. GAAP and tax basis balance sheet at
the end of the reporting period.
When an asset is recovered, an entity generally reports
income on the amount of proceeds in excess of the tax basis or takes a
deduction for the amount by which the tax basis exceeds the proceeds
received. Similarly, the entity takes a deduction for the amount by
which the consideration paid to settle a liability exceeds the tax basis
(a loss) or reports income on the amount by which the tax basis of the
liability exceeds the consideration paid to settle it (a gain).
Under the balance sheet approach, the entity compares
the financial statement carrying amount of each of its assets and
liabilities with the carrying amount or basis of each of those assets
and liabilities for income tax purposes in the relevant taxing
jurisdiction. An entity must analyze any difference between the carrying
amount of an asset or liability for financial reporting purposes and
such amount for income tax purposes to determine whether it is a
temporary difference that gives rise to a future tax deduction or future
taxable income. If taxable income would result, the entity has a taxable
temporary difference and records a DTL with a corresponding deferred tax
expense. If a deduction would result, the entity has a deductible
temporary difference and records a DTA with a corresponding deferred tax
benefit, subject to an assessment of realizability. If no tax
consequence would arise, the basis difference is not a temporary
difference that gives rise to a DTA or DTL.
Example 1-2
Assume the same facts as in
Example 1-1. At the end of the first
year, the future tax consequences of the events
that Entity X has temporarily recognized
differently in its financial statements than it
has recognized in its tax returns (assuming X
were to recover the asset for its financial
statement carrying amount) would be a taxable
gain of $80. That is, the amount by which the $80
that hypothetically would be received upon the
assumed recovery exceeds the current tax basis of
$0. Therefore, X would record a DTL at the end of
the first year representing the future tax
consequence (a future tax payable on an $80 gain
[recovery through sale] or income [recovery
through use]) of recovering the fixed asset for
its financial statement carrying amount. In other
words, the tax benefit from the depreciation of
the asset that X recognizes in the tax basis
financial statements in year 1 will not be
available in future years to offset the $80 of
income assumed to arise upon recovery of the
asset. If the tax rate is 20 percent, X would
record a DTL for $16.
1.3.3.2 Attributes
In some jurisdictions, entities are permitted to carry
forward or back losses (as determined under income tax rules of the relevant
jurisdiction) to offset earnings of a future or prior period (and
potentially get a refund of taxes paid on income of a previous period).
These losses are commonly referred to as NOL carryforwards or carrybacks.
Similarly, an entity may be permitted to carry forward or back income tax
credits that it could not use in the current year. NOLs and tax credits that
may be carried forward are commonly referred to as “attributes.”
1.3.3.2.1 Future Tax Consequences of Attributes
The future tax consequence of an attribute is generally either a deferred
deduction (i.e., an NOL carryforward that can be used to reduce taxable
income of a future period) or a deferred income tax credit (to reduce
the amount of income tax otherwise owed in a future period), each of
which is represented by a DTA. DTAs and corresponding deferred tax
benefits are recorded for attributes, subject to an assessment of
realizability, to reflect the “future tax consequences” of the event
(generation of the NOL or tax credit carryforward) that has occurred in
the entity’s tax basis financial statements. The future tax consequence
is the reduction in taxes owed as a result of applying a credit
carryforward to reduce taxes payable or applying an NOL carryforward to
reduce taxable income of a future period.
1.3.4 Complexities in Applying ASC 740
While the objectives of ASC 740 may seem straightforward in simple scenarios,
there can be a tremendous amount of complexity in the accounting for income
taxes under ASC 740. The above overview may serve as a foundation for an
understanding of the concepts and complexities discussed in the remaining
chapters.