5.8 Examples Illustrating the Determination of the Pattern of Reversals of Temporary Differences

5.8.1 State and Local Tax Jurisdictions

In the computation of an entity’s U.S. federal income tax liability, income taxes that are paid to a state or municipal jurisdiction are deductible. Thus, ASC 740-10-55-20 states, in part:

[A] deferred state [or municipal] income tax liability or asset gives rise to a temporary difference for purposes of determining a deferred U.S. federal income tax asset or liability, respectively. The pattern of deductible or taxable amounts in future years for temporary differences related to deferred state [or municipal] income tax liabilities or assets should be determined by estimates of the amount[s] of those state [and local] income taxes that are expected to become . . . deductible or taxable for U.S. federal tax purposes in those particular future years.

5.8.2 Unrecognized Tax Benefits

Under the tax law, an entity may have a basis for deductions (e.g., repair expenses) and may have accrued a liability for the probable disallowance of those deductions (a UTB). If such deductions are disallowed, they would be capitalized for tax purposes and would then be deductible in later years. ASC 740-10-55-21 states that the accrual of the liability in this situation “has the effect of [implicitly] capitalizing those expenses for tax purposes” and that those “expenses are considered to result in deductible amounts in the later years” in which, for tax purposes, the deductions are expected to be allowed. Moreover, this paragraph states that “[i]f the liability for unrecognized tax benefits is based on an overall evaluation of the technical merits of the tax position, scheduling should reflect the evaluations made in determining the liability for unrecognized tax benefits that was recognized.”

The change in the timing of taxable income or loss caused upon the disallowance of expenses may affect an entity’s realization assessment of a DTA recognized for the tax consequences of deductible temporary differences, operating loss, and tax credit carryforwards. For example, upon disallowance of those expenses, taxable income for that year will be higher. Similarly, taxable income for years after the disallowance will be lower because the deductions are being amortized against taxable income in those years. An entity should consider the impact of disallowance in determining whether realization of a DTA meets the more-likely-than-not recognition threshold in ASC 740.

5.8.3 Accrued Interest and Penalties

An entity that takes an aggressive position in a tax return filing often will accrue a liability in its financial statements for interest and penalties that it would incur if the tax authority successfully challenged that position. Such an entity should schedule a deductible amount for the accrued interest for the future year in which that interest is expected to become deductible as a result of settling the underlying issue with the tax authority.

Because most tax jurisdictions do not permit deductions for penalties, a temporary difference does not generally result from the accrual of such amounts for financial reporting purposes.

5.8.4 Tax Accounting Method Changes

ASC 740-10-55-59 states, in part, that a “change in tax law may require a change in accounting method for tax purposes, for example, the uniform cost capitalization rules required by the Tax Reform Act of 1986.” Under the uniform capitalization rules, calendar-year entities revalued “inventories on hand at the beginning of 1987 . . . as though the new rules had been in effect in prior years.” The resulting adjustment was included in the determination of taxable income or loss over not more than four years. ASC 740-10-55-58 through 55-62 indicate that the uniform capitalization rules initially gave rise to two temporary differences.

ASC 740-10-55-60 and 55-61 describe these two temporary differences as follows:

One temporary difference is related to the additional amounts initially capitalized into inventory for tax purposes. As a result of those additional amounts, the tax basis of the inventory exceeds the amount of the inventory for financial reporting. That temporary difference is considered to result in a deductible amount when the inventory is expected to be sold. Therefore, the excess of the tax basis of the inventory over the amount of the inventory for financial reporting as of December 31, 1986, is considered to result in a deductible amount in 1987 when the inventory turns over. As of subsequent year-ends, the deductible temporary difference to be considered would be the amount capitalized for tax purposes and not for financial reporting as of those year-ends. The expected timing of the deduction for the additional amounts capitalized in this example assumes that the inventory is not measured on a LIFO basis; temporary differences related to LIFO inventories reverse when the inventory is sold and not replaced as provided in paragraph 740-10-55-13.

The other temporary difference is related to the deferred income for tax purposes that results from the initial catch-up adjustment. As stated above, that deferred income likely will be included in taxable income over four years. Ordinarily, the reversal pattern for this temporary difference should be considered to follow the tax pattern and would also be four years. This assumes that it is expected that inventory sold will be replaced. However, under the tax law, if there is a one-third reduction in the amount of inventory for two years running, any remaining balance of that deferred income is included in taxable income for the second year. If such inventory reductions are expected, then the reversal pattern will be less than four years.

5.8.5 LIFO Inventory

ASC 740-10-55-13 states:

The particular years in which temporary differences result in taxable or deductible amounts generally are determined by the timing of the recovery of the related asset or settlement of the related liability. However, there are exceptions to that general rule. For example, a temporary difference between the tax basis and the reported amount of inventory for which cost is determined on a [LIFO] basis does not reverse when present inventory is sold in future years if it is replaced by purchases or production of inventory in those same future years. A LIFO inventory temporary difference becomes taxable or deductible in the future year that inventory is liquidated and not replaced.

For most entities, an assumption that inventory will be replaced through purchases or production does not ordinarily present difficulty. However, if there is doubt about the ability of an entity to continue to operate as a going concern, the entity should evaluate available evidence to determine whether it can make this assumption when measuring DTAs and DTLs under ASC 740. The ability to assume that inventory can be replaced might affect the recognition of a DTA when realization depends primarily on the reversal of a taxable temporary difference. For example, if an entity is unable to replace inventory because of financial or operating difficulties, a taxable temporary difference resulting from LIFO inventory accounting would reverse at that time and not be available to offset the tax consequences of future deductions for retirement benefits that have been accrued for financial reporting purposes but that will become deductible many years in the future when the benefits are paid.

5.8.6 Obsolete Inventory

For financial reporting purposes, inventory may be written down to net realizable value (e.g., when obsolescence occurs). Generally, for tax purposes, the benefit of such a write-down cannot be realized through deductions until disposition of the inventory. Thus, in such circumstances, there is a deductible temporary difference between the reported amount of inventory and its underlying tax basis. This temporary difference should be assumed to be deductible in the period in which the inventory deductions are expected to be claimed (i.e., in the period in which the inventory dispositions occur).

5.8.7 Cash Surrender Value of Life Insurance

Under ASC 325-30, an asset is recognized for financial reporting purposes in the amount of the cash surrender value of life insurance purchased by an entity. ASC 740-10-25-30 cites the “excess of cash surrender value of life insurance over premiums paid” as an example of a basis difference that “is not a temporary difference if the [cash surrender value] is expected to be recovered without tax consequence upon the death of the insured.” If, however, the policy is expected to be surrendered for its cash value, the entity would include in taxable income any excess cash surrender value over the cumulative premiums paid (note that the tax basis in the policy is generally equal to cumulative premiums paid). The resulting taxable temporary difference should be scheduled to reverse in the year in which the entity expects to surrender the policy.

5.8.8 Land

The financial reporting basis of the value assigned to land may differ from the tax basis. Such a difference may result from (1) property acquired in a nontaxable business combination, (2) differences between capitalized costs allowable under accounting standards and those allowable under tax law, or (3) property recorded at predecessor cost for financial reporting purposes because it was acquired through a transaction among entities under common control. Regardless of the reason for the difference, the entity should assume that the temporary difference will reverse in the year in which the land is expected to be sold to an unrelated third party; otherwise, the timing of the reversal would be indefinite.

5.8.9 Nondepreciable Assets

In some jurisdictions, certain office buildings and other real estate cannot be depreciated under local tax law. The tax authority may permit the tax basis of such property to be routinely increased for the approximate loss in purchasing power caused by inflation. The tax basis, as adjusted for indexing, is used to measure the capital gain or loss. For financial reporting purposes, depreciation is recognized on such assets. The effects of indexing for tax purposes and depreciation for financial reporting purposes create deductible temporary differences that reverse upon disposition of the associated assets.

5.8.10 Assets Under Construction

For financial reporting purposes, the carrying amount and tax basis of an asset under construction for an entity’s own use may differ as a result of differences in capitalized costs (e.g., interest capitalized under ASC 835-20 may differ from the amount to be capitalized for tax purposes). The difference between the amount reported for construction in progress for financial reporting purposes and its related tax basis should be scheduled to reverse over the expected depreciable life of the asset, which should not commence before the date on which the property is expected to be placed into service.

5.8.11 Disposal of Long-Lived Assets by Sale

A deductible temporary difference results when, under ASC 360-10-35-37, a loss is recognized for a write-down to fair value less costs to sell for assets to be disposed of by sale. Because the deductions for losses cannot generally be applied to reduce taxable income until they occur, the temporary difference should be assumed to reverse during the period(s) in which such losses are expected to be deductible for tax purposes.

5.8.12 Costs Associated With Exit or Disposal Activities

Under ASC 420, the fair value of certain exit or disposal costs (e.g., contract termination) is recorded on the date the activity is initiated (e.g., contract termination date) and is accreted to its settlement amount on the basis of the discount rate initially used to measure the liability. Generally, an entity cannot apply the deductions for exit or disposal activities to reduce taxable income until they occur; therefore, the resulting deductible temporary differences should be scheduled to reverse during the period(s) in which such losses are expected to be deductible for tax purposes.

5.8.13 Loss Contingencies

Under ASC 450, the estimated losses on contingencies that are accrued for financial reporting purposes when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated are not deductible for tax purposes until paid. The resulting deductible temporary differences should be scheduled to reverse during the periods in which the losses are expected to be deductible for tax purposes.

5.8.14 Organizational Costs

In the U.S. federal tax jurisdiction, an entity generally uses the straight-line method to defer organizational costs and amortize them to income over five years. Such costs are recognized as an expense for financial reporting purposes in the period in which they are incurred unless an entity can clearly demonstrate that the costs are associated with a future economic benefit. If the costs are reported as an expense in the period in which they are incurred, any deductible temporary differences should be scheduled to reverse on the basis of the future amortization of the tax basis of the organizational asset recorded for tax purposes.

5.8.15 Long-Term Contracts

Before the Tax Reform Act of 1986, use of the completed-contract method for tax purposes resulted in significant temporary differences for many entities that used the percentage-of-completion method for financial reporting purposes. The Tax Reform Act of 1986 eliminated this use of the completed-contract method (except for small contractors that are defined under the law), requiring that an entity determine taxable income by using the percentage-of-completion method or a hybrid of the completed-contract and percentage-of-completion methods for contracts entered into after February 1986.

For entities that are permitted to continue using the completed-contract method for tax purposes, a temporary difference will result in future taxable income in the amount of gross profit recognized for financial reporting purposes. The reversal of these differences would be assumed to occur on the basis of the period in which the contract is expected to be completed.

If the percentage-of-completion method is used for both tax and financial reporting purposes, temporary differences may nevertheless result because the gross profit for tax purposes may be computed differently from how gross profit is computed for book purposes. To schedule the reversals of these temporary differences, an entity would generally need to estimate the amount and timing of gross profit for tax and financial reporting purposes.

If a hybrid method is used for tax purposes and the percentage-of-completion method is used for financial reporting purposes, the temporary differences might be allocated between the portions of the contract that are accounted for under the completed-contract method and those accounted for under the percentage-of-completion method for tax purposes. Under this approach, the amount attributable to the use of the completed-contract method for tax purposes might be scheduled to reverse, thereby increasing taxable income, during the year in which the contract is expected to be completed. The amount of temporary differences attributable to differences in the percentage-of-completion methods for financial reporting and tax purposes might be allocated and scheduled on the basis of the estimates of future gross profit for financial reporting and tax purposes.

5.8.16 Pension and Other Postretirement Benefit Obligations

Under ASC 715, an employer generally recognizes the estimated cost of providing defined benefit pension and other postretirement benefits to its employees over the estimated service period of those employees. It records an asset or liability representing the amount by which the present value of the estimated future cost of providing the benefits either exceeds or is less than the fair value of plan assets at the end of the reporting period.

Under U.S. tax law, however, an employer generally does not receive a deduction until it makes a contribution to its pension plan or pays its other postretirement benefit obligations (e.g., retiree medical costs). Because tax law generally precludes an entity from taking deductions for these costs until the pension contribution is made or the other postretirement benefit obligations are paid, the accounting required under ASC 715 usually results in significant taxable or deductible temporary differences for employers that provide such benefits.

ASC 715-30-55-4 and 55-5 explain that a taxable temporary difference related to an overfunded pension obligation will reverse if (1) the plan is terminated to recapture excess assets or (2) periodic pension cost exceeds future amounts funded. For an overfunded obligation, we believe that the pattern of taxable amounts in future years should generally be determined to be consistent with the pattern in scenario (2). That is, we believe that the pattern of taxable amounts in future years that will result from the temporary difference should generally be considered the same as the pattern of estimated net periodic pension cost (as that term is defined in ASC 715-30-20) for financial reporting for the following year and succeeding years, if necessary, until future net periodic pension cost, on a cumulative basis, equals the amount of the temporary difference. Under this approach, additional employer contributions to the plan, if any, are ignored. It may be estimated, however, that in early years, there will be net periodic pension income (because the plan is significantly overfunded). If so, the existing overfunded amount will not be recovered until the later years for which it is estimated that there will be net periodic pension cost.

For an underfunded plan, the pattern of deductible amounts in future years that will result from the temporary difference could be considered the same as the pattern by which estimated future tax-deductible contributions are expected to exceed future interest cost on the benefit obligation existing at the end of the reporting period. This approach is similar to determining the pattern of reversals for other discounted liabilities (e.g., amortizing a loan). Under this approach, each estimated tax-deductible contribution to the plan in future years would be allocated initially to (1) estimated future interest expense on the projected benefit obligation existing at the end of the reporting period and then to (2) the projected benefit obligation existing at the end of the reporting period.

5.8.17 Deferred Income and Gains

For tax purposes, certain revenue or income is taxed upon receipt of cash (e.g., rental income, loan, or maintenance fees received in advance). However, for financial reporting purposes, such income is deferred and recognized in the period in which the fee or income is earned. The amounts deferred in an entity’s balance sheet will result in a deductible temporary difference because, for tax purposes, no tax basis in the item exists.

Temporary differences from revenues or gains deferred for financial reporting purposes, but not for tax purposes, should be assumed to result in deductible amounts when the revenues or gains are expected to be earned or generated (i.e., when the deferred credit is expected to be settled).

5.8.18 Allowances for Doubtful Accounts

The Tax Reform Act of 1986 requires most taxpayers to use the specific charge-off method to compute bad-debt deductions for tax purposes. For financial reporting purposes, entities recognize loan losses in the period in which the loss is estimated to occur. Such recognition creates a deductible temporary difference in the amount of the allowance for doubtful accounts established for financial reporting purposes. It is expected that an allowance for doubtful accounts as of the current balance sheet date will result in deductible amounts in the year(s) in which such accounts (1) are expected to be determined to be worthless for tax purposes or (2) are planned to be sold (if held for sale).

5.8.19 Property, Plant, and Equipment

An entity might find it necessary to schedule the reversals of temporary differences related to depreciable assets for two primary reasons: (1) to assess whether it has sufficient taxable income of the appropriate character, within the carryback/carryforward period available under the tax law, to conclude that realization of a DTA is more likely than not and (2) to calculate the tax rate used to measure DTAs and DTLs by determining the enacted tax rates expected to apply to taxable income in the periods in which the DTLs or DTAs are expected to be settled or realized. In each case, the entity must estimate the amounts and timing of taxable income or loss expected in future years. Further, ASC 740-10-55-14 states, in part, “For some assets or liabilities, temporary differences may accumulate over several years and then reverse over several years. That pattern is common for depreciable assets.”

Example 5-32

The following example illustrates the scheduling of temporary differences for depreciable assets. Assume the following:

An entity acquired depreciable assets for $1,000 at the beginning of 20X1.
For financial reporting purposes, the property is depreciated on a straight-line basis over five years; for tax purposes, the modified accelerated cost recovery method is used.
The following table illustrates the depreciation schedules:

In December 20X1, the temporary difference of $150 (financial statement carrying amount of $800 less tax basis of $650) will result in a future net taxable amount. If the originating differences are considered, the temporary difference of $150 should be scheduled to reverse in the following manner as of the end of 20X1:

If the entity does not consider future originating differences to minimize the complexity of scheduling reversal patterns, a first-in, first-out pattern would be used and the $150 taxable temporary difference would be scheduled as follows on December 31, 20X1: