7.3 Items Excluded in Part From the AETR

Certain items that may affect the AETR can also result in amounts recorded separately from the AETR, such as certain changes in:

Valuation allowances (ASC 740-270-30-7, ASC 740-270-30-11, and ASC 740-270-25-4).
Tax laws and rates (ASC 740-270-25-5 and ASC 740-270-30-11).
Changes in recognition and measurement of UTBs.
Assertions related to outside basis difference exceptions.

These events often affect both beginning-of-the-year tax balances as well as taxes related to current-year activities.

7.3.1 Valuation Allowances

ASC 740-270-30-7 states that “[t]he tax effect of a valuation allowance expected to be necessary” at the end of the year for a DTA originating in the current year should be included in the AETR.

A valuation allowance on beginning-of-the-year DTAs may increase or decrease during the year. ASC 740-270-30-11 states that “[t]he effects of changes in judgment about beginning-of-year valuation allowances . . . shall be excluded from the estimated annual effective tax rate calculation.” However, ASC 740-270-25-4 indicates that “[t]he tax benefit of an operating loss carryforward from prior years shall be included in the effective tax rate computation if the tax benefit is expected to be realized as a result of ordinary income in the current year” (emphasis added).

The examples below illustrate this concept.

Example 7-8

Valuation Allowance on Originating DTA

Assume that during the first quarter of fiscal year 20X1, Entity A, operating in a tax jurisdiction with a 50 percent tax rate, generates a tax credit of $3,000 that, under tax law, will expire at the end of 20X2. At the end of the first quarter of 20X1, available evidence about the future indicates that taxable income of $1,000 and $3,000 will be generated during 20X1 and 20X2, respectively. Therefore, a valuation allowance of $1,000 [$3,000 tax credit – ($4,000 combined forecasted taxable income of 20X1 and 20X2 × 50%)] will be necessary at the end of 20X1. The estimated pretax book income for the full fiscal year is $10,000. The $9,000 difference between book income and taxable income is attributable to tax-exempt income.

Because the valuation allowance relates to the tax attribute originating during the current year, the tax consequences of the $1,000 valuation allowance on the credits are included in the AETR.

The AETR and first-quarter tax expense are computed as follows:

Thus, if pretax accounting income is $5,000 during the first quarter of 20X1, a benefit for income taxes of $750 ($5,000 × [–15%]) would be recognized and net income of $5,750 would be reported for that interim period.

Example 7-9

Decrease in Valuation Allowance on Beginning-of-the-Year DTAs

Assume the following:

At the beginning of fiscal year 20X1, Entity X has a DTA of $4,000 that relates to $20,000 of NOLs that all expire in 20X5. A full valuation allowance is recorded against the DTA because X believes, on the basis of the weight of available evidence, that it is more likely than not that the DTA will not be realized.
Entity X has no other DTAs or DTLs.
Entity X’s tax rate is 20 percent.
At the beginning of the year, X estimates that it will earn $1,000 of income before tax in each of the quarters in 20X1.
Income before tax for the first quarter of 20X1 totals $1,000.
Income before tax for the second quarter of 20X1 totals $1,000.
At the end of the second quarter, X estimates, on the basis of new evidence, that it will earn $30,000 of taxable income in 20X2–20X4. Accordingly, X concludes that it is more likely than not that all of its DTAs will be realized.
The AETR is 0% ($0 projected tax expense ÷ $4,000 forecasted income).

The following table illustrates X’s tax expense (or benefit) in each of the four quarters of 20X1:

Because X estimated that it will earn income of $1,000 in each quarter in the current year, $800 of valuation allowance will be reduced through the AETR ($4,000 projected annual income × 20% tax rate) in accordance with ASC 740-270-25-4. Also in accordance with ASC 740-270-25-4, the remaining valuation allowance of $3,200 will be reduced discretely in the second quarter because the reduction is resulting from changes in judgment over the realizability of the DTA in future years.

Example 7-10

Increase in Valuation Allowance on Beginning-of-the-Year DTAs

Assume that Entity B operates in a tax jurisdiction with a 50 percent tax rate and is computing its ETR for fiscal year 20X2 at the end of its first quarter. At the end of the previous year, 20X1, B recorded a DTA of $4,000 for a tax credit carryforward generated in that year that, according to tax law, expires in 20X3, and B reduced that DTA by a valuation allowance of $1,000 on the basis of an estimate of taxable income of $3,000 in 20X2 and $3,000 in 20X3.

At the end of the first quarter of 20X2, assume that B’s estimate of future taxable income expected in 20X3 is revised from $3,000 to $2,000, and B’s estimate of taxable income expected in 20X2 continues to be $3,000. Pretax book income and taxable income for 20X2 are expected to be the same, and no new tax credits are expected during the year. Because the additional valuation allowance of $500 ($1,000 reduction in estimated 20X3 taxable income × 50%) relates to a change in judgment about the realizability of the related DTA in future years, the entire effect is recognized during the first quarter of 20X2. Thus, if B had pretax accounting income of $2,000 in the first quarter of 20X2 and its AETR for the full fiscal year is 50 percent, it would record income tax expense of $1,500, as computed below, and net income of $500 for the first quarter of 20X2.

7.3.1.1 Recognition of the Tax Benefit of a Loss in an Interim Period

Under ASC 740-270-25-9, the “tax effects of losses that arise in the early portion of a fiscal year shall be recognized only when the tax benefits are expected to be . . . [r]ealized” either during the current year or “as a deferred tax asset at the end of the year.” ASC 740-270-25-10 indicates that an “established seasonal pattern of loss in early interim periods offset by income in later interim periods” is generally sufficient to support a conclusion that realization of the tax benefit from the early losses is more likely than not. In addition, in accordance with ASC 740-270-30-31, limitations on the recognition of a DTA are “applied in determining the estimated tax benefit of an ordinary loss for the fiscal year.” This benefit is “used to determine the estimated annual effective tax rate and the year-to-date tax benefit of a loss.” The term “ordinary loss” in this context excludes SUI items that will be separately reported or reported net of their related tax effects. The tax benefit of losses incurred in early interim periods would not be recognized in those interim periods if available evidence indicates that the income is not expected in later interim periods.

If the tax benefits of losses that are incurred in early interim periods of a fiscal year are not recognized in those interim periods, an entity should not provide income tax expense on income generated in later interim periods until the tax effects of the previous losses are offset. In accordance with ASC 740-270-30-7, the “tax effect of a valuation allowance expected to be necessary for a deferred tax asset” at the end of a fiscal year for deductible temporary differences and carryforwards that originate during the current fiscal year should be spread throughout the fiscal year by an adjustment to the AETR.

7.3.2 Changes in Tax Laws and Rates Occurring in Interim Periods

Under ASC 740-270-25-5, the effects of new legislation are recognized upon enactment, which in the U.S. federal jurisdiction is the date the president signs a tax bill into law. The tax effects of a change in tax laws or rates on taxes currently payable or refundable for the current year are reflected in the computation of the AETR beginning in the first interim period that includes the enactment date of the new legislation. The effect of a change in tax laws or rates on a DTL or DTA is recognized as a discrete item in the interim period that includes the enactment date and accordingly is not allocated among interim periods remaining in the fiscal year by an adjustment of the AETR. If the effective date of a change in tax law differs from the enactment date, affected DTAs or DTLs are remeasured in the interim period that includes enactment; however, the remeasurement should include only the effects of the change on items that are expected to reverse after the effective date. For example, if an entity has two temporary differences that may be affected by a tax law change and expects one to reverse before the effective date of the change and the other to reverse after the effective date, the one that reverses after the effective date would be remeasured for the change in tax law in the interim period of enactment.

7.3.2.1 Retroactive Changes in Tax Laws

Certain changes in tax laws are applied retroactively. When provisions of a new tax law are effective retroactively, they can affect both the current-year measure of tax expense or benefit (either current or deferred) and the tax expense or benefit attributable to income recognized in prior annual periods that ended after the effective date of the retroactive legislation. The effect (if any) on the prior annual period is recognized in the interim period (and annual period) that includes the date of enactment. Such an effect might be reflected as a change to current tax accounts, deferred tax accounts, or both. Amounts pertaining to the prior annual accounting period must be recognized entirely in the period that includes the enactment date and should not be reflected in the current-period AETR.

When retroactive legislation is enacted in an interim period before the fourth quarter of the annual accounting period, the effect on the current annual accounting period is generally recognized by updating the AETR in the period of enactment for the effect of the retrospective legislation. That updated AETR is then applied to the YTD ordinary income through the end of the interim period that includes the enactment date. The cumulative amount of tax expense or benefit for the current year is then adjusted to this amount, which effectively “catches up” the prior interim periods for the change in law. The impact on the entity’s balance sheet should be consistent with its normal policy for adjusting the balance sheet accounts (current and deferred) on an interim basis. For further discussion, see Section 7.5.3.

In certain circumstances, an entity may not recognize an effect of a retroactive change in tax law related to the current annual accounting period by updating the AETR. For example:

SUI items that are separately reported are specifically excluded from the definition of ordinary income and are therefore excluded from the AETR (see Section 7.2.1).
An entity may be unable to estimate part of its ordinary income (or loss). The pretax amount of ordinary income (or loss) that cannot be reliably estimated and the related tax effects should be excluded from the entity’s estimate of its AETR in all periods, and the tax effects of the item that cannot be estimated should be recorded discretely (see Section 7.2.2).
An entity may be unable to estimate an AETR in a foreign jurisdiction in dollars or may be unable to make a reliable estimate of its ordinary income (or loss) or of the related tax (or benefit) for the fiscal year in a jurisdiction. ASC 740-270-30-36(b) indicates that in these cases, “[t]he tax (or benefit) related to ordinary income (or loss) in that jurisdiction shall be recognized in the interim period in which the ordinary income (or loss) is reported” (see Section 7.2.3.2).
Entities are required to account for excess tax benefits and tax deficiencies related to share-based payment awards as discrete items in the period in which they occur (see Section 7.2.4).
An entity might not use the AETR approach to account for its interim income tax provision (generally because the entity cannot make a reliable estimate; see Section 7.5.1).

In these situations, an entity would be required to determine the actual effect of retrospective legislation on income tax expense (or benefit) and balance sheet income tax accounts.

An entity that has not yet issued its report for the interim or annual period that ended before enactment cannot consider the enactment in preparing that report; however, the effect that the retroactive legislation will have on the period being reported should still be disclosed. To determine the amount to disclose in such circumstances, the entity generally must perform computations similar to those described above.

The example below illustrates the accounting for a change in tax rate retroactive to interim periods of the current year.

Example 7-11

Entity C, operating in a tax jurisdiction with a 35 percent tax rate, is computing its AETR for each quarter of 20X2. Entity C’s estimated annual ordinary pretax income is $8,000, which it earns in equal amounts during each quarter of fiscal year 20X2. At the end of the previous year, C recorded a DTA of $350 for a $1,000 liability on the financial statements that is deductible on the tax return when paid. As the payments are made, they reduce the liability throughout the year, as shown in the following table:

Entity C has another temporary difference related to an accumulated hedging loss in the statement of OCI. The following table summarizes the gain (loss) activity during each quarter of 20X2:

The table below illustrates C’s estimated AETR calculation for fiscal year 20X2 at the end of the first quarter. As discussed in Section 7.2, the changes in OCI are excluded from the AETR calculation.

Estimated AETR Calculation on March 31, 20X2

Estimated Change in DTA on March 31, 20X2

At the end of May, legislation was enacted that increased the tax rate for 20X2 and years thereafter to 40 percent. The effect of the change in the tax rate related to the DTA is recognized on the enactment date as a discrete item, and the effect of the change on taxes currently payable is recognized by adjusting the AETR in the interim period of the change.

On the enactment date, the balance sheet liability was $900 and the cumulative loss in OCI was $500. The following table illustrates the calculation of the deferred tax expense that is recorded as a discrete amount and the amount that is recognized through the AETR:

Estimated Change in DTA on June 30, 20X2

Estimated AETR Calculation

Because of the enacted tax rate increase, the DTA related to the cumulative $500 loss in OCI for hedging activity on the enactment date must also be adjusted. The $25 tax benefit ($500 cumulative loss × 5% change in tax rate) related to the adjustment to the DTA for the tax rate increase is a discrete item that is part of continuing operations and therefore affects the tax expense in the quarter of enactment.

The following table summarizes the quarterly income tax on the basis of the above calculations:

Quarterly ETR Calculation

Quarterly OCI Changes

The effect of the change in tax rates should be (1) reported as a separate line item in income tax expense from continuing operations or (2) disclosed in the footnotes. For further discussion, see Chapter 14.

7.3.2.2 Impact of Delayed Effective Dates and the Administrative Implementation of New Legislation

ASC 740-270-55-49 states, in part:

The effect of the new legislation shall be reflected in the computation of the annual effective tax rate beginning in the first interim period that includes the enactment date of the new legislation.

ASC 740-270-55-45 through 55-49 illustrate this guidance:

ASC 740-270

Legislation Effective in a Future Interim Period

55-45 The assumed facts applicable to this Example follow.

55-46 For the full fiscal year, an entity anticipates ordinary income of $100,000. All income is taxable in one jurisdiction at a 50 percent rate. Anticipated tax credits for the fiscal year total $10,000. No events that do not have tax consequences are anticipated.

55-47 Computation of the estimated annual effective tax rate applicable to ordinary income is as follows.

55-48 Further, assume that new legislation creating additional tax credits is enacted during the second quarter of the entity's fiscal year. The new legislation is effective on the first day of the third quarter. As a result of the estimated effect of the new legislation, the entity revises its estimate of its annual effective tax rate to the following.

55-49 The effect of the new legislation shall be reflected in the computation of the annual effective tax rate beginning in the first interim period that includes the enactment date of the new legislation. Accordingly, quarterly tax computations are as follows.

7.3.3 Changes in Judgment Related to UTBs

An entity may change its judgment regarding (1) the validity of a tax position based on the more-likely-than-not recognition threshold or (2) the measurement of the greatest amount of benefit that is more likely than not to be realized in a negotiated settlement with the taxing authority.

For interim financial reporting purposes, the accounting for a change in judgment about a tax position taken or to be taken in the current year is different from the accounting for a change in judgment about a tax position taken in a prior fiscal year. To maintain consistency with the existing requirements of ASC 740-270 for interim reporting, ASC 270, ASC 740-10-25-15, and ASC 740-270-35-6 require the following accounting:

The effect of a change in judgment regarding a tax position taken in a prior fiscal year is recorded entirely in the interim period in which the judgment changes (similarly to taxes on an SUI item).
The effect of a change in judgment regarding a tax position taken in a prior interim period in the same fiscal year is allocated to the current and subsequent interim periods by inclusion in the revised AETR.

7.3.3.1 Changes in Judgment Regarding a Tax Position Taken in the Current Year

The example below demonstrates changes in judgment regarding a tax position taken in the current year.

Example 7-12

In the first quarter of 20X7, an entity:

Estimates that its ordinary income for fiscal year 20X7 will be $4,000 ($1,000 per quarter). Assume a tax rate of 25 percent.
Enters into a transaction that is expected to permanently reduce its 20X7 taxable income by $1,000; thus, its total tax expense for the year is expected to be $750, or ($4,000 - $1,000) × 25%. Assume that the transaction meets the recognition threshold and that the full $250 will be recognized under ASC 740.

Accordingly, for each quarter in 20X7 (provided that earnings are ratable), ordinary income and income tax expense are expected to be $1,000 and $188, respectively.

During the second quarter of 20X7, the entity receives new information indicating that the tax position related to the $1,000 deduction no longer meets the more-likely-than-not recognition threshold but does meet the minimum threshold required to avoid penalties if the position is taken on the tax return; thus, the company intends to still take the uncertain tax position on the 20X7 tax return. Therefore, in preparing its second-quarter financial statements, the entity updates its estimate of the AETR as follows:

On the basis of the new information received in the second quarter, the entity should report the following ordinary income and income tax expense for each quarter during 20X7:

The effect of the change in judgment over a tax position taken in the current fiscal year is recognized by changing the estimated AETR to 25 percent, which does not reflect any benefit for the tax position. Of the $250 total change representing the loss of the tax benefit previously thought to be more likely than not, a $125 UTB is recognized in the second quarter and the remaining UTB of $125 is recognized in the third and fourth quarters.

7.3.3.2 Changes in Judgment Regarding a Tax Position Taken in the Prior Year

The example below demonstrates changes in judgment regarding a tax position taken in the prior year.

Example 7-13

In the first quarter of 20X7, an entity estimates that its AETR for the year will be 30 percent.

In the second quarter of 20X7, the entity receives new information indicating that a tax position taken in 20X6 no longer meets the more-likely-than-not recognition threshold. The benefit recognized for that tax position in the 20X6 financial statements was $400. No similar tax positions were taken or are expected to be taken in 20X7.

Assuming that ordinary income for each of the quarters is $1,000, the entity determines income tax expense in each of the quarters in 20X7 as follows:

The effect of the change in judgment regarding the tax position taken in 20X6 is recorded as a discrete item in the second quarter of 20X7, the period in which the judgment changed, and does not affect the AETR to be applied to 20X7 ordinary income.

7.3.4 Changes in an Indefinite Reinvestment Assertion

An entity may change its indefinite reinvestment assertion related to an investment in a foreign subsidiary or foreign corporate joint venture that is essentially permanent in duration. For interim income tax reporting purposes, the DTL related to the beginning-of-the-year outside basis difference that is expected to reverse in the foreseeable future is recorded as a discrete item in the period of the change in assertion. However, the amounts pertaining to the current year (e.g., current-year earnings) will be captured within the estimated AETR in accordance with ASC 740-270-35-6. For the same reasons discussed in Section 6.2.4.1, the adjustment for the beginning-of-the-year outside basis difference is (1) generally allocated to continuing operations and (2) calculated by using the exchange rate at the beginning of the year.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.