7.5 Other Considerations
Other complexities can arise when entities are determining the appropriate amount of
income tax to recognize in an interim period. ASC 740-270 addresses some of these
complexities.
7.5.1 Inability to Make a Reliable Estimate of the AETR
ASC 740-270-30-18 states:
Estimates of the annual effective tax rate at the end of
interim periods are, of necessity, based on evaluations of possible future
events and transactions and may be subject to subsequent refinement or revision.
If a reliable estimate cannot be made, the actual effective tax rate for the
year to date may be the best estimate of the annual effective tax rate.
If a company’s AETR is highly sensitive to changes in estimates of total ordinary
income (or loss), the AETR may not be considered reliable. This may occur when, for
example, an entity is expecting marginal ordinary income (or loss) and relatively
significant permanent differences or tax credits.
In certain situations, a negative AETR may be projected (e.g., nondeductible expenses
exceed pretax loss). Often these estimates are sensitive to ordinary income and may
be an indicator that reasonable estimates cannot be made. If a reliable estimate of
the AETR cannot be made, the best estimate of the AETR may be the actual ETR for the
YTD.
7.5.2 Nonrecognized Subsequent Events
ASC 740-270-35-3 indicates that at the end of each successive interim period during
the fiscal year, an entity should revise its estimated AETR, if necessary, to
reflect its current best estimate.
Questions have arisen regarding whether an entity’s current best estimate of its AETR
should include events that occurred after the interim balance sheet date but before
its financial statements are issued or are available to be issued (i.e., a
nonrecognized subsequent event as contemplated in ASC 855).
Generally, a nonrecognized subsequent event should not be reflected in the AETR (but
should be disclosed if significant). This approach is based on ASC 855-10-25-3,
which states that nonrecognized subsequent events should not result in the
adjustment of the financial statements.
We are aware of an alternative approach in practice under which an entity’s current
best estimate of its AETR is based on information available up to the date on which
its financial statements are issued or are available to be issued, even though that
might include information that did not exist or was not relevant until after the
interim balance sheet date. Even under this approach, an entity would still be
required to exclude items for which the tax effects must be recognized in the period
in which they occur (e.g., changes in UTBs, changes in tax laws or rates, a change
in tax status, an IPO, or a business combination). Entities should consult with
their accounting advisers before applying this alternative approach.
7.5.3 Balance Sheet Effects of the Interim Provision for Income Taxes
In accordance with ASC 740-10, entities use a balance sheet approach to determine the
annual provision for income taxes. However, for interim financial statements, ASC
740-270 requires entities to determine the YTD income tax expense or benefit by
applying an estimated AETR to YTD ordinary income. Because of the inherent
disconnect between the year-end balance sheet approach of ASC 740-10 and the interim
income statement approach of ASC 740-270, questions have arisen about how to reflect
the YTD expense or benefit on the balance sheet. That is, the YTD tax expense or
benefit that an entity determines under ASC 740-270 will typically not reconcile to
the balance sheet adjustments that would be required if the year-end balance sheet
approach of ASC 740-10 were applied to the current and deferred tax accounts on an
interim basis. ASC 740-270 neither addresses this disconnect nor provides guidance
on how to record the balance sheet effects of recording the interim provision for
income taxes.
An entity should generally adjust its income tax balance sheet accounts as of interim
reporting periods in a manner that is representationally faithful to either the
balance sheet approach of ASC 740-10 (with respect to the measurement of current and
deferred taxes) or the income statement approach of ASC 740-270. For example,
adjusting current and deferred taxes by developing a “split” AETR that consists of
current and deferred components would appear to be representationally faithful to
the income statement approach of ASC 740-270. Alternatively, calculating the actual
deferred YTD tax expense (or benefit) and deriving the adjustment to current taxes
(or calculating current taxes and deriving the adjustment to deferred taxes) would
appear to be representationally faithful to the balance sheet approach of ASC 740-10
(at least with respect to one of the balance sheet components).
Other methods may also be acceptable depending on an entity’s specific facts and
circumstances, including materiality considerations.
Because the method applied to adjust the income tax balance sheet accounts for
interim reporting periods would not be disclosed in the annual financial statements,
entities should consider disclosing the method applied in their interim financial
statements.
Example 7-16
Company A is preparing interim financial statements and
calculates an estimated AETR of 25 percent that, when
applied to YTD ordinary income of $100, results in an
interim expense for income taxes of $25.
To adjust its income tax balance sheet accounts for interim
reporting purposes, A might apply one of the following methods:
- Split estimated AETR — On a forecasted basis, A estimates an 80/20 split between the current and deferred portions of the annual provision for income taxes and applies this split to the interim provision to allocate the adjustment between current and deferred balance sheet accounts.
- Calculate current taxes — Company A calculates its current taxes payable in accordance with tax law applied to YTD income and records a $40 liability. On the basis of the required AETR provision of $25, A adjusts the deferred taxes for the beginning of the year by $15 (a debit entry to the balance sheet).
- Calculate deferred taxes — Company A calculates its deferred taxes as of the interim balance sheet date and adjusts its deferred taxes for the beginning of the year by $10 (a credit entry to the balance sheet). On the basis of the required AETR provision of $25, A recognizes a current liability of $15.
Note that in most cases, none of the methods above produce
the same balance sheet and related expense or benefit that
would arise if the balance sheet approach of ASC 740-10 were
applied.
7.5.4 Required Interim Disclosures
ASC 740-270-50-1 notes that application of the interim-period
requirements for reporting income taxes may result in “significant variations in
the customary relationship between income tax expense and pretax accounting
income.” Entities must disclose the reasons behind such variations in their
interim-period financial statements if the differences are not readily apparent
from the financial statements themselves or from the nature of the business of
the entity.
In addition, for entities that are subject to SEC reporting
requirements, management should consider the requirements in SEC Regulation S-X,
Rule 10-01(a)(5), which states, in part:
The interim financial information shall include
disclosures either on the face of the financial statements or in
accompanying footnotes sufficient so as to make the interim information
presented not misleading. Registrants may presume that users of the
interim financial information have read or have access to the audited
financial statements for the preceding fiscal year and that the adequacy
of additional disclosure needed for a fair presentation may be
determined in that context.
Accordingly, if any annual disclosures have significantly
changed since the most recently completed fiscal year, management should update
them in a manner sufficient to ensure that the interim information presented is
not misleading. See Sections
14.4.1.6 and 14.4.3.3 for examples of situations in which management should
consider updating an entity’s annual disclosures during an interim period.