Chapter 17

FASB ASC Topic 740: Income

Taxes

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Learning objectives

Explain the objectives behind FASB ASC Topic 740, Accounting for Income
Taxes, and the income tax provision process
Calculate the current and deferred income tax expense or benefit
components of a companys income tax provision
Recall what a valuation allowance represents and describe the process by
which it is determined
Explain how a company accounts for its uncertain income tax positions
under ASC 740-10 (a codification of FASB Interpretation (FIN) No. 48,
Accounting for Uncertainty in Income Taxes)
Recognize the different components of a companys disclosure of its income
tax accounts in the financial statements and footnotes and comprehend how
a company computes and discloses the components of its effective tax
rate

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Objectives Of Accounting For Income

Taxes and Income tax Provision Process

The income tax provision includes:

Current year taxes payable or refundable.

Any changes to future income taxes payable or
refundable that result from differences in the timing of
when an item is reported on the tax return compared
to the financial statement.

A company records these future income taxes

payable or refundable on its balance sheet as:

Deferred tax liability (payable)

Deferred tax asset (refundable)
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The intuition for DTL/DTA

Financial reporting: present firm operation based on

economic basis, not cash basis
We need to reconcile tax reporting, based on tax laws, to
financial reporting
For tax purpose
(Cash basis)
Report actual
taxes paid or
refunded (cash
flow out or in) in
the current year

Temporary book-tax differences

Use DTL/DTA account for future

tax payment/refunds

For GAAP purpose

(Accrual basis)
Report current and
expected future
income tax related
cash flow

17-4

Objectives Of Accounting For Income

Taxes and Income tax Provision Process

ASC 740 (Accounting for Income Taxes) applies

only to:

Income taxes levied by the U.S. federal

government,
U.S. state and local governments, and
Non-U.S. (foreign) governments.

The FASB defines an income tax as a tax based

on income, which excludes property taxes, excise
taxes, sales taxes, and value-added taxes.

Non-income taxes are reported as expense

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Income Tax Provision Process

There are two ways to calculate income tax provision
Method 1:

Adjust pretax income for permanent differences.

Identify all temporary differences and tax carryforward
amounts.
Compute the current income tax expense or benefit.
Determine the ending balances in the balance sheet deferred
tax asset and liability accounts.
Evaluate the need for a valuation allowance for gross deferred
tax assets.
Calculate the deferred income tax expense or benefit.
Income tax provision = current + deferred income tax expense

17-6

Objectives of Accounting for Income

Taxes and Income Tax Provision Process

There are two ways to calculate income tax

provision

Method 2: Adjust pretax income by permanent

differences

Permanent differences Book tax differences that do

not reverse over time.
Permanent differences usually affect a companys
effective tax rate and appear as part of its reconciliation
of its effective tax rate with the statutory U.S. tax rate.

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Income tax reconciliation (method 2)

Computation and Reconciliation of the Income

Tax Provision with a Companys Hypothetical Tax
Provision

ASC 740 requires a company to reconcile its:

Reported income tax provision attributable to continuing

operations, with
Amount of income tax expense that would result from applying
its U.S. statutory tax rate to its pretax net income or loss from
continuing operations.

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Financial Statement Disclosure and

Corporation's Effective Tax Rate

Income tax reconciliation

Federal income tax rate%*pretax
income from continuing operation
(hypothetical income tax
provision)
Adjust for permanent booktax-differences

Reported income tax provision

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Financial Statement Disclosure and

Corporation's Effective Tax Rate

17-10

Useful formulas for calculating

income tax provision
Method

2: Income tax provision = (Pretax net

income +/- Permanent book-tax differences
before tax)*34% = Book equivalent to taxable
income*34%

Effective tax rate (ETR) = Income tax provision/net

income
Hypothetical tax provision= Pretax net income*34%

Method

1: Income tax provision = Current income

tax expense + Net Deferred income tax expense

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Adapted Example 17-22

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Computing a Companys Federal Income

Tax Provision (Method 1)

Step one: Adjust Pretax Net Income for All

Permanent Differences

Permanent differences Book tax differences that do

not reverse over time.
Permanent differences usually affect a companys
effective tax rate and appear as part of its reconciliation
of its effective tax rate with the statutory U.S. tax rate.

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Computing a Companys Federal Income

Tax Provision
Step two: Identify All Temporary Differences and Tax
Carryforward Amounts
To compute the deferred tax liability or asset, a company
must calculate the future tax effects attributable to
temporary differences and tax carryforwards.

Temporary differences are book-tax differences that reverse

over time
Temporary differences that are initially favorable (unfavorable)
create deferred tax liabilities (assets).

Initially Favorable-future tax payment; Initially unfavorable-future tax

refund

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Computing a Companys Federal Income

Tax Provision

Temporary differences commonly arise in four

instances.
Favorable difference

Income is taxable after

book recognition (defer
taxable income)

Expense is deductible
before book recognition
(accelerate tax
deduction)

Unfavorable difference

Income is taxable
Expense is deductible
before book recognition after book recognition
(accelerate taxable
(defer tax deduction)
income)

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Computing a Companys Federal Income

Tax Provision

Examples of favorable/unfavorable book-tax

adjustments
Income

Expense

Favorable

Installment sale

Depreciation

Unfavorable

Prepayment revenue Reserve expense

(warranty, bad debt
expense)

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Computing a Companys Federal Income

Tax Provision

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Computing a Companys Federal Income

Tax Provision

Step three: Compute the Current Income Tax

Expense or Benefit

ASC 740 defines the current income tax expense or

benefit as The amount of income taxes paid or payable
(or refundable) for a year as determined by applying the
provisions of the enacted tax law to the taxable income or
excess of deductions over revenues for that year.

The major component of a companys current income

tax expense or benefit is

Income tax liability, or

Refund from its current year operations
17-18

Calculate current tax expense

Pretax net income
+/- Permanent differences
Book equivalent to taxable income
+/- Temporary differences
Taxable income
* Income tax rate
Current income tax

17-19

Example 17-5

What is PCC's current income tax expense,

assuming a tax rate of 34 percent? What tax
accounting journal entry does PCC make to
record its current tax expense?
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Example
Abbot Corporation reported pretax book income of
$500,000. During the current year, the reserve for
bad debts increased by $5,000. In addition, tax
depreciation exceeded book depreciation by
$40,000. Finally, Abbot received $3,000 of taxexempt life insurance proceeds from the death of
one of its officers. Using a tax rate of 34%, Abbot's
current income tax expense or benefit would be:

17-21

Computing a Companys Federal Income

Tax Provision

Step four: Determine the Ending Balances in the

Balance Sheet--Deferred Tax Asset (DTA) and
Deferred Tax Liability (DTB)

Deferred tax liability (future tax payable)

Deferred tax asset (future tax refundable)

How to calculate Deferred Tax Asset and Liability

Accounts?

ASC 740 takes an asset and liability or balance sheet

approach for the computation of the deferred tax expense
or benefit.

Both accounts have cumulative balances

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Computing a Companys Federal Income

Tax Provision

Compute DTA and DTB

1.

Calculate the beginning balance and ending balance of

book tax temporary differences

2.

Unfavorable book tax temporary differenceCurrent taxable

income increasesfuture taxable income will decrease
compared to book income as the difference reverseswe
have DTA: DTA=book tax temporary difference*enacted tax
rate.
Favorable book tax temporary differenceCurrent taxable
income decreasesfuture taxable income will increase
compared to book income as the difference reverseswe
have DTL: DTL=book tax temporary difference*enacted tax
rate.

3.

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Computing a Companys Federal Income

Tax Provision

Determine the Ending Balances in the Balance

Sheet Deferred Tax Asset and Liability Accounts

Deferred tax asset=future tax refund

Deferred tax liability=future tax payment
The company computes the deferred tax liability using
the enacted tax rate that is expected to apply to taxable
income in the period(s) in which the deferred tax liability
is expected to be settled.

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Example 17-6
A) Suppose depreciation expense for book
increases by 2,400,000 and depreciation expense
for tax increases by 3,100,000. By what amount will
PCC increase its deferred tax liabilities as a result?
(assume 34% flat rate)
B) What if depreciation expense for book increases
by 2,400,000 and depreciation expense for tax
increases by 1,700,000.

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Example
Abbot Corporation reported pretax book income of
$500,000. During the current year, the liability for
workers compensation increased by $5,000. In
addition, there is a NOL carryforward of $200,000
(assume that they can be used in this year). Finally,
Abbot paid $3,000 of tax-exempt life insurance
premiums for one of its officers. Using a tax rate of
34%, Abbot's deferred income tax expense or
benefit would be:

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Example 17-9
What is the net increase in PCC's deferred
tax liability related to fixed assets for 2014?

17-27

Example
Price Corporation reported pretax book income of
$600,000 in 2014. Tax depreciation exceeded
book depreciation by $100,000. In addition, the
reserve for doubtful accounts increased by
$40,000. Price had a net deferred tax liability of
$34,000 at the beginning of the year, representing
a net taxable temporary difference of $100,000.
During the year, the company's tax rate decreased
from 34% to 30%. Compute the Company's
deferred income tax expense or benefit for 2014.
17-28

Computing a Companys Federal Income

Tax Provision

Evaluate the Need for a Valuation Allowance for

Gross Deferred Tax Assets

A valuation allowance is required if it is more likely

than not (a likelihood of greater than 50 percent) some
or all of the deferred tax asset will not be realized in the
future.
Valuation allowances operate as contra accounts to the
deferred tax assets on the balance sheet.

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Computing a Companys Federal Income

Tax Provision

Evaluate the Need for a Valuation Allowance for

Gross Deferred Tax Assets

Objective sources

Future Reversals of Existing Taxable Temporary Differences

Valuation allowance is not recognized when the reversing taxable

temporary differences provide sufficient future taxable income

Taxable Income in Prior Carryback Years

Valuation allowance is not recognized when prior years have sufficient

taxable income to offset deferred tax benefit carry back

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Computing a Companys Federal Income

Tax Provision

Evaluate the Need for a Valuation Allowance for

Gross Deferred Tax Assets

Subjective sources

Expected future taxable income exclusive of reversing temporary

differences and carryforwards

A company might support its predictions of future taxable income with

evidence of existing contracts or a sales backlog that will produce enough
taxable income to realize the deferred tax asset when it reverses.

Tax Planning Strategies

Recognize valuation allowances when future taxable income needs to

absorb loss or tax credit carry forwards.

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Computing a Companys Federal Income

Tax Provision

Step 6: Calculate the Total Income Tax Expense

or Benefit

Total income tax provision = current income tax

expense or benefit + deferred income tax expense or
benefit
Total income tax provision = pretax net income adjusted
by permanent book tax differences (book equivalent of
taxable income) * applicable income tax rate

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Accounting for Uncertainty in Income

Tax Positions
FAS 109 provided no specific guidance on how to
deal with uncertain tax positions.
Companies generally applied the principles of
FAS 5, Accounting for Contingencies, to uncertain
tax positions.
The objective of FIN 48 (effective 12/15/2006 and
codified in ASC 740) is to provide a uniform
approach to recording and disclosing tax benefits
resulting from tax positions that are considered to
be uncertain.

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Accounting for Uncertainty in Income

Tax Positions

FIN 48 applies a two step process to evaluating uncertain

tax positions.

Step one: Recognition

Company first determines if it is more likely than not that its tax position on a
particular account will be sustained on IRS examination based on its
technical merits.

If the position can sustain, then recognize tax benefit;

If the position cannot sustain, then recognize uncertain tax benefits;

Step two: Measurement

A company recognizes the largest amount of tax benefit that has a

greater than 50 percent cumulative probability of being sustained on
examination and subsequent litigation.
The amount not recognized is recorded as a liability on the balance
sheet.

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Example 17-18

17-35

Example 17-19

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Accounting for Uncertainty in Income

Tax Positions

Other ASC 740 requirements.

Firms have to monitor subsequent events that might change

the companys assessment that a tax position will be
sustained on audit and litigation.
Firms have to accrue interest and any applicable penalties
on liabilities it establishes for potential future tax obligations.
Firms have to disclose uncertain tax positions in detail.

Schedule UTP.

Being phased in over time. Effective in 2014 for large corporations. Firms
have to report any federal income tax position for which an unrecognized
benefit has been recorded and give details.

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The UTP disclosure of

Microsoft

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Financial Statement Disclosure

Balance Sheet Classification.

ASC 740 requires companies (public and private) to disclose their

deferred tax assets and liabilities on their balance sheets and
classify them as either current or noncurrent.

ASC 740 permits companies to net deferred tax assets and

liabilities based on their classification and present the net amount
on the balance sheet.

If a DTA is related to a long-term asset, the DTA is classified as

noncurrent; if a DTA is related to a short-term asset, the DTA is classified
as current (NOT when it reverses)

Net current deferred tax assets and liabilities

Net noncurrent deferred tax assets and liabilities

ASC 740 does not permit netting of deferred tax assets and
liabilities that are attributable to different tax jurisdictions (e.g.,
domestic VS foreign)

17-39

Financial Statement Disclosure and

Corporation's Effective Tax Rate

Income Tax Footnote Disclosure

ASC 740 mandates that a company disclose:

Components of the net deferred tax assets and liabilities reported on its
balance sheet (5% or more of the total balance)
Total valuation allowance recognized for deferred tax assets.

ASC 740 also requires publicly traded companies to disclose these

components:

Current tax expense or benefit.

Deferred tax expense or benefit.
The benefits of operating loss carryforwards.
Adjustments of a deferred tax liability or asset for enacted changes in tax
laws or rates.
Adjustments of the beginning-of-the-year balance of a valuation allowance
because of a change in circumstances.
17-40

Financial Statement Disclosure and

Corporation's Effective Tax Rate

17-41

Homework
38,

39, 41, 43, 45, 46, 47, 49, 51, 52, 54, 55,
56, 58, 66, 71, 72, 73, 74

17-42