Reporting entities are required to file income tax returns and pay income taxes in the domestic (federal, state, and local) and foreign jurisdictions in which they do business. GAAP requires that financial statements be prepared on an accrual basis and that, consequently, the reporting entity is required to accrue a liability for income taxes owed or expected to be owed with respect to income tax returns filed or to be filed for all applicable tax years and in all applicable jurisdictions.
A longstanding debate has involved the controversial recognition of benefits (or reduced obligations) related to income tax positions that are uncertain or aggressive and which, if challenged, have a more-than-slight likelihood of not being sustained, resulting in the need to pay additional income taxes, often with interest and—sometimes—penalties added.
Preparers have objected to presenting income tax obligations for such positions, often on the not unreasonable theory that to do so would provide taxing authorities with a ”road map” to the challengeable income tax positions taken by the reporting entity.
Since I posted about “Learn Accounting for Income Tax in 1 Minute”, I received bounce of e-mails contain confusions around the accounting for income tax. Talking about accounting for income tax, distinguishing between temporary and permanent difference is the most challenging part before deferred tax [liability and asset]. A comprehensive description and guideline is definitely required. So, in this post, I will be focus on this issue. Read on…
Accounting for Uncertainty in Income Taxes [ASC 740-10-05]
With the June 2006 issuance of ASC 740-10-05, Accounting for Uncertainty in Income Taxes, uncertain income tax positions were to become subject to formal recognition and measurement criteria, as well as to extended disclosure requirements under GAAP.
To respond to the concerns of its private company constituents, FASB granted a one-year deferral of the effective date of ASC 740-10-05 for certain nonpublic enterprises. As the end of the deferral period approaches, those same constituents are requesting either an outright exemption for nonpublic enterprises or an additional deferral until the conclusion of an ongoing joint project between the FASB and IASB to converge US GAAP and IFRS income tax accounting standards.
The computation of taxable income for the purpose of filing income tax returns differs from the computation of net income under GAAP for a variety of reasons. In some instances, referred to as temporary differences, the timing of income or expense recognition varies. In other instances, referred to as permanent differences, income or expense recognized for income tax purposes is never recognized under GAAP, or vice versa. An objective under GAAP is to recognize the income tax effects of transactions in the period that those transactions occur. Consequently, deferred income tax benefits and obligations frequently arise in financial statements.
The basic principle is that the deferred income tax effects of all temporary differences (which are defined in terms of differential bases in assets and liabilities under income tax and GAAP accounting) are to be formally recognized. To the extent that deferred income tax assets are of doubtful realizability—are not “more likely than not to be realized”—a valuation allowance is provided, analogous to the allowance for uncollectible receivables.
The process of inter-period income tax allocation, which gives rise to deferred income tax assets and liabilities, has been required under GAAP for decades, although the measurement philosophy has evolved substantially over the years. As with many accounting measurements, the prescribed methodology has varied depending upon whether the primary objective was accuracy of the balance sheet or of the income statement. While the income statement had long been viewed as being of greatest concern, with the completion of the FASB’s current conceptual framework several decades ago the emphasis shifted to the balance sheet. This ultimately precipitated a major change in the inter-period income tax allocation rules, culminating in the issuance of ASC 740.
Under ASC 740, purchase price allocations made pursuant to purchase-method business combinations under ASC 805 (and recognized values pursuant to acquisition-method business combinations under its replacement standard, ASC 805 are made gross of income tax effects, and any associated income tax benefit or obligation is recognized separately.
Post-combination changes in valuation allowances for an acquired entity’s deferred income tax assets no longer automatically reduce recorded goodwill and intangibles. The accounting depends upon whether the changes occur during or after the expiration of the measurement period.
If the change occurs during the prescribed measurement period, not to exceed one year from the acquisition date, it is first applied to adjust goodwill until goodwill is eliminated, with any excess adjustment remaining being recorded as a gain from a bargain purchase.
If the change occurs subsequent to the measurement period, it is recognized in the period of change as a component of income tax expense or benefit, or, in the case of certain specified exceptions, as a direct adjustment to contributed capital. Notably, the transition provisions of ASC 805 require this treatment to be applied prospectively after the effective date of the standard, even with respect to acquisitions that were originally recorded under the predecessor standard.
The income tax effects of net operating loss or tax credit carry-forwards are treated as deferred income tax assets just like any other deferred income tax benefit. With its balance sheet orientation, ASC 740 requires that the amounts presented be based on the amounts expected to be realized, or obligations expected to be liquidated. Use of an average effective income tax rate convention is permitted. The effects of all changes in the balance sheet deferred income tax assets and liabilities flow through the income tax provision in the income statement; consequently, income tax expense is normally not directly calculable based on pretax accounting income in other than the simplest situations.
Discounting of deferred income taxes has never been permitted under GAAP, even though the ultimate realization and liquidation of deferred income tax assets and liabilities is often expected to occur far in the future. The issuance of CON 7, which deals with the use of present value in accounting measurements, did not end this prohibition. In any event, the inability to predict accurately the timing of the realization of deferred income tax benefits or the payment of deferred income tax payments would make discounting very difficult to accomplish.
Evolution of Accounting for Income Taxes
The differences in the timing of recognition of certain expenses and revenues for income tax reporting purposes versus the timing under GAAP had always been a subject for debates in the accounting profession. The initial debate was over the fundamental principle of whether or not income tax effects of timing difference should be recognized in the financial statements.
At one extreme were those who believed that only the amount of income tax currently owed ( as shown on the income tax return for the period) should be reported as periodic income tax expense, on the grounds that potential changes in tax law and the vagaries of the entity’s future financial performance would make any projection to future periods speculative. This was the “no allocation” or “flow-through” position.
At the other extreme were those who held that the matching principle demanded that reported periodic income tax expense be mechanically related to pretax accounting income, regardless of the amount of income taxes actually currently payable. This was the “comprehensive allocation” argument. The middle ground approach, known as “partial allocation“, acknowledged the need for some deferred income tax provision, but only when actual future income tax payments or benefits could be accurately predicted. This debate was settled in the late 1960s: comprehensive income tax allocation became GAAP.
The other key debate was over the measurement strategy to be applied to inter-period income tax allocation. When, in the 1960s and 1970s, accounting theory placed paramount importance on the income statement, with much less interest in the balance sheet, the method of choice was the “deferred method,“ which invoked the matching principle.
The annual income tax provision (consisting of current and deferred portions) was calculated so that it would bear the expected relationship to pretax accounting income; any excess or deficiency of the income tax provision over income taxes payable was recorded as an adjustment to the deferred income tax amounts reflected on the balance sheet. This practice, when applied, resulted in a net deferred income tax debit (subject to some limitations on asset realization) or a net deferred income tax credit, which did not necessarily mean that an asset or liability, as defined under GAAP, actually existed for that reported amount.
By the late 1970s, accounting theory (reflected in FASB’s conceptual framework) made the financial reporting priority the statement of financial position (balance sheet). Primary emphasis was placed on the measurement of assets and liabilities—which, under CON 6’s definitions, clearly would not include certain deferred income tax benefits or obligations as these were then measured. To compute deferred income taxes consistent with a balance sheet orientation requires use of the “liability method”. This essentially ascertains, as of each balance sheet date, the amount of future income tax benefits or obligations that are associated with the reporting entity’s assets and liabilities existing at that time.
Any adjustments necessary to increase or decrease deferred income taxes to the computed balance, plus or minus the amount of income taxes owed currently, determines the periodic income tax expense or benefit to be reported in the income statement. Put another way, income tax expense is the residual result of several other balance-sheet-oriented computations.
ASC 740 required that all deferred income tax assets are given full recognition, whether arising from deductible temporary differences or from net operating loss or tax credit carry-forwards. Under ASC 740 it is necessary to assess whether the deferred income tax asset is realizable.
Testing for realization is accomplished by means of a “more-likely-than-not” criterion that indicates whether an allowance is needed to offset some or all of the recorded deferred income tax asset. While the determination of the amount of the allowance may make use of the scheduling of future expected reversals, other methods may also be employed [Read it on my next post: Deferred Tax Asset and Its Valuation Allowance].
Distinguishing Temporary and Permanent Differences
Deferred income taxes are provided for all temporary differences, but not for permanent differences. Thus, it is important to be able to distinguish between the two. How? Let’s discuss it. Read on…
While many typical business transactions are accounted for identically for income tax and financial reporting purposes, there are many others subject to different income tax and accounting treatments, often leading to their being reported in different periods in financial statements than they are reported on income tax returns. The term “timing differences”, used under prior GAAP, has been superseded by the broader term “temporary differences” under current rules.
Under income statement oriented GAAP, timing differences were said to originate in one period and to reverse in a later period. These involved such common items as alternative depreciation methods, deferred compensation plans, percentage-of-completion accounting for long-term construction contracts, and cash basis versus accrual basis accounting.
The more comprehensive concept of temporary differences, consistent with the modern balance sheet orientation of GAAP, includes all differences between the income tax basis and the financial reporting carrying value of assets and liabilities, if the reversal of those differences will result in taxable or deductible amounts in future years. Temporary differences include all the items formerly defined as timing differences, and other additional items.
Temporary differences under ASC 740 that were defined as timing differences under prior GAAP can be categorized as follows:
[-]. Revenue recognized for financial reporting purposes before being recognized for income tax purposes – Revenue accounted for by the installment method for income tax purposes, but fully reflected in current GAAP income; certain construction-related revenue recognized using the completed-contract method for income tax purposes, but recognized using the percentage-of-completion method for financial reporting purposes; earnings from investees recognized using the equity method for accounting purposes but taxed only when later distributed as dividends to the investor. These are future taxable temporary differences because future periods’ taxable income will exceed GAAP income as the differences reverse; thus they give rise to deferred income tax liabilities.
[-]. Revenue recognized for income tax purposes prior to recognition in the financial statements – Certain taxable revenue received in advance, such as prepaid rental income and service contract revenue not recognized in the financial statements until later periods. These are future deductible temporary differences, because the costs of future performance will be deductible in the future years when incurred without being reduced by the amount of revenue deferred for GAAP purposes. Consequently, the income tax benefit to be realized in future years from deducting those future costs is a deferred income tax asset.
[-]. Expenses deductible for income tax purposes prior to recognition in the financial statements – Accelerated depreciation methods or shorter statutory useful lives used for income tax purposes, while straight-line depreciation or longer useful economic lives are used for financial reporting; amortization of goodwill and non-amortizable intangible assets over a 15-year life for income tax purposes while not amortizing them for financial reporting purposes unless they are impaired. Upon reversal in the future, the effect would be to increase taxable income without a corresponding increase in GAAP income. Therefore, these items are future taxable temporary differences, and give rise to deferred income tax liabilities.
[-]. Expenses recognized in the financial statements prior to becoming deductible for income tax purposes – Certain estimated expenses, such as warranty costs, as well as such contingent losses as accruals of litigation expenses, are not tax deductible until the obligation becomes fixed. In those future periods, those expenses will give rise to deductions on the reporting entity’s income tax return. Thus, these are future deductible temporary differences that give rise to deferred income tax assets.
In addition to these familiar and well-understood categories of timing differences, temporary differences include a number of other categories that also involve differences between the income tax and financial reporting bases of assets or liabilities. These include:
[-]. Reductions in tax-deductible asset bases arising in connection with tax credits – Under the provisions of the 1982 income tax act, taxpayers were permitted a choice of either full ACRS depreciation coupled with a reduced investment tax credit, or a full investment tax credit coupled with reduced depreciation allowances. If the taxpayer chose the latter option, the asset basis was reduced for tax depreciation, but was still fully depreciable for financial reporting purposes. Accordingly, this type of election is accounted for as a future taxable temporary difference, that gives rise to a deferred income tax liability.
[-]. Investment tax credits accounted for by the deferral method – Under GAAP, investment tax credits could be accounted for by either the “flow through” method (full recognition in the period the asset is placed in service, by far the most common method in practice), or by the “deferral” method (recognition in income over the useful lives of the assets giving rise to the credit). Thus, a future deductible temporary difference existed, with which a deferred income tax asset would be associated.
NOTE: These two categories are no longer of much interest since the investment tax credit was eliminated and is not presently available to taxpayers under current tax law. In the past, however, Congress has reinstated the credit to provide an incentive for businesses to invest in productive equipment. Future reinstatement always remains a possibility, given the cyclical nature of the US economy.
Increases in the income tax bases of assets resulting from the indexing of asset costs for the effects of inflation. Occasionally proposed but never enacted, enacting such a provision to income tax law would allow taxpaying entities to finance the replacement of depreciable assets through depreciation based on current costs, as computed by the application of indices to the historical costs of the assets being re-measured. This reevaluation of asset costs would give rise to future taxable temporary differences that would be associated with deferred income tax liabilities since, upon the eventual sale of the asset, the taxable gain would exceed the gain recognized for financial reporting purposes resulting in the payment of additional tax in the year of sale.
Certain business combinations accounted for by the purchase method or the acquisition method. Under certain circumstances, the amounts assignable to assets or liabilities acquired in business combinations will differ from their income tax bases. Such differences may be either taxable or deductible in the future and, accordingly, may give rise to deferred income tax liabilities or assets. These differences are explicitly recognized by the reporting of deferred income taxes in the consolidated financial statements of the acquiring entity. Note that these differences are no longer allocable to the financial reporting bases of the underlying assets or liabilities themselves, as was the case under the old net of tax method.
A financial reporting situation in which deferred income taxes may or may not be appropriate would include life insurance (such as key person insurance) under which the reporting entity is the beneficiary. Since proceeds of life insurance are not subject to income tax under present law, the excess of cash surrender values over the sum of premiums paid will not be a temporary difference under the provisions of ASC 740, if the intention is to hold the policy until death benefits are received.
On the other hand, if the entity intends to cash in (surrender) the policy at some point prior to the death of the insured (i.e., it is holding the insurance contract as an investment), which would be a taxable event, then the excess surrender value is in fact a temporary difference, and deferred income taxes are to be provided thereon:
Temporary Differences from Share-Based Compensation Arrangements
ASC 718-50 contains intricate rules with respect to accounting for the income tax effects of different types of share-based compensation awards. The complexity of applying the income tax provisions contained in ASC 718-50 is exacerbated by the complex statutes and regulations that apply under the US Internal Revenue Code (IRC). The American Job Creation Act of 2004 added IRC §409A that contains complicated provisions regarding the timing of taxability of specified amounts deferred under nonqualified deferred compensation plans.
In general, amounts deferred under specified types of nonqualified plans are currently includable in gross income to the extent the benefits are not subject to a substantial risk of forfeiture unless certain requirements are met. An incentive stock option (ISO or statutory option governed by IRC §422) is not subject to §409A; however, certain nonqualified stock option (NQSO or non-statutory) plans are subject to these requirements.
Differences between the accounting rules and the income tax laws can result in situations where the cumulative amount of compensation cost recognized for financial reporting purposes will differ from the cumulative amount of compensation deductions recognized for income tax purposes. Under current income tax law applicable to certain NQSO awards, an employer recognizes an income tax deduction for the intrinsic value of the option on the date that the employee exercises the option. The intrinsic value is computed as the difference between the option’s exercise price and the market price of the stock on the date of exercise.
Under ASC 718-50 this type of equity award is recognized at the fair value of the options at grant date with compensation cost recognized over the requisite service period. Consequently, during the period from grant date until the end of the requisite service period, the reporting entity is recognizing compensation cost in its financial statements with no corresponding income tax deduction.
Because the award described above is accounted for as equity (and not as a liability), the credit that offsets the debit to compensation cost is to additional paid-in capital. This results in a future deductible temporary difference between the carrying amounts of additional paid-in capital for financial reporting and income tax purposes, thus giving rise to a deferred income tax asset and corresponding deferred income tax benefit.
At exercise, to the extent that the income tax deduction based on intrinsic value exceeds the cumulative compensation cost recognized for financial reporting purposes, the income tax effect (the effective income tax rate multiplied by the cumulative difference) is credited to additional paid-in capital rather than being reflected in the income statement as a deferred income tax benefit.
The IRC provides employers the ability to obtain a current income tax deduction for payments of dividends (or dividend equivalents) to employees that hold non-vested shares, share units, or share options that are classified under ASC 718-50 as equity. Under this scenario, the payment of the dividends is charged to retained earnings under ASC 718-50 irrespective of the fact that the employer/reporting entity obtains a tax deduction for the payment as taxable compensation. The income tax benefit realized from deducting these payments is to be recorded as an increase to additional paid-in capital and, as explained in depth in the discussion of ASC 718-50 in Chapter 19, included in the pool of excess tax benefits available to absorb tax deficiencies on share-based payment awards.
Temporary Differences Arising From Convertible Debt with A Beneficial Conversion Feature
Issuers of debt securities sometimes structure the instruments to include a non-detachable conversion feature. If the terms of the conversion feature are “in-the-money” at the date of issuance, the feature is referred to as a “beneficial conversion feature”. Beneficial conversion features are accounted for separately from the host instrument under ASC 470-20.
The separate accounting results in an allocation to additional paid-in capital of a portion of the proceeds received from issuance of the instrument that represents the intrinsic value of the conversion feature calculated at the commitment date, as defined. The intrinsic value is the difference between the conversion price and the fair value of the instruments into which the security is convertible multiplied by the number of shares into which the security is convertible.
The convertible security is recorded at its par value (assuming there is no discount or premium on issuance). A discount is recognized to offset the portion of the instrument that is allocated to additional paid-in capital. The discount is accreted from the issuance date to the stated redemption date of the convertible instrument or through the earliest conversion date if the instrument does not include a stated redemption date.
For US income tax purposes, the proceeds are recorded entirely as debt and represent the income tax basis of the debt security, thus creating a temporary difference between the basis of the debt for financial reporting and income tax reporting purposes.
ASC 740-10-55 specifies that the income tax effect associated with this temporary difference is to be recorded as an adjustment to additional paid-in-capital. It would not be reported, as are most other such tax effects, as a deferred tax asset or liability in the balance sheet.
Other Common Temporary Differences
Other common temporary differences include:
- Accounting for investments. Use of the equity method for financial reporting while using the cost method for income tax purposes.
- Accrued contingent liabilities. These cannot be deducted for income tax purposes until the liability becomes fixed and determinable.
- Cash basis versus accrual basis. Use of the cash method of accounting for income tax purposes and the accrual method for financial reporting.
- Charitable contributions that exceed the statutory deductibility limitation. These can be carried over to future years for income tax purposes.
- Deferred compensation. Under GAAP, the present value of deferred compensation agreements must be accrued and charged to expense over the employee’s remaining employment period, but for income tax purposes these costs are not deductible until actually paid.
- Depreciation. A temporary difference will occur unless the modified ACRS method is used for financial reporting over estimated useful lives that are the same as the IRS-prescribed recovery periods. This is only permissible for GAAP if the recovery periods are substantially identical to the estimated useful lives.
- Estimated costs (e.g., warranty expense). Estimates or provisions of this nature are not included in the determination of taxable income until the period in which the costs are actually incurred.
- Goodwill. For US federal income tax purposes, amortization over fifteen years is mandatory. Amortization of goodwill is no longer permitted under GAAP, but periodic write-downs for impairment may occur, with any remainder of goodwill being expensed when the reporting unit to which it pertains is ultimately disposed of.
- Income received in advance (e.g., prepaid rent). Income of this nature is includable in taxable income in the period in which it is received, while for financial reporting purposes, it is considered a liability until the revenue is earned.
- Installment sale method. Use of the installment sale method for income tax purposes generally results in a temporary difference because that method is generally not permitted to be used in accordance with GAAP.
- Long-term construction contracts. A temporary difference will arise if different methods (e.g., completed-contract or percentage-of-completion) are used for GAAP and income tax purposes.
- Mandatory change from the cash method to the accrual method. Generally one-fourth of this adjustment is recognized for income tax purposes each year.
- Net capital loss. C corporation capital losses are recognized currently for financial reporting purposes but are carried forward to be offset against future capital gains for income tax purposes.
- Organization costs. GAAP requires organization costs to be treated as expenses as incurred. For income tax purposes, organization costs are recorded as assets and amortized over a 60-month period. Also see Permanent differences below.
- Uniform cost capitalization (UNICAP). Income tax accounting rules require manufacturers and certain wholesalers to capitalize as inventory costs, certain costs that, under GAAP are considered administrative costs that are not allocable to inventory.
Permanent differences are book-tax differences in asset or liability bases that will never reverse and therefore, affect income taxes currently payable but do not give rise to deferred income taxes. Common permanent differences include:
- Club dues. Dues assessed by business, social, athletic, luncheon, sporting, airline and hotel clubs are not deductible for federal income tax purposes.
- Dividends received deduction. Depending on the percentage interest of the payer owned by the recipient, a percentage of the dividends received by a corporation are nontaxable. Different rules apply to subsidiaries.
- Goodwill—nondeductible. If, in a particular taxing jurisdiction, goodwill amortization is not deductible, that goodwill is considered a permanent difference and does not give rise to deferred income taxes.
- Lease inclusion amounts. Lessees of automobiles whose fair value the IRS deems to qualify as a luxury automobile are required to limit their lease deduction by adding to taxable income an amount determined by reference to a table prescribed annually in a revenue procedure.
- Meals and entertainment. A percentage (currently 50%) of business meals and entertainment costs are not deductible for federal income tax purposes.
- Municipal interest income. A 100% exclusion is permitted for investment in qualified municipal securities. Note that the capital gains applicable to sales of these securities are taxable.
- Officer’s life insurance premiums and proceeds. Premiums paid for an officer’s life insurance policy under which the company is the beneficiary are not deductible for income tax purposes, nor are any death proceeds taxable.
- Organization and start-up costs. GAAP requires organization and start-up costs to be treated as expenses as incurred. Certain organization and start-up costs are not allowed amortization under the tax code. The most clearly defined are those expenditures relating to the cost of raising capital. Also see temporary differences above.
- Penalties and fines. Any penalty or fine arising as a result of violation of the law is not allowed as an income tax deduction. This includes a wide range of items including parking tickets, environmental fines, and penalties assessed by the US Internal Revenue Service.
- Percentage depletion. The excess of percentage depletion over cost depletion is allowable as a deduction for income tax purposes.
- Wages and salaries eligible for jobs credit. The portion of wages and salaries used in computing the jobs credit is not allowed as a deduction for income tax purposes.