4.2 Basic approach for deferred taxes

The tax provision for a given year as computed under ASC 740 represents not only the amounts currently due, but also the change in the cumulative future tax consequences of items that have been reported for financial reporting purposes in one year and taxable income purposes in another year (i.e., deferred tax). Under ASC 740, the current and deferred tax amounts are computed separately, and the sum of the two equals the total provision. The total tax expense is meant to match the components of pretax income with their related tax effects in the same year, regardless of when the amounts are actually reported on a tax return. Therefore, it is necessary to determine which filing positions a reporting entity would take based on information available at the time the provision is calculated.

In ASC 740, the computation of the tax provision focuses on the balance sheet. A temporary difference is created when an item has been treated differently for financial reporting purposes and for tax purposes in the same period, and when it is expected to reverse in a future period and create a tax consequence. The tax effect of these differences, referred to as deferred taxes, should be accounted for in the intervening periods. A deferred tax asset or liability is computed based on the difference between the book basis for financial reporting purposes and the tax basis of the asset or liability.

This asset and liability method, required by ASC 740, measures the deferred tax liability or asset that is implicit in the balance sheet; it is assumed that assets will be realized, and liabilities will be settled at their carrying amounts. If the carrying amounts of assets and liabilities differ from their tax bases, implicit future tax effects will result from reversals of the book-and tax-basis differences.

Step 1: Identify temporary differences. There are two categories of temporary differences: (1) taxable temporary differences that will generate future tax (i.e., deferred tax liabilities) and (2) deductible temporary differences that will reduce future tax (i.e., deferred tax assets). Temporary differences are most commonly identified and quantified by (1) preparing a tax balance sheet and comparing it with the financial statement balance sheet and (2) reviewing the reconciliation of book income with taxable income.

Step 2: Identify tax loss carryforwards and tax credits. A reporting entity may have US federal, state and local, and foreign tax loss carryforwards and certain tax credits. Tax loss carryforwards typically include net operating losses (NOLs) and capital losses, which, depending on the relevant jurisdiction’s applicable tax law, may be carried back to prior periods and/or forward to future periods to offset taxable income. Tax credits may include research and development credit (R&D credit), foreign tax credits, the US federal corporate alternative minimum tax credit (CAMT credit), investment tax credits, and other tax credits. Tax credits generally provide a “dollar-for-dollar” benefit against taxes payable.

Step 3: Determine the tax rate to apply to temporary differences and loss carryforwards. The applicable tax rate is the rate, based on enacted tax law, that will be in effect in the period in which temporary differences reverse or are settled. TX 4.3 discusses several factors that should be considered in determining the applicable rate.

Step 4: Calculate deferred tax assets and liabilities. For gross temporary differences and tax loss carryforwards, this entails multiplying the gross balance by the applicable tax rate. Tax credits generally provide a “dollar-for-dollar” benefit and therefore are already tax-effected.

Step 5: Evaluate the need for a valuation allowance. Under ASC 740, deferred tax assets resulting from deductible temporary differences, loss carryforwards, and tax credit carryforwards must be recorded, and then subjected to a test for realizability. A valuation allowance must be established for deferred tax assets if it is “more-likely-than-not” that they will not be realized. TX 5 discusses the valuation allowance assessment in detail.

4.2.1 Scheduling of temporary difference reversals

Scheduling of temporary differences may be necessary when recognizing and measuring deferred tax assets and liabilities. For example, when enacted tax rates are scheduled to change in future years or will become effective in future years, the year in which taxable and deductible temporary differences are expected to be reported on the tax return affects the measurement of the deferred tax asset or liability. This is because the applicable tax rate would be different depending on the year of expected reversal. If temporary differences are expected to reverse during years in which different levels of tax rates are expected to be applied based on varying levels of income (i.e., graduated rates), this also could affect the measurement of the deferred tax asset or liability. Similarly, any rate differential should be considered in the measurement of deductible temporary differences that are expected to reverse and be realized through a carryback to a year with a different tax rate than the current enacted rate.

Minimizing complexity is an appropriate consideration in selecting a method for determining reversal patterns. The methods used for determining reversal patterns should be systematic and logical. The same method should be used for all temporary differences within a particular category of temporary differences for a particular tax jurisdiction. Different methods may be used for different categories of temporary differences. If the same temporary difference exists in two tax jurisdictions (for example, U.S. federal and a state tax jurisdiction), the same method should be used for that temporary difference in both tax jurisdictions. The same method for a particular category in a particular tax jurisdiction should be used consistently from year to year. A change in method is a change in accounting principle under the requirements of Topic 250. Two examples of a category of temporary differences are those related to liabilities for deferred compensation and investments in direct financing and sales-type leases.

Refer to TX 5.8 for further discussion on scheduling future taxable income in connection with a valuation allowance assessment. Refer to Example TX 7-1 for further discussion on scheduling related to changes in tax rates.