Accounting Standards Codiﬁcation (ASC) 740, Income Taxes addresses how companies should account for and report the effects of taxes based on income. While the scope of ASC 740 appears to be self-explanatory, the unique characteristics of different tax regimes across the United States and the world can make it difﬁcult to determine whether a particular tax is based on income.
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. This guidance removes certain exceptions to the general principles of ASC 740 and simplifies several other areas. ASU 2019-12 is effective for public business entities for annual reporting periods beginning after December 15, 2020, and interim periods within those reporting periods. For all other entities, it is effective for annual periods beginning after December 15, 2021, and interim periods within annual periods beginning after December 15, 2022. Early adoption is permitted in any interim or annual period. If a reporting entity chooses to early adopt, it must adopt all changes as a result of the ASU. The transition provisions vary by amendment.
If a tax system is based on the greater of an income-based calculation and a non-income-based calculation, ASU 2019-12 requires the amount of tax that is based on income to be accounted for under ASC 740 as an income-based tax, with any incremental amount accounted for as a non-income-based tax (i.e., “above the line”) recognized entirely in the period incurred. This amendment should be applied on either a retrospective basis for all periods presented or a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.
What is a tax provision?
An income tax provision represents the reporting period’s total income tax expense. This includes federal, state, local, and foreign income taxes. The ASC 740 income tax provision consists of current and deferred income tax expense.
Current income tax expense (benefit) includes the income tax payable (receivable) for the current period based on applying current tax law to current period taxable income or loss.
Deferred income tax expense (benefit) represents the anticipated future tax expense (benefit) from activity in past or current periods. These future expenses (benefits) arise due to temporary differences between book and tax value for certain items.
ASC 740 applies to all entities but only to entity-level taxes. Passthrough tax provisions only occur for jurisdictions that have income-based tax at the entity level. Thus, calculating the ASC 740 provision for income taxes usually concerns only C-corporations.
How does a corporation calculate its income tax provision under ASC 740?
Add the current and deferred income tax provisions to get the total ASC 740 income tax provision.
The current income tax provision equals the taxes reported on current year returns (if available) plus any adjustments for prior year returns.
However, the current income tax provision must exclude uncertain tax benefits except to the extent the relevant tax authority will more likely than not sustain the underlying position.
Companies may estimate the current income tax provision to issue financial statements before filing the related tax return.
To estimate the current income tax provision:
- Start with pretax GAAP income.
- Add or subtract net permanent differences.
- Add or subtract the net change in temporary differences.
- Subtract usable loss carryforwards.
- Multiply the result by the tax rate (21% for federal tax on C-corporations).
- Subtract usable tax credits, tax credit carryforwards, and the benefit of current year loss carrybacks.
Adjustments for prior year returns and uncertain tax benefits also apply to an estimated current provision.
ASC 740 mandates a balance sheet approach to accounting for income taxes. Companies recognize and measure deferred tax liabilities and deferred tax assets plus any required tax valuation allowances, then use the changes in these accounts to calculate the corporate deferred income tax provision.
Multiply total taxable temporary differences by the expected tax rate at the time the differences will reverse—based on currently enacted law—to calculate the deferred tax liability. Repeat this step with deductible temporary differences and loss carryforwards—then add total tax credit carryforwards—to obtain the deferred tax asset.
Next, create a deferred tax asset valuation allowance for the portion of the deferred tax asset with no more than a 50% chance of realization. Record the effect of uncertain tax benefits on deferred tax assets and liabilities.
The deferred income tax provision (benefit) equals the net deferred tax liability (asset) at the end of the year minus the net deferred tax liability (asset) at the beginning of the year.