Deferred tax assets and liabilities are often overlooked in a company’s financial reporting. In this issue of the Tax Insight, we look at ASC 740 requirements for accounting for income taxes and deferred taxes, and factors to consider when determining whether a valuation allowance should be established.
FASB Accounting Standards Codification (ASC) 740, Accounting for Income Taxes (previously FASB Statement No. 109) outlines the following requirements:
- Recognition of the estimated taxes payable or refundable on tax returns for the current year as a tax liability or asset.
- Recognition of a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards.
ASC 740 provides the following formula for calculating the income tax provision.
Current Income Tax Provision + Deferred Income Tax Provision = Total Income Tax Provision
The current tax expense or benefit is defined in ASC 740-20-20 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.” Generally, the current provision calculation is the same as completing a current year tax return for the entity, with a few modifications.
DEFERRED TAX ASSETS
A deferred tax liability or asset represents the increase or decrease in taxes payable or refundable in future years as a result of “temporary differences.” Temporary differences arise when events are recognized in one period on the financial statement but are recognized in another period on the tax return. Deductible temporary differences reduce taxable income in future periods and create deferred tax assets.
Deferred tax assets and liabilities can result from the following:
- Provision for loan and lease losses
- Recognition of loan origination fees
- Other post-employment benefits expense
- Carryforwards (e.g. NOLs, capital losses, credits, etc.)
Generally, deferred tax assets (DTAs) are generated via book expenses being incurred with a corresponding tax deduction, or a tax income item being generated without a corresponding book income pickup. An example would be an allowance for doubtful accounts, expensed for book purposes as incurred but non-deductible until the receivable is completely written off.
Deferred tax liabilities (DTLs) are generated via tax deductions occurring with a corresponding book expense or book income being generated without a corresponding tax income pickup. An example would be depreciation expensed for book purposes via straight line amortization, vs. MACRS for tax purposes (acceleration).
DTAs and DTLs are calculated by multiplying the applicable tax rate times the amount of the temporary difference or carryforward. The measurement of DTAs is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized. The realizability of all DTAs must be evaluated each period.
Valuation allowances are one of the areas frequently challenged by auditors. When determining whether a valuation allowance (VA) should be established, the first step is assessing the likelihood of deferred taxes being realized. If it is more likely than not that the DTAs will not be realized, you must establish a VA to reduce the DTA to net realizable value. There are four criteria to consider when deciding whether a VA is needed:
- Taxable income in carryback years if carryback is permitted.
- Taxable temporary differences
- Future taxable income exclusive of taxable temporary differences
- Tax planning
When reviewing positive and negative evidence, the general rule is that three years (or 12 quarters) of cumulative losses are hard to overcome. It is important to look at your financial planning analysis. For example, if you have an item that you can carry back because you paid taxes this year, then that asset is of immediate value so you would not have a valuation allowance against it.
SECTION 382 CONSIDERATIONS
Deferred tax assets, such as net operating loss (NOL) carryforwards, can be used to offset future taxable income thereby reducing a company’s tax burden and increasing its cash flow in a given year. However, NOLs can be subject to certain limitations, such as IRC Section 382. Section 382 generally requires a corporation to limit the amount of its income in future years that can be offset by historic losses, i.e. NOLs and certain built-in losses, after a corporation has undergone an ownership change. The Section 382 base limitation is calculated by multiplying the fair market value of the loss corporation by the federal long-term tax exempt rate. Careful consideration must be given to analyzing NOLs given the potential impact future NOL utilization can have on future cash flows of a company and ultimately the value of the company. For more information, contact your VRC representative.