Financial Accounting for Income Taxes in a Changing Tax Environment

The primary source of funding for governments is derived through the collection of taxes and as economic pressures arise, governments look for avenues to increase the collection of tax revenue.

As U.S. federal, state and foreign tax laws are subject to continual updates, companies are faced with the challenge of analyzing and accounting for the impact on their financial statements. Collectively, company tax, financial reporting, and operations personnel must address these impacts to ensure that the financial statements clearly and materially reflect the company’s current and future tax liabilities, opportunities and potential exposures. This task has been further complicated with the continually expanding expectation for precision, being promulgated by the SEC, Public Company Accounting Oversight Board ("PCAOB") and the Company’s auditor, on behalf of the financial statement users, related to the computation and disclosure of tax matters.

Exploring Recent History of Accounting for Income Taxes

Over the past eleven years, we have experienced a monumental shift in the expectations regarding the financial accounting and reporting of a company’s income tax asset or liability. There has been increased focus on the consistency, comparability, and disclosure surrounding income taxes within the financial statements. The genesis of the increased complexity in accounting for income taxes can be traced back to the release of FAS 109 which was issued in 1992, and replaced APB 11, which had previously been the U.S. GAAP Standard for Accounting for Income Taxes. FAS 109 changed the perspective from an income statement approach to a balance sheet approach with a heavier emphasis on the future tax treatment of items of income and expense that are recognized in different periods for book and tax return reporting. The expectations were greatly enhanced with the enactment of Sarbanes Oxley legislation in 2003, followed by the issuance of Financial Interpretation Number 48 ("FIN 48"), in 2006 – both of which increased the pressure on documentation expectations and narrowed the scope for the application of judgment. The current trend continues along the path of expanding the expectations regarding documentation of tax processes and income tax positions within the company’s work papers, coupled with the pressure for more expansive disclosures surrounding the judgments inherently required in the area of income tax conclusions.

The expanding expectations for documentation and detail disclosures surrounding judgments applied to accounting for income taxes can be contrasted with the historical approach taken by companies, whereby it was generally accepted, without explicit disclosures, that there would be inherent judgments assumed within the financial reporting for income taxes. It was generally acknowledged that the determination of a company’s income tax liability could be quite intricate due to the complexity of applying the tax laws of multiple jurisdictions to the company’s financial results. While the complex nature is still an acknowledged factor, the desire for transparency within financial reporting is the driving factor in the increased emphasis on documentation and disclosure.

Reporting Challenges when Tax Laws Change

A key element of ASC 740 requires a company to provide for income taxes based upon enacted tax legislation as of the last day of the financial statement reporting period.  Companies must have procedures in place to not only compute the impact of an enacted tax law change, but also to be able to monitor the actual enactment of new legislation within all tax jurisdictions in which the company operates. Further, a company needs to understand the legislative process within each jurisdiction to properly determine whether legislation is considered enacted under ASC 740. For example, over the past few years the United Kingdom has systematically been reducing the Corporate Income tax rates each year. The history has been that the expected rate reductions have been announced in budget resolutions issued early in the calendar year; however, the final step in the enactment process is not completed until August. Thus under ASC 740, these tax rate changes would be accounted for in the financial statements issued for the period that includes the August enactment date. Note that under International Financial Reporting Standards ("IFRS") the requirement is to include income tax law changes when they are substantially enacted, which could be an earlier date. Another example would include the U.S. enactment of legislation in early January 2013, which retroactively extended the R&D credit for years beginning January 1, 2012. Because the legislation was not signed into law by President Obama until January 2013, a company with a December 31 year end could not recognize R&D credits earned for activity in 2012 as an income tax benefit until the first quarter of 2013.

In addition to reflecting tax law changes in the proper accounting period, the financial reporting team needs to focus on the impact of the tax law change on the balance sheet and income statement. A company’s income tax expense includes a provision for taxes currently payable and a deferred provision for the tax impact of items recognized in different periods for book and tax return reporting. Most often, the current portion of the income tax provision is straight forward since it is based purely on the amounts currently payable or refundable. The deferred income tax provision is based upon the reversing temporary differences created from book and tax income/expense for a particular transaction or series of transactions being reporting in different periods. When temporary differences exist as of a reporting period, a company is required to determine the tax impact of these items based upon the income tax rates that are currently enacted and expected to apply in the period in which the temporary differences are expected to reverse. Therefore, a company needs to estimate when the differences will reverse. For example, assume that a company has taken an accelerated rate of depreciation, as provided by the tax statutes in a particular jurisdiction, that is in excess of the amount recorded for financial statement reporting purposes in the amount of $1 million. Further, assume that the jurisdiction(s) in which this deduction is being reflected enacts legislation that will reduce their corporate income tax rate from the current rate of 25% by 1% per year for the subsequent three years until it reaches the final new rate of 22%. The company would have recorded an initial income tax expense of $250,000 and deferred tax liability ("DTL") of $250,000, (25% of $1 million). When the new legislation is enacted the company would need to estimate what years the $1 million will reverse and apply the rate for that year. The table below demonstrates the computation of revised DTL of $226,000. The $24,000 difference would be recorded as an income tax benefit in the period of enactment.

A single tax law change in any one jurisdiction may not result in extensive complexity; however, changes in multiple jurisdictions could cause significant complications. This struggle is being experienced by multi-national companies as well as companies operating in multiple state jurisdictions since a number of states have been quite active in enacting tax rate changes, as well as their methodologies of apportioning taxable income within their jurisdiction.   

Potential U.S. Tax Reform

There currently is a continuous narrative regarding the perceived need and desire to implement significant U.S. tax reform, in particular to the taxation of multi-national corporations. While the probability of extensive tax reform can be a subject of great debate, if enacted, it has the potential to provide significant income tax accounting and reporting complexity for many companies. Some of the significant questions for consideration are: (1) will significant reform be enacted; (2) what would it look like; (3) what would the impact be? Currently, the “if enacted” question is the focal point. However, the other two questions are topics that are clearly worthy of discussion.

Prior to the enactment of any applicable legislation, companies should consider the following:

• Are you equipped to analyze and communicate the impact on your financial statements in an effective and efficient manner?
• What impact would tax reform have on your effective tax rate in the current and future years?
• What would the immediate impact be on your balance sheet and income statement?
• Will you now need to establish a deferred tax liability on a portion of foreign earnings that were previously considered to be essentially permanently reinvested?
• What would be the impact of now having a portion of your worldwide income subject to U.S. tax each year?
• What would the impact be on your foreign tax credit position?
• Would it be advantageous to make or postpone distributions from a foreign operation?
• Would you be prepared to make pre-emptive disclosures regarding potential impacts on your expected future effective tax rate as any proposals reach a stage of possibility?

Much of the discussion surrounding potential tax reform is centered around the lowering of the U.S. statutory tax rate of 35% to be more competitive, coupled with some form of taxation on worldwide earnings. While this is all speculative, there is one simple guideline to keep in mind when it comes to a statutory tax rate being reduced. When a statutory rate is reduced, it is obviously a positive for future cash taxes payable; however, the deferred tax position at the date of enactment will have an immediate impact on your balance sheet and income statement. When a company has an overall net deferred tax asset in a jurisdiction in which the statutory tax rate is being reduced, a reduced statutory rate will result in a current year charge to income tax expense since the asset will now be less valuable as it will be realized at a lower rate than originally expected. For example, assume a deferred tax asset for net operating loss carry forwards of $1 million, which were valued at 35% at the date they were incurred. If tax reform were to reduce the statutory rate to 25%, the value of the deferred tax asset will be reduced by $100,000 (10% of $1 million), resulting in an immediate charge to earnings.

The inherent complexities contained within multi-jurisdictional tax laws and their application, coupled with the increasing expectation for transparency and precision, continue to present many challenges to those responsible for the financial reporting for income taxes.