QUINLAN: Hughlene, let's start with a baseline question, why is accounting for income taxes so important?

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1 September 2015 Segment 4 TRANSCRIPT 1. Challenges Related to Accounting for Income Taxes SURRAN: For many accountants, accounting for income taxes remains one of the most difficult subjects within the profession. The rules governing income tax accounting have been around for some time with the FASB having issued Statement No. 96 in 1987 which superseded APB Opinion No. 11, Accounting for Income Taxes issued in However over the ensuing years the business environment has grown increasingly more complex. In addition, the way that governments (federal, state, local and foreign) levy taxes has become more complicated. It is no wonder that accountants still struggle with the topic. As a result we thought it was a good time to take a fresh look at this hard to understand subject. So we asked our own Michael Quinlan to look into it. He recently met with Dr. Hughlene Burton to review the basic concepts related to ASC 740 Income Tax Accounting. In their discussion, Dr. Burton reviews how deferred taxes come about, the fundamental requirements involved in the accounting for income taxes with corresponding disclosures, issues surrounding uncertain tax positions and the latest developments related to this challenging topic. Dr. Burton is an Associate Professor of Accounting and Chair of the Department of Accounting at the University of North Carolina at Charlotte. Prior to academia, she worked in public accounting with both Deloitte and Ernst and Young. QUINLAN: Hughlene, I want to welcome you to the program. BURTON: Mike, thank you for having me today. QUINLAN: Hughlene, let's start with a baseline question, why is accounting for income taxes so important? BURTON: Well, you're calculating the tax provision, which is a large percentage based on income, and you have to have this calculation to get net income for companies. This is also the calculation for effective tax rate, and that is something that all of your publicly-traded companies have to disclose to the public. So it becomes a very important factor in the financial statements. QUINLAN: So what is included in the provision for income taxes line on the income statement? - 1 -

2 BURTON: It's one line on the income statement/provision for income tax, but it includes a lot of numbers. It includes both federal taxes, state income taxes, and any foreign taxes that a company has to pay. It includes the current taxes you have to pay, and the deferred taxes. So it's all taxes that are based on income. You'll see one line item on the financial statements, but it's made up of 5, 10, 15 different numbers that you have to calculate. QUINLAN: Hughlene, help us understand, why is the calculation of the tax provision so difficult? BURTON: As I mentioned, the tax provision, Mike, has both the current provision and it has the deferred part. That means the person who is preparing a tax provision has to know all the rules for income and deductions for financial statement purposes, but they also have to know the rules for the various taxing authorities. That includes the federal government for the U.S. It includes all the state governments. It includes the foreign governments wherever they're located. For someone to understand all the financial reporting which includes hundreds of pronouncements, and also keep up with all the changes that are made each year in the various taxing authorities is very difficult, because you're going to have to know when to pay taxes for tax return purposes, but also when to include the information in the financial statements, and not a lot of people know both. 2. Permanent and Temporary Differences QUINLAN: Let's look at permanent differences. What is a permanent difference? BURTON: The easiest way for someone to understand a permanent difference is that this is an item of income, or it's a deduction that is included in the financial statements, but you'll never see it on the tax return, or vice versa; it's an item on the tax return that's never reported in the financial statements. A good example of a permanent item would be the interest on a municipal bond. Municipal bonds are not taxable for federal purposes, the interest, but you include that income in total income on the financial statements. So it's a permanent difference. You're never going to pay tax on it, on the tax return, but you have to include the income in the financial statement pretax income number. QUINLAN: Could you give us another example? BURTON: Another example would be an item that's actually on the tax return that you never see in the financial statements, such as Internal Revenue Code Section 199, the domestic production deduction. For companies that are allowed to take this deduction, it's an additional deduction on the tax return that is not ever included in pretax income on your financial statements

3 QUINLAN: Hughlene, what effect does the permanent difference have on the tax provision? BURTON: Well the permanent item has an impact on the effective tax rate. When you're looking at a tax provision, you see a tax law and it says, "Provision for Income Tax." You'll also see in the footnote of a company, an effective tax rate. That effective tax rate is the total tax provision divided by pretax income. That is not the same as if you took the statutory rate multiplied by pretax income, and one of the big impacts, the reason that there is a difference between the effective tax rate and the statutory rate are the permanent items. QUINLAN: So what about temporary differences? What is a temporary difference? BURTON: Well, Mike, a temporary difference is an item expense or income that is either included income or deductible on the financial statements. It's also going to be included as income or deductible on the tax return. It's just going to be in a different time period. For example, where you capitalize an asset and we're allowed to take depreciation, but for financial statement purposes, we use one method for taking depreciation. For tax return purposes, we use a different method. We're still going to depreciate the same cost for both book and tax. For example, if we capitalize a million-dollar asset, over time we're going to deduct and take an expense of a million dollars. But the timing, the year that we take that deduction is different for tax purposes than it is for financial statement purposes. QUINLAN: So what effect does a temporary difference have on the tax provision? BURTON: The temporary difference creates deferred taxes. So when you're looking at the total tax provision, you've got current, and you've got deferred taxes. The temporary differences create the deferred taxes. Temporary differences do not increase or decrease the total amount of taxes that we have in our tax provision. It just separates the amount between current and deferred. So, even if you didn't have the temporary differences, the tax provision you would have on the financial statements would be the same as with the temporary differences. It's just that with the temporary differences, you're splitting out that provision into the amount we're actually going to pay today and the amount we will pay in the future. 3. Calculating Tax Provisions and Valuation Allowances QUINLAN: And how many separate tax provisions need to be calculated? BURTON: You need to calculate-the easiest answer is that you need to calculate a separate tax provision for every tax return the company is going to file

4 The rules apply for all jurisdictions. If you are going to file a consolidated federal return, if you have to file 50 state returns, and you might file 10 foreign tax returns, you need a separate provision for each of your jurisdictions. The reason that you need a separate provision for each of the jurisdictions is that each jurisdiction has a different tax law, and every time you have a different tax law, the temporary differences we talked about, the permanent differences we've talked about, they're different. Some states do not allow certain depreciation deductions that the federal government does. The foreign countries have very different tax laws than the U.S. So because all of the taxing jurisdictions have different rules, you need to calculate separate provisions. QUINLAN: Why should a company make a return to provision calculation and adjustment? BURTON: Mike, that's a very good question because a lot of companies might think this is not important. One of the things that happens is that we calculate our tax provision for the financial statements, generally within three months after year-end. Publicly-traded companies have to calculate their tax provision much faster, but the actual tax return is not filed until after that period of time. If a company gets an extension, then their tax return is not filed until about 8-1/2 months after year-end. From the time you have done the tax provision until you actually file the tax return, many things could have changed. Estimates could have changed. The tax - actually, a tax law could have changed. So what is actually on the tax return may be different from what is in the financial statement provision. So when you file your tax return, you need to look at what actually went on the tax return, compared to what you had in the tax provision, and any of those adjustments, any differences you need to adjust. You need to do that because if the difference is because of a temporary difference, if you don't make the return to provision adjustment, you may overstate overall tax expense on the two years. If you've got a permanent item, if you had not calculated that difference last year, the tax expense for that permanent item would never get in the financial statements if you don't do a return to provision adjustment. So it's very important that all companies look at the differences that they have on there, when they actually file the tax return versus what was in the tax provision and make that adjustment as quickly as possible. QUINLAN: How about valuation allowance? What is a valuation allowance? BURTON: One of the underlying concepts of financial accounting is conservatism, and so every time - when you're recording an asset, you've got to make sure that you're actually going to get the benefit of that asset

5 We don't want a company to put a lot of assets on their balance sheet that they never are going to get the benefit from. So if you record deferred tax assets, a company must examine those assets to see if they're actually going to get a tax benefit. In the U.S., we don't have a tax system that will allow us to take a deduction and get a benefit unless we have income. So if you're not going to get the benefit of the deferred tax assets, then you have to set up a valuation allowance. It's a contra account against the deferred tax asset. On the balance sheet, you would record your deferred tax assets at a gross number. You set up a valuation allowance for the amount that you don't think you're going to get the value of, and then on the balance sheet what actually gets shown is the net amount. QUINLAN: So how does a company determine if it needs to book a valuation allowance? BURTON: A company would look at their deferred tax assets, and examine them, and look at the future to see if they are going to have enough income in the right period of time, and the right character, the right type of income. If they can show that they will have enough income that they're going to be able to offset the future deductions, because a deferred tax asset means that you're going to have future deductions on your tax return. If you can show that you're going to have enough income to offset those deductions, then you don't need a valuation allowance. However, if there is no proof, and you're looking at all sources of future income, if you can't show that you're going to have enough income in the future to take advantages of the deductions that you have, then you have to set up a valuation allowance for that amount. QUINLAN: Does the valuation allowance reverse over time? BURTON: It can. It may not, but it can, and generally speaking what happens is, as you actually get the benefit of the deferred tax assets, then the valuation allowance will be reversed. Sometimes, you have to set up a valuation allowance because you've set up a deferred tax asset in, say, In 2015, when you're looking at the financial statements, you don't know if you're going to be able to have enough income to offset that deduction. So you set up a valuation allowance. A year goes by, and you realize that we now have more profit. We've got a new client. We now have enough income. We can show that there will be enough income that we can use it against the deductions. We would reverse the valuation allowance. QUINLAN: Hughlene, what challenges does the valuation allowance present to auditors? BURTON: Mike, that's a great question. It is one of the more difficult areas of the provision, accounting for income tax, because it's a judgment-based call, and auditors have to go in - the client will prepare their financial statements. They will review all the information. They generally will write up a memo explaining all of the steps they went through in determining whether they need a valuation allowance, or not, determining how they - you - 5 -

6 know, showing how they came up with the amount of valuation allowance that they think should be recorded. The auditor then goes in and takes that information and looks over it, reviews to see if they agree. A lot of determination of, "Will we have enough income in the future," is a judgment-based call, and any time you have a judgment-based call, the auditor's judgment may be different than the corporation's management's judgment, and so it becomes an issue. It is an area of the provision that is always discussed very thoroughly with a client so that you make sure that you make the right number on the financial statements. 4. Uncertain Tax Positions and Effective Tax Rates QUINLAN: What about uncertain tax positions? What is an uncertain tax position? BURTON: An uncertain tax position, an easy way of thinking about this is an aggressive tax position. This is a position that a corporation is going to take on one of their tax returns that may not be upheld if it were audited. It's based on the actual law, and you would record an uncertain tax position if there's a more than 50 percent chance that under the technical tax law you would not be allowed that deduction under audit by the taxing authority. So the easy way to think about this is when you're taking a very aggressive position. QUINLAN: And how does a company determine if it has an uncertain tax position? BURTON: A company has to look at all of their tax positions, deductions that they have taken, income that they're going to include or exclude, and then they have to look at the law, the technical tax law and make a determination. Again, this is a judgment call, but you make a determination based on the technical tax law. Is it more likely than not going to be upheld by the taxing authority? So we have decided, for example, that we would take a deduction for research and development costs. If we were audited, is it a greater than 50 percent chance that the IRS would uphold that deduction? If there's more than a 50 percent chance that the IRS would uphold that position, it's not an uncertain tax position. If it's less than 50 percent chance, you've got an uncertain tax position. QUINLAN: So it sounds like this is another area that could be difficult for auditors. BURTON: It is another area that's very difficult. You're looking at a two-step process when looking at the uncertain tax position. You're looking to say, "First of all, we cannot recognize a tax benefit for an item that is not more likely than not going to be upheld by the taxing authority. There has to be a greater than 50 percent chance the taxing authority would - 6 -

7 uphold it, but in addition to that, even if the taxing authority would uphold the position, we may not get the entire deduction - the benefit of the entire deduction." So that is even a more difficult area to look at for the auditor. For example, in my R&D example, if we took a thousand-dollar deduction, we looked at the relevant authority, and it's more likely than not it would be upheld. So there's a greater than 50 percent chance that we would be allowed to take that deduction. The second step that the auditor has to look at is how much of that deduction would actually be upheld. Many times, the IRS would say, "We will allow you to take a deduction, but we're not going to allow you to take the full thousand-dollar deduction. You're only going to get 800 dollars." In that situation, the second step that the auditor has to really look at is how much of the deduction will you actually get, and if you take a thousand-dollar deduction, but in the auditor's opinion you're only going to be able to get an 800-dollar benefit, you have to record a liability. As you said Mike, it is a very difficult area. It is something that you will have to discuss with the taxpayer. The taxpayer is going to have to look to professionals for a lot of help. In many cases, they get letters from attorneys - valuation experts to help them in determining how much they need to put on their financial statements as an uncertain tax position. QUINLAN: Hughlene, how does the disclosure of uncertain tax positions help a reader of financial statements? BURTON: In many cases, you've got the uncertain tax position recorded, but it may not be separately stated on the face of the balance sheet. If you look at the footnote with the disclosures, it will tell a reader of the financial statements - this is a position the company has taken that it's more likely than not - if the company is audited by a taxing authority, they're going to owe additional taxes. It's a liability that they may owe in the future, and by just looking at the balance sheet, you may not see that liability. Also, if a company has a lot of uncertain tax positions, a reader of the financial statements may determine that the company is a riskier investment proposition, because the company has decided to take some very aggressive tax positions. QUINLAN: What is the difference between a company's effective tax rate and the statutory tax rate? BURTON: The statutory tax rate is the tax rate that's enacted by the tax law. So the statutory tax rate is the same rate for all companies with the same amount of income. For corporations in the United States, most large corporations, the statutory rate is either 34 or 35 percent currently. The effective tax rate is the actual tax provision. It includes not only the current taxes but also the deferred taxes, as your total tax provision, federal, state and foreign, divided by - 7 -

8 pretax income. It is the tax rate that you're using to come up with a tax provision for the financial statements. If you take pretax income on the financial statements and multiply that by the effective tax rate, you will get the provision for income taxes. QUINLAN: What creates a difference between the effective tax rate and the statutory tax rate? BURTON: Well, for a company, they prepare what's called an effective rate reconciliation. It is in the footnotes to the financial statements. The statutory rate that they use is the federal rate-only. The effective rate includes the state rate and the foreign rate. The items that will increase or decrease the statutory rate to compute the effective tax rate would be state income taxes, foreign tax rate differentials, and permanent differences. Also, changes. We mentioned changes in the valuation allowance. If there was a change in a prior year valuation allowance, that changes the effective rate. Another way of thinking about this is there are items that - when we compute our taxes - they're called discrete items. Discrete items in a tax calculation will have an impact on the effective rate, so that you can go from the statutory rate, you adjust for these items and you get the effective tax rate. 5. Tax Disclosures QUINLAN: Let's switch to talking about disclosures. Why is disclosure of tax information in the footnotes important? BURTON: The information in the income statement and balance sheet are usually one-line, two-line items. The disclosure in the footnotes gives the details. It will break out the difference between whether it's a federal tax or a foreign tax. It breaks out the difference between current taxes and deferred taxes. It also gives information about what is creating the deferred taxes, how much of a valuation allowance you actually compute. It also gives information about taxes that were computed for items such as discontinued operations, and it will tell the reader of the financial statements information such as do we have net operating losses, do we have credit carryovers? When are those going to expire? That information. So it's an expanded explanation of that one line item that you see in the income statement. QUINLAN: Why are the taxes for earnings from some foreign subsidiaries not included on the balance sheet? - 8 -

9 BURTON: The rules - if a company owns a controlled foreign corporation that is - are for a corporation that owns more than 50 percent that's incorporated in a foreign country. The income is included in the financial statements because it is part of the consolidated financial statements. The U.S. government is not able to tax that income unless the foreign subsidiary pays a dividend back to the parent, or they sell the stock in that foreign corporation. So there are a lot of earnings that our foreign subsidiaries have that we've not paid tax in the U.S. on. There is an exception in the financial reporting rules that basically say, if the U.S. parent has control and intent to permanently reinvest the foreign earnings in the foreign country, you do not have to set up deferred taxes for that income on the financial statements currently. The reason behind that is, yes, eventually we will pay U.S. tax on it, but it is so far in the future it is considered to be more like a permanent difference than a temporary difference, and so therefore they don't have to set up the deferred taxes on that amount. They do have to disclose the amount of foreign earnings that they've not set up deferred taxes for and, if they can, the amount of taxes that they would owe when that income became taxable in the U.S. QUINLAN: Hughlene, why is the disclosure of this information important? BURTON: It's telling - it is not recorded. This is - if it's a lot of income, it could tell the reader that this company is going to owe a substantial amount of taxes in the future. You see the income is in the financial statements. The tax provision looks very low compared to that amount of income because we've not provided the taxes for it. You want to let the reader know how much of the income that's included in the income statement this year that we've not set up taxes for, but in the future we are going to owe these taxes. 6. Looking Forward QUINLAN: Hughlene, is there anything that is particularly topical now relating to accounting for income taxes that our viewers should be aware of? BURTON: Well, a couple things. There are some changes coming, small changes with how we're going to disclose information. In the future, deferred taxes will be reported only as long-term liabilities instead of having to split them out between current and long-term liabilities. The other hot area is still in the uncertain tax positions. Some of the things that are coming down the pike are coming because the SEC is starting to look at these areas

10 One of the biggest questions is part of the disclosure requirement is to actually disclose, in detail, any of your uncertain tax positions that you reasonably expect to turn around in the next 12 months. A lot of companies are not disclosing that information, and the SEC is starting to ask questions about that. The other area that is hot right now is in the valuation allowance area. In we had a lot of losses for companies, and when the companies had these losses they set up a lot of valuation allowances. As they're becoming more profitable, those valuation allowances are now being taken off the books, and one of the places that we're having to look at very carefully is when does that valuation allowance need to be taken off the books? How much of that valuation needs to be taken off the books? So those are the two more difficult areas are the areas that accountants need to pay a lot of attention to right now. The other area that we're going to have to look at for accounting for income taxes is as the FASB - are issuing new standards, they're having an impact on accounting for income tax. So, for example, a number of years ago, the FASB issued a new standard for business combinations. It made a major change to the way that we accounted for income tax. So if a company is entering into a business combination, they need to make sure that they account for the income taxes correctly. Another new standard that has been issued and will become effective in a few years is the new standard for revenue recognition. It's going to change when a company recognizes revenue for the financial statements. At this time, there has been no change in the Internal Revenue Code. So at this point in time, unless the company requests an accounting change for tax purposes, there will be some major differences between when you recognize income for financial statement purposes and when you recognize that income for tax purposes. So I would say that any time we have a new FASB pronouncement come out, you need to make sure that you take into considerations the impact you have on the tax provision. QUINLAN: Hughlene, we've covered a lot of ground today. If you could leave our viewers with one final thought about accounting for income taxes, what would that be? BURTON: Mike, that's a great question. It is a difficult concept. You have to stay current with the accounting pronouncements. You have to stay current with the changes in the tax law. It is very important that you know the differences. It is very important that you don't put off computing your tax provision to the last minute. It takes a lot of time, a lot of thought and effort to calculate the tax provision, and it is an important factor in the financial statements. It can't be overlooked

11 QUINLAN: Hughlene, lot of great information. Thanks for being here today. BURTON: Thanks for inviting me. SURRAN: Based on the high level of interest in this area Executive Enterprise Institute has arranged for Hughlene Burton to present two full day workshops on, "Income Tax Accounting" and "Advanced Income Tax Accounting" in Orlando in November. Both programs will be led by subject matter expert Hughlene Burton and are being offered on November 19th and 20th in Orlando. Registration for these programs is now open, so be sure to contact your SmartPros account representative or follow the registration information on the screen