Accounting for Income Taxes Calculations & Concepts

Accounting for Income Taxes Calculations & Concepts

Notice The following information is not intended to be written advice concerning one or more Federal tax matters subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2

Agenda Current and Deferred Tax Expense Calculation Deferred Taxes Valuation Allowance Investment in Subsidiaries & Equity Method Investees Business Combinations Interim Financial Reporting Financial Statement Presentation and Disclosures Intraperiod Tax Allocations and Items Excluded from Continuing Operations Rate Reconciliation 3

Basic Concepts of FASB ASC 740 Income Taxes 4

Current and Deferred Tax Expense Calculation 5

Overview of FASB ASC 740 Pre Tax Book Income Total Income Tax Expense After-Tax Book Income Permanent Differences Rate Reconciliation State/ Foreign Income Tax Expense Book/Tax Differences Temporary Differences Beginning Temporary Differences Temporary Differences Not Originating on Schedule M-1 Ending Temporary Differences Book Balance Sheet Tax Balance Sheet Taxable Income Loss/ Credit Carry-forwards Deferred Tax Asset/ Liability (EOY) Valuation Allowance Current Tax Expense Deferred Tax Asset/ Liability (BOY) Deferred Tax Expense 6

Overview of Accounting for Income Taxes Income Tax Expense Current Tax Expense Deferred Tax Expense Current Tax Expense/(Benefit) Deferred Tax Expense/(Benefit) Based on Tax Return (Amount owed to Government) +/- = Based on Change in Deferred Tax Assets, net of any valuation allowance, and Deferred Tax Liabilities (BOY to EOY) Total Income Tax Expense/(Benefit) Separate calculations for each tax-paying component in which company operates U.S. federal, one or more states, one or more foreign jurisdictions, etc. 6

Steps in Applying FASB ASC 740 1. Determine current tax expense for each tax-paying component in which taxpayer operates by applying applicable current year tax rate(s) to book income adjusted for permanent differences and current year change in temporary differences 2. Identify and account for temporary differences at end of current year 3. Identify operating loss and tax credit carryforwards 4. Perform the provision-to-return reconciliation 5. Determine appropriate tax rate(s) to utilize in measuring deferred taxes 6. Recognize DTL for taxable temporary differences 7. Recognize DTA for deductible temporary differences + carryforwards 8

Steps in Applying FASB ASC 740 (Cont'd) 8. Determine need to reduce DTA by valuation allowance 9. Determine that unrecognized tax benefits are properly accounted for 10. Determine deferred tax expense, generally equal to change in net DTA or DTL during year 11. Determine total income tax expense = current tax expense (step 1) + deferred tax expense (step 10) 12. Review income tax effects of share based compensation - confirm rates applied and tax treatment 13. Address financial statement reporting issues Balance sheet classification/presentation of DTAs and DTLs Intraperiod tax allocation Footnote disclosures (including rate reconciliation) Unrecognized tax benefit disclosures 9

Book Income vs. Taxable Income Book income computed based on U.S. GAAP Taxable income computed based on the Internal Revenue Code (US) Book Income Taxable Income Permanent differences impact the effective tax rate Refers to items of income that are not taxable or expenses that are not deductible currently and will not result in taxable or deductible amounts in the future and/or cannot be anticipated in future periods. Changes in temporary differences give rise to deferred taxes Differences between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the amount reported in the financial statements is recovered or settled. 10

Common Permanent Differences 50% of meals and entertainment (nondeductible) Fines and penalties (nondeductible) Officer s life insurance premiums, in certain cases (nondeductible) Tax-exempt interest income (nontaxable) Dividends-received deduction (deductible for tax but not for book) 199 deduction (deductible for tax but not for book) Country Club Dues (nondeductible) 162m (nondeductible excess compensation) Incentive stock options(nondeductible) 11

Deferred Taxes Objective is to recognize deferred tax assets and liabilities for expected future tax consequences of events that have been recognized in the financial statements or tax returns 12

Temporary Differences ASC 740-10-20 defines a temporary difference as a difference between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled, respectively An assumption inherent in an entity s statement of financial position is that the reported amounts of assets and liability will be recovered and settled, respectively Based on that assumption, a difference between the tax basis of an asset or a liability and its reported amount will result in taxable or deductible amounts in some future year(s) 13

Temporary Differences Common causes of temporary differences Recognition of income or expenses in different periods for book and tax purposes (book-tax differences) Business combinations (assets recorded at FMV for book and adjusted basis for tax) Changes in accounting method ( 481(a) adjustment creates deferred income item for tax which does not exist for book) 14

Temporary Differences (Cont'd) Questions to be answered concerning temporary differences Does a temporary difference exist? Is the temporary difference a taxable temporary difference or a deductible temporary difference? Is there an exception to recording deferred taxes with respect to the temporary differences? 15

Identification of Temporary Differences Best practice construction of tax basis balance sheet and comparison with book balance sheet Alternative method an inventory of temporary differences, adjusted for business combinations and other items identified in ASC 740 as creating temporary differences NOTE: DTAs and DTLs are computed based on temporary differences at end of current year (not just the current year book-tax difference) 16

Question What are some temporary differences that you have run across on provisions you have worked on? 17

Common Temporary Differences Allowance for doubtful accounts PP&E (different depreciation lives/methods) Inventory book/tax differences (UNICAP, valuation reserves) Prepaid expenses Intangibles and goodwill Accruals and reserves Deferred income 481(a) adjustments Nonqualified Stock Options/Restricted Stock 18

Taxable vs. Deductible Temporary Differences Taxable temporary difference (TTD) Deductible temporary difference (DTD) Assets Book carrying value > tax basis Tax basis > book carrying value Liabilities Tax basis > book carrying value Book carrying value > tax basis 19

Taxable vs. Deductible Temporary Differences (Cont'd) Taxable temporary difference (TTD) Deductible temporary difference (DTD) Current / Prior Periods Book income > taxable income Taxable income > book income Future Periods Taxable income > book income Book income > taxable income 20

Review Questions 21

Review Question 1 What items affect total income tax expense? A. Pretax Income B. Permanent Book/Tax Differences C. Temporary Book/Tax Differences D. All of the above E. A & B Only 22

Review Question 2 If Company B s pretax Income is $1,000 and includes taxexempt interest income of $500, what would be the income tax expense with a 40% tax rate? A. $200 B. $420 C. $245 D. $525 23

Review Question 3 If all other facts remain the same as in Question 2, except Company B s has a favorable depreciation M-1 of $700, what would be the Total Income Tax Expense (with 40% tax rate)? A. $200 B. $480 C. $525 D. $350 24

Review Question 4 Assuming the facts from Review Question 3, what entry would be recorded for the provision? Debit Credit A. Income Tax Payable 80 Current Income Tax Benefit (80) Deferred Income Tax Expense 280 Deferred Taxes (280) B. Deferred Income Tax Expense 600 Deferred Taxes (600) C. Current Income Tax Expense 280 Income Tax Payable (280) Deferred Income Tax Expense 280 Deferred Taxes (280) D. Deferred Taxes 320 Deferred Income Tax Benefit (320) 25

Review Question 5 ABC Company s Current Tax Calculation is as follows: Pretax Book Income $150,000 Meals & Entertainment 1,000 Depreciation (25,000) Deferred Revenue 40,000 Taxable Income 166,000 ABC Company pays taxes at a 34% rate for Federal income tax purposes and 6% for State income tax purposes Question: What is ABC s Current Tax Expense? A. $56,440 B. $63,014 C. $66,400 D. $60,000 26

Review Question 6 Which of the following is an example of a common taxable temporary difference? A. Meals & Entertainment B. Goodwill C. Bad Debt Reserve D. Deferred Revenue 27

Review Question 7 What is an example of a common deductible temporary difference? A. Cash Surrender Value of Life Insurance B. Penalties C. Prepaid Expense D. Accrued Litigation Expense 28

Deferred Taxes 29

Recognition of Deferred Taxes General rule deferred taxes recognized for all temporary differences Exceptions Excess of tax over book basis of a domestic or foreign subsidiary where difference is not apparent to reverse within the foreseeable future (generally within one year) Excess of book over tax basis of a foreign subsidiary where difference is considered indefinitely reinvested Excess of book over tax basis of a domestic subsidiary where difference may be recovered tax-free Component two book goodwill Other specified items 30

Common Operating Loss and Tax Credit Carryovers Item Net operating losses Capital losses General business credits Foreign tax credits Minimum tax credit Normal U.S. Federal Carryback/ Carryforward Period Back 2 years; forward 20 years (generally) Back 3 years; forward 5 years Back 1 year; forward 20 years (generally) Back 1 year; forward 10 years Carryforward indefinitely 31

Deferred Taxes Balance sheet approach Deferred tax expense not calculated directly Deferred tax assets (DTAs) and liabilities (DTLs) are calculated based on differences in book and tax bases of assets and liabilities + future tax benefits of carryovers Deferred tax expense generally equals difference between BOY net DTA or DTL and EOY net DTA or DTL 32

Example of Balance Sheet Approach At the beginning of the current year, Company X has a net deferred tax liability of $100,000 recorded on its balance sheet. At the end of year, the calculated net deferred tax liability reported on X s balance sheet is $140,000. X s deferred income tax expense for the year is $40,000 ($140,000 EOY DTL - $100,000 BOY DTL). 33

Tax Rates for Deferred Tax Computations ASC 740-10-30-8 enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized U.S. federal tax jurisdiction Generally flat 34% or 35% rate Exceptions Small taxpayers graduated tax rates taken into account Taxpayers anticipating future losses lowest graduated rate used to measure deferred taxes, if graduated rates are a significant factor 34

Tax Rates for Deferred Tax Computations (Cont d) Other issues Taxpayers anticipating to pay AMT for indefinite future utilize applicable currently enacted regular tax rate (e.g., 34% or 35%) to compute DTA/DTL Special deductions (e.g., percentage depletion, 199 deduction) generally not considered in determining applicable tax rate for computing DTAs and DTLs Exception for items that are in substance adjustments to the tax rate, such as anticipated future dividends received deduction with respect to undistributed earnings of domestic investees, i.e., book-tax difference anticipated to reverse through receipt of dividends eligible for DRD Some portion of the future effects of special deductions are implicitly recognized in determining (a) the average graduated tax rate to be used for measuring deferred taxes and (b) the need for a valuation allowance 35

Tax Rates for Deferred Tax Computations (Cont'd) State jurisdictions Rates vary from jurisdiction to jurisdiction May be possible to combine states with similar profiles or insignificant amounts of income and utilize blended state rate Federal/state interaction State rate is effectively reduced by fact that state taxes are deductible for federal purposes General formula for state rate net of federal effect is [state rate (state rate x federal rate)] Assuming a U.S. federal statutory rate of 35% and an enacted state rate of 10%, an appropriate tax rate to use for an aggregate calculation would be 41.5% [35% + 10% - (10% x 35%)] 36

Computation of Deferred Tax Asset and Liability General formula for deferred tax liability DTL = taxable temporary differences (TTD) x applicable tax rate General formula for deferred tax asset DTA = [(deductible temporary differences (DTD) + operating loss carryforwards) x applicable tax rate] + tax credit carryforwards NOTE: No netting of TTDs/DTDs prior to application of tax rate; no netting of DTA and DTL at this point in process 37

Computation of Deferred Tax Expense and Benefit Net DTA or DTL at EOY Minus: Net DTA or DTL at BOY Equals: Deferred Income Tax Expense (Benefit) Decrease in net DTA / increase in net DTL = expense Increase in net DTA / decrease in net DTL = benefit Note: Adjustments for business combinations, certain business dispositions and certain other adjustments would alter the above equation 38

Review Question 8 ABC Company had the following BOY temporary differences: Bad Debt Reserve 10,000 Deferred Revenue 65,000 PP&E (100,000) ABC Company pays tax at a rate of 34% for federal income tax purposes and 6% for state income tax purposes ABC Company s Current Year Book to Tax Reconciliation is as follows: Pretax Book Income $150,000 Meals & Entertainment 1,000 Depreciation (25,000) Deferred Revenue 40,000 Taxable Income 166,000 Based on the facts above, what is ABC Company s deferred tax expense/(benefit) for the current year? A. ($6,000) B. ($5,694) C. $7,592 D. $8,234 39

Provision-to-Return Differences Occur as a result of actual numbers utilized in preparing tax return differing from estimates utilized in preparing tax provision True-up process in subsequent year Permanent differences adjust income tax expense in current year to reflect impact of discrepancy on amount of tax paid in prior year Temporary differences adjust DTA or DTL in current year to reflect impact of discrepancy on amount of tax paid in prior year Evaluate true-up items to determine if the change from provision to return was the correction of an error or change in estimate 40

Case Study Review RHM case study fact Complete case study parts I to 5 41

Valuation Allowance 42

Valuation Allowance General Concept Valuation allowance must be recognized to the extent that it is more likely than not that some or all of the deferred tax asset will not be realized FASB ASC 740-10-30-5(e): Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized. 43

Reasons for a Valuation Allowance Valuation allowance should reduce DTA to the amount that is more likely than not to be realized Recognition or non-recognition of a valuation allowance is not optional Valuation allowance must be adjusted as circumstances change 44

Valuation Allowance Sources of Income Realization of tax benefits of DTDs and carryovers is dependent upon enterprise having: Sufficient taxable income Of an appropriate character Within the statutory carryback/carryforward period 45

Valuation Allowance Sources of Income (Cont d) Sources of income: Taxable income in carryback years if carryback is permitted by tax law Future reversals of existing temporary differences Forecasted future taxable income exclusive of reversing temporary differences and carryforwards Additionally, tax-planning strategies generally do not represent a source of taxable income by themselves but instead, if executed successfully, increase taxable income of the appropriate character and in the appropriate periods to allow for realization of the tax benefits 46

Valuation Allowance Sources of Income (Cont'd) If evidence of one or more sources of taxable income is sufficient to support a conclusion that no valuation allowance is needed, it is generally not necessary to consider other potential income sources Taxable income in prior years and future reversals of TTDs are generally more objective than projections of future taxable income 47

Valuation Allowance Level of Analysis Need for valuation allowance must often be determined separately for each tax-paying component due to differing carryback/carryover rules Even within a single tax-paying component, need for valuation allowance with respect to different types of carryovers must often be evaluated individually due to different carryback/carryover periods and differing limitations on utilization 48

Steps in Determining Valuation Allowance 1. Determine gross amount of DTAs and DTLs 2. Determine amount of taxes paid during available carryback period 3. Obtain general understanding of pattern and timing of reversals of temporary differences and length of available carryback/carryforward periods 4. Determine extent to which it is more likely than not that tax benefits of DTDs and carryforwards (DTAs) will be realized through carryback or through offsetting future TTDs 5. Determine amount and timing of future taxable income necessary to realize remaining balance of DTA 49

Steps in Determining Valuation Allowance (Cont'd) 6. Determine whether evidence exists to support conclusion that it is more likely than not that future income will be sufficient to allow realization of remaining DTA 7. If necessary, consider availability of prudent and feasible tax-planning strategies 8. Consider existence of negative evidence concerning realizability of DTA 9. Reach overall conclusion concerning amount of valuation allowance required to reduce DTA to amount that more likely than not will be realized 50

Scheduling Temporary Differences An exercise or analysis performed to determine the pattern and timing of reversal of temporary differences Not mandatory under FASB ASC 740, but useful in determining whether DTAs will be realized via utilization to offset future taxes that would otherwise be payable when DTLs reverse Methods employed should be systematic, logical, and applied consistently from year to year Degree of detail is a matter of professional judgment 51

Exercise Scheduling Assume that X has a DTA of $34 attributable to a $100 DTD expected to reverse next year and a DTL of $34 attributable to a $100 TTD expected to reverse next year. Assume that the DTA and DTL are in the same tax jurisdiction and are of the same character. Is a valuation allowance needed? (Assume no taxes paid in prior years and no future taxable income exclusive of reversing temporary differences and carryforwards and no taxplanning strategies are available.) Would your answer change if the DTD was not expected to reverse until five years in the future? 52

Valuation Allowance Evidence Weigh positive evidence (indicating DTA will be realized) against negative evidence (indicating DTA will not be realized) Items weighted based on extent to which they can be objectively verified Examples of Negative evidence Cumulative losses in recent years Past/expected future losses Brief carryback and carryforward periods Special character of income (e.g., capital gains, foreign source income) required to realize tax benefits History of carryforwards expiring unused 53

Valuation Allowance Evidence (Cont'd) Examples of Negative evidence (Cont d) Management has historically been unable to accurately forecast future earnings Unfavorable trends, developments, or contingencies Going-concern issues Examples of Positive evidence Strong earnings history Appreciated net asset values Taxes paid in potential carryback years Availability of tax-planning strategies Favorable recent developments Sales backlog 54

Tax-Planning Strategies Description Prudent and feasible actions (including elections for tax purposes) that an enterprise ordinarily might not take but would take, if necessary, to realize a tax benefit for an operating loss or tax credit carryforward before it expires Goal is to alter timing or character of future taxable income or deductible expenses Reasonable effort must be made to identify tax-planning strategies prior to booking valuation allowance 55

Tax-Planning Strategies (Cont'd) Tax benefit must be reduced by net-of-tax amount of costs or losses that would be recognized if strategy were implemented Examples of potential tax-planning strategies Sale and leaseback of plant and equipment (if overall appreciation in company net assets) Switch from tax-exempt to taxable investments Disposition of obsolete or excess inventory Tax-planning strategies must provide sufficient evidence that gains or additional income would generate positive taxable income and not solely reduce a taxable loss 56

Accounting for Valuation Allowance Balance sheet impact of valuation allowance Decreases amount of deferred tax asset Allocated between current deferred and noncurrent deferred tax assets for that tax jurisdiction on a pro rata basis (FASB ASC 740-10-45-5) Income statement impact of valuation allowance Increase in valuation allowance generally increased tax expense/decreased net book income Decrease in valuation allowance generally decreased tax expense/increased net book income 57

Exercises Valuation Allowance 1. A historically profitable company has TTDs in excess of DTDs + carryforwards within the same tax jurisdiction. Could a valuation allowance be needed? 2. A company that has historically been unprofitable and anticipates losses continuing for several years sets up a valuation allowance equal to the full amount of the gross deferred tax asset. Is such treatment appropriate? 58

Review Questions 59

Review Question 1 Which of the following is not an example of negative evidence when considering the need for a valuation allowance? A. Cumulative losses in previous years B. Strong earnings history C. History of NOLs expiring unused D. Loss Contingencies 60

Review Question 2 One of the examples of negative evidence is cumulative losses in recent years. True or False: When evaluating cumulative losses, the Company should consider taxable losses rather than pretax book losses. 61

Review Question 3 Company ABC is expecting taxable losses for the next three years. It currently has DTAs totaling $100 and DTLs totaling $60, all of which are expected to reverse next year and are of the same character. Without regard to carryback periods and tax-planning strategies, how much of a valuation allowance, if any, should be set up? A. $40 B. $100 C. $60 D. No valuation allowance is necessary 62

Review Question 4 Which of the following would not be considered a source of taxable income when determining if a valuation allowance is necessary? A. Company X has historically been profitable and is expected to continue to have taxable income. B. Company X is expected to engage in a sale-leaseback of its operating assets. C. Company X had taxable income in the previous two years (carrybacks are available). D. Company X is expected to sell appreciated assets E. None of the above. 63

Review Question 5 Company XYZ is expecting taxable income of $300, $400, and $500 in future years 1, 2, and 3. XYZ s only DTA is $500 related to a NOL carryforward that will expire at the end of future year 3. Assuming a 35% tax rate and no other sources of taxable income, what should be the VA at the end of the CY? A. $300 B. $80 C. $500 D. No VA is needed 64

Review Question 6 Who is responsible for determining if a VA is necessary, and if it is necessary the amount of VA to be recorded on the books? A. Audit Partner B. Tax Partner C. Audit Committee D. Company Management 65

Case Study Complete case study parts 7 to 10 66

Investment in Subsidiaries & Equity Method Investees 67

Overview Inside/outside basis differences Investment in subsidiaries and equity method investments ASC 740 applies to foreign operations Consolidated in the U.S. financial statements, or Accounted for by the equity method Taxation of foreign earnings 68

Inside Basis vs. Outside Basis Inside Basis Differences Arise from differences between the financial statement carrying amounts and tax basis of a subsidiary s (both domestic and foreign) assets and liabilities. Outside Basis Differences Arise from difference between the financial statement carrying amount and the tax basis of the parent company s basis of the investment in an investee (components of outside basis difference could include capital, earnings & CTA) 69

Example Outside Basis Difference for Foreign Subsidiary Stock Book Carrying Values Capital 20 20 Tax Basis Net Income 90 00 Translation (OCI) 10 00 120 20 Tax Basis (20) Temporary Difference 100 Assume earnings and profits of 100 70

Outside Basis Differences Summary Subsidiary Corporate joint venture Other equity methods VIEs Taxable Temp Diff Deductible Domestic Foreign Temp Diff Tax free recovery or pre-1993 exception FASB ASC 740-30- 25-18(b) Indefinite reversal criteria exception FASB ASC 740-30-25-18(a) Same rules as a subsidiary General rules of ASC 740; no exceptions DTA prohibited, unless apparent test met - FASB ASC 740-30-25-9 Same rules as a subsidiary (control of how and when earnings are distributed must be considered) 71

Investments in Subsidiaries Foreign versus Domestic U.S. UK 1 UK 2 France Germany 72

Investments in Subsidiaries Deductible Temporary Difference Excess tax basis related to outside basis difference for both domestic and foreign subsidiaries No deferred tax asset unless basis difference apparent to reverse in foreseeable future Foreseeable future generally believed to be within one year Excess foreign tax credits on expected recovery through dividend distributions Same prohibitions noted above apply Consider tax liabilities to other jurisdictions (i.e., withholding taxes) 73

Investments in Subsidiaries Domestic Taxable Temporary Differences No taxable temporary difference exist if: Law provides a means by which the subsidiary may be recovered tax-free, and The company expects it will ultimately use that means If no tax-free options exist due to current ownership percentage, assess intent with respect to timing of settlement of minority interest If the indefinite reversal criteria is met, a deferred tax liability shall not be recognized for the undistributed earnings of a domestic subsidiary that arose in fiscal years beginning on or before December 15, 1992 unless it becomes apparent that the temporary difference will reverse in the foreseeable future 74

Investments in Subsidiaries A domestic or foreign subsidiary remits earnings to a parent entity after the parties consider numerous factors, including the following: Financial requirements of the parent entity Financial requirements of the subsidiary Operational and fiscal objectives of the parent entity, both long-term and short-term Remittance restrictions imposed by governments Remittance restrictions imposed by lease or financing agreements of the subsidiary Tax consequences of the remittance. 75

Investments in Subsidiaries Foreign Taxable Temporary Differences The presumption: It shall be presumed that all undistributed earnings of a subsidiary will be transferred to the parent entity. Accordingly, the undistributed earnings of a subsidiary included in consolidated income shall be accounted for as a temporary difference The indefinite reversal criteria: The presumption that all undistributed earnings will be transferred to the parent entity may be overcome, and no income taxes shall be accrued by the parent entity, if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings or that the earnings will be remitted in a tax-free liquidation A parent entity shall have evidence of specific plans for reinvestment of undistributed earnings of a subsidiary which demonstrate that remittance of the earnings will be postponed indefinitely Experience of the entities and definite future programs of operations and remittances are examples of the types of evidence required to substantiate the parent entity's representation of indefinite postponement of remittances from a subsidiary 76

Investments in Subsidiaries Foreign Taxable Temporary Differences (Cont d) The exception: If the indefinite reversal criteria is met, a deferred tax liability shall not be recognized for an excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary unless it becomes apparent that the temporary difference will reverse in the foreseeable future 77

Investments in Foreign Subsidiaries Foreign Taxable Temporary Differences (Cont d) Exception (FASB ASC 740-30-25-17 and 25-18a) Applies to entire excess of financial carrying amount over the tax basis of investment Not applicable to inside basis differences Applicable only to foreign subsidiaries and foreign corporate joint ventures Criteria to apply Plan to re-invest indefinitely Remitted in a tax free manner Will not reverse in foreseeable future 78

ASC 740-30-25-17 Considerations Policy may differ by subsidiary Treatment of Subpart F income (unrealized Subpart F) Continued reinvestment of prior earnings when future earnings may be repatriated Impact of fixed dividend payments Foreign branches Not limited to U.S. jurisdiction Plans to sell subsidiary 79

ASC 740-30-25-17 Considerations Supporting Indefinite Reinvestment In order to support an indefinite reinvestment of earnings example documentation may include: Significant inter-company or third party debt which would require cash Details of plant expansion to be undertaken Acquisitions planned Documentation of advertising or promotion campaign planned Providing funding for other group members Debt covenants restricting dividend payments 80

ASC 740-30-25-17 Considerations Supporting Indefinite Reinvestment (Cont d) In order to support an indefinite reinvestment of earnings example documentation may include: Additional borrowing plans Past activities of the entity Confirm consistency with other areas 81

Business Combinations 82

Overview Accounting for Income Taxes on Business Combinations: Types of Acquisitions, Consideration Transferred and Acquisition Accounting Goodwill Bargain Purchase Interaction with Acquirer s Positions Measurement Period

Types of Acquisitions Taxable (Asset Acquisition) Taxes paid by the acquiree at acquisition Selling shareholders are taxed on the distributions associated with the sale of the entity Asset and liabilities are generally stepped up or down to fair market value based upon the provisions of the tax law (IRC 1060 allocation in the U.S.) Nontaxable (stock acquisition) No taxes are paid by the acquiree at acquisition Selling shareholders are taxed on the difference between the consideration received and the tax basis in the shares The tax basis of assets and liabilities is generally carried over

Consideration Transferred The consideration transferred may include assets or liabilities of the acquirer that have carrying amounts that differ from the fair values at the acquisition date Exception Results in gain or loss for difference between fair value and acquirer s carrying amount, unless transferred assets or liabilities remain in combined entity after the business combination Replacement share-based payment awards use a fair value based measure Equity securities issued as consideration should be measured at the fair value on the acquisition date Items excluded from consideration transferred include the following Practice issue Settlements of preexisting relationships Compensation for future employee services Acquisition related costs (professional fees, due diligence costs and the like, including reimbursement of such costs) Determining whether a portion of consideration from the seller is a reimbursement of acquisition-related costs

Acquisition Accounting Step 1: Recognize fair values of identifiable assets acquired and liabilities assumed (ignoring the tax basis) Step 2: Recognize current taxes payable or receivable from prior tax periods, including those related to unrecognized tax benefits Step 3: Identify tax basis of assets acquired and liabilities assumed and compare to recognized fair values Step 4: Recognize DTAs and DTLs on temporary differences of identifiable assets acquired and liabilities assumed Step 5: Recognize DTAs for the tax benefits of operating loss and tax credit carryforwards Step 6: Recognize valuation allowance on DTAs (acquired and existing) with changes to existing DTAs recognized outside of acquisition accounting Step 7: Recognize goodwill for residual (if the FMV of assets acquired is greater than the purchase price, a bargain purchase gain is reflected in pretax income equal to the difference) Step 8: Recognize a DTA and an adjustment to goodwill for excess deductible tax goodwill

Acquisition Accounting Example Assumptions Company A, a calendar year corporation, acquires Company B on January 1, 20X1, for $1,000,000 in a nontaxable transaction that is accounted for as a purchase Company A has no temporary differences or carryforwards prior to the acquisition The enacted tax rate for 20X1 and all future years is 40 percent Identifiable assets acquired and liabilities assumed have the following FMV and tax bases: Fair Value Tax Basis All deductible temporary differences reverse in the same periods as at least an equivalent amount of taxable temporary differences. Company B has no net operating loss or tax credit carry forwards. Deductible (Taxable) Temporary Difference Current assets $300,000 $350,000 $50,000 Property, plant, and equipment 800,000 400,000 (400,000) Liabilities, excluding warranty reserve and deferred taxes (200,000) (200,000) - Warranty reserve (100,000) - 100,000 Identifiable net assets acquired $800,000 $550,000 $(250,000)

Acquisition Accounting Example Final Allocation Current assets $300,000 Property, plant, and equipment 800,000 Deferred tax asset 60,000 Goodwill 300,000 Warranty reserve (100,000) Other liabilities (200,000) Deferred tax liability (160,000) Purchase price $1,000,000 The deferred tax liability of $160,000 results from the $400,000 taxable temporary difference between the assigned value and the tax basis of the property, plant, and equipment, multiplied by the enacted tax rate of 40 percent. The deferred tax asset of $60,000 is the result of the enacted tax rate multiplied by the sum of the deductible temporary differences - $50,000 attributable to inventory and $100,000 of warranty reserve. No valuation allowance is required since deductible temporary differences will offset taxable temporary differences. No deferred taxes are recorded for the goodwill as ASC 740 specifically excludes nondeductible goodwill from deferred tax recognition.

Acquisition Accounting When determining the measurement of the acquiree s deferred taxes, the acquirer considers its attributes on the measurement of the deferred tax assets and liabilities For example, an acquirer may not be able to assert the indefinite reversal criteria of ASC 740-30 for its acquired subsidiary. Although the acquiree may have previously been able to make such an assertion, deferred taxes related to outside basis differences of acquired investments should be recorded as part of the acquisition accounting

Goodwill Non-deductible goodwill is an exception to the recognition of deferred taxes No deferred taxes are recorded on non-deductible goodwill Two components of goodwill: First Component: Lesser of book or tax goodwill Second Component: Excess book or tax goodwill Example Example A Example B Book Tax Book Tax First Component $ 600 600 $ 600 $ 600 Second Component 200 200 Total Goodwill $ 600 800 800 600

Second Component Tax Goodwill ASC 805 Guidance on Second Component Tax Goodwill At the acquisition date, if tax-deductible goodwill is in excess of financial reporting goodwill, a deferred tax asset is recognized for the excess over financial reporting goodwill Apply simultaneous equation in ASC 805-740-25-9 and 805-740- 55-9 to determine the deferred tax asset related to component two tax goodwill Preliminary Temporary Difference (the excess of tax goodwill over financial statement goodwill) (Tax rate (1 - Tax Rate))

Second Component Tax Goodwill Example Assumptions Company A, a calendar year corporation, acquires Company B on January 1, 20X1, for $1,000,000 in a nontaxable transaction that is accounted for as a purchase. Company A has no temporary differences or carry forwards prior to the acquisition. The enacted tax rate for 20X1 and all future years is 40 percent. Identifiable assets acquired and liabilities assumed have the following fair values and tax bases: Fair Value Tax Basis All deductible temporary differences reverse in the same periods as at least an equivalent amount of taxable temporary differences. Company B has no net operating loss or tax credit carry forwards. Deductible (Taxable) Temporary Difference Current assets $300,000 $350,000 $50,000 Property, plant, and equipment 800,000 400,000 (400,000) Goodwill - 650,000 TBD Liabilities, excluding warranty reserve and deferred taxes (200,000) (200,000) - Warranty reserve (100,000) - 100,000 Identifiable net assets acquired $800,000 $550,000 $(250,000)

Second Component Tax Goodwill Example Deferred taxes are first calculated and goodwill adjusted as in the previous illustration, which yields book basis goodwill of $300,000. First and second component goodwill at that point would be as follows: Book Tax First Component $300,000 $300,000 Second Component 350,000 $300,000 $650,000 The deferred tax asset with respect to component 2 goodwill would be calculated as follows: Initial temporary difference $350,000 At (40% / (1 40%)).6666 Deferred tax asset $233,000

Second Component Tax Goodwill Example Goodwill is reduced by the additional deferred tax asset to $67,000 based on the prior calculation First and second component goodwill at that point would be as follows Final Allocation Book Tax First Component $67,000 $67,000 Second Component 583,000 $67,000 $650,000 Current assets $300,000 Property, plant, and equipment 800,000 Deferred tax asset 60,000 Deferred tax asset on component two tax goodwill 233,000 Goodwill 67,000 Warranty reserve (100,000) Other liabilities (200,000) Deferred tax liability (160,000) Purchase price $1,000,000

Specific Application Issues of Goodwill Two acceptable approaches to the amortization of component two tax goodwill Tax amortization starts with second component tax goodwill and thus reverses the deferred tax asset first until it is reduced to zero and then begin to recognize a deferred tax liability, or Tax amortization of tax deductible goodwill on a pro-rata basis between the first and second component goodwill Results in a reduction of the deferred tax asset for the portion of amortization allocated to component two goodwill and a build of a deferred tax liability for component one goodwill Policy election that once made would be applied consistently to all acquisitions

Goodwill in Multiple Jurisdictions Under ASC paragraph 740-10-30-5, deferred taxes are determined separately for each tax-paying component in each tax jurisdiction An entity determines first and second component goodwill for each tax-paying component rather than at the financial statement level While ASC Topic 350, Intangibles Goodwill and Other, requires that goodwill be allocated to reporting units, for accounting for income tax purposes an entity may need to allocate the financial reporting goodwill to a lower level. When an entity allocates goodwill to a lower level, the entity should use a methodology that is consistent with the methodology that was used to determine the allocation of goodwill to the reporting units for financial statement purposes

Goodwill in Multiple Jurisdictions ABC Corp. completes a non-taxable business combination of DEF Corp. on January 1, 20X9. DEF has one reporting unit with two subsidiaries in two different jurisdictions, Subsidiary 1 (U.S.) and Subsidiary 2 (Canada). Total financial reporting goodwill for DEF is $800, of which $600 relates to the U.S. subsidiary and $200 relates to the Canadian subsidiary. Additionally, there is $600 of carryover tax-deductible goodwill, of which $200 relates to the U.S. subsidiary and $400 relates to the Canadian subsidiary. ABC determines the first and second components of goodwill as follows: Financial Reporting Carrying Amount U.S. Subsidiary Tax Basis Canadian Subsidiary Financial Reporting Carrying Amount Tax Basis First Component $ 200 $200 $200 $200 Second Component 400 - - 200 $600 $200 $200 $400 In accounting for this acquisition, ABC recognizes a deferred tax asset for the second component tax goodwill in the Canadian subsidiary even though total financial statement goodwill exceeds tax goodwill.

Bargain Purchases Accounting for Bargain Purchases Bargain purchases occur if the acquisition-date amounts of the identifiable assets acquired and liabilities assumed, excluding goodwill, exceed the sum of (i) the fair value of consideration transferred, (ii) the fair value of any noncontrolling interest in the acquiree, and (iii) the fair value of any previously held equity interest in the acquiree The Standards require the recognition of a gain for a bargain purchase since a bargain purchase represents an economic gain, which should be immediately recognized by the acquirer in earnings Bargain purchase gain is determined after deferred taxes have been established in acquisition accounting Bargain purchase gain results in an outside basis difference that is recognized outside of the acquisition The bargain purchase gain is reflected in earnings [profit or loss] and will not be shown as an extraordinary item

Reduction in Acquirer s Valuation Allowance If acquirer s deferred tax assets become realizable because of a business combination, recognize tax benefits in earnings or contributed capital If the new combined entity intends to file a consolidated tax return subsequent to the acquisition, deferred taxes should be calculated on a consolidated tax return basis as of the acquisition date Consideration should be given to the interaction of the acquirer s and acquired entities tax attributes as permitted under the tax law We believe, a determination is made which acquiree deferred tax assets would be recognizable based on the acquiree facts first, then any additional amount of consolidated deferred tax assets that become recognizable as a result of the business combination would be recognized by a reduction of the acquirer s valuation allowance through continuing operations or contributed capital

Reduction in Acquirer s Valuation Allowance Example Company C acquired Company D on January 1, 2009, for $20,000,000 in a nontaxable business combination accounted for as a purchase Company D will be included in Company C s consolidated tax return The identifiable net assets acquired have a fair value of $15,000,000 and a tax basis of $12,000,000. All of the temporary differences are taxable The enacted tax rate for 2009 and all future years is 40 percent Company D has no tax attribute carryforwards Immediately prior to the acquisition, Company C does not have any temporary differences but has an operating loss carry forward of $5,000,000; a deferred tax asset and a corresponding valuation allowance of $2,000,000 have been recognized by Company C for the tax benefits of that carry forward, prior to the acquisition As a result of the acquisition, management of Company C determines that the net operating loss carry forward can be utilized to offset the taxable temporary differences of Company D; the remainder of the deferred tax asset will require a valuation allowance at the acquisition date

Reduction in Acquirer s Valuation Allowance Final Allocation Identifiable assets $15,000,000 Goodwill 6,200,000 Deferred tax liability (1,200,000) Purchase price $20,000,000 The deferred tax liability of $1,200,000 is recorded with respect to the $3,000,000 taxable temporary differences for identifiable assets. However, the interaction of companies C and D must be considered at the acquisition date. The assumptions indicate that of the $5,000,000 NOL carryforward of Company C, $3,000,000 will be recognizable through offset of the taxable income which will result from the reversal of Company D s taxable temporary differences. Therefore, a deferred tax asset, net of valuation allowance, of $1,200,000 (40 percent times $3,000,000) should be recognized. This amount will be recorded as a tax benefit at the date of acquisition, outside of acquisition accounting.

Measurement Period The measurement period is the period after the acquisition date during which the acquirer may adjust the provisional amounts recognized for the business combination The measurement period ends as soon as the acquirer receives the information it was seeking about facts and circumstances that existed as of the acquisition date or learns that more information is not obtainable The measurement period cannot exceed one year from the acquisition date Measurement period adjustments are recognized retrospectively After the measurement period ends, the acquirer shall revise the accounting for a business combination only to correct an error If the initial accounting for a business combination is incomplete, the acquirer shall disclose: The reasons why the initial accounting is incomplete The items for which the initial accounting is incomplete The nature and amount of any measurement period adjustments

Measurement Period Example ABC acquires DEF on January 1, 20X1 for $120,000 in a nontaxable business combination. The independent appraisal report for the property, plant and equipment (PP&E) had not been received by the time ABC issued its financial statements for the three months ended March 31, 20X1. The PP&E is depreciated straight-line over ten years for financial statement purposes and five years for tax purposes. Goodwill is not deductible for tax purposes. The enacted tax rate for all future years is 35 percent Presented below are the provisional fair values recognized for financial statement purposes and the tax bases of assets and liabilities acquired: Provisional Fair Value Tax Basis Property, plant and equipment 60,000 50,000 Net current assets 40,000 40,000 Goodwill 23,500 0 Deferred tax liability (3,500) 0 Consideration Transferred 120,000 90,000 Deferred tax liability for PP&E = (Financial statement value $60,000 tax basis $50,000) x 35 percent = ($3,500)

Measurement Period Example (continued) On September 30, 20X1, during the measurement period, ABC received the independent appraisal report for the PP&E that indicates that the fair value at January 1, 20X1 was $70,000. The tax basis does not change. Additionally, the measurement period ends on September 30, 20X1, the date management determined that it has received all the information it was seeking about circumstances that existed as of the acquisition date. Presented below are the fair values recognized as of the acquisition date for financial statement purposes and for tax purposes: Fair Value Tax Basis Property, plant and equipment 70,000 50,000 Net current assets 40,000 40,000 Goodwill 17,000 0 DTL (7,000) 0 Consideration Transferred 120,000 90,000 Deferred tax liability for PP&E = (Financial statement value $70,000 tax basis $50,000) x 35 percent = ($7,000)

Measurement Period Example (continued) The following entries would be recorded to adjust the provisional amounts as if the accounting for the business combination had been completed at the acquisition date: Account Description Amount DR PP&E $10,000 CR Goodwill (10,000) DR Goodwill 3,500 CR Deferred tax liability (3,500) Additionally, the following entries are recorded to revise the comparative information for prior periods presented in the financial statements: Account Description Amount Explanation DR Depreciation expense $750 (($70,000 - $60,000) / ten years x ¾ (nine months)) CR PP&E (750) DR Deferred tax liability 263 ($750 x 35% tax rate) CR Deferred tax benefit (263)

Measurement Period Within the measurement period, changes to valuation allowances and acquired tax uncertainties are recognized in goodwill (or bargain purchase gain if goodwill is reduced to zero) Only if based on new information about factors that existed at the acquisition date Information arising about factors that did not exist at the acquisition date (even if it is prior to the close of the measurement period) are recognized in earnings or contributed capital Thereafter, changes recognized in earnings or contributed capital This particular requirement will apply to changes in valuation allowances and unrecognized tax benefits acquired in prior business combinations as well

Interim Financial Reporting 107

Overview of Interim Reporting ASC 740-270 provides guidance on Interim Financial Reporting U.S. GAAP for interim financial reporting is not as expansive as U.S. GAAP for annual reporting, and interim financial reporting is viewed as a component of annual reporting Recognize income tax expense for interim periods based on an estimated effective tax rate on ordinary income plus any discrete items The complexity of the estimated annual effective tax rate calculation will depend upon: The number of tax jurisdictions in which the company operates, The nature and extent of the permanent difference items, and The ability to make reliable estimates 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with 108

Estimated Annual Effective Tax Rate Total tax expense for the year results from separate calculation of current tax expense and deferred tax expense Estimates of both current and deferred tax expense attributable to ordinary income will be required to calculate the estimated annual effective tax rate for the year The rate is the ratio of estimated annual income tax expense on ordinary income to estimated pretax ordinary income 109

Estimated Annual Effective Tax Rate (Cont'd) Assumptions based on fairly predictable future income Includes anticipated tax credits, foreign rates, capital gains rates, and tax-planning strategies Excludes tax effects of significant unusual or infrequently occurring items that are separately reported or reported net of tax, including discontinued operations 110

Estimated Annual Effective Tax Rate Example At March 31, 20X1, Company A estimates that ordinary income for the year will be $1,000. The estimated ordinary income for 20X1 includes $100 of nondeductible expenses and $100 of tax-exempt income. Company A estimates that its net deductible temporary differences will increase $200 during 20X1. $30 of tax credits are estimated to be available in 20X1. No valuation allowance was deemed necessary. 111

Estimated Annual Effective Tax Rate Example 1 Current Deferred Total Pretax Income $1,000 $1,000 Permanent Differences: Life Ins Premium Tax Exempt Inc 100 (100) 100 (100) Timing Differences: Depreciation Expense Reserves Taxable Income (100) 300 $1,200 100 (300) $(200) $1,000 Tax Rate Tax 40% $480 40% (80) 40% 400 Less Tax Credits Net Current Tax (30) $450 $(80) (30) $370 Estimated annual effective tax rate 45% (8%) 37% 112

Application of Estimated Annual Effective Tax Rate Applied to YTD income to arrive at YTD tax expense Current Qtr. tax expense = calculated YTD tax expense less tax expense recorded in prior interim period(s) Estimated rate reviewed/revised each quarter 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with 113

Application of Estimated Annual Effective Tax Rate (Cont'd) Consider the following example: Estimated pretax income for full year 1,000 Estimated Current Tax Rate (450/1,000) = Therefore, if actual Q1 income was $200, the Q1 tax provision would be $74 (200x37%). If the actual Q2 income was $300, the 2Q tax provision would be determined as follows: YTD Income ($500) x 37% $185 Less: tax exp recorded in Q1 74 Q2 tax expense $111 45.0% Estimated Deferred Tax Rate (300) + 100 = (200) net temporary difference (200) * 40% = 80 (80/1000) (8%) Estimated Annual Effective Rate 37.0% 114

Estimated Annual Effective Tax Rate (Cont'd) Changes in tax laws or rates The effects of these changes on taxes currently payable and deferred tax assets and liabilities should be recognized as a discrete event in income from continuing operations in the interim period that includes the enactment date of the changes The effect of these changes is calculated based on temporary differences and current taxable income as of the date of enactment Effect of these changes should not be allocated to subsequent interim periods by an adjustment of the estimated annual effective tax rate Treatment of a retroactive change is similar 115

Estimated Annual Effective Tax Rate (Cont'd) Consider the following example: Assuming that a federal income tax rate change was enacted in Q2 and is effective retroactively to the beginning of the year. The deferred tax catch-up adjustment would be computed as follows: Net taxable temporary diff at the date of enactment Old Tax Law New Tax Law 20,000 20,000 Tax Rate 35% 30% Def Tax Liability 7,000 6,000 Catch-up adjustment of $1,000 (benefit) would be recorded in Q2 as part of the deferred tax provision along with any impact on taxes currently payable. 116

Changes in Indefinite Reversal Assertion If assessment changes during an interim period, the effect should be recorded in the interim period of the change The deferred tax effects associated with the outside basis difference existing at the beginning of the year should be recognized as a discrete item in the period of change and allocated entirely to continuing operations The deferred tax effects associated with the outside basis difference arising during the current year may be recognized as an adjustment to the estimated annual effective tax rate 117

Accounting for Uncertainty in Income Taxes Changes in judgment that result in subsequent recognition, derecognition, or remeasurement of tax positions taken in prior annual periods should be recognized as a discrete item in the interim period in which the change in judgment occurs Impact of such changes is not reflected in the estimated annual effective tax rate (not spread over future interim periods) Changes to positions taken in an earlier interim period within that same annual period are reflected in the annual effective rate to be applied to year-to-date ordinary income 118

Changes in Valuation Allowance Changes in circumstances can cause a change in judgment about the future realizability of a deferred tax asset and result in a revision to the valuation allowance For interim reporting purposes, the accounting recognition for changes in the valuation allowance will depend upon when realization is expected (i.e., in the current year or in future years) 119

Changes in Valuation Allowance (Cont'd) Recognize amount of change as a discrete item in the interim period the event occurs related to: An increase or decrease in the BOY valuation allowance caused by a change in judgment about the realizability of deferred tax assets in future years. 120

Changes in Valuation Allowance (Cont'd) Recognize as part of the annual effective tax rate in the period the event occurs the amount related to: A benefit expected to be realized because of current year ordinary income, or A valuation allowance expected to be necessary at the end of the year for deductible temporary differences originating during the current year. 121

Tax Effect of Losses A tax benefit may be recognized for a loss that arises early in a fiscal year if it is expected to: Be realized during the year, or Become recognizable as a deferred tax asset at the end of the year An established seasonal pattern of losses in early interim periods offset by income in later interim periods might be sufficient evidence If tax effect of losses are not recognized in early interim periods, tax effects of income in later interim periods not recognized until previous interim losses are utilized 122

Review Questions 123

Review Question 1 Facts Company A has computed its estimated annual effective tax rate for fiscal 20X1. However, due to expected break-even operations, small changes in expected income result in large changes to the estimated annual effective tax rate. In computing its first quarter tax expense, how should Company A calculate the income tax rate applicable to ordinary income? A. Must compute an estimated annual effective tax B. May compute an estimated annual effective tax rate C. All of the above D. None of the above 124

Review Question 2 Facts Company A has computed its estimated annual effective tax rate for fiscal 20X1 to be 45%. Quarter 1 Pretax Income was $500, and Quarter 2 Pretax Income was $400. What is Company A s Quarter 2 tax expense? A. $225 B. $405 C. $180 D. None of the above 125

Review Question 3 US Parent Company has foreign subs which meet the indefinite reversal criteria. During the second quarter, US Parent Company determines that it will distribute foreign earnings later in the current year and in future years to meet changed cash requirements in the U.S. The change in the assessment for beginning-of-the-year earnings should be reflected A. In the estimated annual effective tax rate B. All in the second quarter C. Not until the quarter in which the foreign earnings are actually distributed D. None of the above 126

Review Question 4 At the end of the prior year, Company had a NOL carry- forward and full valuation allowance on the related deferred tax asset. During the second quarter, Company determines that taxable income in future years will be sufficient to fully utilize the NOL. The impact of the change in the valuation allowance should be A. Reflected in the estimated annual effective tax rate. B. Recognized entirely in the second quarter C. In the quarter when taxable income reaches the level necessary in order to utilize all of the NOL D. None of the above 127

Financial Statement Presentation and Disclosures 128

Financial Reporting Considerations Balance sheet presentation of deferred tax assets/ liabilities Intraperiod tax allocation Principal footnote disclosures Rate reconciliation Unrecognized tax benefits 129

Balance Sheet Presentation of DTAs/DTLs Net current deferred tax asset or liability (for a particular tax-paying component) 1. Tax effect of DTDs and TTDs related to current assets and liabilities 2. Tax effect of DTDs and TTDs not related to an identifiable book asset or liability (e.g., a Sec. 481(a) adjustment) to the extent expected to reverse in succeeding 12 months 3. Tax effect of carryforwards expected to reduce taxes payable within succeeding 12 months 4. A pro rata portion of the total valuation allowance for deferred tax assets based on the ratio of the current deferred tax asset to the total deferred tax asset 130

Balance Sheet Presentation of DTAs/DTLs (Cont'd) Net noncurrent deferred tax asset or liability (for a particular tax-paying component) 1. Tax effect of DTDs and TTDs related to noncurrent assets and liabilities 2. Tax effect of DTDs and TTDs not related to an identifiable book asset or liability (e.g., a Sec. 481(a) adjustment) to the extent expected to reverse more than 12 months in the future 3. Tax effect of carryforwards expected to reduce taxes payable more than 12 months in the future 4. A pro rata portion of the total valuation allowance for deferred tax assets based on the ratio of the noncurrent deferred tax asset to the total deferred tax asset 131

Intraperiod Tax Allocations and Items Excluded from Continuing Operations 132

Intraperiod Tax Allocation Intraperiod tax allocation is the process of allocating tax expense or benefit to components of comprehensive income (such as continuing operations, discontinued operations, and other comprehensive income) and directly to shareholders equity 133

Intraperiod Tax Allocation Categories among which income tax expense or benefit are to be allocated Continuing operations Discontinued operations Extraordinary items Each component of other comprehensive income, including reclassification adjustments Items charged or credited directly to equity Note that extraordinary items will no longer exist after 2015 for calendar year companies 134

Step-by-Step Approach (ASC 740-20-45) Step 1: Determine total income tax expense (current and deferred taxes) Step 2: Calculate income tax expense related to continuing operations Step 3: Allocate remaining income tax expense to other items 135

Continuing Operations Income tax expense or benefit allocated to continuing operations should include: The tax effects of pretax income/loss from continuing operations +/- Changes in BOY valuation allowance for deferred tax assets (due to changes in expectations about realization in future years) The tax effects of changes in tax laws or rates The tax effects of changes in tax status Tax deductible dividends paid to shareholders 136

Remaining Components Total tax expense Expense allocated to continuing operations Expense allocated to remaining components If two or more components, allocate to each item in proportion to their individual tax effects on income tax expense or benefit for the year Use with-and-without approach where the tax effect is the difference between total tax expense calculated without item and with the item Tax benefit or loss carryforward or carryback generally allocated based on source of income (e.g., income from continuing operations) in current year 137

Intraperiod Tax Allocation Exceptions to the General Rule Change in tax status (ASC 740-20-45-8c) Tax deductible dividends paid to shareholders (ASC 740-20-45-8d) Changes in tax laws or rates (ASC 740-20-45-8b) Valuation assessment of losses from continuing operations (ASC 740-20-45-7) Changes in circumstances that cause a change in judgment about the realization of DTA s in future years (ASC 740-20-45-8a) 138

Continuing Operations Changes in Tax Laws, Rates, or Tax Status Always allocated to continuing operations Changes in tax laws or rates determined using a with and without approach Includes DTA or DTL initially recognized in other comprehensive income Change in tax status 139

Continuing Operations Loss Exists Example In 20X6 Company A sells certain assets that qualify as discontinued operations. The sale results in a gain of $900. Company A also has a $500 loss from continuing operations. Continuing operations ($500) Discontinued operations $900 Pretax income $400 140

Continuing Operations Loss Exists Example (Cont'd) Accordingly, assuming the company has a 40% tax rate, income tax expense should be allocated as follows: Total income tax expense (($900-$500) x 40%) $ 160 Less tax benefit allocated to the loss from continuing operations (40% x 500) (200) Tax expense allocated to gain from disc. ops. $ 360 The gain from discontinued operations is considered a source of future taxable income when determining the tax benefit to be recognized from continuing operations. 141

Example of Intraperiod Allocation Assume Company X has a tax rate of 40% and generates tax credits from operating activities during the year of $330, more than offsetting tax expense for the year of $280. The $50 excess credit is considered realizable in future years, and the entire $330 tax credit is considered realizable from continuing operations. Pretax income is attributable in 2006 as follows: Continuing operations $300 Discontinued Operations $400 Pretax income $700 142

Example of Intraperiod Allocation (Cont'd) Accordingly, income tax expense should be allocated as follows: Total income tax expense (benefit) $ (50) Less: tax expense allocated to continuing operations before credits (40% x 300) 120 Tax credits (330) Tax expense (benefit) allocated to continuing operations $(210) Tax expense allocated to Discontinued Operations $ 160 143

Review Questions 144

Review Question 1 Income tax expense should be allocated to continuing operations, discontinued operations, extraordinary items, other comprehensive income, and items charged directly to stockholder s equity all on a pro rata basis. True False 145

Review Question 2 The tax effects of which of the following items should be included in income tax expense from continuing operations and measured using a with-and-without approach? A. Change in tax laws or rates B. Change in tax status C. Both A and B D. Neither A nor B 146

Financial Statement Disclosures FASB ASC 740 requires disclosure of a number of items including (1) components of significant deferred tax assets (pre-allocation of valuation allowance) and liabilities, tax effected, (2) current and deferred tax expense, (3) Certain information about unrecognized tax benefits, (4) NOL information, and (5) rate reconciliation Basic flow of numbers is from tax provision workpapers to draft footnote and/or tax return review memorandum to financial statements 147

Financial Statement Disclosures (Cont'd) Components of net deferred tax asset or liability Total of all deferred tax liabilities Total of all deferred tax assets pre-allocation of valuation allowance Total valuation allowance Net change in valuation allowance during the year Tax effect of each type of temporary difference that gives rise to a significant portion of DTAs and DTLs (public entities only) 148

Financial Statement Disclosures (Cont'd) Amount of income tax expense or benefit allocated to: Continuing operations Discontinued operations Extraordinary items Each component of other comprehensive income, including reclassification adjustments Items charged or credited directly to equity Reconciliation of expected (statutory) tax rate (expense) to actual tax rate (expense) Amounts and expiration dates of operating loss and tax credit carryforwards 149

Financial Statement Disclosures (Cont'd) Components of income tax expense or benefit allocated to continuing operations including: Current tax expense or benefit Deferred tax expense or benefit Investment tax credits Benefits of operating loss carryforwards Effects of changes in tax law, rates, or tax status Effects of adjustments to BOY valuation allowance Information concerning temporary differences for which deferred taxes are not recognized 150

Review Questions 151

Review Question 1 A portion of a deferred tax asset related to tax credit carryforwards is expected to reverse during the next year while the remainder is expected to reverse in several years. How should this deferred tax asset be classified on the balance sheet? A. Current Tax Payable B. Current Deferred Tax Asset C. Non-current Deferred Tax Asset D. Both Current and Non-current Deferred Tax Asset 152

Review Question 2 Net Book Income $1,000 BOY Accrued Expenses DTD 750 EOY Accrued Expenses DTD 500 BOY TTD related to OCI items 400 EOY TTD related to OCI items 300 Tax Rate 40% What are the amounts shown in the income statement for deferred income tax expense or benefit? A. $100 expense B. $100 benefit C. $60 expense D. $60 benefit 153

Review Question 3 Current and deferred income tax expense from continuing operations are required to be disclosed in the financial statements. True False 154

Case Study Complete case study part 13 155

Rate Reconciliation 156

Purpose of the Rate Reconciliation Reconciliation of the reported amount of income tax expense attributable to continuing operations for the year to the amount of income tax expense that would result from applying the domestic federal statutory tax rate to pretax income from continuing operations Objective is to reconcile domestic federal statutory rate of 34%/35% with actual effective tax rate obtained by dividing income tax expense attributable to income from continuing operations by the pretax book income from continuing operations May be presented as percentages or dollar amounts 157

Factors Impacting the Rate Reconciliation Major Factors Nondeductible expenses Nontaxable income State Tax Expense (net of federal benefit) Changes in prior years taxes due to audits or amended returns Changes in tax laws or rates Changes in valuation allowance Equity in earnings of affiliates subject to reduced taxation because of dividends received deduction for tax purposes Changes in unrecognized tax benefits and/or related interest and penalties 158

Factors Impacting the Rate Reconciliation (Cont'd) Items commonly increasing effective tax rate State tax expense (net of federal effect) Tax effect of nondeductible expenses Items commonly decreasing effective tax rate Tax effect of nontaxable income Foreign tax rates lower that US rate Tax credits 159

Factors Impacting the Rate Reconciliation (Cont'd) Return to Provision Adjustments Return to provision adjustments are needed to true-up provision to return amounts Commonly result from the use of estimates at the time of determining the provision, items not considered at the time of determining the provision or items which may be immaterial at the time of determining the provision Return to provision adjustments need to be evaluated to determine if they are changes in estimates or corrections of errors eworkpapers have columns that help identify provision to return adjustments 160

Factors Impacting the Rate Reconciliation (Cont'd) Valuation Allowance Change in valuation allowance will impact effective tax rate Reduction or release of valuation allowance Increase or set-up of valuation allowance Tax Exposure and Tax Law Changes Changes in unrecognized tax benefits generally impact effective tax rate Changes in tax laws (rates) generally impact effective tax rate 161

Example 3 Calculation of Rate Reconciliation Facts Pretax Income of $100,000 M-1s Permanent M-1s M & E 15,000 Officers Life Insurance Premiums 10,000 Tax Exempt Interest - 5,000 Total Permanent M-1s 20,000 Temporary M-1s -10,000 Total Permanent & Temporary M-1s 10,000 Federal statutory tax rate of 35% State tax rate of 5% 162

Example 3 Calculation of Rate Reconciliation (Cont'd) Domestic Federal Statutory Tax Rate Assume 35% (Large Corp.) Pretax Income Expected Income Tax from continuing Tax Expense Rate operations 100,000 35,000 35% 163

Example 3 Calculation of Rate Reconciliation (Cont'd) Provision Calculation Current Federal Income Tax Expense: Pretax Income 100,000 Total M-1s State Current Tax Expense 10,000-5,500 Taxable Income 104,500 Tax Rate 35% Current Federal Income Tax Expense 36,575 Current State Income Tax Expense: State Taxable Income 110,000 Tax Rate 5% Current State Income Tax Expense 5,500 164

Example 3 Calculation of Rate Reconciliation (Cont'd) Provision Calculation Deferred Federal Income Tax Expense: Favorable Temporary M-1s Less State tax benefit 10,000-500 Tax Rate 35% Deferred Federal Income Tax Expense 3,325 Deferred State Income Tax Expense: Favorable Temporary M-1s 10,000 Tax Rate 5% Deferred State Income Tax Expense 500 165

Example 3 Calculation of Rate Reconciliation (Cont'd) Total Tax Expense Current Tax Expense $ 42,075 Deferred Tax Expense 3,825 Total Tax Expense $ 45,900 Actual Effective Tax Rate Reported Total Tax Expense $ 45,900 Pretax Book Income $100,000 Actual Effective Tax Rate 45.90% 166

Example 3 Calculation of Rate Reconciliation (Cont'd) Pretax Income From Continuing Operations Tax Effect in $ Tax Effect in Percentage 100,000 35,000 35% Reconciling Items M & E 15,000 5,250 5.25% Officers Life Insurance Premiums 10,000 3,500 3.5% Tax Exempt Interest (5,000) (1,750) (1.75%) 167

Example 3 Calculation of Rate Reconciliation (Cont'd) State Tax Expense State Current Tax Expense $ 5,500 State Deferred Tax Expense $ 500 Total State Tax Expense $ 6,000 Net of federal benefit Total State Tax Expense $ 6,000 Adjustment for federal benefit (1 35%) 65% State Tax, net of federal benefit $ 3,900 168

Example 3 Calculation of Rate Reconciliation (Cont'd) Tax Effect in $ Tax Effect in Percentage Pretax Income 100,000 35,000 35% Reconciling Items M & E 15,000 5,250 5.25% Officers Life Insurance Premiums 10,000 3,500 3.5% Tax Exempt Interest (5,000) (1,750) (1.75%) State Tax Expense 6,000 3,900 3.90% Actual Effective Tax Rate 45.90% 169

Example 3 (Effect of RTP, Valuation Allowance, UTBs) Pretax Income From Continuing Operations Reconciling Items Tax Effect in $ Tax Effect in Percentage 100,000 35,000 35% M & E 15,000 5,250 5.25% Officers Life Insurance Premiums 10,000 3,500 3.5% Tax Exempt Interest (5,000) (1,750) (1.75%) State Tax Expense 3,900 3.90% Return to Provision Adjustment 5,000 5.0% Valuation Allowance (Release) (10,000) (10%) Unrecognized Tax Benefits 0 0% Total Tax Expense and ETR 40,900 40.9% 170

Review Questions 171

Review Question 1 What factor causes a difference between the domestic federal statutory tax rate and an actual effective tax rate: A. Prepaids B. Accrued Expenses C. Permanent Book/Tax Differences D. Temporary Book/Tax Differences 172

Review Question 2 What factor would typically decrease the actual effective tax rate? A. Officers Life Insurance Premiums B. Tax-Exempt Interest Income C. State Taxes D. Prior Year Temporary True Up adjustments 173

Review Question 3 Facts Pretax book income 20,000 Unfavorable Permanent M-1s 3,000 Federal Rate 34% State Rate 6% What is the State Tax, net of federal benefit? A. $1,380 B. $897 C. $759 D. $911 174

Review Question 4 A deferred tax asset can affect the current year effective tax rate even if there is no change in the deductible temporary difference in current year. True False 175

Review Question 5 Tax Effect in $ Tax Effect in Percentage Pretax Income from Continuing Operations 100,000 35,000 35% Reconciling Items M & E 10,000 3,500 3.5% Club Dues 5,000 1,750 1.75% Tax Exempt Interest (13,000) (4,550) (4.55%) If Club Dues were $8,000, what would be the impact on the effective tax rate? A. 3.5% increase B. 2.8% increase C. 3.5% decrease D. 2.8% decrease 176

Review Question 6 Original: Tax Effect in $ Tax Effect in % Valuation Allowance (Release) (10,000) (10.0%) Revised: Valuation Allowance (Establishment) 5,000 Given $100,000 book income in Question 5, if a valuation allowance was set up in the current year, what would be its impact on the effective tax rate? A. 5% decrease B. 1.75% increase C. 5% increase D. 1.75% decrease 177

Review Question 7 The estimated annual effective tax rate for 2nd Quarter should be based on the prior year annual effective tax rate. True False 178

What Questions Do You Have? 179

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