1

An Introduction to Accounting for Income Taxes

Level Two
Dixon Hughes
2010

* The FASB has recently completed its codification process that combines all financial
accounting standards into one complete text (similar to the Internal Revenue Code). As
part of that process standards will no longer be referred to by the old numbers. The old
references are left in this manual for simplicity sake. Information regarding Accounting
for Income Taxes can be found in Section 740 of the Codification.
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ACCOUNTING FOR INCOME TAXES

Introduction and Overview

Objectives The objectives of this phase are to:

 Establish the objectives of ASC 740.

 Review the basic principles of accounting for income taxes.
 Learn the components of a company’s income tax provision.

Overview of ASC 740

In arriving at net income or loss on their financial statements companies generally must take into
account income tax expense or income tax benefit. Authoritative guidance relative to accounting
for income taxes is found in SFAS Statement 109, Accounting for Income Taxes, which can now
be found in Section 740 of the FASB’s codification..

ASC 740 established financial accounting and reporting standards for the effects of income taxes
that result from an enterprise’s activities during the current and preceding years. It requires an
asset and liability approach for financial accounting and reporting for income taxes. This
Statement supersedes SFAS 96 and APB 11.

Objectives of Accounting for Income Taxes

The objectives of accounting for income taxes are to recognize (a) the amount of taxes payable
or refundable for the current year and (b) deferred tax liabilities and assets for the future tax
consequences of events that have been recognized in an enterprise’s financial statements or tax
returns.

Basic Principles of Accounting for Income Taxes

The following basic principles are applied in accounting for income taxes at the date of the
financial statements:
a. A current tax liability or asset is recognized for the estimated taxes payable or
refundable on tax returns for the current year.
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b. A deferred tax liability or asset is recognized for the estimated future tax effect
attributable to temporary differences and carryforwards.
c. The measurement of current and deferred tax liabilities and assets is based on
provisions of the enacted tax law; the effects of future changes in tax laws or rates are
not anticipated.
d. The measurement of deferred tax assets is reduced, if necessary, by the amount of any
tax benefits that, based on available evidence, are not expected to be realized.

Book Income versus Taxable Income

Income tax expense reflected on a company’s financial statements seldom equals the amount that
it actually pays to taxing authorities on a current basis. This reflects the fact that income tax
expense on the financial statements is computed based on book income while income tax expense
on the company’s tax return(s) is computed based on taxable income. Book income and taxable
income are seldom the same due to the fact that book income is computed using Generally
Accepted Accounting Principles whereas taxable income is computed using the rules contained
in the Internal Revenue Code (or equivalent state or foreign statute).

Differences between book income and taxable income are classified into the following two
categories:

 Permanent differences – items reflected on the company’s financial statements or its tax
return, but never on both

 Temporary differences – items reportable on both the company’s financial statements and
its tax return, but in different periods

Temporary differences give rise to deferred income taxes, while permanent differences impact a
company’s effective tax rate.

Example

For the current year, Alpha Corporation reports pretax book income of $1,000,000. It is subject
to tax in a single jurisdiction which imposes tax at a flat 40 percent rate. A reconciliation of book
income to taxable income for the current year is as follows:

Pretax book income $1,000,000

Nondeductible fines and penalties 20,000
Excess of accelerated over tax depreciation (100,000)

Taxable income $920,000

Current tax expense @ 40% $368,000

The amount computed above reflects Alpha’s current income tax expense for the year. In
addition, Alpha will report deferred income tax expense of $40,000, reflecting the fact that
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Alpha’s taxable income will exceed its book income in future periods as tax depreciation falls
below book depreciation (i.e., as the temporary difference resulting from the use of accelerated
depreciation for tax purposes “reverses” in future periods). Alpha’s total income tax expense on
its current year financial statements is computed as follows:

Current income tax expense $368,000

Deferred income tax expense 40,000

Total income tax expense $408,000

Alpha’s effective tax rate is 40.8%, computed as follows:

$408,000 total income tax expense / $1,000,000 pretax book income = 40.8%

Note that Alpha’s effective tax rate of 40.8% exceeds the statutory rate of 40%. Such excess of
Alpha’s effective rate over the statutory rate is attributable to the existence of the nondeductible
fines and penalties (a permanent difference), which operate to increase Alpha’s effective tax rate.
The effect of the fines and penalties on Alpha’s effective tax rate can be proven as follows:

($20,000 fines and penalties x 40% statutory tax rate) / $1,000,000 pretax book income = .8%

Components of Income Tax Expense

From the preceding example, it can be seen that a company’s total income tax expense (or
benefit) consists of the following two components:

Current income tax expense (benefit)

+ Deferred income tax expense (benefit)

Total income tax expense (benefit)

The current provision should be very familiar to everyone because it is essentially a calculation
of the estimated current tax liability on a tax return basis. The deferred provision is based on
temporary differences and tax attribute carryforwards.

Where a company is subject to tax in multiple jurisdictions – U.S. federal, one or more states,
one or more foreign jurisdictions, etc. – a separate calculation of income tax expense is
theoretically required for each taxing jurisdiction.
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Underlying Theory

As mentioned above, the major authoritative guidance with respect to accounting for income
taxes is found in ASC 740, Accounting for Income Taxes. ASC 740 provides that a company’s
total income tax expense or benefit consists of the two components discussed above – current
income tax expense (benefit) and deferred tax expense (or benefit). The current component
reflects the amount of taxes actually payable (or the actual refund to be received) by the
company as a result of its operations during the current period. The deferred component reflects
the recognition of deferred tax assets and deferred tax liabilities for the expected future tax
consequences of events that have been recognized in the financial statements or tax returns (but
not yet in both).

SFAS adopts a balance sheet approach to the computation of deferred taxes. Under such
approach, deferred tax expense or benefit is not calculated directly. Instead, deferred tax assets
(DTAs) and deferred tax liabilities (DTLs) are calculated based on differences in the book and
tax bases of assets and liabilities as well as the anticipated future tax benefits associated with
carryovers of net operating losses, tax credits, etc. Once the company’s DTAs and DTLs have
been calculated they are netted and the company’s deferred income tax expense or benefit for the
year is computed by comparing the company’s net DTA or DTL at the end of the year with its
net DTA or DTL at the beginning of the year. Such net change constitutes the company’s
deferred income tax expense or benefit for the year. The following table reflects the possible
outcomes of such comparison and the resulting effect on the company’s tax liability and net
income: (Slide7)

Tax Expense / Effect on Net

Beginning of Year End of Year Benefit Income
Net DTA Larger DTA Benefit Increase
Net DTA Smaller DTA Expense Decrease
Net DTA DTL Expense Decrease
Net DTL Larger DTL Expense Decrease
Net DTL Smaller DTL Benefit Increase
Net DTL DTA Benefit Increase
____________________________________________________________________________

Example

At the beginning of the year, Zeta Corporation has a net deferred tax liability of $100,000
recorded on its balance sheet. At the end of the year, the calculated deferred tax liability reported
on Zeta’s balance sheet is $140,000. X’s deferred income tax expense for the year is $40,000
($140,000 end-of-year DTL - $100,000 beginning-of-year DTL).
ASC 740 uses the balance sheet approach in computing the provision for income taxes.

ASC 740 is applicable to:

Domestic federal income taxes
Foreign, state and local taxes based on income
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Domestic and foreign operations that are consolidated, combined or accounted for
by the equity method
Foreign enterprises in preparing financial statements under US GAAP

Summary of the History of Accounting for Income Taxes

APB 11 APB 11 was issued in 1967. This statement used the deferred method to
calculate the income tax provision. This method focused on the income
statement. The goal was to make sure the current tax provision was accurate.
Any difference was recorded as deferred taxes. APB 11 used a “with” and a
“without” calculation. First taxes were calculated “with” both permanent and
timing differences. Then current taxes were calculated “without” timing
differences.

The amount calculated “without” the timing differences were the total tax
provision. The amount calculated “with” the timing differences was the current
provision. The difference between the amount calculated “with” the timing
differences and “without” them was recorded as deferred taxes.

The basic formula under APB 11 was:

Pretax income
+/- Permanent Differences
Taxable Income
X Tax Rate
Tax Provision

To understand the APB # 11 calculation, we must understand what is a

permanent difference and what is a timing difference.

What is the definition of a permanent difference? What are some examples?

Any item that will effect either the tax return or the financial statements, but will
never effect the other. Some examples include municipal bond interest and key-
man life insurance.

What is the definition of a timing difference? What are some examples?

Any item that will effect both the tax return and the financial statements, but
effects them in different periods. Good examples would be any type of reserve
or depreciation.

A criticism of APB 11 was that the deferred taxes recorded on the balance sheet
were difficult to understand, and were actually meaningless to the financial
statement user.
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SFAS 96 The Financial Accounting Standards Board in an attempt to correct this
problem issued SFAS 96 in 1987. This statement used the liability method,
which focused on the balance sheet. The deferred taxes recorded on the
balance sheet were actually calculated at each balance sheet date, as opposed
to a number that was a residual of the income tax calculations performed
under APB 11.

Under SFAS 96 the book/tax differences, other than those of a permanent

nature, were called “temporary differences”. SFAS 96 also introduced the
concept of “scheduling” the reversal of the temporary differences, which was
used in doing hypothetical tax calculations. The result of these hypothetical
calculations was the deferred tax asset or liability recorded on the balance
sheet. The change in the net deferred tax balance during the year resulted in
the deferred tax provision.

Major controversy developed after the issuance of SFAS 96. The major
criticisms related to the mechanical and burdensome nature of the calculations
and, more importantly, the fact that expected future income could not be
taken into consideration in performing the calculations. The inability to
consider future income significantly restricted companies’ ability to record
deferred tax assets. As a result of these criticisms SFAS 96 never became
effective.
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SFAS 109 Instead, the FASB made some necessary changes and issued Statement No.
109 in 1992. SFAS 109 maintained the liability method introduced in SFAS
96. However, the computations were significantly simplified in that
“scheduling” is not always required. SFAS 109 also continues to use
temporary differences. These are the differences that create deferred taxes.

Why do temporary differences create deferred taxes and permanent

differences do not?
Deferred taxes are recorded for taxes due in the future or future tax benefits.
Permanent differences do not create deferred taxes because they will not
create income or a deduction in the future. Only temporary differences will
affect the tax return in the future.

The most significant difference between SFAS 96 and SFAS 109 is that under
ASC 740 expected future taxable income can now be considered in evaluating
whether a deferred tax asset is realizable. In fact, SFAS 109 requires all
deferred assets to be recorded. If the asset will not be realized, a “valuation
allowance” will be recorded. The concept of a “valuation allowance” was a
new concept introduced in SFAS 109 and will be discussed in detail later in
this course.

To date, companies seem pleased with SFAS 109. As we will see, however,
SFAS 109 requires significantly more judgment by both company
management and its auditors.

SFAS 109 was codified as ASC 740.

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Purpose of Accounting For Income Taxes

Learning Upon completion of this phase, participants will be able to:

Objectives
 Distinguish financial accounting concepts from income tax return concepts.

Introduction As tax accountants, we are all familiar with the tax rules. We may not be as
familiar with financial accounting concepts. To become more familiar with
these concepts, we must first:

1. Learn some financial statement concepts, and

2. Distinguish between financial statement concepts and tax return concepts.

First, we must understand fundamental financial concepts such as

1. Effective tax rate versus statutory tax rate, and

2. The matching principle.

1) Effective What do the terms effective tax rate and statutory tax rate mean?
Tax Rate and
Statutory Tax The statutory tax rate is the rate of tax to be applied to taxable income as
Rate prescribed by the applicable tax law. For example, the U. S. Federal statutory
tax rate for 1998 is 35 percent for taxable income in excess of $10 million.

The effective tax rate is the tax rate computed by dividing financial statement
income tax expense by pretax income.

These are two fundamental tax rate concepts that may be new, but they are
crucial in our understanding of accounting for income taxes. Effective tax
rate is a financial statement concept, while statutory rate is a technical tax
concept. Both come in to play in connection with accounting for income
taxes. The effective tax rate is similar to an average tax rate that is calculated
for income tax purposes.
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Can anyone explain the matching principle?
2) Matching
Principle This principle states that expenses must be recorded in the period that the
matching income is reported. This concept is a key accounting principle. It is
also the foundation for how we account for income taxes. Rather than simply
recording taxes paid to taxing jurisdictions as income tax expense, the FASB
chose a method that attempts to match the income tax with the income that
generates the expense. That is why the tax provision includes both a current
and a deferred provision.
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Temporary Differences

Objectives Upon completion of this phase, participants will be able to:

 Define, Identify and Measure Temporary Differences

Instructor Note In this phase the instructor should discuss the definition of a temporary
difference and the different types of temporary differences. It is important to
use as many examples as necessary for the participants to understand how to
determine a temporary difference. Along with the case study this phase
should take about 2 hours to complete.

Introduction The first step in preparing a corporation’s tax accrual is the calculation of
temporary differences. In order to accurately calculate this crucial step you
must:
1. Know what a temporary difference is.
2. Be able to identify all temporary differences.
3. Accurately measure temporary differences.
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Definition of What is the definition of a temporary difference?
Temporary ASC 740 defines a temporary difference as the difference between the tax
Difference 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.

Note, however, that under such definition, a book-tax basis difference

attributable to an item which will give rise to nontaxable income or a
nondeductible expense does not constitute a temporary difference. Examples
of such items include:

 Accruals of tax-exempt exempt income

 Accruals of fines and penalties
 Cash surrender value of officers’ life insurance where management
intends to hold the policy until the death of the insured
 Investments in 80%-or-more-owned subsidiaries where management
intends to recover its investment through dividends or through
liquidation of the subsidiary under Section 332

Common causes of temporary differences include:

 Recognition of income or expenses in different periods for book and

tax purposes
 Certain business combinations where assets are recorded at fair market
value for book purposes while retaining their original basis for tax
purposes
 Certain changes of tax accounting methods giving rise to a deferred
income item for tax purposes but no corresponding item for financial
reporting purposes

As noted earlier, temporary differences typically give rise to the recognition

of deferred tax assets or liabilities.

ASC 740 separates temporary differences into “taxable” and “deductible”

differences. Thus, it is also important to be able to differentiate between a
“deductible” temporary difference and a “taxable” temporary difference.

Taxable What is a “taxable” temporary difference?

Temporary A “taxable” temporary difference is one that will result in future income. A
Difference deferred tax liability is created by a “taxable” temporary difference.

Deductible What is a “deductible” temporary difference?

Temporary A “deductible” temporary difference is one that will result in a reduction of tax
Difference in future years from either a tax deduction or a net operating loss carryforward
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or a credit carryforward. “Deductible” temporary differences create a deferred
tax asset.

Theoretical Approach

In keeping with the general balance sheet approach adopted by the FASB,
SFAS provides the following rules for classifying temporary differences as
TTDs or DTDs:

Assets Liabilities
Taxable temporary Book carrying value > Tax basis > book
difference (TTD) tax basis carrying value
Deductible temporary Tax basis > book Book carrying value >
difference (DTD) carrying value tax basis

Practical Approach

As discussed earlier, companies seldom construct tax basis balance sheets;

consequently, it is frequently necessary to employ an alternative approach to
classifying temporary differences as TTDs or DTDs. Such approach involves
examining the effect of the temporary difference on the relationship of taxable
income to book income in future periods and is summarized in the following
table:

Current / Prior Future Periods

Periods (Generally)
Taxable temporary Book income > Taxable income > book
difference (TTD) taxable income income
Deductible temporary Taxable income > Book income > taxable
difference (DTD) book income income

Example 1
As of the end of the current year, Beta Corporation has claimed deprecation
deductions for book and tax purposes of $250,000 and $350,000, creating a
cumulative temporary difference of $100,000. In the future, Beta’s taxable
income will exceed its book income as it claims larger depreciation deductions
for book purposes that for tax purposes; consequently, this temporary

At the end of the current year, Delta Corp. has a balance in the warranty
reserve account on its financial statements of $200,000. For tax purposes, no
deduction is allowed for warranty expense until costs are actually incurred;
consequently, a temporary difference exists. In the future, Delta’s taxable
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income will be less than its book income as costs incurred relative to the
warranties are allowable as a deduction for tax purposes; consequently, this
temporary difference is classified as a deductible temporary difference.
(Alternatively, such conclusion can be arrived at by observing that Beta’s book
basis in the reserve ($200,000) exceeds its tax basis in the reserve ($0).)

t
difference is classified as a taxable temporary difference. (Alternatively, such
conclusion can be arrived at by observ9ing that Beta’s book basis in its fixed
assets will exceed its tax basis since less depreciation was claimed in prior
years for book purposes than for tax purposes.)

Example 2

At the end of the current year, Delta Corp. has a balance in the warranty reserve
account on its financial statements of $200,000. For tax purposes, no deduction
is allowed for warranty expense until costs are actually incurred; consequently,
a temporary difference exists. In the future, Delta’s taxable income will be less
than its book income as costs incurred relative to the warranties are allowable
as a deduction for tax purposes; consequently, this temporary difference is
classified as a deductible temporary difference. (Alternatively, such conclusion
can be arrived at by observing that Beta’s book basis in the reserve ($200,000)
exceeds its tax basis in the reserve ($0).)

Identifying Second, you must be able to identify temporary differences.

Temporary
Differences Where do we find temporary differences?
Balance Sheet
Income Statement
Schedule M-3
Footnotes

Temporary differences can frequently be identified by scanning the

company’s balance sheet. Many current year book/tax temporary differences
result from changes in balance sheet account balances between the beginning
and end of the year. Examples of items that frequently fall into this category
are the allowance for doubtful accounts and reserves for items such as
warranties and litigation. Other temporary differences can be identified by
examining prior years’ workpapers and looking for items where a special tax
calculation has been performed. Current year tax amounts and the resulting
book/tax differences can then be calculated. Examples of items falling into
this category include depreciation expense and costs capitalized for tax
purposes under the uniform capitalization rules. Other differences can be
found in the prior year’s income statement, Schedule M-3 or the footnotes to
the financial statement.
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Examples of What are examples of some common temporary differences:

Temporary
Differences Taxable Temporary Differences
Installment Sale
Depreciation

Deductible Temporary Differences

Prepaid Income
Reserves
NOL and credit carryforwards

Other common temporary differences include:

Account Potential Temporary Differences

Marketable securities Mark-to-market for book
Allowance for doubtful No tax deduction until accounts
accounts actually written off
Inventory Valuation reserves for book

Additional capitalized costs under

UNICAP rules
Property, plant, and Different depreciation lives /
equipment methods

Impairment write-downs for book

Intangible assets
Equity method investments
Investments in partnerships
Different cost recovery methods
for book and tax
Cost method for tax; equity
method for book
Book/tax basis differences in
underlying assets/liabilities

Accrued compensation Generally no tax deduction until

paid
Pension liability (or asset) Differing book/tax actuarial
computations

Generally no tax deduction unless

contribution made by due date of
return
Postretirement benefits Generally not tax deductible until
paid
Other accruals Reserves for warranties, litigation,
self-insurance, etc. generally not
deductible for tax until paid
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State tax accruals State deferred taxes not currently
deductible on federal return
Deferred income Advance payments deferred for
book may be currently taxable
______________________________________________________________________________

Example

Theta Corporation’s allowance for doubtful accounts increased from $100,000

at the beginning of the year to $125,000 at the end of the year. An analysis of
such account reveals current year bad debt expense of $40,000 and net charge-
offs of $15,000. For tax purposes, Theta is allowed no deduction for the amount
recorded on the books as bad debt expense ($40,000); however, it is allowed to
claim a current-year tax deduction for the $15,000 of net charge-offs.
Consequently, Theta must increase its pre-tax book income by $25,000
($40,000 of disallowed bad debt expense - $15,000 of deductible net charge-
offs) in arriving at current-year taxable income. Note that the amount of such
required adjustment could be arrived at by calculating the increase in Theta’s
allowance for doubtful accounts during the year, i.e., $125,000 - $100,000 =
$25,000.
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Measuring the Lastly, after identifying temporary differences, we must be able to measure
Amount the amount. Under the balance sheet approach adopted in ASC 740,
temporary differences are identified by constructing a tax basis balance sheet
for the company and comparing the figures reflected on it with the
corresponding figures reflected on the company’s book balance sheet.
Temporary differences arise to the extent that there are differences between
the figures reflected on the company’s tax basis balance sheet and those
reflected on its book basis balance sheet.

To measure a temporary difference we have to:

Calculated book basis

- Calculated tax basis
Temporary Difference

Example

The book and tax basis balance sheets of Gamma Corporation, as well as
temporary differences resulting from differences between such balance sheets,
as of the end of are as follows:

Temporary
Book Basis Tax Basis Difference
Cash $100,000 $100,000 $0
A/R, net 250,000 275,000 25,000
Inventories 300,000 350,000 50,000
PP&E, net 1,000,000 800,000 (200,000)
Total assets $1,650,000 $1,525,000
A/P $200,000 $200,000 $0
Accrued 100,000 0 100,000
expenses
Sec. 481(a) adj. 0 30,000 (30,000)
Notes payable 500,000 500,000
Common stock 500,000 500,000
Retained 350,000 295,000 N/A
earnings
Total liabilities $1,650,000 $1,525,000
and equity

Remember the change in a temporary difference is the current year Schedule

M-3 item.

We must remember that identifying and measuring temporary differences is

the first step in calculating the provision for income taxes. Therefore, proper
identification is crucial to an accurate calculation of deferred taxes.
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Under ASC 740 temporary differences should be computed each year

independently. As a practical matter, few companies maintain comprehensive
tax basis records on an ongoing basis. Moreover, it may be unduly expensive
and time consuming to construct such records at year-end in order to permit the
comparison of book and tax basis balance sheets described above. As a
consequence, most companies utilize an alternative approach to identifying
temporary differences. Such method is commonly referred to as the rollforward
method. If applied consistently and thoughtfully, the rollforward method will
yield cumulative temporary difference amounts equivalent to those obtained
through strict application of the balance sheet approach.

______________________________________________________________________________

Example

Gamma Corp. utilizes the rollforward method to keep track of temporary differences. During the
year, it changes tax accounting methods resulting in a $40,000 positive Section 481(a)
adjustment. Its current year (20X5) workpapers are as follows:

Per Tax Accrued Section

Current Bad Debts UNICAP Depreciation Expenses 481(a)
Return
Prior year
temporary
differences:
20X2 $5,000 $5,000 $(25,000) $20,000
20X3 5,000 10,000 (50,000) $10,000
20X4 5,000 15,000 (75,000) $40,000
Total @ BOY $15,000 $30,000 $(150,000) $70,000 $0

Pre-tax book
income $500,000
Bad debts 10,000 10,000
UNICAP 20,000 20,000
Depreciation (50,000) (50,000)
Accruals 30,000 30,000
Sec. 481(a)
adjustment 10,000 10,000
Taxable
income $520,000
Temporary
difference @
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EOY (before
adjustment) $25,000 $50,000 $(200,000) $100,000 $10,000
Record
originating
Sec. 481(a)
adjustment $(40,000)
Temporary
difference @
EOY $25,000 $50,000 $(200,000) $100,000 $(30,000)

Note that the cumulative temporary differences at the end of the current year with respect to bad
debts, UNICAP, depreciation, and accrued expenses are obtained by simply adding the current
year Schedule M-1/M-3 adjustments to the sums of the prior year Schedule M-1/M-3
adjustments for each of the items. Also note that an adjustment is required to record the
origination of the temporary difference related to the Section 481(a) adjustment, i.e., what is
reflected on Schedule M-1 or M-3 is only the reversal of such temporary difference. Finally,
note that the end-of-year cumulative temporary differences for Gamma are the same as obtained
in the previous example utilizing the balance sheet method. (Observe that a tax basis balance
sheet could be constructed by adjusting Gamma’s book basis balance sheet for the temporary
differences calculated using the rollforward method. This serves as a proof of the equivalence of
such methods.)

Group
Exercise
Introduction & As we have discussed, temporary differences are the basis
Rationale for the computation of both the current and deferred
provisions under ASC 740. For this reason, it is
important to accurately identify and measure temporary
differences.
Task Using the information provided for the OBD LTD,
complete the carryforward schedule of temporary
differences and tax loss carryforwards..
Context
Size & 4-6
Composition Table Groups

Sharing Select a table spokesperson to represent your table group

when we reconvene.
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OBD Ltd

Case Study – Part 1

Identification and Measurement of Temporary Differences

Information Provided:

 Information about OBD’s operations for 2010

 Temporary difference worksheets

Required:

 Identify and measure the temporary differences at 12/31/08 and 12/31/09

 Complete the temporary difference worksheet.

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OBD Ltd
Case Study – Part 1 (Continued)
Additional Information

Pension Reconciliation of Expense to Accrual (Dr) Cr

2008 2010

Accrued pension cost, beginning of the year $ 5,000 $ 20,000

Net periodic pension costs 65,000 95,000
Contributions (50,000) (45,000)
Accrued pension cost, end of the year 20,000 70,000
Schedule M-3 difference
Net periodic pension cost 65,000 95,000
Tax deductible contribution 50,000 45,000

Schedule M-1 Amount 15,000 50,000

Installment Sale:

In 2008, OBD sold an asset for a book and tax gain of $500,000. The gain will be recognized
under the installment sale provisions for tax purposes. Ten percent of the gain was recognized
for tax purposes in 2010. $125,000 of the gain will be recognized in 2010, $150,000 of the gain
will be recognized in 2010 and the remaining gain will be recognized in 2011.

Other Information

Accumulated depreciation: Tax > Book (12/31/08) = $205,000

Accumulated depreciation: Tax > Book (12/31/09) = $175,000

Tax Basis of inventory (12/31/08) = $387,000; Book Basis of Inventory (12/31/08) = $300,000.
Tax Basis of inventory (12/31/09) = $468,000; Book Basis of Inventory (12/31/09) = $384,000.

Deferred Compensation Reserve

Balance at 12/31/08 $100,000
Balance at 12/31/09 40,000

A restructuring reserve of $100,000 was established at 12/31/08; at 12/31/09, the book balance in
the reserve was $135,000. The company actually spent $50,000 in restructuring during 2010.

The company’s reserve for bad debts at 12/31/08 was $25,000. During 2010 the company’s bad
debt expense was $80,000 while they actually wrote off $45,000 of bad debts.
 Current Tax Provision

Learning Upon completion of this phase, participants will be able to:

Objectives
Calculate a corporation’s current tax provision.

Introduction The next step in calculating a company’s income tax provision is to calculate
the current portion of the provision. Many times we want to calculate the
current provision first. But remember that the current changes in temporary
differences give us most of the Schedule M-1 items. Therefore, it is easier to
calculate the current provision if all the temporary differences have already
been calculated.

To calculate the current provision, we need to know two things:

1. The method used to calculate the current provision and
2. The appropriate tax rate to use in the calculation.

The current portion of the tax provision should be very familiar to everyone
because it is essentially a calculation of the estimated tax liability of the
current year on a tax return basis.

Definition of What is your definition of current tax liability or benefit?

Current Tax
Liability or ASC 740 defines the current tax liability or benefit as: The amount of income
Benefit taxes paid or payable (or refundable) for a year as determined by applying the
provision of the enacted tax law to the taxable income or excess of deductions
over revenues for that year.

In theory, current income tax expense for a particular jurisdiction is simply

the amount of income tax liability (before prepayments) reflected on the
company’s current year income tax return for such jurisdiction. If the current
year reflects a loss (or excess credits) which give rise to a refund of prior
years’ taxes, the financial statements will reflect a current tax benefit equal to
the refund which the company will receive (as reflected on Form 1139, Form
1120X, etc.).
Calculating the How do you calculate the current tax provision?
Current Tax As discussed earlier, taxable income is frequently computed utilizing different
Provision accounting methods than those utilized in preparing the company’s financial
statements. The utilization of such differing accounting methods gives rise to
temporary book/tax differences. In addition, the Internal Revenue Code
specifically excludes certain items from income and specifically disallows a
deduction for other items. Such provisions of the Code result in permanent
book/tax differences to the extent that the item is taken into account in
computing book income. In addition, permanent differences may arise where
the Code provides for an imputed income item or a deduction that is not taken
into account in computing book income.

So to calculate the current provision the typical method is to adjust pre-tax

book income by all Schedule M-1 items (these include both temporary and
permanent differences). After adjusting for Schedule M-1 items the amount
is reduced by any net operating loss carryforwards. The resulting amount,
taxable income, is then multiplied by the appropriate tax rate to arrive at the
current tax provision. The current provision should consider alternative
minimum tax and available tax credits. The formula for this calculation is:

Pre-tax book income

+/- Schedule M-1 adjustments
Taxable income before NOLs
- NOL carryforward
Taxable income
X Applicable tax rate
Current tax provision before tax credits
- Tax credits
Expected current tax liability (provision)

Identifying Permanent Differences

Many permanent differences can be identified by scanning the income
statement for account titles that correspond with Code provisions dealing
income items that are permanently nontaxable and expense items that are
permanently nondeductible, e.g., municipal bond interest, fines and penalties.
Other permanent differences can be identified by examining prior year returns
for imputed income items or deductions which were not reflected in the
financial statements, e.g., percentage depletion, dividends-received deduction.
Common permanent differences include:

Item Reason
50% of meals and Permanently nondeductible
entertainment expenditures
Fines and penalties Permanently nondeductible
Officers’ life insurance Permanently nondeductible
premiums
Municipal bond interest Permanently excludible
Life insurance proceeds Permanently excludible
Increase in cash surrender Permanently excludible
value of life insurance
policies
Dividends-received Deductible for tax but not for book
deduction
Percentage depletion Deductible for tax but not for book
Deduction for qualified Deductible for tax but not for book
production activity income
Appropriate What is the appropriate tax rate to use?
Tax Rate A company should use the tax rate that applies that year. That means that if
the company has taxable income over $10 million, the appropriate rate would
be 35 percent. If taxable income is under $10 million, the appropriate rate
would be 34 percent. For small companies that receive the benefit of the
graduated rates, that benefit must be calculated. In addition, it is important to
remember that if the company is subject to the alternative minimum tax, this
tax must be calculated and that would be the amount used for the current
provision.

A current provision must be calculated for federal, state and foreign taxes. A
separate calculation must be computed for any jurisdiction where the taxes are
a material amount. If state or foreign taxes are calculated separately for a
particular state or country, the appropriate tax rate for that state or country
will be used.

However, what tax rate is used if all state or foreign taxes are calculated
together?

This is the case in most instances. In this situation, a blended rate based on
the various state and foreign tax rates should be calculated. This blended rate
is not just an average rate, but rather should be a weighted average based on
the percentage of income taxed in each jurisdiction.

After having calculated a separate current provision for federal, state and
foreign taxes, the three amounts will be added together to produce the total
current tax provision. The total current tax provision is then added to the
deferred tax provision to produce the total provision for income taxes found
on a company’s financial statements.

Computation of Current Income Tax Expense or Benefit

Once current year taxable income or loss has been calculated, the computation
of current income tax expense or benefit is generally relatively straightforward.
If there is income in the current year, current income tax expense is computed
by simply applying the appropriate current year tax rate(s). If there is a loss in
the current period, current income tax benefit is computed by determining the
amount of tax refund that will result from the carryback of such loss, i.e., by
applying tax rates in the carryback year(s).

Tax credits operate to reduce current income tax expense or increase current
income tax benefit to the extent that they reduce taxes otherwise payable in the
current period or create or increase a refund of taxes paid in prior periods. Tax
credits generate a dollar-for-dollar tax benefit (subject to applicable
limitations).

Example

During 20X5, Lambda Corporation sustains a $1,000,000 net operating loss.

Such loss may be carried back to 20X3 and 20X4. Lambda had $500,000 of
taxable income in each of the years 20X3 and 20X4. The tax rate for 20X5 is
40%. Lambda paid $150,000 of tax in 20X3 and $175,000 of tax in 20X4. The
current income tax benefit reflected by Lambda on its 20X5 financial
statements will equal $325,000 ($150,000 refund from 20X3 + $175,000 refund
from 20X4).
________________________________________________________________

True-Ups
As mentioned earlier, the amount shown on the financial statements as current
income tax expense or benefit is theoretically the total of the company’s actual
current-year income tax liability or refund as determined by examining the
company’s income tax returns (including any refund claims). In practice, the
financial statements are typically prepared prior to the finalization of the
company’s income tax return(s) for the year. As a consequence, the numbers
utilized to prepare the tax provision are frequently estimates of the numbers
that will appear on the company’s income tax return when it is filed. For
example, the depreciation figure on the return may differ from the figure used
in preparing the provision or a detailed analysis of the meals and entertainment
account prior to the filing of the return may show that certain amounts are
exempt from the general 50-percent reduction.

Frequently, a comparison is performed identifying differences between the

numbers utilized in preparing the tax provision and the numbers utilized in
preparing the tax return. Such differences are “trued up” as part of the tax
provision preparation process for the succeeding taxable year. The true-up
process differs depending upon whether the prior year discrepancy relates to a
permanent difference or a temporary difference. The true-up process in each
case is as follows (Slide 29):

Type of Difference True-Up Process

Permanent Adjust current income tax
expense in succeeding year to
reflect impact of discrepancy on
amount of tax paid in prior year
Temporary Adjust deferred income tax
asset/liability in succeeding year
 to reflect impact of discrepancy
on amount of tax paid in prior
year

________________________________________________________________

Example

For 20X9, its initial year of operations, Gamma Corporation reported current income tax expense
of $358,000 and deferred income tax expense of $62,000, i.e., total income tax expense of
$420,000. (A 40% tax rate was used in all computations.) A reconciliation of Gamma’s 20X9 tax
provision to its 20X9 income tax return is as follows:

Per Provision Per Return Difference

Pre-tax book income $1,000,000 $1,000,000 $0
Excess tax depreciation (300,000) (350,000) (50,000)
Accrued Liabilities 40,000 50,000 10,000
Bad Debt Allowance 80,000 75,000 (5,000)
UNICAP 25,000 35,000 10,000
Meals and entertainment 50,000 40,000 (10,000)

Taxable income $895,000 $850,000 $(45,000)

If actual numbers had been utilized, 20X9 current income tax expense would have equaled
$340,000 and 20X9 deferred income tax expense would have equaled $76,000, i.e., total income
tax expense of $416,000. In 20X9, the following “true-up” entry will be required:

Dr Income taxes payable $18,000

Cr Current income tax expense $ 4,000
Cr Deferred income tax liability $14,000

Note that this entry accomplishes three things:

1. It eliminates the balance remaining in Gamma’s current income taxes payable account
(i.e., $358,000 - $18,000 = $340,000 - $340,000 actually paid = $0).
2. It adjusts Gamma’s cumulative income tax expense to actual (i.e., $420,000 - $4,000 =
$416,000, assuming no income tax expense in 20X9 other than the true-up adjustment).
3. It adjusts Gamma’s deferred income tax liability account to the computed amount (i.e.,
$62,000 + $14,000 = $76,000, assuming no change in deferred taxes in 20X9).
 Deferred Tax Provision

Learning Upon completion of this phase, participants will be able to:

Objectives
 Calculate a corporation’s net deferred tax liability or asset pursuant to
ASC 740.

Introduction After calculating a company’s current tax provision, the next step is to calculate
its deferred provision. As with the current provision, a deferred tax provision
must be calculated for federal, state and foreign taxes. ASC 740 requires the
deferred tax provision be calculated using a five-step approach. The five steps
include:

1. Estimate the applicable tax rate

2. Determine the gross deferred tax liability
3. Determine the gross deferred tax asset
4. Determine the gross deferred tax asset for credit carryforwards
5. Record a valuation allowance if necessary
Applicable Rate What is the applicable rate to use?
Generally, companies only have to apply one single flat tax rate to all temporary
differences. However, if the tax rate changes, a more detailed analysis may be
needed. In this case, two rates may need to be used. The current tax rate would
be applied to any temporary differences that are expected to reverse before the
rate changes. The new tax rate would be applied to any temporary differences
that are expected to reverse after the rate change.

ASC 740 provides that the tax rate(s) to be used in computing deferred tax
assets and liabilities are the “enacted tax rate(s) expected to apply to taxable
income in the period(s) in which the item giving rise to the DTA or DTL is
expected to reverse.” The tax rate(s) applicable in the year in which the
temporary difference giving rise to the TTD or DTD originates is generally
irrelevant.
_______________________________________________________________
Example

Zeta Corporation operates in a single taxing jurisdiction. The tax rate for 20X5
is 40%; however, legislation enacted in 20X5 will cause such rate to fall to 30%
in 20X6 and subsequent years. A $100,000 taxable temporary difference
originates in 20X5. In determining the deferred tax liability attributable to such
temporary difference, Zeta will apply a tax rate of 30% (i.e., the enacted rate
expected to apply in the year in which the TTD is expected to reverse).
________________________________________________________________
Application to U.S. Federal Income Taxes

In general. Under current U.S. federal tax law, most profitable corporations pay
tax at a flat rate of either 34 percent or 35 percent due to the phase-out of
graduated tax rates for large corporate taxpayers. As a consequence, it is
generally possible to compute DTAs and DTLs for U.S. federal income tax
purposes using a flat rate of 34% or 35%.

Small taxpayers. Small companies which expect to receive a benefit from

graduated tax rates in the year(s) in which temporary differences are expected to
reverse should apply the expected average tax rate for each such year to
reversing temporary differences in calculating deferred tax assets and liabilities.

Companies anticipating future losses. Companies anticipating losses in the

years in which temporary differences are expected to reverse should utilize the
lowest graduated tax rate (currently 15%) to record DTAs and DTLs with
respect to items reversing in such years.

Companies expecting to be subject to the AMT. Taxpayers expecting to be

subject to the alternative minimum tax in future years should utilize regular
income tax rates (e.g., 34% or 35%) to measure DTAs and DTLs. To the extent
that the company pays AMT in excess of regular income tax in a later year, a
minimum tax credit (a DTA) will be generated in such year.
________________________________________________________________
______________
Deferred assets and liabilities must be calculated for the beginning of the year
and the end of the year. The amount that is calculated in the five-step process
discussed above is the amount that will be reported on a company’s balance
sheet. Remember that ASC 740 requires the assets and liabilities be recorded.
If the amounts are material separately, they must be separately stated on the
balance sheet. In many cases the amounts are not material and only the net
deferred asset or deferred liability will be reported.

Example 1
Lambda Corp. reasonably expects to have taxable income (taking into account
reversing temporary differences) of $200,000 in all future years. In this case,
the tax rate to be used to compute Lambda’s DTAs and DTLs is calculated as
follows:

($50,000 x 15%) + ($25,000 x 25%) + ($25,000 x 34%) + ($100,000 x 39%) /

$200,000 = 30.625%
_______________________________________________________________

Example 2

Alpha Corp. has a single taxable temporary difference of $100,000 (all of

which originated in the current year), that is expected to reverse in the
succeeding taxable year. Alpha reasonably anticipates sustaining operating
losses in such year in excess of the reversing TTD. In computing the current-
year DTL related to such TTD, Alpha must utilize a tax rate of 15%. This
results in a DTL (and deferred tax expense) of $15,000 being recorded in the
current year. If no taxes are, in fact, paid in the subsequent year Alpha will
reduce the DTL to $0 (since the temporary difference has reversed) and record
deferred income tax benefit of $15,000.
_______________________________________________________________

State Income Taxes

The above discussion of tax rates considered only U.S. federal income taxes.
Most companies also pay state (and possibly local) income taxes in one or
more jurisdictions. Theoretically, separate deferred tax calculations are
required for each state (and local) jurisdiction in which the company is subject
to tax. Moreover, where separate calculations are performed, state (and local)
deferred taxes must be calculated first and reflected as an additional
temporary difference in performing the federal deferred tax calculation (i.e.,
state deferred taxes represent a book liability with a zero tax basis). This
sequential treatment is required due to the fact that state income taxes are
deductible in computing federal taxable income.

While income tax rates vary significantly from jurisdiction to jurisdiction,

states generally utilize a tax base which resembles federal taxable income. (A
notable exception is the Michigan Single Business Tax). This being said, it
should be noted that states frequently modify federal taxable income in a
number of ways in arriving at state taxable income. For example, states often

 Provide for an exclusion of interest on federal obligations from the tax

base
 Provide for the inclusion of interest on municipal obligations in the tax
base
 Disallow a deduction for state and local income taxes
  Provide for alternative cost recovery methods

Notwithstanding differences between federal and state laws, as well as

interstate differences, it may be possible to –

 Combine states with similar laws / rates and / or insignificant amounts of

income and use a “blended” state rate, and / or
 Utilize a single overall “blended” tax rate, incorporating both the federal
rate and the company’s “effective” state rate (i.e., the nominal state rate
adjusted to reflect the fact that state income taxes are deductible for
federal income tax purposes).

Note that the use of such approach may not be reasonable in certain cases,
e.g., where significant differences exist between federal and state tax laws,
where a valuation allowance is necessary for state purposes but not for federal
purposes, etc.

Computing “Blended” Tax Rate

Where it is determined that it is appropriate to utilize a single “blended” tax

rate to measure a company’s DTAs and DTLs, the following steps should
generally be followed:

1. Determine the nominal tax rates in the states (and municipalities) in which the
corporation conducts business. In this regard, it is important to note that state
tax rates frequently change and that the appropriate rate to utilize in measuring
DTAs and DTLs is the enacted rate for future years in which TTDs and DTDs
are expected to reverse.

2. Identify differences between federal and state tax laws that may cause the
company’s “effective” tax rate in a particular state to differ from the nominal
state tax rate. The existence of such differences can frequently be ascertained
by comparing the nominal tax rate in a particular state with the rate
determined by dividing (1) state income taxes by (2) federal taxable income.
For example, assume that the nominal state tax rate is 5%; however, interest
on municipal obligations is taxable for state purposes. If federal taxable
income is $1,000,000, excluding $100,000 of municipal bond interest, the
company’s state tax liability will be $55,000 [($1,000,000 + $100,000) x 5%].
This reflects an effective state rate of 5.5% ($55,000 / $1,000,000) when
expressed as a function of federal taxable income. To the extent that it is
determined that material differences exist between the tax base in a particular
state and the federal tax base, the nominal state rate should be adjusted to
reflect the effect of such differences.
3. In general, a company is taxed only on that portion of its total income that is
apportioned to a particular state; consequently, the computation of a
“blended” rate for multiple states involves weighting the tax rates (as adjusted,
if necessary) for the states in which the company conducts business by the
anticipated apportionment factors for the years in which the company’s TTDs
and DTDs are expected to reverse. In this regard, it is important to note that
state apportionment factors seldom remain constant over time due to plant
shutdowns, entry into new markets, business restructurings, etc.;
consequently, caution should be utilized in using historical apportionment
percentages as proxies for expected future apportionment percentages.

4. If a single “blended” federal / state rate is to be utilized (as opposed to

performing the state and federal deferred tax calculations in a sequential
manner), one additional step is required. Specifically, the state rate calculated
in Step 3 must be reduced to reflect the fact that state income taxes are
deductible in computing federal taxable income. The general formula for
computing a company’s “effective” state tax rate (i.e., its state tax rate taking
into account the benefit to be derived on the company’s federal return) is as
follows:

State rate – (state rate × federal rate) = effective state rate

The effective state rate computed utilizing this formula is added to the federal
tax rate to arrive at the “blended” tax rate to be used in computing the
company’s DTAs and DTLs.
_______________________________________________________________

Example

Alpha Corporation is subject to federal income tax at a rate of 35%. In

addition, it is subject to tax in State A and State B, which impose tax at the
rate of 8% and 10%, respectively. State A follows federal law in the
computation of state taxable income. State B follows federal law except that it
requires the inclusion of municipal bond interest in state taxable income.
Alpha estimates that municipal bond interest will be equal to 5 percent of
federal taxable income in future years. In addition, Alpha projects that it will
derive 40% of its future years’ income in State A and 60% of its future years’
income in State B.

It is determined that it is reasonable to use a single “blended” tax rate to

measure Alpha’s DTAs and DTLs. Such “blended” rate is computed as
follows:

1. The nominal rate of 10% in State A does not need to be adjusted, since State
A law with respect to the computation of taxable income mirrors federal law.
The State B nominal rate of 8% must be adjusted, however, to reflect the fact
 that municipal bond interest is taxable in State B. The “adjusted” rate in State
B can be calculated as follows:

(100% + 5%) x 8% = 8.4%

2. A “blended” state rate can then be obtained by multiplying the “adjusted”

state rates by the anticipated apportionment percentages. The calculation is as
follows:

(10% x 40%) + (8.4% x 60%) = 9.04%

3. Finally, Alpha’s “blended” federal / state rate can be computed as follows:

35% + [9.04% - (9.04% x 35%)] = 40.876%

_______________________________________________________________

Foreign Income Taxes

Due to the wide divergence of many foreign country’s tax laws from those of
the United States, it is generally necessary to perform separate income tax
calculations for each foreign taxing jurisdiction in which the company has
significant operations.

Computation of Deferred Tax Provision

In General

Deferred assets and liabilities must be calculated for the beginning of the year
and the end of the year. The amount that is calculated in the five-step process
discussed above is the amount that will be reported on a company’s balance
sheet. Remember that ASC 740 requires the assets and liabilities be recorded.
If the amounts are material separately, they must be separately stated on the
balance sheet. In many cases the amounts are not material and only the net
deferred asset or deferred liability will be reported.

Deferred Tax Liability

Once the amount of a company’s taxable temporary differences and the

appropriate tax rate have been identified, the computation of the company’s
deferred tax liability is relatively straightforward. Such computation can be
performed utilizing the following formula:

Taxable temporary differences × applicable tax rate = deferred tax liability

(DTL)
 Note that this number reflects the company’s gross DTL, i.e., TTDs and
DTDs are not netted prior to applying the applicable tax rate (although DTAs
and DTLs may be netted in some cases for presentation purposes on the
financial statements). The reasons for not netting TTDs and DTDs include –

1. The requirement that companies disclose the amount of both their gross DTAs
and their gross DTLs in the financial statements, and

2. The fact that the valuation allowance (discussed in a subsequent section) is a

function of the amount of the company’s gross deferred tax asset, as opposed
to its net DTA or DTL.

Deferred Tax Asset

The computation of a company’s deferred tax asset (prior to consideration any

necessary valuation allowance) is a bit more complicated. Such computation
can be performed utilizing the following formula:

[(Deductible temporary differences + loss and deduction carryforwards) ×

applicable tax rate] + tax credit carryforwards = gross deferred tax asset
(DTL)

Note that this number reflects the company’s gross DTA, i.e., TTDs and
DTDs are not netted prior to applying the applicable tax rate (although DTAs
and DTLs may be netted in some cases for presentation purposes on the
financial statements). The reasons for not netting TTDs and DTDs include –

1. The requirement that companies disclose the amount of both their gross DTAs
and their gross DTLs in the financial statements, and

2. The fact that the valuation allowance (discussed in a subsequent section) is a

function of the amount of the company’s gross deferred tax asset, as opposed
to its net DTA or DTL.

In addition, note that the number computed using the above formula reflects
the company’s DTA prior to consideration of the need for a valuation
allowance (considered in the next section).
Computation of Deferred Tax Expense / Benefit

The difference between the deferred tax amount at the beginning of the year
and the deferred tax amount at the end of the year will be the deferred tax
provision or benefit that will be recorded on the income statement.

The formula is as follows:

Net DTA or DTL at end of year

- Net DTA or DTL at beginning of year
Deferred income tax expense (benefit)

The following table summarizes the effect of changes in a company’s net

DTA or net DTL o income tax expense (benefit):

Change in Net DTA / DTL Result

Decrease in net DTA Deferred income tax expense
Increase in net DTL Deferred income tax expense
Increase in net DTA Deferred income tax benefit
Decrease in net DTL Deferred income tax benefit

As with the current provision, the deferred tax provision must be calculated
separately for federal, state and foreign purposes. In the case of state and
foreign taxes, the deferred tax for each material taxing jurisdiction must be
calculated separately. The need for a valuation allowance also must be
considered separately for each taxing jurisdiction.

The current provision is added to the deferred tax provision to produce the
total tax provision found on a company’s income statement.

Once the tax amounts are calculated, they must recorded on the books. A
typical journal entry to record the tax provision would look like this:

Debit Credit

Current Tax Provision P/L XXXX

Deferred Taxes Provision P/L XXXX
Accrued Taxes Payable B/S XXXX
Deferred Tax Payable B/S XXXX
Unremitted As a general rule, ASC 740 provides that deferred taxes are to be recognized
Foreign for all temporary differences.
Earnings
Exceptions
ASC 740 retains selected historical exceptions to the recognition of deferred
taxes. In general, these exceptions reflect retention of the “indefinite reversal
criteria” contained in APB 23 In today’s global environment, many
companies have foreign operations. Under the current tax law, earnings from
foreign subsidiaries are not taxed until the earnings are repatriated back to the
domestic parent. Because of this tax benefit, many corporations leave the
foreign earnings invested overseas indefinitely. For financial reporting
purposes all foreign earnings are reported currently. There would appear to
be a temporary difference for unremitted foreign earnings.

APB 23 provides that deferred taxes should not be recognized for certain
temporary differences. One of those differences is unremitted earnings of
subsidiaries, when reversal is indefinite. ASC 740 repeals APB 23 except for
the rules regarding unremitted foreign earnings. As such, corporations that do
not plan to remit earnings from their foreign subsidiaries do not have to
provide deferred taxes for these earnings. When the earnings are repatriated,
a current tax liability will be computed.

A company must include in the footnote to the financial statements a note that
deferred taxes have not been computed for unremitted foreign earnings
because the company plans to reinvest the earnings indefinitely. If possible,
the amount of tax that will be due when the earnings are repatriated to the
parent company should be disclosed.

Example

Delta Corporation, a domestic corporation, owns 100 percent of the stock of

Sigma Corporation, a foreign corporation. Delta originally paid $1,000,000
for its Sigma stock. Sigma has earned $500,000 since the date of its
acquisition by Delta and has made no distributions. As a consequence, Delta
has a book basis in the Sigma stock of $1,500,000 (determined utilizing the
equity method). Delta’s tax basis in the Sigma stock is its original cost of
$1,000,000; consequently, there exists a $500,000 temporary difference with
respect to Delta’s investment in the Sigma stock. In general, a deferred tax
liability would have to be provided with respect to such temporary difference;
however, no deferred taxes need be provided where Delta management
reasonable represents that it does not expect to repatriate the Sigma earnings
in the foreseeable future and there is no evidence to the contrary (e.g., there is
no history of Delta withdrawing earnings from Sigma).
Introduction The 5th step in calculating a company’s deferred tax provision is
determining the need for a valuation allowance. This course will
introduce the concept of a valuation allowance but the topic will be
covered in detailed in the intermediate class.
How does a company determine if it must record a valuation allowance?

Realization of Realization of Deferred Tax Assets

Deferred Tax
Assets All deferred tax assets must be recorded under ASC 740, but a valuation
allowance is required if the deferred tax asset is “impaired.”

“Impaired” When is deferred tax asset “impaired”?

Deferred Tax
Asset In general, realization of the deferred tax asset is a reduction in future taxes
payable or an increase in future taxes refundable assuming that the deductible
differences and carryforwards are the last items to enter into future taxable
income. A deferred tax asset is “impaired” when it is more likely than not
they will not be realized. When this situation occurs, a valuation allowance is
required.
“More Likely What is meant by “more likely than not”?
Than Not”
The test to see if a deferred tax asset is “more likely than not” to be realized is
a probability level of more than 50%. The FASB concluded that there should
not be different requirements for recognition of a deferred tax asset for
deductible temporary differences and tax loss carryforwards. In substance,
both are amounts deductible on tax returns in future year. The FASB also
decided that “the more likely than not” criterion is capable of appropriately
dealing with all forms of negative evidence, including cumulative losses in
recent years.

The establishment of a valuation allowance reduces the deferred tax asset

reflected on the company’s balance sheet. The effect of such reduction is that
the net DTA represents the amount of future tax benefits that more likely than
not will be realized. Note than the potential valuation allowance may range
from zero to the entire gross amount of the company’s DTA, i.e., the valuation
allowance is not limited to the excess (if any) of the company’s DTAs over its
DTLs.

In addition, the establishment or elimination of a valuation allowance (or a

change in its amount) impacts the company’s income statement as follows:

Change in
Valuation Effect on Tax Effect on
Allowance Expense Earnings
Increase Increase Decrease
Decrease Decrease Increase
_______________________________________________________________

Example

Theta Corporation calculates a gross DTA of $250,000 and a DTL of

$150,000 as of the close of the current year. If Theta determines that $100,000
of the tax benefits represented by the DTA will not be realized, it must
establish a valuation allowance of $100,000. Such amount reduces the DTA
reflected on Theta’s balance sheet to $150,000 and increases Theta’s deferred
income tax expense for the year by $100,000.

If, in the succeeding year, Theta determines that a valuation allowance of only
$75,000 is needed, it will increase the net DTA reflected on its balance sheet
by $25,000 and reduce deferred income tax expense for the year by $25,000.
Deferred Tax How can we determine if a deferred tax asset is “more likely than not” to be
Asset-“More realized?
Likely Than
Not” Future realization of the tax benefit of an existing deductible temporary
difference or carryforward ultimately depends on the existence of sufficient
taxable income of the appropriate character (i.e. ordinary or capital) within
the carryback or carryforward period available under the appropriate tax law.
ASC 740 requires consideration of future taxable income and other available
evidence when assessing the need for a valuation allowance. Various
assumptions and strategies (including elections for tax purposes) are implicit
in estimates of expected future taxable income. ASC 740 does not try to
establish detailed criteria and other rules and requirements for those types of
assumptions and strategies. The following four items are possible sources of
taxable income, which may be available under the tax law to realize a tax
benefit for deductible temporary differences and carryforwards:

1. Future reversal of existing taxable differences

2. Taxable income in carryback years (if carryback is permitted under
applicable law)
3. Tax planning strategies
4. Future taxable income (exclusive of reversing taxable temporary
differences)

The inclusion of #4 in the list of future sources of income is one of the most
significant changes from SFAS 96. It is the source of income that requires
significant judgement to assess (and audit).

Evidence available about each of these possible sources of taxable income

will vary for different tax jurisdictions and, possibly, from year to year. To
the extent that any one source provides assurance of realization, it is
unnecessary to look to other sources. If future taxable income from other
than reversing differences provides sufficient assurance, then it is unnecessary
to determine whether reversing taxable differences provides appropriate
income to offset the deductions. Or if taxable differences exceed deductible
differences and an available tax-planning strategy assures that all reversing
deduction can be offset against reversing taxable income, it is unnecessary to
consider other future taxable income. However, all sources must be
considered before a valuation allowance is established.

Even if a company operates within a single taxing jurisdiction, the need for a
valuation allowance with respect to different types of carryovers must often be
evaluated individually due to differing carryback / carryforward periods and
differing limitations on utilization. For example, a profitable company may
have a valuation allowance where one of its DTAs is attributable to foreign tax
credits and its does not anticipate having sufficient foreign source income
within the foreign tax credit carryback / carryforward period. Similarly, if a
taxpayer operates in multiple taxing jurisdictions, the need for a valuation
 allowance must often be determined separately for each jurisdiction due to
differing carryback / carryforward rules. This creates the possibility of a
company having a valuation allowance with respect to a DTA at the state level
but not the federal (or, less commonly, vice versa) where, for example, a DTD
will reverse within the federal carryforward period but following the expiration
of the (shorter) state carryforward period.

In evaluating the need for a valuation allowance, taxable income in prior years
and future reversals of TTDs are generally considered to constitute more
objective evidence than projections of future income; consequently, the
recommended process for analyzing the need for a valuation allowance
presented below is based on justifying realization of as much as possible of a
company’s DTAs on past income and reversing TTDs prior to relying on
projections of book income to justify the lack of a need for a valuation
allowance. This approach increases the objectivity inherent in determining the
necessary valuation allowance amount.
________________________________________________________________

Example

In 20X4, its initial year of operations, Theta reports taxable income of

$400,000 and pays tax of $136,000. For financial reporting purposes, Theta
reports income tax expense of $204,000, consisting of current income tax
expense of $136,000 and deferred income tax expense of $68,000. Theta’s
balance sheet reflects (1) a deferred tax asset of $170,000 attributable to a
$500,000 deductible temporary difference expected to reverse in the succeeding
year and (2) a $238,000 deferred tax liability attributable to taxable temporary
differences of $700,000 expected to reverse in equal amounts over the
succeeding five years.

In determining the need for a valuation allowance against the $170,000 gross
DTA, it can be concluded that -

1. $136,000 of the DTA will be realized through carryback of $400,000 of the

reversing DTD from 20X5 to 20X4.
2. The remaining $34,000 of the DTA will be realized through offsetting of the
remaining $100,000 of the reversing DTD against the $140,000 ($700,000 / 5)
of TTDs expected to reverse in 20X5.

As a consequence, no valuation allowance is needed even if Theta is unable to

reasonably project book income for 20X5 and later years. [Note that if the
amount of the DTD had exceeded $1,100,000 ($400,000 taxable income within
carryback period + $700,000 of reversing taxable temporary differences within
carryforward period), it would be necessary for Theta to reasonably project
book income at least equal to such excess within the 21 year period beginning
in 20X5 in order for it to be concluded that no valuation allowance is needed.]
 Step in Determining Valuation Allowance

A systematic approach to evaluating an appropriate valuation allowance with

respect to a company’s DTAs involves some or all of the following steps:

1. Determine the gross amount of the company’s DTA and DTL.

2. Determine the amount of taxes paid during any available carryback period.

3. Obtain a general understanding of the pattern and timing of reversals of

temporary differences and the length of available carryback / carryforward
periods, i.e., perform “quick and dirty” scheduling.

4. Determine the extent to which it is more likely than not that the tax benefits of
DTDs and carryforwards (DTAs) will be realized through carryback or through
the offsetting of future reversing TTDs.

5. Determine the amount and timing of future taxable income necessary to realize
the remaining balance of the gross DTA.

6. Determine whether evidence exists to support the conclusion that future income
will be sufficient to allow realization of the remaining DTA.

7. If necessary, perform, more detailed scheduling of reversal patterns and / or

obtain more detailed projections of future income.

8. If necessary, consider the availability of tax planning strategies.

9. Consider the existence of negative evidence concerning realizability of the

company’s DTA.

10. Reach an overall conclusion concerning the amount of valuation allowance

required to reduce the company’s DTA to the amount that more likely than not
will be realized.

Group Exercise

Introduction & In order to effectively calculate a tax provision, it is

Rationale important to be able to apply the 5-step approach to
calculate the deferred tax asset or liability and integrate
the result with the current tax provision to arrive at the
total tax provision.
Task Use the additional information provided on OBD Ltd to
calculate the 2010 tax provision. The 5-step approach
should be used to determine the beginning and end of
year net deferred tax asset or liability.
Context
Size & 4-6
Composition Table Groups

Sharing Select a table spokesperson to represent your table group

when we reconvene.
 OBD Ltd

Case Study – Part 2

Calculation of 2010 Tax Provision

Facts/Assumptions:

 Refer to Case Study –Part 1 (and the solution thereto) for relevant information through
December 31, 2009

 2010 Activity

Pretax income - $2,500,000

The 12/31/10 excess of tax over book basis in inventory as a result of Section 263A is
$50,000.
As a result of a major customer’s financial trouble, a provision for bad debts of $150,000 was
recorded during 2010. Bad debt charge-offs totaled only $30,000.
The 2010 book pension expense (net periodic pension cost) is $125,000, while the tax
deductible contribution was $70,000.
2010 book depreciation expense exceeded tax depreciation by $72,000.
The 12/31/10 balance in the reserve for deferred compensation is $50,000.
The 12/31/10 balance in the restructuring reserve is $115,000.
OBD Ltd earned $150,000 in tax-exempt (municipal bond) interest, and $50,000 in General
Motor Corporation dividends. Tax-exempt interest comes from bonds issues by the same
state OBD Ltd is incorporated in. The dividend income is subject to a 70% DRD deduction.
The DRD is not available for state tax purposes.
OBD Ltd received $1,000,000 in life insurance proceeds from a key-man life insurance
policy. The life insurance proceeds came from the death of the company’s president.

 Assume that the U.S. federal statutory tax rate was 34% for 2009 and 35% for 2010.
 Assume the average state rate for both years was 9%.
 Assume that no valuation allowance is required for 12/31/09 or 12/31/10.

Required

 Calculate OBD Ltd’s 2010 tax provision, separately showing the current and deferred
components for both federal and state purposes.
 Prepare the journal entry to record OBD Ltd’s 2010 tax provision.
 Financial Statement Presentation and Basic Disclosure
Requirements

Objectives Upon completion of this phase, participants will be able to

 Describe and review the income statement and balance sheet presentation
and footnote disclosure requirements related to ASC 740.

Introduction As important as an accurate calculation of the provision for income taxes is,
the presentation of that information in a client’s financial statements may be
important. Shareholders and other financial statement users need to be able to
understand exactly what is included in a company’s tax provision. The
presentation of the tax provision affects a company’s 1) balance sheet; 2)
income statement; and 3) footnotes to the financial statements.

ASC 740 includes specific requirements that stipulate what a corporation

must include in their financial statements regarding the income tax accounts.
Some of the requirements are:
Balance Sheet In a classified balance sheet, deferred tax assets and liabilities are classified as
current or noncurrent based on the classification of the related asset or
liability. A temporary difference is related to an asset or liability if reduction
of the asset or liability causes the temporary difference to reverse.

If deferred tax assets or liabilities are not related to a book asset or liability,
they should be classified according to the expected reversal date of the
temporary differences

What are some examples of a temporary difference that are not related
to an asset or liability?

Examples of these items include Section 248 organization costs, a cumulative

effect on an accounting method change, and deferred tax assets related to tax
loss or credit carryforwards.

ASC 740 requires that current and noncurrent tax assets and liabilities from a
particular jurisdiction be segregated; the current asset and liability should be
offset and presented as a single amount, and the noncurrent asset and liability
should be similarly accounted for. Netting of deferred tax assets and
liabilities attributable to different tax jurisdictions is not permitted under ASC
740. However, in practice, only material items are presented separately.
Therefore, in most cases all deferred assets and liabilities will be netted and
only the net amount will be shown on the balance sheet. But remember, if the
separate amounts are material alone, they must be shown separately.

Example

Beta Corp. has two temporary differences – a TTD related to the use of
accelerated depreciation for tax purposes and a DTD related to certain accruals
for which no tax deduction is allowed until they are paid in the succeeding
year. The TTD will give rise to a noncurrent DTL since it relates to a
noncurrent asset (property, plant, and equipment), while the DTD will give rise
to a current DTA since it relates to a current liability (accrued expenses).
________________________________________________________________

Netting of DTAs and DTLs on Balance Sheet

ASC 740 permits the netting of current DTAs and current DTLs to the extent
that the DTAs and DTLs relate to the same taxing jurisdiction. Likewise,
noncurrent DTAs and noncurrent DTLs may be netted to the extent that they
relate to the same taxing jurisdiction. The result is a single net current DTA or
DTL, as well as a single net noncurrent DTA or DTL for each taxing
jurisdiction in which it operates.
 A DTA attributable to one taxing jurisdiction may not be netted against a DTL
attributable to another taxing jurisdiction even if both items are current or
noncurrent. Consequently, a corporation operating in multiple jurisdictions may
reflect both a current DTA and a current DTL, as well as both a noncurrent
DTA and a noncurrent DTL.
________________________________________________________________

Example

Lambda Corp. is subject to U.S. federal income tax, as well as state income tax
in State X. an analysis of the computed DTAs and DTLs as of the close of the
current year is as follows:

Current DTA – federal $50,000

Current DTL – federal $(20,000)
Current DTA – state $10,000
Current DTL – state $(20,000)
Noncurrent DTA – federal $40,000
Noncurrent DTL – federal $(60,000)
Noncurrent DTA – state $10,000
Noncurrent DTL – state $(20,000)

On Lambda’s year-end balance sheet, it will reflect the following:

Current DTA ($50,000 - $20,000) $30,000

Current DTL ($20,000 - $10,000) $(10,000)
Noncurrent DTL ($60,000 + $20,000 –
$40,000 – 10,000) $(30,000)

Income The provision for income taxes must be computed for all components of a
Statement company’s operations. However, the line item listed on the income statement
as provision for income taxes is only the tax expense or benefit allocated to
continuing operations. Tax amounts must be allocated to other categories
such as discontinued operations or extraordinary items. These items are
presented net of tax on the financial statements.

To calculate the amount of tax that should be allocated to other categories of

income, a “with” and “without” calculation must be made. The “with”
calculation includes all items of income while the “without” calculation does
not include the particular category (i.e. discontinued operations or
extraordinary items). The difference between the two tax calculations is the
amount of tax expense or benefit allocated to that category. The difference
between the total tax calculated and the amount allocated to all other
categories is the amount allocated to continuing operations.
Footnote Most readers of financial statements will not be able to understand what is
Disclosure included in a company’s tax provision by just looking at the balance sheet and
the income statement. More important to the user of financial statements is
the information contained in the footnotes to the financial statements. ASC
740 requires the following footnote disclosures:

1. A breakdown of the tax expense or benefit allocated to continuing

operations and other categories of income.

Intraperiod tax allocation addresses the way in which a company’s total

income tax expense or benefit for a particular year is allocated among:

 Income (or loss) from continuing operations

 Income (or loss) from discontinued operations
 Extraordinary items
 Items included on other comprehensive income (e.g., mark-to-market
gains and losses with respect to certain marketable securities, certain
foreign currency translation gains and losses)
 Items charged or credited directly to equity

Under ASC 740, income tax expense or benefit for a given year is allocated
first to income from continuing operations. The income tax expense or benefit
allocated to continuing operations should include –

 The tax effects of pretax income or loss from continuing operations

 Changes in the valuation allowance (with limited exceptions)
 The tax effects of changes in tax laws or rates
 The tax effects of a change in tax status (e.g., conversion from a C
corporation to an S corporation)

After the amount allocable to current operations is determined, the remainder

of the income tax expense or benefit is allocated as follows:

 If there is only one other category, the entire remaining amount is

allocated to such category.

 If there are two or more other categories, the remaining amount is

allocated among such categories in proportion to their individual tax
effects on income tax expense or benefit for the year.
Footnote 2. Significant components of income tax expense attributable to
Disclosure continuing operations including:
(continued) Current tax expense or benefit;
Deferred tax expense or benefit;
Tax benefits of operating loss carryforwards;
Tax expense that results from allocating certain tax benefits
either directly to contributed capital or to reduce goodwill or
other noncurrent intangible
assets of an acquired entity;
Adjustments of a deferred tax asset or liability for enacted
changes in tax
laws or rates or a change in the tax status of the company; and
Adjustments of the beginning-of-the-year balance of a
valuation allowance because of a change in circumstances that
causes a change in judgement about the realizability of the
related deferred tax asset in future years.
3. An effective rate reconciliation. This calculation will reconcile the
federal statutory rate to the company’s effective tax rate. Public
companies must disclose either percentages or dollar amounts, while
nonpublic companies need disclose only the nature of the significant
reconciling items. Public companies must separately disclose any
item that is 5% or more of the companies tax rate. Other items can be
netted and shown as one line item.
4. Gross deferred tax liabilities, gross deferred tax assets, the valuation
allowance, and the net change in the valuation allowance.
5. The approximate tax effect of each type of temporary difference and
carryforwards that gives rise to significant portions of the deferred tax
liabilities or assets before the valuation allowance.
6. The nature and effect of any significant matters affecting
comparability of information for all periods presented unless
otherwise evident from other disclosures.
7. The amount and expiration dates of tax loss and credit carryforwards.
8. Any portion of the valuation allowance for deferred tax assets from
which subsequent recognition would be used to reduce goodwill or
other noncurrent intangible assets of acquired entities or would be
allocated directly to equity.
9. Description of any temporary difference for which no deferred tax
liability has been recognized.

Generally required disclosures are discussed in this section while subsequent

sections consider –

 The rate reconciliation

 Selected specialized disclosures
 Components of the Net Deferred Tax Asset or Liability / Tax Effects of
Temporary Differences

ASC 740 requires that a company disclose the following amounts in the
footnotes to its financial statements:

 Total of all deferred tax liabilities (federal, state, and foreign)

 Total of all gross deferred tax assets (federal, state, and foreign)
 Total valuation allowance

Note that these numbers combine (1) current and noncurrent DTAs and (2)
current and noncurrent DTLs. In addition, note there is no netting of DTAs
and DTLs even if they relate to the same tax jurisdiction and are classified
similarly on the balance sheet. This reporting differs from reporting on the
balance sheet where (1) current and noncurrent DTAs and DTLs are reported
separately and (2) netting of current (or noncurrent) DTAs and DTLs is
permitted where they relate to the same tax jurisdiction.

ASC 740 also requires that a company disclose the tax effect of each type of
temporary difference that gives rise to a significant portion of deferred tax
assets and liabilities. This information is typically reported on a combined
basis for all tax jurisdictions in which the company operates; consequently, if
a “blended” tax rate is utilized, the amounts reflected in the tax footnote are
calculated by multiplying the amount of each temporary difference by the
blended tax rate. For example, if the amount of a particular TTD is $100,000
and the blended tax rate is 40%, the tax effect of the particular temporary
difference is a DTL of $40,000.

Change in Valuation Allowance

ASC 740 requires that a company disclose in the financial statement footnotes
the net change (if any) in the valuation allowance between the beginning and
end of the year. In addition, the footnotes frequently contain a brief discussion
of the criteria utilized by management in assessing the need for a valuation
allowance. An example of such a discussion is given in the following
example.

Loss and Credit Carryforwards

ASC 740 requires footnote disclosure of the amount(s) of any loss or credit
carryforwards and their scheduled expiration dates. Where the company has
no loss or credit carryforwards, the footnotes should generally contain a
statement to such effect.
 Rate Reconciliation

The objective of the rate reconciliation is to reconcile the “expected” U.S.

federal statutory income tax rate of 34% or 35% with the company’s “actual”
(or “effective”) rate determined utilizing the following formula:

Income tax expense attributable to income from continuing operations ÷ pre-

tax book income

It is mandatory that a public company include such reconciliation in the

footnotes to its financial statements. The reconciliation can be shown based on
either percentages or dollars of tax (or both). In the case of a non-public
company, a formal rate reconciliation is not required; however, the company
must disclose items significantly influencing its effective tax rate.
_______________________________________________________________
Items Commonly Increasing “Effective” Tax Rate

The following items commonly cause a company’s effective tax rate to exceed
the expected tax rate:

 State income taxes (net of federal benefit)

 Tax effect of nondeductible expenses (permanent differences)
 Increase in valuation allowance
_______________________________________________________________

Items Commonly Decreasing “Effective” Tax Rate

The following items commonly cause a company’s effective tax rate to fall
below the expected tax rate:

 Tax effect of nontaxable income items (permanent differences)

 Income tax credits
 Decrease in valuation allowance
 Equity in earnings of affiliates not subject to tax at statutory rate due to
availability of dividends-received deduction
_______________________________________________________________
 Other Items Affecting “Effective” Tax Rate

Depending on the company’s particular circumstances, the following items

may either increase or decrease the expected rate in arriving at a company’s
actual rate:

 Tax rate differential between United States and foreign jurisdictions in which
the company operates
 “True-up” of prior-year tax provision to prior-year return
 Changes in prior years’ taxes due to audits or amended returns
 Changes in tax laws or rates
 Changes in tax status (In this regard, note that conversion of a C corporation
into an S corporation will not typically result in the elimination of all of the
corporation’s deferred tax assets and liabilities, since the corporation will be
subject to the Section 1374 tax on built-in gains to the extent that such gains
are recognized within the 10-year period subsequent to the date of change in
status.)
_______________________________________________________________

Example

.:

%
Computed “expected” tax 34.00
expense
State and local taxes, net 6.60
of federal benefit
Nondeductible meals and .34
entertainment
Tax-exempt municipal (.34)
bond interest
Foreign tax rate (.90)
differential
39.70

Selected information concerning the computation of the amounts contained in

the above table is as follows:

1. The state and local taxes, net of federal benefit, percentage equals the stated
state rate of 10% - (1 - .34) = 6.60%.
2. The amount for nondeductible meals and entertainment equals $50,000 of
nondeductible meals and entertainment times the expected rate of 34% =
$17,000. This amount is divided by pretax book income to express it as a
percentage.
 3. The amount for tax-exempt municipal bond interest equals $50,000 of
nondeductible meals and entertainment times the expected rate of 34% =
$17,000. This amount is divided by pretax book income to express it as a
percentage.
4. The corporation derived $500,000 of its pretax income from foreign
operations. Foreign income tax imposed on such income equaled $125,000. If
tax had been imposed on such income at the federal statutory rate of 34%, the
company’s income tax on such income would have equaled $170,000. The
percentage benefit of foreign tax rates being lower than the U.S. statutory rate
is calculated as follows: [($170,000 tax at U.S. statutory rate - $125,000
foreign tax expense) / $5,000,000 pretax book income] = .90%.
5. The actual rate equals $2,005,000 of income tax expense divided by pretax
book income of $5,000,000.
__________________________________________________________________

Implementation ASC 740 was required to be adopted for fiscal years beginning after
of ASC 740 December 15, 1992. Most of our clients should have already adopted ASC
740. Future adoptions will result from 1) “S” Corporations converting to “C”
Corporations; 2) the formation of new companies; 3) spin offs of companies;
and 4) foreign companies that begin business in the United States (many
foreign countries still use ABP 11 standards for foreign financial statements).

If a company must adopt ASC 740, there may be a “catch-up” effect that must
be reported. The “catch-up” effect is the difference (as of the earliest date
that ASC 740 is applied) between the net deferred tax asset or liability
determined under ASC 740 and the net deferred tax balance determined under
the existing standard. This “catch-up” adjustment is generally reported as a
“cumulative effect of a change in accounting principle, which is usually the
last line before net income on the income statement.
 Exxon Mobil Corp.
CONSOLIDATED BALANCE SHEET

Note
Reference Dec. 31 Dec. 31
Number 2005 2004
(millions of dollars)
Assets
Current assets
Cash and cash equivalents $ 28,671 $ 18,531
Cash and cash equivalents – restricted 3, 14 4,604 4,604
Notes and accounts receivable, less estimated doubtful amounts 5 27,484 25,359
Inventories
Crude oil, products and merchandise 3 7,852 8,136
Materials and supplies 1,469 1,351
Prepaid taxes and expenses 3,262 2,396

Total current assets $ 73,342 $ 60,377

Investments and advances 7 20,592 18,404
Property, plant and equipment, at cost, less accumulated depreciation and depletion 8 107,010 108,639
Other assets, including intangibles, net 7,391 7,836

Total assets $ 208,335 $ 195,256

Liabilities
Current liabilities
Notes and loans payable 5 $ 1,771 $ 3,280
Accounts payable and accrued liabilities 5 36,120 31,763
Income taxes payable 8,416 7,938

Total current liabilities $ 46,307 $ 42,981

Long-term debt 12 6,220 5,013
Annuity reserves 15 10,220 10,850
Accrued liabilities 6,434 6,279
Deferred income tax liabilities 17 20,878 21,092
Deferred credits and other long-term obligations 3,563 3,333
Equity of minority and preferred shareholders in affiliated companies 3,527 3,952

Total liabilities $ 97,149 $ 93,500

Commitments and contingencies 14

Shareholders’ equity
Benefit plan related balances $ (1,266) $ (1,014)
Common stock without par value (9,000 million shares authorized) 5,743 5,067
Earnings reinvested 163,335 134,390
Accumulated other nonowner changes in equity
Cumulative foreign exchange translation adjustment 979 3,598
Minimum pension liability adjustment (2,258) (2,499)
Unrealized gains/(losses) on stock investments — 428
Common stock held in treasury (1,886 million shares in 2005 and 1,618 million shares in 2004) (55,347) (38,214)

Total shareholders’ equity $ 111,186 $ 101,756

Total liabilities and shareholders’ equity $ 208,335 $ 195,256

The information on pages 52 through 75 is an integral part of these statements.

 Exxon Mobil Corp.
CONSOLIDATED STATEMENT OF INCOME

Note
Reference
Number 2005 2004 2003
(millions of dollars)
Revenues and other income
Sales and other operating revenue (1) (2)
$ 358,955 $ 291,252 $ 237,054
Income from equity affiliates 6 7,583 4,961 4,373
Other income 4,142 1,822 5,311

Total revenues and other income $ 370,680 $ 298,035 $ 246,738

Costs and other deductions

Crude oil and product purchases $ 185,219 $ 139,224 $ 107,658
Production and manufacturing expenses 26,819 23,225 21,260
Selling, general and administrative expenses 14,402 13,849 13,396
Depreciation and depletion 10,253 9,767 9,047
Exploration expenses, including dry holes 964 1,098 1,010
Interest expense 496 638 207
Excise taxes (1)
17 30,742 27,263 23,855
Other taxes and duties 17 41,554 40,954 37,645
Income applicable to minority and preferred interests 799 776 694

Total costs and other deductions $ 311,248 $ 256,794 $ 214,772

Income before income taxes $ 59,432 $ 41,241 $ 31,966

Income taxes 17 23,302 15,911 11,006

Income from continuing operations $ 36,130 $ 25,330 $ 20,960

Cumulative effect of accounting change, net of income tax — — 550

Net income $ 36,130 $ 25,330 $ 21,510

Net income per common share (dollars) 10

Income from continuing operations $ 5.76 $ 3.91 $ 3.16
Cumulative effect of accounting change, net of income tax — — 0.08

Net income $ 5.76 $ 3.91 $ 3.24

Net income per common share – assuming dilution (dollars) 10

Income from continuing operations $ 5.71 $ 3.89 $ 3.15
Cumulative effect of accounting change, net of income tax — — 0.08

Net income $ 5.71 $ 3.89 $ 3.23

 17. Income, Excise and Other Taxes

2005 2004 2003

U.S. Non-U.S. Total U.S. Non-U.S. Total U.S. Non-U.S. Total
(millions of dollars)
Income taxes
Federal or non-U.S.
Current $ 5,462 $ 17,052 $ 22,514 $ 4,410 $ 12,030 $ 16,440 $ 1,522 $ 7,426 $ 8,948
Deferred – net (584) 362 (222) (1,113) 122 (991) 996 645 1,641
U.S. tax on non-U.S. operations 208 — 208 56 — 56 71 — 71

5,086 17,414 22,500 3,353 12,152 15,505 2,589 8,071 10,660

State 802 — 802 406 — 406 346 — 346

Total income taxes 5,888 17,414 23,302 3,759 12,152 15,911 2,935 8,071 11,006
Excise taxes 7,072 23,670 30,742 6,833 20,430 27,263 6,323 17,532 23,855
All other taxes and duties
Other taxes and duties 51 41,503 41,554 26 40,928 40,954 22 37,623 37,645
Included in production and manufacturing expenses 1,182 1,075 2,257 982 951 1,933 976 812 1,788
Included in SG&A expenses 202 558 760 215 503 718 211 463 674

Total other taxes and duties 1,435 43,136 44,571 1,223 42,382 43,605 1,209 38,898 40,107

Total $ 14,395 $ 84,220 $ 98,615 $ 11,815 $ 74,964 $ 86,779 $ 10,467 $ 64,501 $ 74,968

All other taxes and duties include taxes reported in production and manufacturing and selling, general and administrative (SG&A) expenses. The
above provisions for deferred income taxes include net (charges)/credits for the effect of changes in tax laws and rates of $199 million in 2005,
$318 million in 2004, and $124 million in 2003. Income taxes (charged)/credited directly to shareholders’ equity were:

2005 2004 2003

(millions of dollars)
Cumulative foreign exchange translation adjustment $ 158 $ (180) $ (233)
Minimum pension liability adjustment (90) (49) (381)
Gains and losses on stock investments 236 53 (331)
Other components of shareholders’ equity 224 183 107

The reconciliation between income tax expense and a theoretical U.S. tax computed by applying a rate of 35 percent for 2005, 2004 and 2003, is
as follows:

2005 2004 2003

(millions of dollars)
Earnings before federal and non-U.S. income taxes
United States $ 16,098 $ 11,067 $ 9,438
Non-U.S. 42,532 29,768 22,182

Total $ 58,630 $ 40,835 $ 31,620

Theoretical tax $ 20,521 $ 14,292 $ 11,067

Effect of equity method accounting (2,654) (1,736) (1,531)
Non-U.S. taxes in excess of theoretical U.S. tax 4,719 3,093 1,635
U.S. tax on non-U.S. operations 208 56 71
U.S. tax settlement — — (541)
Other U.S. (294) (200) (41)

Federal and non-U.S. income tax expense $ 22,500 $ 15,505 $ 10,660

Total effective tax rate 41.4% 40.3% 36.4%

 The effective income tax rate includes state income taxes and the Corporation’s share of income taxes of equity companies. Equity company
taxes totaled $2,226 million in 2005, $1,180 million in 2004, and $983 million in 2003, primarily outside the U.S.

Deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting
purposes and such amounts recognized for tax purposes.

Deferred tax liabilities/(assets) are comprised of the following at December 31:

Tax effects of temporary differences for: 2005 2004

(millions of dollars)
Depreciation $ 17,000 $ 16,732
Intangible development costs 4,809 4,733
Capitalized interest 2,311 2,279
Other liabilities 2,457 3,295

Total deferred tax liabilities $ 26,577 $ 27,039

Pension and other postretirement benefits $ (2,654) $ (2,613)

Tax loss carryforwards (1,996) (2,399)
Other assets (5,091) (3,761)

Total deferred tax assets $ (9,741) $ (8,773)

Asset valuation allowances 566 686

Net deferred tax liabilities $ 17,402 $ 18,952

Deferred income tax (assets) and liabilities are included in the balance sheet as shown below. Deferred income tax (assets) and liabilities are
classified as current or long term consistent with the classification of the related temporary difference — separately by tax jurisdiction.

Balance sheet classification 2005 2004

(millions of dollars)
Prepaid taxes and expenses $ (2,081) $ (1,221)
Other assets, including intangibles, net (1,540) (1,406)
Accounts payable and accrued liabilities 145 487
Deferred income tax liabilities 20,878 21,092

Net deferred tax liabilities $ 17,402 $ 18,952

The Corporation had $41 billion of indefinitely reinvested, undistributed earnings from subsidiary companies outside the U.S. Unrecognized
deferred taxes on remittance of these funds are not expected to be material.
Group Exercise

Introduction & Now that the participants know how to calculate and
Rationale record the income tax provision pursuant to ASC 740,
they should understand the financial statement disclosure
requirements and the significance thereof.
Task Using the OBD Ltd information in the Case Study (Parts
1, 2 and 3), the participants should prepare the income tax
footnote for 2010. This presentation includes the
computation of a rate reconciliation. The participants
should also indicate how the tax accounts should be
presented on the income statement and balance sheet.
Context
Size & Individually
Composition Individually
Sharing Ask for two to three volunteers to read their footnote and
put their rate reconciliation on a flip chart. During the
discussion, the instructor should attempt to solicit the
participants’ views on the significance of the various
disclosure items. In other words, how does the disclosure
assist the reader in better understanding the tax position of
the company.

Case Study – Part III

Using the OBD Ltd. information in the Case Study (Parts 1, and 2), the participants
should prepare the income tax footnote for 2010. This presentation includes the
computation of a rate reconciliation. The participants should also indicate how the tax
accounts should be presented on the income statement and balance sheet.
 Tax Contingencies and Uncertain Tax Positions

In General

Tax exposure items or tax contingencies arise when a company takes positions in filing its
income tax returns that it feels may ultimately be successfully challenged by taxing authorities.
For example, a company may claim a current deduction on its income tax return for an item
which the relevant taxing authorities may assert is permanently nondeductible or should be
capitalized and amortized. In such cases, a contingent liability exists to the extent of the potential
tax underpayment. Positions taken by companies in the past with respect to such tax
contingencies have varied; consequently, the FASB has recently issued an interpretation
designed to increase consistency among companies in the reporting of tax contingencies. The
interpretation, ASC 740-10-25 is effective for years ending after December 31, 2006 for public
companies. The standard is effective for years after December 15, 2008 for private companies.
ASC 740-10-25 applies to all companies but at this time it is not yet effective for pass-through
entities or not-for-profit corporations.

Moreover, ASC 740-10-25 applies to all tax positions with respect to which the statute of
limitations is open as of the date of adoption. This will require a company to report a change in
accounting principle in the period of adoption (generally resulting in a charge to income in the
current period).

This change could have important implications for a company’s financial statements. We will
take some time to discuss issues that arise in the practice. Please come prepared to have a
discussion on this topic.

Tax Benefits of Uncertain Tax Positions - Recognition

In ASC 740-10-25, the FASB uses the “benefit recognition” approach to recognizing uncertain
tax positions. It set forth the following general rules for recognizing uncertain tax positions:

 The financial statement effects of a particular tax position shall be recognized only when
it is more likely than not that such position will be sustained based solely on the
technical merits of the position (without consideration of the probability of audit, the
likelihood that the issue will be raised upon audit, or the possibility of offsetting the
proposed deficiency with respect to one item with other items). More likely than not
means that it is more likely that the tax position will be sustained based on its technical
merits, as evidenced by factors such as (1) unambiguous tax law supporting the position,
(2) widely understood administrative procedures, (3) prior audit experience with respect
to similar positions, and (4) favorable legal precedent.
  If a tax benefit is not initially recognized with respect to a particular tax position,
subsequent recognition occurs in the earliest of (1) the period in which the probable
recognition threshold is met, (2) the tax matter is resolved with the relevant taxing
authority, or (3) the statute of limitations for examination of the return(s) containing such
position expires.

 If a previously recognized tax benefit no longer satisfies the probable recognition

threshold, the amount of tax benefit recognized in prior periods with respect to the tax
position shall be derecognized in the period in which it becomes more likely than not that
the position would not be sustained on audit. Derecognizing a previously recognized tax
benefit involves decreasing the amount of a previously recorded asset or setting up (or
increasing the amount of) a liability. Setting up or increasing a valuation allowance is not
an acceptable means of derecognizing a previously recognized tax benefit.

Tax Benefits of Uncertain Tax Positions – Measurement

ASC 740-10-25 uses a two step process to measure the amount that can be recorded for an
uncertain tax position. The first step is to determine the probability of sustaining the tax
position. To go to the second step the position must meet the more likely than not threshold
(more than 50%). If a particular tax position satisfies the more likely than not recognition
threshold, the cumulative probability of sustaining the amount must be calculated. The amount
of tax benefit recognized by the company should represent the amount where the cumulative
probability is greater than 50%. (Note that if the more likely than not recognition threshold is
not satisfied with respect to a particular unit of measurement, no tax benefit is recognized even if
management estimates that some tax benefit will ultimately be received, e.g., as a result of
negotiations with the taxing authority.)
________________________________________________________________________

Balance Sheet Classification

Where a taxpayer claims a larger tax benefit on a tax return with respect to a particular tax
position than is reflected in the financial statements, such difference is reflected on the
company’s balance sheet as either –

 A reduction in a deferred tax asset (if settlement of the tax position would result in the
reduction of a DTD or a decrease in an NOL or credit carryover) or

 A liability (in all other cases).

Where a liability is recognized, such liability should not be classified as a deferred tax liability
unless it arises from a TTD that is created by a tax position that has met the more likely than not
recognition threshold. In other cases, the liability constitutes current taxes payable, with balance
sheet classification dependent upon when the company expects the liability to be paid.
Interest and Penalties

Interest shall be accrued in the financial statements on the difference (if any) between the tax
reflected in the financial statements and the tax reported on the return as filed to the extent that
such difference is attributable to uncertain tax positions. Penalties shall be accrued in the
financial statements where the position taken on the return does not meet the minimum statutory
threshold for penalty avoidance.
________________________________________________________________________

Financial Statement Disclosures

ASC 740-10-25 requires additional disclosures in the footnotes. Under ASC 740-10-25
companies must disclose –

 An annual reconciliation of “unrecognized tax benefits” on an aggregated world-wise

basis
– Gross amount of increases or decreases relating to prior period positions
– Gross amount of increases or decreases relating to the current period
– Amounts of decreases relating to settlements with taxing authorities
– Reductions due to expiration of statute of limitations

 Amount of unrecognized tax benefits that if recognized would impact the ETR

 Open years by jurisdiction

 Total amounts of interest and penalties

 Policy election on classification of interest and penalties

 “Reasonably possible” significant changes in recognized tax benefits over the next 12
months

 Qualitative and quantitative disclosure

– Nature of the uncertainty
– Events that could cause a change
– Estimate of the range of the change

________________________________________________________________________

Problem
Gamma Corp. anticipates claiming a $2 million research and experimentation credit on its
current year return. One-half of such credit relates to Project A and the other one-half relates to
Project B. Gamma feels that it is more likely than not (based on analysis of relevant tax law) that
the credit claimed with respect to Project A will ultimately be allowed, while the credit claimed
with respect to Project B will be disallowed. Management anticipates that that the probability of
sustaining 100% of the credit claimed with respect to Project A is 10%; the probability of
sustaining 90% is 30%; the probability of sustaining 80% is 15% and the probability of
sustaining 70% is 20% and that the probability of sustaining 100% of the credit claimed with
respect to Project B is 0%; the probability of sustaining 90% is 0%; the probability of sustaining
80% is 5%; the probability of sustaining 70% is 10%;%; the probability of sustaining 60% is
10%; the probability of sustaining 50% is 15% of the credit claimed with respect to Project B
being allowed.