ASC 740 Provision for Income Taxes
Last Updated November 18, 2021
ASC 740 governs how companies recognize the effects of income taxes on their financial statements under U.S. GAAP. This applies only to taxes based on income—not sales, payroll, or property taxes—per ASC 740-10.
Calculating the provision for income taxes under ASC 740 presents a difficult technical challenge. However, the market’s most powerful tax provision software provides practitioners an accurate calculation, intuitive design, and thorough footnotes. See how Tax Prodigy Provision untangles ASC 740’s complexity.
What is a tax provision?
An income tax provision represents the reporting period’s total income tax expense. This includes federal, state, local, and foreign income taxes. The ASC 740 income tax provision consists of current and deferred income tax expense.
Current income tax expense (benefit) includes the income tax payable (receivable) for the current period based on applying current tax law to current period taxable income or loss.
Deferred income tax expense (benefit) represents the anticipated future tax expense (benefit) from activity in past or current periods. These future expenses (benefits) arise due to temporary differences between book and tax value for certain items.
ASC 740 applies to all entities but only to entity-level taxes. Passthrough tax provisions only occur for jurisdictions that have income-based tax at the entity level. Thus, calculating the ASC 740 provision for income taxes usually concerns only C-corporations.
How does a corporation calculate its income tax provision under ASC 740?
Add the current and deferred income tax provisions to get the total ASC 740 income tax provision.
The current income tax provision equals the taxes reported on current year returns (if available) plus any adjustments for prior year returns. However, the current income tax provision must exclude uncertain tax benefits except to the extent the relevant tax authority will more likely than not sustain the underlying position.
Companies may estimate the current income tax provision to issue financial statements before filing the related tax return. To estimate the current income tax provision:
- Start with pretax GAAP income.
- Add or subtract net permanent differences.
- Add or subtract the net change in temporary differences.
- Subtract usable loss carryforwards.
- Multiply the result by the tax rate (21% for federal tax on C-corporations).
- Subtract usable tax credits, tax credit carryforwards, and the benefit of current year loss carrybacks.
Adjustments for prior year returns and uncertain tax benefits also apply to an estimated current provision.
ASC 740 mandates a balance sheet approach to accounting for income taxes. Companies recognize and measure deferred tax liabilities and deferred tax assets plus any required tax valuation allowances, then use the changes in these accounts to calculate the corporate deferred income tax provision.
Multiply total taxable temporary differences by the expected tax rate at the time the differences will reverse—based on currently enacted law—to calculate the deferred tax liability. Repeat this step with deductible temporary differences and loss carryforwards—then add total tax credit carryforwards—to obtain the deferred tax asset.
Next, create a deferred tax asset valuation allowance for the portion of the deferred tax asset with no more than a 50% chance of realization. Record the effect of uncertain tax benefits on deferred tax assets and liabilities.
The deferred income tax provision (benefit) equals the net deferred tax liability (asset) at the end of the year minus the net deferred tax liability (asset) at the beginning of the year.
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What are permanent and temporary differences?
Permanent differences between GAAP and tax amounts never reverse. GAAP income excluded from tax, nondeductible expenses, and the effects of certain credits all represent permanent differences. For federal tax, examples include interest on state and municipal bonds (tax-exempt income), entertainment expenses (nondeductible expense), and fines (nondeductible expense). Permanent differences affect the current provision and therefore the effective tax rate under ASC 740. They do not create deferred tax assets or liabilities because they never reverse in the future.
Temporary differences between GAAP and tax amounts will reverse in the future. For example, consider an asset with a useful life of 10 years, no salvage value, and a cost of $100,000. A company uses bonus depreciation rules to claim $100,000 in tax depreciation during the property’s first year in service. For GAAP purposes, the company uses the straight-line method resulting in $10,000 of book depreciation. The $90,000 difference in depreciation expense – and basis – represents a temporary difference.
This results in zero difference between GAAP and tax income over the long term. GAAP pretax income initially exceeds taxable income by $90,000. Each year after, the company recognizes $10,000 GAAP depreciation expense and $0 tax depreciation expense, reversing the temporary difference by $10,000. By the end of year 10, the asset has zero basis, and the company has recognized $100,000 of depreciation expense for both book and tax purposes.
Temporary differences create deferred tax assets or liabilities because their reversal affects future tax expense. Usually, this results in no net change to the ASC 740 provision for income tax – the change in the current tax provision offsets the change in the deferred tax provision. However, tax rate changes and valuation allowances can cause the total provision for income tax to change.
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What reporting and disclosures are required under ASC 740?
The total ASC 740 provision for income tax goes on the income statement. Companies may choose whether to report current and deferred tax expense on the income statement or as a separate disclosure.
ASC 740 requires the balance sheet to net all deferred tax assets and liabilities that can offset for tax purposes—usually meaning they relate to the same jurisdiction for the same entity. However, companies must disclose the total value of both deferred tax assets and liabilities.
Public companies must perform a tax rate reconciliation. They can reconcile either the expected tax—based on the statutory rate multiplied by GAAP pretax income—to the total income tax provision,
or the statutory rate to the effective tax rate (ETR). Companies calculate the ETR by dividing the total income tax provision by GAAP pretax income. Nonpublic companies must disclose significant effective tax rate reconciliation items but need not provide a numerical reconciliation.
Additional disclosures required under ASC 740 include: net change in the total valuation allowance, method of accounting for income taxes, nature of temporary differences, policy for classifying interest and penalties, amounts and expiration dates of NOL and tax credit carryforwards, and many other items.
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