Income Tax Accounting SFAS 109 (ASC 740-10)

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Income Tax Accounting SFAS 109 (ASC 740-10)
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Course Objectives

• Understand and apply basic concepts and
  procedures of SFAS 109
• Understand the how to identify temporary
  differences
• Understand how to calculate the current and
  deferred tax provisions
• Understand the basics of the valuation allowance
• Understand how the tax provision affects
  financial statements and its role in the audit
• Ensure client compliance with financial statement
  disclosure requirements

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Objectives of ASC 740-10

• Recognize
• The amount of taxes payable or refundable for the
  current year
• 2. Deferred tax liabilities and assets for the
  future tax consequences of events that have been
  recognized in a companys financial statements or
  tax returns

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Basic Principles

• A current tax liability or asset is
  recognized for the estimated taxes payable or
  refundable on tax returns for the current year
• A deferred tax liability or asset is
  recognized for estimated future taxes created by
  temporary differences
• The measurement of current and deferred taxes
  is based on the provisions of the enacted tax law
• Measurement of deferred tax assets is reduced
  if they will not be recognized.

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Components of Income Tax Expense

• Current income tax expense (benefit)
• Deferred income tax expense (benefit)
• Total income tax expense (benefit)

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Balance Sheet Approach
Balance Sheet Approach

• SFAS 109 requires the balance sheet approach to
  compute deferred taxes
• To compute the expense you must compare the
  beginning balance to the ending balance

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Balance Sheet Approach
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ASC 740-10 Applicability

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

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Hi Course Objectives story
History of Accounting for Income Taxes

• APB 11
• Issued in 1967
• Used the Deferred Method
• Calculation was a with and without method

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History of Accounting for Income Taxes

• The basic formula under APB 11 was
• Pretax income
• /- Permanent Differences
• Taxable Income
• X Tax Rate
• Tax Provision

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History of Accounting for Income Taxes

• FASB 96
• Issued in 1996
• Used the Liability Method
• Required extensive scheduling
• Assumed co. would have not future income

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History of Accounting for Income Taxes

• FASB 109
• Issued in 1992
• Maintained liability method
• Simplified the scheduling requirement
• Required all deferred assets to be recorded
• Introduced the concept of a valuation allowance

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Temporary Differences
The difference between the tax basis of an asset
or liability and its reported amount in the
financial statements that will result in taxable
or deductible amounts in future years when the
reported amount of the asset or liability is
recovered or settled, respectively.
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Types of Temporary Differences
Taxable Temporary Differences Differences that
will result in taxable amounts in future years
when the related asset or liability is recovered
or settled. Deductible Temporary
Differences Differences that will result in
deductible amounts in future years when the
related asset or liability is recovered or settled
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Types of Temporary Differences
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Types of Temporary Differences
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Types of Taxable Temporary Differences
Revenue or gain that are taxable after they are
recognized in book income. Ex. Installment
Sales Expenses or losses that are deductible
before they are recognized in book income.
Ex. Depreciation
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Types of Deductible Temporary Differences
Revenue or gains that are taxable before they are
recognized in book income. Ex. Prepaid
Income Expenses or losses that are deductible
after they are recognized in book income. Ex.
Reserves NOLs and credit carryforwards
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Calculation of the Balance of a Temporary
Difference
Calculation of Temporary Difference Calculated
Book Basis - Calculated Tax Basis Total Temporary
Difference
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Deferred Tax Provision Five Step Process

• Estimate the applicable tax rate
• Determine the gross deferred tax liability
• Determine the gross deferred tax asset
• Determine the gross deferred tax asset for credit
  carryforwards
• Record a valuation allowance, if necessary

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Tax Rates Used

• U.S. Federal Income Tax Rate
• Regular
• AMT
• State Income Taxes
• Blended Tax Rate
• Foreign Income Taxes

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Deferred Tax Liability

• DTL Taxable temporary differences X applicable
  tax rate

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Deferred Tax Asset

• DTA (Deductible temporary differences loss
  and
• deduction carryforwards) X applicable federal
  rate
• tax credit carryforwards.

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Deferred Tax Expense/Benefit

• Net DTA or DTL at end of year
• Less Net DTA or DTL at beginning of year
• Deferred income tax expense (benefit)

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Effect of Change in Net DTA or DTL
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Exception to the General Rule

• APB 23 Permanently reinvested earnings in a
  foreign subsidiary

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Valuation Allowance

• Impairment Approach
• A valuation allowance is required if the
  deferred tax asset is impaired
• Realization Test
• A probability level of more than 50
• A single criterion more likely than not
• Future Taxable Income is Required

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Future Taxable Income

• Future reversals of existing taxable temporary
  differences
• Taxable income in carryback years
• Tax-planning strategies
• Future taxable income (exclusive of reversing
  temporary differences and carryforwards)

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Tax Planning Strategies

• Tax-planning strategies will accelerate income so
  that the company can take advantage of future
  deductible differences.
• Tax-planning strategies must be prudent and
  feasible.
• The company does not have to actually implement
  the strategy.

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Tax Planning Strategies

• Sale of operating assets
• Change of inventory method
• Elect out of the installment method
• Elect the alternative depreciation system

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Positive and Negative Evidence

• Negative Evidence
• Cumulative losses
• History of expiring tax benefits
• Expectation of future losses
• Unsettled circumstances
• Brief carryback or carryforward period

• Positive Evidence
• Existing contracts or sales backlog
• Appreciated asset value over tax basis
• Strong earnings history

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Valuation Allowance

• RECOGNITION OF AN OPERATING LOSS OR ADJUSTMENTS
  TO BEGINNING-OF-YEAR VALUATION ALLOWANCE
• When incurred - source of loss
• Subsequently
• Operations if based on future income
• Source of income if based solely on current year
  income

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Valuation Allowance - Change

• EFFECT OF A CHANGE IN THE VALUATION ALLOWANCE
  THAT RESULTS FROM A CHANGE IN CIRCUMSTANCES MUST
  BE INCLUDED IN INCOME FROM CONTINUING OPERATIONS.

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Valuation Allowance - Change

• CHANGE IN JUDGMENT ABOUT REALIZABILITY
• Affects Current Quarter If For Future Years
• Affects Remaining Interim Periods If For Future
  Interim Periods

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Valuation Allowance Change at Interim Date

• DECREASE IN VALUATION ALLOWANCE IS SEGREGATED
  INTO TWO COMPONENTS
• Portion related to a change in estimate regarding
  the current year's income
• Taken into income by prospectively adjusting
  effective tax rate for current year
• Portion related to a change in estimate about
  future years' income
• Taken into income as a discrete event in the
  quarter of the change in estimate

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Tax Effect of a Change in Tax Law

• MEASURED AND RECORDED ON THE ENACTMENT DATE
• May be necessary to estimate temporary difference
  at interim dates
• RETROACTIVE APPLICATION - EITF ISSUE 93-13
• Impact on disc. operations, extraordinary and
  cumulative effect items
• REQUIRED DISCLOSURES

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Change in Tax Law or Tax Rate

• CURRENT TAX EXPENSE
• Calculate New ETR
• Apply New ETR To Year-To-Date Income
• Cumulative Catch-Up Adjustment
• DEFERRED TAX EXPENSE
• Apply New Tax Rate to Deferred Tax Accounts
• Impact of Change in Deferred Taxes Affects
  Quarter of Enactment

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Current Tax liability

• The amount of income taxes paid or payable (or
  refundable) for a year as determined by applying
  the provisions of the enacted tax law to the
  taxable income or excess of deductions over
  revenues for that year.

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Expected Current Tax Provision

• Pretax Income
• /- Schedule M-1 adjustments
• Taxable Income Before NOL Carryforward
• - NOL Carryforward
  
• Taxable Income
• x Applicable Tax Rate
• Current Tax Provision before Credits
• - Applicable Tax Credits
• Expected Current Tax Provision

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Permanent Differences

• Permanent Differences arise from income that is
  permanently nontaxable and expense items are
  permanently nondeductible.
• Another way of saying it
• Permanent differences are items that impact
  either the financial statements or the tax return
  but not the other

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Examples of Permanent Differences

• 50 of Meal and Entertainment
• Fines and Penalties
• Officers Life Insurance Premiums and Proceeds
• Municipal Bond Interest
• Dividends Received Deduction

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Cases
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Cases Deferred Tax Calculation

• Net Deferred Tax (Liability) Asset 2008
  2009
• Net taxable temporary differences-
  state (294,000) (163,000)
• State Rate 8 8
• Net state deferred tax liability (23,520)
  (13,040)
• Net taxable temporary differences -
  federal (294,000) (163,000)
• Less state deferred tax 23,520
  13,040
• (270,480) (149,960)
• Federal Rate 28 26
  
• Net Federal deferred tax (liability) asset
  (75,734) (38,990)

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Cases Current Provision

• State Federal
• Pretax Income 3,200,000 3,200,000
• Less State Taxes (134,480)
• Schedule M-1 adjustments
• Key-Man Life Insurance (1,500,000)
  (1,500,000)
• Tax-Exempt Interest (150,000)
  (150,000)
• Dividends Received Deduction
  (40,000)
• Change in Temporary Differences 131,000
  131,000
• Taxable Income 1,681,000
  1,506,520
• Tax Rate 8 26 Current
  Tax Expense 134,480
  391,695

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Cases - Provision

• Summary of Total Tax Provision (Benefit)
• Current Tax Provision
• Federal 391,695
• State 134,480
• Total 526,175
• Deferred Tax Provision
• Federal (36,744)
• State (10,480)
• Total (47,224)
• Total Tax Provision 478,951

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Cases Rate Reconciliation

• The reasons for the difference between income
  taxes computed by applying the statutory federal
  income tax rate and income tax expense in the
  financial statements are
• Statutory Rate 832,000 26.00
• State taxes, net of federal tax benefit
  91,760 2.87
• Key-man life insurance (390,000)
  (12.19)
• Tax-exempt interest ( 39,000)
  (1.22)
• Dividends Received Deduction ( 10,400)
  ( .32)
• Change in of tax rate ( 5,409)
  ( .17)
• Effective tax rate 478,951 14.97

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Cases Balance Sheet Presentation

• Deferred income tax assets and liabilities
  consist of the following
• Deferred income tax assets
• Inventories 17,000
• Bad Debts 73,100
• Pension Costs 35,700
• Restructuring Reserve 39,100
• Deferred Compensation 17,000
• Provincial Taxes 3,390
• Gross Deferred Tax Asset 185,290
• Deferred income tax liabilities
• Depreciation 237,320
• Deferred Tax Liability 52,030
  

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True-Ups

• During the provision work, a comparison is
  performed to identify any differences between the
  numbers used in last years tax provision and the
  amounts used on the tax return.
• The differences are trued up as part of the tax
  provision preparation process for the succeeding
  year.

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True Up Process
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True Up Process
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True Up Process - 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 Gammas 20X9
tax provision to its 20X9 income tax return is as
follows
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True Up Process - Example
What is the adjustment that is needed?
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True Up Process - Example
What is the adjustment that is needed? Dr Income
taxes payable 18,000 Cr Current income tax
expense 4,000 Cr Deferred income tax
liability 14,000
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Uncertain Tax Positions
Tax issues created the most problems found under
Sarbanes-Oxley and 404 Numerous restatements
were required because of the tax provision In
response FASB undertook a project to govern how
uncertain tax positions would be reported
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Former Practices
Tax Contingencies or cushion were hid and not
disclosed in detail Tax Directors were very
proprietary with the calculation and were
reluctant to discuss with the auditors Concern
that if the information was included in the audit
workpapers the IRS would have access to them
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Former Practices

• Tax Contingencies are reported using either
• Loss Contingency approach SFAS 5
• Best Estimate approach 50/50
• Tax Advantaged Transaction approach reverse
  SFAS 5

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Former Practices
Had to use a consistent approach The likelihood
of a taxing authority discovering the issue on
examination should not be considered Support for
each reserve amount and any change was required
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FASBs Concerns
Diversity of reporting of tax contingencies Felt
the standards needed strengthening Use of tax
contingencies had become too flexible and used to
manipulate income Reporting and disclosure
lacked transparency
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SECs Position

• SEC also concerned about the reporting of tax
  contingencies
• Many SEC letters were been issued on this matter
  in the 6 to 9 months prior to the issuance of FIN
  48 (ASC 740-10)
• Dealing with the SEC very different than FASB and
  IRS

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FIN 48 (ASC 740-10)
Released July 13, 2006 Benefit Recognition
Approach More likely than not
threshold Cumulative Probability
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Objectives of FIN 48 (ASC 740-10)

• Clarify accounting for income taxes
• Provide greater consistency in criteria used to
  recognize, derecognize, and measure benefits
  related to income taxes
• Establish consistent thresholds, thereby
  improving relevance and comparability of
  financial statement reporting

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Scope of FIN 48 (ASC 740-10)

• Applies to all income tax positions
• A tax position is defined as a position taken in
  a previously filed return or expected to be taken
  in a future return
• A position can result in a permanent reduction of
  taxes (permanent differences), a deferral of
  taxes (temporary differences), or a change in the
  expected realizability of deferred tax assets
• FIN 48 also encompasses decisions not to file an
  income tax return, jurisdictional allocations
  (i.e., transfer pricing) and characterization of
  income

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FIN 48 (ASC 740-10)

• Recognition criteria focuses primarily on
  technical tax law
• Widely understood administrative procedures
  considered
• Each position assessed separately
• Detection risk not considered

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Highly Certain Tax Positions

• FIN 48 applies to all income tax positions
• Distinguishes between highly certain and
  uncertain tax positions
• Highly certain tax positions
• Clearly meets the MLTN recognition standard and
  greater than 50 likely that 100 of benefit will
  be sustained based on clear and unambiguous tax
  law

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FIN 48 (ASC 740-10)

• Introduces concept of Unit of Account
• Based on facts and circumstances
• Aggregate or
• Separate each project

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Unit of Account

• The appropriate unit of account for a tax
  position is a matter of judgment and requires
  consideration of
• The manner in which the enterprise prepares and
  supports its income tax return, and
• The approach the enterprise anticipates the
  taxing authority will take during an examination
• Once established, should be consistently applied
  to similar positions from period to period unless
  change in facts and circumstances indicates that
  a different unit of account is more appropriate

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Two Step Process

• The application of FIN 48 to an uncertain tax
  position (UTP) requires a two-step process that
  separates recognition from measurement
• Step 1 Recognition Threshold
• Step 2 Measurement of the Benefit

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Step 1 Initial Recognition

• A tax benefit is recognized when it is more
  likely than not to be sustained based on the
  technical merits of the position
• Conclusion regarding financial statement
  recognition takes into account technical merits
  and facts and circumstances
• Assumes that tax position will be examined by the
  taxing authority
• Each position must stand on its own merits
• Administrative practices and precedents deal with
  limited technical violations of the tax law
• Authority will not take issue with the tax
  position
• Broad understanding in practice

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Step 2 Measurement

• A tax position that meets the MLTN recognition
  threshold shall initially and subsequently be
  measured as the largest amount of tax benefit
  that is greater than 50 likely of being realized
  (cumulative probability concept)
• Based upon facts and circumstances determined at
  the reporting date

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Step 2 Measurement

• Differences related to timing (deduction itself
  is not in question)
• Recognition threshold is achieved
• Not all tax positions require detailed
  consideration of possible outcome amounts and
  percentage likelihood associated with each amount
  (cumulative probability approach)

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Example Step 1

• A company takes a deduction that creates a tax
  benefit of 100. How likely of being sustained
  on technical merit must the deduction be before
  the company can record the benefit?
• Under the first step the position must be
  more than 50 likely of being sustained on its
  technical merit to take the benefit. The amount
  that should be recognized will depend on the
  cumulative probability in the second step.

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Example Step 2

• From the previous example if the cumulative
  probability the position will be sustained is 30
  for a 100 deduction, 40 for an 80 deduction,
  55 for a 60 deduction and 80 for a 30
  deduction. How much should be deducted?

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Example Step 2
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Change in Judgment

• Subsequent recognition, derecognition or
  change in measurement
• Requires new information vs. new evaluation
• Reporting date vs. financial statement issuance
  date
• Change from rules under FAS 5

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Subsequent Recognition

• Subsequent recognition occurs when any of the
  following conditions are met
• The MLTN threshold is met by the reporting date
• The tax matter is effectively settled through
  examination, negotiation or litigation
• The statute of limitations expires

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Subsequent Recognition

• Applies to those positions not initially
  recognized
• Effectively settled defined
• Taxing authority completed all exam procedures
• No appeal or litigation is intended
• Enterprise considers it remote that the tax
  position would be subsequently examined or
  reexamined
• Presume taxing authority has full knowledge of
  all relevant information

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Sources of New Information

• Developments in the audit
• Revenue Agents report
• Changes in the law
• Notice of Proposed Adjustment
• Experience in prior audits
• APA
• Taxing authority program changes
• Public statements by tax authority

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Balance Sheet Presentation

• Tax contingencies should be included in the
  current income tax payable for amounts expected
  to be paid within 12 months.
• Amounts that are expected to be paid after 12
  months should be in a long-term payable.
• FIN 48 does not allow tax contingencies to be
  part of the deferred tax accounts or the
  valuation allowance.

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Effective Date

• FIN 48 applies to annual periods beginning after
  December 15, 2006 for public companies
• Effective for annual periods beginning after
  December 15, 2008 for private companies
• Same rules apply for public and nonpublic
  companies
• One-time disclosure of cumulative effect

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Cumulative Effect

• The cumulative effect of the change in net assets
  requires an adjustment to beginning retained
  earnings. If the adjustment relates to a
  business combination, the effect requires an
  adjustment to goodwill.

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Disclosure Requirements

• FIN 48 requires additional footnote disclosure
  including
• 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

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Disclosure Requirements

• FIN 48 requires additional footnote disclosure
  including
• 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

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Disclosure Requirements

• FIN 48 requires additional footnote disclosure
  including
• 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

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Changes Caused by FIN 48 (ASC 740-10)

• Must reexamine
• Non-income based taxes
• Planning and controls
• Regulations S-K and MD A disclosures
• Implementation of other new accounting
  standards

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Interest and Penalties

• Interest is a period cost
• Interest accrual is based upon the difference
  between the amount of tax benefit recognized in
  the financial statements and the amount
  recognized in the tax return
• Accrue statutory penalties when a tax position
  does not meet the minimum statutory threshold
  required to avoid penalties
• Consider administrative practices and
  precedents of the tax authority

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Interest and Penalties

• Tax law provisions that address interest and
  penalties may vary between jurisdictions, periods
• Classification of interest and penalties is an
  accounting policy election

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Other Related Topics
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Application of ASC 740-10 to Foreign Subsidiaries

• MEASURE TEMPORARY DIFFERENCES SEPARATELY FOR EACH
  FOREIGN SUBSIDIARY
• U.S. GAAP v. TAX BASIS UNDER FOREIGN LAW
• VALUATION ALLOWANCES DETERMINED IN LIGHT OF
  FOREIGN LAW
• REVIEW UNCERTAIN FOREIGN TAX POSITIONS

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Application of ASC 740-10 to Foreign Branches

• BRANCH INCOME SUBJECT TO BOTH FOREIGN AND US TAX
• ADDITIONAL SET OF TEMPORARY DIFFERENCES
• US GAAP vs. US Tax
• US TAX RECORDED NET OF US FOREIGN TAX CREDIT
• TAX POSTURE OF US HEAD OFFICE RELEVANT IN
  DETERMINING NEED FOR VALUATION ALLOWANCE

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Inside Basis Temporary Difference

• FAS 109 APPLIES TO DIFFERENCES IN FINANCIAL
  REPORTING CARRYING VALUE AND TAX BASIS OF FOREIGN
  SUBSIDIARIES ASSETS (i.e., INSIDE BASIS)
• MEASURE TEMPORARY DIFFERENCES SEPARATELY FOR EACH
  FOREIGN SUBSIDIARY
• US GAAP vs. TAX BASIS UNDER FOREIGN LAW
• VALUATION ALLOWANCES DETERMINED IN LIGHT OF
  FOREIGN LAW

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Outside Basis Temporary Difference

• THE DIFFERENCE BETWEEN THE FINANCIAL REPORTING
  AMOUNT AND THE TAX BASIS OF THE INVESTMENT ON THE
  INVESTORS FINANCIAL STATEMENTS.

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Methods Of Accounting For Investments

• COST
• EQUITY
• CONSOLIDATION

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Cost Method Of Accounting

• INVESTMENT RECORDED AT INITIAL COST
• RECOGNIZE INCOME AS DIVIDENDS ARE RECEIVED
• NET ACCUMULATED EARNINGS OF THE INVESTEE
  SUBSEQUENT TO THE DATE OF INVESTMENT ARE
  RECOGNIZED BY THE INVESTOR TO THE EXTENT
  DISTRIBUTED AS DIVIDENDS
• DIVIDENDS RECEIVED IN EXCESS OF EARNINGS
  SUBSEQUENT TO THE DATE OF INVESTMENT ARE
  CONSIDERED A RETURN OF INVESTMENT AND ARE
  RECORDED AS REDUCTIONS OF THE COST OF
  THE INVESTMENT

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Cost Method Of Accounting - Continued

• A DEFERRED TAX LIABILITY IS RECOGNIZED FOR AN
  EXCESS OF THE AMOUNT FOR FINANCIAL REPORTING OVER
  THE TAX BASIS OF AN INVESTMENT IN A
  LESS-THAN-20-PERCENT-OWNED FOREIGN INVESTEE.
• A DEFERRED TAX ASSET IS RECOGNIZED FOR AN EXCESS
  TAX BASIS OVER THE AMOUNT FOR FINANCIAL REPORTING
  OF AN INVESTMENT IN A LESS-THAN-20-PERCENT-OWNED
  FOREIGN INVESTEE.

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Equity Method Of Accounting

• ONE-LINE CONSOLIDATION CONCEPT
• MUST BE FOLLOWED BY AN INVESTOR WHO HAS THE
  ABILITY TO EXERCISE SIGNIFICANT INFLUENCE OVER
  OPERATING AND FINANCIAL POLICIES OF AN INVESTEE
  EVEN THOUGH THE INVESTOR HOLDS 50 PERCENT OR LESS
  OF THE VOTING STOCK.
• 20 PERCENT OR MORE OF THE VOTING STOCK LEADS TO
  THE PRESUMPTION THAT, IN ABSENCE OF EVIDENCE TO
  THE CONTRARY, AN INVESTOR HAS THE ABILITY TO
  EXERCISE SIGNIFICANT INFLUENCE OVER AN INVESTEE.

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Equity Method - Continued

• INVESTMENT ORIGINALLY RECORDED AT THE COST OF
  SHARES ACQUIRED.
• INVESTMENTS CARRYING AMOUNT IS INCREASED OR
  DECREASED BY THE INVESTORS PROPORTIONATE SHARE
  OF EARNINGS OR LOSSES AND DECREASED BY ALL
  DIVIDENDS RECEIVED.
• REVENUE CONSISTS OF THE INVESTORS PROPORTIONATE
  SHARE OF EARNINGS AND AMORTIZATION OF ANY
  PURCHASED PREMIUM.

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Equity Method - Continued

• IF EQUITY IS TO BE REALIZED IN THE FORM OF
  DIVIDENDS, INCOME TAXES SHOULD BE RECOGNIZED AS
  IF THE EARNINGS WERE DISTRIBUTED AS A DIVIDEND,
  APPLYING ANY APPLICABLE DIVIDENDS RECEIVED
  DEDUCTIONS, FOREIGN TAX CREDITS, TAXES TO BE
  WITHHELD, ETC.
• IF EQUITY IS TO BE REALIZED IN THE FORM OF A
  DISPOSITION, INCOME TAXES SHOULD BE ACCRUED AT
  THE APPROPRIATE RATES (CAPITAL GAIN RATES, IF
  APPLICABLE).

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Foreign Subsidiaries

• A DEFERRED TAX LIABILITY IS NOT RECOGNIZED FOR
  THE EXCESS OF THE AMOUNT FOR FINANCIAL REPORTING
  OVER THE TAX BASIS OF AN INVESTMENT IN A FOREIGN
  SUBSIDIARY OR A FOREIGN CORPORATE JOINT VENTURE
  THAT IS ESSENTIALLY PERMANENT IN DURATION (i.e.,
  THE OUTSIDE BASIS DIFFERENCE).

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APB 23 (ASC 740-30) Exception vs. Election

• Not an election
• Exception applies if the specific facts and
  circumstances warrant
• Based on a companys ability and intent to
  control the reversal of a taxable temporary
  difference (i.e. the outside basis difference in
  the stock of CFC due to unrepatriated earnings)

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APB 23 (ASC 740-30) Issues

• FAS 109 INCORPORATES UNREMITTED EARNINGS IN THE
  OUTSIDE BASIS DIFFERENCE
• The outside basis" also includes
• SAB 51 gains
• Currency translation adjustments

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SFAS 123R

• SFAS 123R applies to all transactions involving
  the issuance by a company of its own equity in
  exchange for goods or services
• Currently SFAS 123R does not apply to share-based
  payment transactions with non-employees or ESOPs.

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SFAS 123R

• 123R requires all entities to recognize
  compensation expense in an amount equal to the
  fair value of share-based payments granted to
  employees.

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Compensation Expense

• Compensation expense will be recognized over the
  requisite service period
• How the compensation is recorded depends on the
  vesting schedule
• Cliff Vesting
• Graded Vesting

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Forfeitures

• 123R requires companies to estimate forfeitures
  on the date of grant
• In subsequent periods, estimates can be adjusted
• Changes in estimates will be a cumulative effect
  of a change in accounting estimate

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Stock Compensation

• SFAS 123R requires companies to use fair value
  to measure share-based payments to employees
• Fair Value is determined at date of grant
• Value is never remeasured

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Fair Value

• If an observable market price exists for an
  option with the same or similar terms, companies
  should use that price
• Otherwise, a valuation technique based on
  established financial economic theory should be
  used

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Valuation Models

• Must be consistent with the fair value
  measurement objective and
• Capable of incorporating all the substantive
  characteristics unique to employee stock options

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Factors Considered in Fair Value

• Exercise Price
• The expected term of the award
• Current Price
• Expected Volatility
• Expected Dividends
• Risk Free Interest Rate

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Application of ASC 740-10 to Stock Options

• The compensation deduction on the financial
  statements give rise to a deferred tax asset
  under SFAS 109.
• The deferred tax is not remeasured for any future
  changes in the fair value before the tax
  deduction is taken
• A need for a valuation allowance should be
  considered

110
Effect on DTA Tax Deduction

• At the time of the tax deduction is taken the DTA
  is written off
• If the tax deduction is larger than the book
  deduction the excess tax benefit is treated as an
  increase to paid-in capital
• If there is a tax benefit deficiency it is
  recorded as a decrease in paid-in capital if
  excess tax benefits exist

111
SFAS 123R

• A company should not recognize a credit to APIC
  for windfall tax benefits unless such windfall
  benefit reduces taxes payable. Therefore, a
  company would only be allowed to credit APIC when
  a benefit is received.

112
Effect of ASC 740-10 for ISOs

• Companies should not record a deferred tax asset
  for ISOs because they cannot assume that these
  awards will result in a tax deduction
• A current tax benefit will result if there is a
  disqualifying dispostion

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Accounting for Income Taxes - Interim

• FIN 18 Accounting for Income Taxes in Interim
  Periods amended APB 28
• Tackles how to measure the tax provision for
  interim reports when the actual tax expense is
  based on annual income.
• Allows estimates and judgments to determine the
  interim tax provision

114
Accounting for Income Taxes

• Income taxes for interim reporting is divided
  into
• Those applicable to income from continuing
  operations
• Those applicable to significant, unusual or
  infrequently occurring items, discontinued items
  and extraordinary items
• Tax effect of the second set of items are
  calculated separately and added to tax expense
  for the quarter

115
Annual Effective Rate Method

• To calculate the provision under the annual
  effective rate method you must
• Determine the projected income, all permanent and
  temporary differences, credits and carryforwards
  for the entire year
• Calculate the tax liability for the year
• Calculate the ETR for the year and
• Apply the ETR to quarterly earnings

116
Annual Effective Rate Method

• Estimated ETR is applied to year-to-date income
• Prior quarter income taxes are deducted to
  compute the current quarterly income tax expense

117
Post Sarbanes-Oxley

• Prior to Sarbanes-Oxley many companies did not
  separate the income tax provision into current
  and deferred
• APB 11 approach
• Currently, a complete tax provision that shows a
  breakdown of current and deferred taxes are
  required for public companies

118
Updating the Annual Estimate

• A company must update its ETR each quarter
• An accurate projection of ETR is very important
• Because it is an estimate the amount may change
  during the year
• If ETR is miscalculated early in the year it is
  better to overstate taxes in the earlier quarter

119
Operating Losses in an Interim Period

• SFAS 109 addresses the case where a company has
  an operating loss for a quarter
• Under SFAS 109 realization of a tax benefit must
  be assured beyond a reasonable doubt before the
  benefit may be recognized in the financial
  statements

120
Operating Losses in an Interim Period

• A company can recognize a tax benefit of a
  to-date operating loss
• Prior periods of income are present against which
  the current loss can be applied
• Tax credits are available to offset the tax
  effect of the operating loss
• The company has established seasonal patterns of
  income in subsequent interim periods

121
Accounting Changes in Interim Periods

• SFAS 3 deals with how to report accounting
  changes in interim reports
• General recommendation is that changes should be
  made in the first quarter
• Cumulative effect of change if change is made
  any a subsequent quarter all prior quarters must
  be restated
• Retroactive type change if previous annual
  reports must be restates so do the interim reports

122
Intraperiod Tax Allocations

• Income tax expense or benefit must be allocated
  among
• Continuing operations
• Discontinued operations
• Extraordinary items
• Items charged or credited directly to
  shareholders equity

123
Intraperiod Tax Allocations

• The tax effects of the following items are
  charged or credited directly to equity
• Adjustments of opening RE for certain changes in
  accounting principles or a correction of an error
• Gains and losses included in comprehensive income
  but excluded from net income
• A change in contributed capital
• Change in basis of tax assets in a pooling of
  interest
• Dividends that are paid on unallocated shares
  held by an ESOP
• Deductible temporary differences that existed at
  the date of a quasi reorganization

124
Intraperiod Tax Allocations

• Tax benefit of NOLs are reported in the same
  manner as the source of the income or loss in the
  current year
• Exceptions to this rule are
• Tax effects of deductible temporary differences
  that existed at the date of a purchase business
  combination
• Tax effects of deductible temporary differences
  that are allocated directly to stockholders
  equity

125
Allocation Between Types of Income

• If there is only one item other than continuing
  operations, the portion of income tax expense or
  benefit that remains after the allocation to
  continuing operations is allocated to that item.
• Use a with and without calculation

126
Allocation Between Types of Income

• If there are two or more other items, the amount
  of tax that remains after the allocation to
  continuing operations shall be allocated among
  the other items in proportion to their individual
  effect on income tax expense or benefit for the
  year.
• The sum of the separate tax effects may not equal
  the amount of income tax that remain to be
  allocated.

127
Balance Sheet Presentation

• Classified Balance Sheet
• Break out current and noncurrent portions
• Netting of Deferred Tax Assets and Liabilities of
  the Same Jurisdiction
• No Netting of Deferred Tax Assets and Liabilities
  from Different Jurisdictions

128
Financial Statement Disclosures

• Tax expense or benefit allocated to continuing
  operations and other categories
• Significant components of income tax
• Effective rate reconciliation
• Gross deferred tax liabilities, gross deferred
  tax assets, the valuation allowance and the net
  change in the valuation allowance

129
Financial Statement Disclosure

• Tax effect of each type of temporary difference
  and carryforward that gives rise to significant
  portions of the deferred tax liabilities or
  assets
• Significant matters affecting comparability of
  information for all periods presented
• Amounts and expiration dates of tax loss and
  credit carryforwards

130
Financial Statement Disclosure

• Any portion of the valuation allowance or
  deferred tax assets for which subsequent
  recognition would be used to reduce goodwill or
  other noncurrent intangible assets of an acquired
  entity or would be allocated directly to equity

131
Rate Reconciliation

• The objective of the rate reconciliation is to
  reconcile the expected US federal statutory
  income tax rate of 34 or 35 with the companys
  actual or effective tax rate.
• Items that Impact the Effective Tax Rate
• State and foreign taxes (net of federal benefit)
• Permanent Differences
• Changes in the Valuation Allowance
• Income Tax Credits
• True Ups and changes in Cushion or change in
  prior year tax
• Changes in Tax Rates

132
Cases Rate Reconciliation

• The reasons for the difference between income
  taxes computed by applying the statutory federal
  income tax rate and income tax expense in the
  financial statements are
• Statutory Rate 832,000 26.00
• State taxes, net of federal tax benefit
  91,760 2.87
• Key-man life insurance (390,000)
  (12.19)
• Tax-exempt interest ( 39,000)
  (1.22)
• Dividends Received Deduction ( 10,400)
  ( .32)
• Change in of tax rate ( 5,409)
  ( .17)
• Effective tax rate 478,951 14.97

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