Constructing the effective tax rate reconciliation and income tax provision disclosure.

• Author: Nellen, Annette

While tax information on the financial statements presented under FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes, continues to be a focus of investors and analysts, tax issues also continue to rank as one of the largest causes for financial restatements. Audit Analytics reports that Topic 740-related issues were the second-highest cause of 2017 and 2016 financial restatements (tying with revenue recognition issues in 2017). Further, an analysis by PwC reveals that 22% of 2017 SEC income tax comment letters originated from the effective tax rate (ETR) reconciliation (see Stay Informed: 2017 SEC Comment Letter Trends: Income Taxes, available at tinyurl.com/y3ow5ct8). Because tax practitioners often create or audit the income tax provision and related disclosures, it is important for tax students and professionals to understand how they are constructed.

Intermediate or advanced financial textbooks discuss temporary and permanent differences, deferred tax assets (DTAs), deferred tax liabilities (DTLs), and the corresponding journal entries. Tax textbooks often discuss book-tax reconciliations as they relate to Schedules M-1 or M-3 of Form 1120, U.S. Corporation Income Tax Return. However, coverage of the ETR reconciliation in either case is often high-level (or not covered at all), meaning many students enter the accounting profession without studying or preparing this important component of the financial statements.

This column walks the reader through a discussion of current and deferred tax expense as a bridge to ultimately preparing the rate reconciliation. It illuminates which book-tax differences do and do not affect ETR. Further, this column offers extensions to show how valuation allowances, differences in tax rates across time, and tax credits affect the ETR and how each item is presented in the rate reconciliation. After completing the basic exercises in this primer and the comprehensive examples in the accompanying Excel workbook, the reader will have a firmer grasp on what moves ETR, providing a better understanding of tax planning tools that affect not only tax dollars paid in various periods but also the tax disclosures on the financial statements. (The Excel workbook can be downloaded with the online version of this article at thetaxadviser.com/evans.)

As such, it can serve as an instructional supplement in both financial accounting and corporate tax courses. While Topic 740 applies to any entity that prepares financial statements under GAAP (including C corporations, flowthrough entities, and not-for-profits), this column focuses on publicly traded C corporations. Instructors may choose to assign the accompanying problems or to distribute the problems with solutions to serve as a study guide for the students.

Prerequisite knowledge

Since many tax and financial textbooks offer beneficial, in-depth analyses of common differences between financial and taxable income and how to prepare a book-tax reconciliation, this column assumes a base knowledge of common differences and whether they are temporary or permanent. Users will focus instead on how temporary and permanent differences relate to current and deferred tax expense and ultimately to the ETR calculation.

Which book-tax differences affect the ETR?

To best answer this question, this column considers two basic examples that also serve to review how to calculate current and deferred income tax expense. In Example 1, the company has one book-tax difference that is temporary in nature. In Example 2, another company has one book-tax difference that is permanent. Each corporation is a publicly traded, domestic corporation. Table 1 illustrates the book-tax reconciliation for each company.

Example 1: T Corp. begins operations in year 1. It earns $500,000 in revenues in year 1 and in year 2. It incurs $300,000 in ordinary, deductible expenses for its business each year. In year 1, T incurs a $10,000 short-term capital loss. It generates $10,000 of long-term capital gains in year 2.

Example 2: P Corp. begins operations in year 1. It earns $500,000 in revenues in year 1 and in year 2. It incurs $300,000 in ordinary, deductible expenses for its business each year. Each year, it also spends $10,000 for a life insurance policy on its CEO, which is not deductible for tax purposes.

Current and deferred components of the income tax provision (ASC Paragraph 740-10-50-9)

All entities are required to disclose the current and deferred income tax expense components of the total income tax provision from continuing operations. T and P will each calculate current tax liability and expense by multiplying taxable income by the 21% corporate tax rate enacted in the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Twill also record a DTA because the capital loss carryforward will cause taxable income to be lower in the future (relative to future financial income), as Table 1 illustrates. ASC Paragraph 740-10-10-3 requires T to measure its DTA using the currently enacted rate at which the temporary difference will reverse, which under the TCJA is also 21%. Therefore, Twill record a year 1 DTA of $2,100 ($10,000 x 21%). To balance the entry, it will credit deferred income tax expense, creating a benefit for the same amount.

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