Tax Reform Is in the Books

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Another interim reporting period is rounding the corner, which means it is time to update the feature story in many of today’s Notes to the Financial Statements—the income tax footnote and the effects of the Tax Cuts and Jobs Act (TCJA).

Believe it or not, the Financial Accounting Standards Board’s accounting rules in ASC 740, Income Taxes, have just one interim disclosure requirement: to disclose the reasons for significant variations in the customary business relationship between income tax expense and pretax accounting income, if those reasons are not otherwise obvious in the financial statements or in the nature of the entity’s business. This seemingly simple requirement is actually challenging to execute. To fulfill the intended disclosure objective, preparers may benefit from a refresher on the interim financial reporting rules for income taxes.

Interim Events: Ordinary Income or Discrete Item?

An entity has two primary objectives when it comes to accounting for income taxes:

  • to record current taxes payable or refundable as of the balance sheet date; and
  • to record deferred taxes for estimated future tax effects arising from temporary differences, including net operating loss carrybacks and tax credit carryforwards.

To compute the total interim tax provision, the focus shifts to events and transactions that are either included in or excluded from ordinary income. Events and transactions included in ordinary income are used to derive the estimated annual effective tax rate (AETR), whereas events or transactions that are excluded are treated as discrete items. A discrete item is accounted for:

  • within the interim period that the event or transaction took place; and
  • at the applicable rate or rates (it is not a component of the estimated AETR).

In many cases, entities must apply judgment to determine whether an event (such as a change in valuation allowance) is discrete. In some cases, ASC 740 is clear about what events are discrete (such as unusual or infrequent items, a cumulative effect of a change in accounting principle, and discontinued operations, among others). A change in enacted tax laws or tax rates is defined clearly in ASC 740 as a discrete item. Based on this guidance, all adjustments stemming from the TCJA must be recognized as discrete components of income tax expense and all of it must be attributed to income from continuing operations.

In theory, an entity should have recorded and disclosed the full effects of the TCJA in its report for the period ended December 31, 2017. In reality, an entity would have recorded its best estimate based on the facts and information it had at the time. Questions still linger, and both the FASB and the Securities and Exchange Commission are monitoring those questions heading into the next quarter—questions such as, how are multinationals applying the mandatory repatriation tax and dividend exemption, how are entities implementing the new anti-base-erosion provisions, and have entities assessed whether certain tax benefits are still realizable or whether they are eligible for certain carryforwards and incentives? The TCJA encroaches on other financial reporting areas, too, such as hedge accounting, share-based compensation, and goodwill impairment testing. For example, if an entity uses an income approach for goodwill testing, the changes brought on by the TCJA might influence certain forecasts and projections, causing the fair value of a reporting unit to dip below its carrying value. An entity’s disclosures about potential impairment of goodwill due to tax reform could be a focal point if the entity’s report is up for review.

Because of the inherent uncertainties in tax law, entities must apply significant judgment throughout the entire accounting framework in ASC 740, making it one of the most complicated financial reporting topics in the FASB Accounting Standards Codification.

SAB 118: A Measurement Period Approach

Because the TCJA was enacted in late December 2017, many preparers had little time to assess and reflect upon its effects before issuing their financial statements. In response, the SEC issued temporary guidance to help entities complete and report their accounting for the effects of the TCJA.

Essentially, SEC guidance establishes a one-year “measurement period approach” which is similar to the measurement approach when the accounting for a business combination is incomplete by the time financial statements are issued. To bridge the gaps from one interim report to the next, the SEC’s Standard Accounting Bulletin No. 118 requires an entity to update its initial estimate of the TCJA’s effects on a quarterly basis until the entity has completed and finalized its accounting (which must be within one year of the TCJA’s enactment date). If an entity applies SAB 118, it must disclose:

  • the open areas of accounting under ASC 740;
  • the amounts of current and deferred taxes associated with those open areas; and
  • what additional information is needed to complete the accounting.

For accounting that is in progress, an entity must disclose:

  • the provisional amounts recorded to reflect the entity’s estimate of the TCJA’s income tax effects; and
  • the measurement period adjustments that were recorded during the reporting period—including a description of the adjustments, the amount of the adjustments, and the effects of the adjustments on the entity’s effective tax rate.

Interim Disclosures: Material Uncertainties and Matters Affecting Comparability

Because of the inherent uncertainties in tax law, entities must apply significant judgment throughout the entire accounting framework in ASC 740, making it one of the most complicated financial reporting topics in the FASB Accounting Standards Codification. The income tax provision is a critical accounting estimate under U.S. generally accepted accounting principles. Therefore, an entity’s presentation of the tax provision, its components, and the related disclosures about significant estimates within the income tax footnote and uncertainties within management’s discussion and analysis (MD&A) are frequent hot topics for regulators, users, and reviewers of financial statements.

Some required disclosures frequently commented on by regulators, including the SEC, involve:

  • circumstances surrounding uncertain tax positions;
  • circumstances when an entity does not recognize certain deferred tax liabilities (such as APB 23, the indefinite reversal criterion);
  • the basis for recording (or not recording) a valuation allowance against a related gross deferred tax asset;
  • matters affecting comparability of financial statements from one period to the next, such as notable changes in enacted tax laws, rates, or taxable status;
  • disclosures when it is at least reasonably possible that a material change in estimate may occur in the near future; and
  • subsequent events related to the income tax provision.

Without a doubt, entities must consider all these factors in any reporting period. For interim financial reporting purposes, however, an entity must do its best to focus its disclosures on events driving the estimated AETR and matters affecting the comparability of the financial statements from one period to the next (such as the measurement period adjustments that were recorded to income during the quarter).

This gets us back to our interim disclosure objective. The objective is not to repetitively fulfill every requirement of ASC 740. In fact, SEC representatives have often commented that entities must not make redundant disclosures solely as an exercise in compliance with financial disclosure requirements.

To fulfill the one interim disclosure requirement on paper, the best advice you can follow is to estimate your tax provision using evidence as of the balance sheet date, disclose what you know, and disclose perhaps even more about what you don’t know until the next interim reporting period.

Pilar Garcia is managing editor of Checkpoint Catalyst: US GAAP, Thomson Reuters Tax & Accounting.

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