Chapter 15:
Financial Statement Presentation & Disclosure
Chapter Summary
ASC 740 not only provides guidance on the calculation of income tax expense, but also includes requirements for the presentation in the financial statements of the tax provision, uncertain tax positions, and deferred tax assets and liabilities. In addition to the information provided on the face of the financial statements, certain disclosures must be made according to the standard. These requirements and related interpretations are discussed in this chapter.
15.1 Balance Sheet Presentation of Deferred Taxes
15.1.1 Principles of Balance Sheet Classification
Deferred tax assets and liabilities must be classified in the balance sheet as current or noncurrent. The deferred tax assets and liabilities should receive the same classification as the financial statement asset or liability generating the temporary difference that gave rise to the deferred tax asset or liability. For classification purposes, deferred tax balances related to temporary differences of financial statement assets and liabilities do not consider when a temporary difference is expected to reverse. For example, temporary differences related to inventory and vacation accruals will be classified as current because these balances are current in the financial statements. A temporary difference related to property, plant, and equipment should only be classified as noncurrent, thus mirroring the classification of the underlying asset on the financial statements and ignoring the fact that a portion of the temporary difference may reverse in the current year as a result of depreciation.
Deferred tax balances can also be generated from temporary differences that are not related to financial statement assets and liabilities. Common examples include (1) organizational costs expensed for financial reporting, but deferred for tax return purposes, (2) long-term contracts accounted for using the percentage-of-completion method for financial reporting purposes and under completed contract for tax purposes, and (3) unremitted earnings of a foreign subsidiary that are not considered indefinitely reinvested. These deferred tax assets and liabilities should be classified in the balance sheet based on their expected reversal date (i.e., the year in which the temporary difference reversal or carryforward is expected to affect the amount of taxes payable or refundable). If a deduction or carryforward is expected to expire unused, it should be classified as noncurrent. In certain instances, there could be both a current and noncurrent portion related to a temporary difference that is not related to a financial statement asset or liability.
15.1.2 Valuation Allowance and Balance Sheet Classification
When companies have recorded valuation allowances against net deferred tax assets and carryforwards, consideration must be given to classification of the valuation allowance. ASC 740-10-45-5 states that “the valuation allowance for a particular tax jurisdiction shall be allocated between current and noncurrent deferred tax assets for that tax jurisdiction on a pro rata basis.”
The pro rata allocation, as opposed to a specific identification allocation, should be performed on a gross basis (i.e., before the netting of deferred tax assets and deferred tax liabilities). This can produce unusual results. For example, assume that a valuation allowance has been provided for particular deductible differences or carryforwards for which the deferred tax assets are classified as noncurrent. Despite this, a portion of the valuation allowance should be allocated on a pro rata basis to any current deferred tax assets. An unusual outcome may also result if a valuation allowance has been used to reserve the entire net deferred tax asset. See Chapter TX 5 for a more detailed discussion of valuation allowances. Example 15-1 demonstrates the pro rata allocation of a valuation allowance.
Example 15-1: Pro Rata Allocation of a Valuation Allowance
A company has current and noncurrent deferred tax assets of $100 and $200, respectively, and current and noncurrent deferred tax liabilities of $200 and $40, respectively. This results in a net deferred tax asset of $60. It is determined that a valuation allowance is required based on significant negative evidence. The deferred tax liabilities will reverse in a manner that allows for recognition of deferred tax assets in an equal amount, thus requiring a valuation allowance of $60 against the net deferred tax asset.
The valuation allowance is allocated based on the gross deferred tax assets (assuming a single tax jurisdiction), as presented below:
The following table summarizes the computed amounts and amounts presented on the balance sheet:
15.1.3 Offsetting and Multiple Jurisdictions
ASC 740-10-45-6 requires that all current deferred tax assets and liabilities within a single tax jurisdiction be offset and presented as a single amount and that all noncurrent deferred tax assets and liabilities within a single tax jurisdiction be offset and presented as a single amount. The paragraph also states that the current and noncurrent deferred tax assets and liabilities of different tax-paying entities or different jurisdictions cannot be netted. A classification procedure must be completed for each applicable tax-paying entity in each tax jurisdiction. Therefore, in a single balance sheet, deferred taxes may appear under four different classifications: current asset, current liability, noncurrent asset, and noncurrent liability.
A question may arise as to whether netting is permitted in a jurisdiction that does not allow tax consolidation, but has annual elective group relief provisions for affiliated members. To answer this question, it must first be determined whether the companies are considered a single tax-paying component. We believe that the determining factors for this classification are (1) whether the taxing authorities can pursue one subsidiary for the other’s income tax liabilities and (2) whether the election allows for offset in all cases (e.g., whether it allows carryback or carryforward of losses among affiliated members). If the taxing authority can pursue one subsidiary for the other’s income tax liabilities and if offset is unconditionally available, the subsidiaries may be considered, in substance, a single tax-paying component, which would make offsetting appropriate. However, if both of these conditions are not met, the two entities should be considered separate tax-paying components and the deferred tax balances should not be offset, irrespective of whether the entity plans to avail itself of the group relief provisions.
15.1.4 Contingencies and Uncertain Tax Positions
Due to the complexity and interpretation of tax law, it may be unclear whether positions taken in an entity’s income tax return will be sustained or will result in additional tax payments in future periods. Accounting for these positions in accordance with the ASC 740 guidance on accounting for unrecognized tax benefits will frequently result in the recognition of potential tax liabilities or a decrease in recognized tax assets. The financial reporting and disclosure requirements related to contingencies and uncertain tax positions are discussed in Section TX 15.5 and Chapter TX 16.
15.2 Balance Sheet Disclosures
ASC 740 and SEC regulations require the following disclosures relating to deferred tax balance sheet accounts:
1. Gross deferred tax liabilities, gross deferred tax assets, the valuation allowance, and the net change in the valuation allowance
ASC 740-10-50-2 requires disclosure of the total deferred tax assets and the total deferred tax liabilities computed under the basic model described in Section TX 4.1. This would exclude deferred tax charges related to intercompany transactions and deferred tax credits arising from leveraged leases. The taxes paid on an intercompany transaction accounted for under ASC 740-10-25-3(e) are different from deferred tax assets recognized under ASC 740-10-30-5 because the prepaid tax from an intercompany transfer represents an asset resulting from a past event whose tax effect is simply deferred.
There will be circumstances in which judgments about future taxable income (i.e., excluding reversals) enter into the determination of the valuation allowance. In such cases, we expect that management will find it most prudent to indicate in the financial statements the extent to which realization of the tax assets is dependent on such future taxable income. As discussed in Section TX 15.8.5.3, in some situations, the SEC staff expect certain incremental disclosures with respect to deferred tax assets. See Section TX 15.8.
In certain rare situations it may be appropriate to use a zero rate or to write off the asset against the valuation allowance. The effect is to reduce the amounts of gross deferred tax assets and valuation allowance that are disclosed. A write-off might be appropriate, for example, if a company has a loss carryforward that has not yet expired in a country where it no longer conducts business. As with many other areas of ASC 740, such a determination will require the application of professional judgment and a careful consideration of the relevant facts and circumstances.
There are certain carryforwards (e.g., certain AMT and foreign tax-credit carryforwards) that, because of an entity’s particular facts and circumstances, have a corresponding full valuation allowance. We believe that in situations where the likelihood of utilization is remote, it is acceptable to write off the deferred tax asset against the valuation allowance, thereby eliminating the need to disclose the gross amounts.
If limitations caused by a change in ownership (Section 382) mathematically preclude use of a portion of a carryforward or a deductible difference, writing off the deferred tax asset against the valuation allowance is considered appropriate. When there are carryforwards and built-in losses that are subject to the same aggregate limitation, it is appropriate to reflect the permanent loss of tax benefits as an unallocated reduction of gross deferred tax assets.
2. The approximate tax effect of each type of temporary difference
and carryforward that gives rise to significant portions of deferred tax liabilities and assets (prior to valuation allowances)
ASC 740-10-50-2 requires that public companies disclose the amounts of significant types of temporary differences. SEC Regulation S-X Rule 4-08(h) does not impose a mechanical hurdle for determining which types of temporary differences are, in fact, significant. Judgment must therefore be applied to ensure a reasonable and meaningful presentation. However, as a practical benchmark, we believe that a particular type of temporary difference should be considered significant if its deferred tax effects equal 5 percent or more of either total deferred tax assets (i.e., before valuation allowance) or total deferred tax liabilities, whichever is greater.
3. The nature and effect of any significant matters affecting comparability
of information for all periods presented (unless otherwise evident from other disclosures)
4. The amounts and expiration dates of loss and tax credit carryforwards
for tax purposes
Companies should also disclose the nature and potential effects of any tax law provision that might limit the availability or utilization of those carryforward amounts (e.g., limitations caused by change in ownership).
For both regular tax and AMT, there is an annual limitation under Section 382 on the use of loss and other carryforwards and of certain built-in losses if there has been a cumulative change in ownership of more than 50 percent within a three-year period.
If the annual limitation is triggered, it could result in a permanent loss of potential tax benefit (e.g., when an entire carryforward cannot be utilized prior to its expiration because of the annual limitation). Therefore, the recorded deferred tax asset and the amount of carryforward disclosed should be reduced. When such limitation delays the utilization of loss carryforwards and built-in losses that arose from a purchase business combination, disclosure on the use of loss carryforwards is appropriate.
The rules for computing a change in ownership are complex. However, it is possible for the limitation to apply to an entity that is not an acquired entity in a business combination. The limitation could be triggered, among other events, by exercises of stock options, conversions of convertible debt or preferred stock, new common stock offerings, or treasury share purchases.
Unless the prospect of such a change in ownership is remote, we recommend disclosing the potential limitation in all circumstances by means of a brief statement such as, “If certain substantial changes in the entity’s ownership occur, there would be an annual limitation on the amount of the carryforward(s) that can be utilized.” If there are circumstances (e.g., a planned public offering or outstanding convertible debt whose exercise price is below market) that make the change in ownership reasonably possible in the foreseeable future, a general description of those circumstances may be warranted. More specific disclosures concerning the limitation should be made if the triggering event is probable. Disclosure of the amount of the annual limitation is required if the event actually occurs. Refer to ASC 946-740-55-2 for additional guidance on certain regulated investment companies.
5. Any portion of the valuation allowance for deferred tax assets for which subsequently recognized tax benefits will be credited directly to contributed capital
6. Temporary differences for which a deferred tax liability has not been recognized because of the exceptions to comprehensive recognition of deferred taxes related to subsidiaries and corporate joint ventures:
a. A description of the types of temporary differences and the types of events that would cause those differences to become taxable
b. The cumulative amount of each type of temporary difference
c. Temporary differences related to investments in foreign subsidiaries and foreign joint ventures, which would include, but would not be limited to, unremitted earnings and cumulative translation adjustments, the amount of unrecognized deferred tax liability if determining that amount is practicable, or a statement that determination is not practicable
d. The amount of any unrecognized deferred tax liability for each type of temporary difference (e.g., unremitted domestic corporate joint venture earnings prior to 1993 for calendar-year companies), excluding temporary differences related to investments in foreign subsidiaries and foreign corporate joint ventures
No disclosure is required for unremitted earnings of domestic subsidiaries if such earnings are not a temporary difference. This is because the parent expects to receive these earnings tax-free (see Chapter TX 11). In addition, earnings that arose prior to the mandatory effective date of ASC 740, which would have been a temporary difference exception “grandfathered” by the standard, do not require disclosure.
For foreign subsidiaries and corporate joint ventures, the disclosures apply to unremitted earnings and, if applicable, to the entire excess book over tax outside basis.
If it is at least reasonably possible that within one year there will be a change in either an indefinite reversal assertion or in the expected method of recovery of the investment in a domestic subsidiary, disclosure under ASC 275-10-50-9, which is discussed in Section TX 15.7, may be required.
7. The amount of income tax expense or benefit allocated to each component of other comprehensive income, including reclassification adjustments, either on the face of the statements in which those components are displayed or in the notes to the financial statements as required by ASC 220-10-45-12
8. Specific disclosures required in the separate statements of a member of a consolidated tax group (See Chapter TX 14)
15.3 Income Statement Presentation
Total income tax expense or benefit for the year generally equals the sum of total income tax currently payable or refundable (i.e., the amount calculated in the income tax return) and the total deferred tax expense or benefit.
15.3.1 Deferred Tax Expense or Benefit
The total deferred tax expense or benefit for the year generally equals the change between the beginning-of-year and end-of-year balances of deferred tax accounts (i.e., assets, liabilities, and valuation allowance) on the balance sheet. In certain circumstances, however, the change in deferred tax balances is reflected in other asset and liability accounts. These circumstances include the following:
If a business combination has occurred during the year, deferred tax liabilities and assets, net of the valuation allowance, are recorded at the date of acquisition as part of the purchase price allocation (see Section TX 10.4). When a single asset is purchased, other than as part of a business combination in which the amount paid is different from the tax basis of the asset, the tax effect should be recorded as an adjustment to the carrying amount of the related asset.
ASC 805, Business Combinations, changes the accounting for the initial recognition of acquired deferred tax assets subsequent to the acquisition date. The release of a valuation allowance that does not qualify as a measurement period adjustment is reflected in income tax expense (or as a direct adjustment to equity as required by ASC 740), subject to the normal intraperiod allocation rules discussed in Chapter TX 12. The release of a valuation allowance within the measurement period resulting from new information about facts and circumstances that existed at the acquisition date is reflected first as an adjustment to goodwill, then as a bargain purchase gain (ASC 805-740-45-2).
Similarly, adjustments to uncertain tax positions made subsequent to the acquisition date are recognized in earnings, unless they qualify as measurement period adjustments. See Section TX 10.5.5 for a discussion of evaluating whether an adjustment within the measurement period relates to circumstances that were included in the acquirer’s assessment at the date of the acquisition.
See Section TX 10.6.2 for a discussion of adjustments to uncertain tax positions and initial recognition of pre-reorganization benefits subsequent to “fresh start” reporting.
Other changes in the deferred tax balances, including those resulting from foreign currency exchange rate changes, may not be classified as a tax expense or benefit:
When the U.S. dollar is the functional currency, revaluations of foreign deferred tax balances are reported as transaction gains and losses or, if considered more useful, as deferred tax benefit or expense, as described in ASC 830-740-45-1.
When the foreign currency is the functional currency, revaluations of foreign deferred tax balances are included in cumulative translation adjustments. The revaluations of the deferred tax balances are not identified separately from revaluations of other assets and liabilities.
15.3.2 Interest and Penalties
ASC 740-10-45-25 gives companies the option of classifying interest as a component of income tax expense or interest expense and of classifying penalties as a component of income tax expense or another expense classification, depending on their accounting policy. The guidance requires that companies disclose their policy and the amount of interest and penalties charged to expense in each period, as well as the cumulative amounts recorded in the balance sheet.
Even though ASC 740-10-50-19 does not offer guidance on the balance sheet classification of accrued interest and penalties, we believe that it should be consistent with the income statement classification. ASC 740 is also silent on the topic of classification of interest income received as it relates to income taxes. We believe that the classification of interest income and interest expense should be consistent (i.e., either as a component of tax expense or as a pretax income line item). See Section TX 16.6.1.1 for a discussion on interest income on uncertain tax positions.
15.3.3 Professional Fees
Companies often incur professional fees by working with attorneys and/or accountants to minimize income tax payables (e.g., implement tax strategies, resolve tax contingencies, or defend tax strategies). These fees do not represent payments to taxing authorities and therefore should not be classified in the income statement as income tax expense or benefit.
15.3.4 Change in Tax Laws, Rates, or Status
Adjustments to all deferred tax balances are reflected in continuing operations, including those that arise by charge or credit to other categories, when those adjustments reflect enacted changes in tax laws, tax rates, or tax status. (See further discussion of the accounting for changes in tax rates and tax status in Chapters TX 7 and TX 8, respectively.)
When a rate change is enacted with retroactive effects, ASC 740-10-30-26 specifies that the current and deferred tax effects of items not included in income from continuing operations that arise during the current year but before the date of enactment should be adjusted to reflect the rate change as of the enactment date. The adjustment should be reflected in income from continuing operations. If an election to change an entity’s tax status is approved by the tax authority or filed, if approval is not necessary, in year 2 before the issuance of financial statements for year 1, the effect of the change in tax status should not be recognized in year 1’s financial statements. In accordance with ASC 740-10-50-4, however, the entity’s financial statements for year 1 should disclose (1) the change in the entity’s tax status for year 2 and (2) the effects of the change, if material. Example 15-2 illustrates the application of a change in tax laws and how this presentation is affected by intraperiod allocation.
Example 15-2: Change in Tax Law When Prior Year Results Are Restated for Discontinued Operations
Background/Facts:
In a prior year, a provincial tax law was enacted, which resulted in a charge to Company A’s consolidated financial statements. Pursuant to ASC 740-10-45-15, this effect was appropriately recorded in continuing operations in the financial statements for that fiscal year. In the current year, Company A agreed to sell all of its operations in the country in which the tax law changed and to recast the operations from this jurisdiction to discontinued operations pursuant to ASC 360, Property, Plant, and Equipment. The results from continuing operations no longer include any operations in the jurisdiction in which the tax law change was enacted.
Question:
Should the effects of the tax law change that were originally recorded in continuing operations also be reclassified to discontinued operations, or should they remain in continuing operations in the recasted financial statements?
Analysis/Conclusion:
Section TX 12.2.3.2.4.1 discusses the intraperiod allocation for prior years that are subject to recasting under ASC 360. The amount of taxes associated with the discontinued operations should be the difference between the taxes previously reported in continuing operations and the amount of taxes allocated to continuing operations after the ASC 360 triggering event. ASC 740-10-35-4 and ASC 740-10-45-15 state that deferred tax liabilities and assets shall be adjusted for the effect of a change in tax laws or rates. The effect shall be included in income from continuing operations for the period that includes the enactment date.
Subsequent to disposal, Company A will have no operations in the jurisdiction in which the tax law was enacted. There are no provisions in ASC 740 that would allow Company A to “backwards trace” the effects of this tax law change and reclassify them as discontinued operations. Therefore, the effect of the tax law change on deferred tax assets and liabilities should remain in continuing operations.
15.3.5 Income Taxes and Net Income Attributable to Noncontrolling Interests
The financial statement amounts reported for income tax expense and net income attributable to noncontrolling interest differ based on whether the subsidiary is a C-corporation or a partnership. The tax status of each type of entity causes differences in the amounts a parent company would report in its consolidated income tax provision and net income attributable to noncontrolling interests.
C-corporation: A C-corporation is generally a taxable entity and is responsible for the tax consequences of transactions by the corporation. Therefore, a parent that consolidates a C-corporation would include the income taxes of the C-corporation, including the income taxes attributable to the noncontrolling interest, in the consolidated income tax provision. Net income attributable to the noncontrolling interest would be calculated as the noncontrolling interest’s share of the C-corporation’s net income, which would include a provision for income taxes.
Partnership: The legal liability for income taxes of a partnership generally does not accrue to the partnership itself. Instead, the investors are responsible for income taxes on their share of the partnership’s income. Therefore, a parent that consolidates a partnership would only report income taxes on its share of the partnership’s income in the consolidated income tax provision. This would result in a reconciling item in the parent’s income tax rate reconciliation that should be disclosed, if material. Net income attributable to the noncontrolling interest would be calculated as the noncontrolling interest’s share of the partnership’s net income, which would not include a provision for income taxes.
Note: The guidance relating to “partnerships” should also be applied to other “pass-through” entities, such as limited liability companies and subchapter S-corporations.
Example 15-3: Presentation of Income Tax and Net Income Attributable
to Noncontrolling Interest When the Subsidiary is a C-Corporation
or a Partnership
Background/Facts:
Company A has a 70 percent ownership interest in Subsidiary B. The other 30 percent is owned by an unrelated party. Company A consolidates the financial statements of Subsidiary B. Company A had pre-tax income from continuing operations of $400 for the year ended December 31, 2009. This amount includes $100 of pre-tax income from continuing operations from Subsidiary B. Company A’s tax rate for the period is 40 percent For purposes of this example the tax effects of any outside basis differences have been ignored and Subsidiary B is assumed to have no subsidiaries of its own.
Question:
How should income tax expense and net income be determined and presented in the consolidated financial statements if Subsidiary B is a C-corporation or a partnership?
Analysis/Conclusion:
When the subsidiary is a partnership, income attributable to noncontrolling interest would be a reconciling item in Company A’s tax rate reconciliation that should be disclosed if material.
15.4 Income Statement Disclosures
ASC 740 and SEC regulations require the following disclosures about income statement amounts:
1. The amount of income tax expense or benefit allocated to continuing operations and the amounts separately allocated to items that are included in other categories, such as discontinued operations, changes in accounting principles, and extraordinary items
The amount of income tax expense or benefit allocated to continuing operations would ordinarily be shown on the face of the income statement.
2. A reconciliation (using dollar amounts or percentages) of the income tax expense attributable to continuing operations to the statutory regular tax rate applied to pretax income from continuing operations
The reconciliation should include the estimated amount and the nature of each significant reconciling item.
Common rate differentials include the following:
— Change in the valuation allowance for deductible temporary differences or carryforwards (adjusted for expirations of carryforwards or their use in the current year)
— Use of the current year’s permanent differences or tax credits in the calculation of taxes payable or deferred taxes
— The effect on beginning deferred tax balances of rate changes enacted in the current year and the effect on temporary differences originating in the current year if expected to reverse in a year for which a different rate has been enacted
— Foreign tax rates differential related to unremitted foreign earnings that are reinvested indefinitely
— When graduated rates are a significant factor, changes to the prior year’s assessment of expected future level of annual taxable income and the difference between the average rate at which deferred taxes are provided and the incremental effect implicit in the reconciliation
Although ASC 740 does not define a “significant” item in the rate reconciliation, Rule 4-08(h) of Regulation S-X currently requires disclosure of individual reconciling items that are more than 5 percent of the amount computed by multiplying pretax income by the statutory tax rate (e.g., for a U.S.-based entity subject to the 35 percent statutory tax rate, any item that increases or decreases the tax rate by 1.75 percent). Care should be taken to ensure that items are not disaggregated to avoid this requirement, reconciling items below this threshold are displayed in appropriate categories, and groupings are consistent from year to year.
3. Significant components of income tax expense attributable to continuing operations include the following:
a. Current tax expense or benefit
b. Deferred tax expense or benefit (exclusive of the effects of other components listed below)
c. Investment tax credits
ASC 740-10-50-20 requires disclosures about the method of accounting for investment tax credits and the amounts involved (if material). Without reference to materiality, the U.S. tax law also requires that the method of accounting for the investment credit be disclosed in any filing with a federal agency, including the SEC, in which the credit is used.
Generally accepted accounting principles in certain countries outside the United States may allow specific tax credits (e.g., research and experimentation credits) to be reflected outside of income tax expense and reported on a net basis against the expense to which they relate. However, we do not believe that this presentation complies with U.S. GAAP. Rather, we believe that tax credits should be presented as a component of income tax expense.
d. Government grants (to the extent recognized as a reduction of income tax expense)
e. The benefits of operating loss carryforwards
ASC 740-10-55-212 through 55-216 includes an example illustrating this disclosure.
f. Tax expense that results from allocating certain tax benefits directly to contributed capital
g. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates, or a change in the tax status of the entity
As with the 1993 Tax Act, when there is an enacted change in tax rates that is retroactive to the beginning of the current year, a question arises as to the amount that should be disclosed pursuant to ASC 740-10-50-9(g). Should the amount disclosed be the total adjustment at the enactment date (including the adjustment of deferred taxes provided during the current year prior to the enactment date), or should the amount disclosed be the effect of the rate change on beginning-of-year deferred tax balances? We believe that disclosure of either amount is acceptable.
The effect of the rate change on beginning-of-year deferred tax balances may be easier to measure, and its use may simplify reporting. If prior to the enactment date no items have given rise to tax entries other than to continuing operations, this amount should be included in the rate reconciliation.
Further, the effect of the rate change on deferred taxes previously provided against continuing operations in the current year may not be particularly meaningful by itself. Current and deferred taxes would need to be adjusted as of the enactment date, but ASC 740-10-50-9(g) does not specifically require the disclosure of the effect of the rate change on taxes currently payable. When current or deferred tax entries have been made during the year to categories other than continuing operations, their adjustment as of the enactment date, which would be reflected in continuing operations, must also be disclosed in the rate reconciliation.
We believe that it would generally be adequate to disclose (1) the effect of the rate change on beginning-of-year deferred tax balances and (2) the effect of the rate change on current and deferred taxes provided prior to the enactment date in categories other than continuing operations. Both of these items should be included in the rate reconciliation. Other disclosures might also be satisfactory. In any case, the amount(s) disclosed should be clearly described.
h. Adjustments to the beginning-of-the-year balance of a valuation allowance resulting from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years
ASC 740-10-55-79, states that “the sum of the amounts disclosed for the components of tax expense should equal the amount of tax expense that is reported in the statement of earnings for continuing operations.” Insignificant components can be grouped in an “other” category. ASC 740-10-55-212 through 55-216 provides three illustrative examples to satisfy this disclosure requirement.
15.5 Disclosures for Uncertain Tax Positions
15.5.1 Annual Disclosures
Disclosures for uncertain tax positions require the use of professional judgment. While management might be concerned with including information in the financial statements that could be helpful to the taxing authority examining its disclosures, stakeholders, whose needs often differ from those of the taxing authorities, base their investment decisions on the same financial statements. ASC 740 addresses this tension in part by requiring a qualitative discussion of only those positions that management expects will change significantly within the next 12 months. Further, for public entities, the quantitative rollforward of unrecognized tax benefits is prepared on a worldwide aggregated basis. More recently, many U.S. taxpayers are now required to furnish certain information about their uncertain tax positions to the Internal Revenue Service by attaching “Schedule UTP” to their income tax returns.
As these disclosure requirements are considered, a question that may arise is the periods that the annual disclosure requirements of unrecognized tax benefits should be provided for. The introduction to ASC 740-10-50-15 and 50-15A indicates that the disclosures should be provided at the end of each annual reporting period presented. To meet this requirement, we believe disclosures related to historical information reflected in the financial statements (e.g., the tabular reconciliation of unrecognized tax benefits) should be based on the years for which the relevant income statements are presented. For disclosures that are primarily forward-looking in nature (e.g., the total amount of unrecognized tax benefit that, if recognized, would affect the effective tax rate), we believe it is appropriate to present this information as of the most recent balance sheet date only. However, we are aware that an alternative point of view is that the requirements of ASC 740-10-50-15 and 50-15A should be presented for all post-adoption periods presented. We believe either approach is acceptable for disclosures that are primarily forward-looking in nature.
15.5.1.1 Disclosure of Accounting Policy on Classification of Interest and Penalties
Entities are required to disclose their accounting policy for the classification of interest and penalties in the footnotes to the financial statements. The policy chosen must be applied consistently.
See Section TX 16.6.3 for a discussion of the accounting policy election for classification of tax-related interest and penalties.
15.5.1.2 Total Amount of Interest and Penalties Recognized in the Statement
of Operations and Total Amount of Interest and Penalties Recognized
in the Statement of Financial Position
ASC 740 requires an annual disclosure of the total tax-related interest and penalties recorded in the statement of operations and the total amount of interest and penalties accrued as of the balance sheet date.
Questions may arise as to whether this disclosure should be (1) net of any interest income and (2) net of any potential tax benefit. We believe that interest expense should be disclosed on a gross basis. However, if an entity also wishes to disclose the amount of interest income, as well as any related tax benefits, it would not be precluded from doing so.
15.5.1.3 Reasonably Possible Significant Changes in Unrecognized Tax Benefits That May Occur Within the Next 12 Months
Companies must disclose the nature of uncertain positions and related events if it is reasonably possible that the positions and events could change the associated recognized tax benefits within the next 12 months (including previously unrecognized tax benefits that are expected to be recognized upon the expiration of a statute of limitations within the next year).
Specifically, ASC 740 requires the following disclosures:
Nature of the uncertainty
Nature of the event that could occur within the next 12 months to cause
the change
Estimate of the range of the reasonably possible change or statement that an estimate of the range cannot be made
In preparing this disclosure, we believe that all facts and circumstances, including the likelihood that a taxing authority will (or will not) identify an uncertain tax position, should be considered. Thus, if an uncertain tax position does not meet the recognition threshold, but management expects the statute of limitations to expire within the next 12 months and does not expect the taxing authority to identify the exposure, the total amount of the unrecognized tax benefit should be disclosed to note that a change is expected within the next 12 months, provided the amount is significant.
Although the disclosure noted in ASC 740-10-50-15(d) is an annual disclosure, ASC 740 did not change the early warning disclosure requirements of ASC 275. Accordingly, disclosures for reasonably possible significant changes in unrecognized tax benefits should be disclosed on a rolling 12-month basis. As a result, at each interim period, entities should have processes and controls in place that allow them to identify unrecognized tax benefits capable of changing significantly within the next 12 months.
15.5.1.4 Tax Years Still Subject to Examination by a Major Tax Jurisdiction
ASC 740 requires that entities report all tax years that remain open to assessment by a major tax jurisdiction. We believe in certain situations, it may be conceivable that a major tax jurisdiction might be disclosed in a jurisdiction where the company has not filed a tax return. For example, the company may have taken a tax position regarding a tax status of one of its entities whereby the potential tax exposure related to the company could be significant. In this fact pattern, the company may need to provide the tax jurisdiction for the related exposure.
Exhibit 15-1: Illustrative Disclosure: Accounting for Unrecognized Tax Benefits
This exhibit appears in ASC 740-10-55-217 and illustrates the guidance in ASC 740-10-50-15 for disclosures about uncertainty in income taxes.
The Company or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 20X1. The Internal Revenue Service (IRS) commenced an examination of the Company’s U.S. income tax returns for 20X2 through 20X4 in the first quarter of 20X7 that is anticipated to be completed by the end of 20X8. As of December 31, 20X7, the IRS has proposed certain significant adjustments to the Company’s transfer pricing and research credits tax positions. Management is currently evaluating those proposed adjustments to determine if it agrees, but if accepted, the Company does not anticipate the adjustments would result in a material change to its financial position. However, the Company anticipates that it is reasonably possible that an additional payment in the range of $80 to $100 million will be made by the end of 20X8. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows.
At December 31, 20X7, 20X6, and 20X5, there are $60, $55, and $40 million of unrecognized tax benefits that if recognized would affect the annual effective tax rate.
The Company recognizes interest accrued related to unrecognized tax benefits in interest expense and penalties in operating expenses. During the years ended December 31, 20X7, 20X6, and 20X5, the Company recognized approximately $10, $11, and $12 million in interest and penalties. The Company had approximately $60 and $50 million for the payment of interest and penalties accrued at December 31, 20X7, and 20X6, respectively.
15.5.1.5 Tabular Reconciliation of Unrecognized Tax Benefits
15.5.1.5.1 Comprehensive Basis
This quantitative disclosure requirement calls for a reconciliation of the beginning and ending balances of the unrecognized tax benefits from uncertain positions. This rollforward is required on a comprehensive basis. Therefore, it must include all unrecognized benefits, whether they are reflected in a liability (liability for unrecognized tax benefits), a decrease in a deferred tax asset (irrespective of whether a valuation allowance would be required), or even an off-balance-sheet exposure such as a questionable stock option windfall benefit that has not been recorded because the Board prohibits recognition prior to an actual reduction in taxes payable.
Example 15-4: Including in the Tabular Reconciliation Items That Do Not Initially Result in a Liability for Unrecognized Tax Benefits
Example 1
Background/Facts:
Assume that various tax positions taken on a tax return resulted in an NOL carryforward with a potential benefit of $10 million and that the related DTA would have attracted a full valuation allowance. Assume also that only $3 million of the potential $10 million tax benefit satisfies the recognition and measurement requirements of ASC 740.
Question:
What amount should be included in the tabular reconciliation of unrecognized tax benefits?
Analysis/Conclusion:
$7 million, the difference between the amount taken on the tax return ($10 million) and the amount that was recognizable for financial reporting purposes ($3 million), should be included in the tabular reconciliation of unrecognized tax benefits. In this case, the gross DTA and related valuation allowance reported in the income tax footnote (for reporting balance sheet NOLs and valuation allowances) should be $3 million and none of the $3 million would be recognized on the balance sheet (deferred tax asset of $3 million offset by $3 million valuation allowance). The $7 million reduction in the DTA is considered an unrecognized tax benefit and would be included in the annual tabular reconciliation, regardless of the valuation allowance. In summary, all gross unrecognized tax benefits, whether they result in a liability or a reduction of DTAs and/or refundable amounts, should be included in the tabular reconciliation.
Example 2
Background/Facts:
Company A expects to file a refund claim (related to a current period tax position) after the balance sheet reporting date, and an unrecognized tax benefit of $10,000 will be included within the refund claim.
Question:
Should this unrecognized tax benefit be included in the year-end tabular reconciliation, even though the refund claim that will give rise to the unrecognized tax benefit has not been filed as of the balance sheet date?
Analysis/Conclusion:
Yes. Whether a claim for refund is filed as of the current-period balance sheet date or is expected to be filed, and is related to a current period or prior period tax position, at some later date, a tax position may be included in a refund claim if that claim must be evaluated for recognition and measurement under the ASC 740 accounting model. When the expected benefits included in a refund claim are not fully recognized in the financial statements because the underlying position fails the requirement for recognition/measurement (e.g., the refund claim is based on aggressive tax planning), the portion of the tax benefit that does not meet recognition/measurement requirements (i.e., the unrecognized tax benefit) cannot be recorded in the financial statements. Though not recognized in the financial statements, the unrecognized tax benefit associated with this claim must be disclosed in the tabular reconciliation as required by ASC 740-10-50-15A(a).
Example 3
Background/Facts:
In the fourth quarter of 20X1, Company A, generated a loss of $1 million related to the sale of an investment. Because Company A did not have ordinary income or capital gains in the current year or the applicable carry-back periods, the loss became a carryforward. Management expects to take a tax return filing position characterizing the loss as ordinary rather than capital in nature. There is some support in the law for the position; however, in applying ASC 740-10-25-6, management concludes that the position does not meet the more-likely-than-not recognition threshold. The applicable tax rate in the jurisdiction is 40 percent for both ordinary income and capital gains; however, capital losses can only be used to offset capital gains. Company A recognized a $400 thousand deferred tax asset (DTA) because the carryforward constitutes a tax attribute regardless of the nature of the loss. In 20X2, Company A generated a profit that was all ordinary in nature and utilized all of its loss carryforwards to reduce taxable income and taxes payable.
Question:
How should the unrecognized tax benefit (UTB) be recorded and presented in 20X1 and 20X2?
Analysis/Conclusion:
At December 31, 20X1, a liability for the UTB will not be recorded as the tax position to be taken characterizing the loss as ordinary has not resulted in a potential underpayment of tax. We believe, nonetheless, that $400 thousand of UTB should be included in the 20X1 tabular reconciliation. ASC 740-10-50-15A requires a tabular reconciliation of the beginning and ending balances of UTBs. ASC 740-10-20 defines a UTB as “the difference between a tax position taken or expected to be taken in a tax return and the benefit recognized and measured pursuant to Subtopic 740-10.” We believe this requirement is intended to apply comprehensively, to all changes to tax return positions which would arise based upon application of the ASC 740 recognition and measurement principles. That includes positions characterizing a loss carryforward since the characterization determines the tax consequences of the attribute. The capital loss attribute that would arise if the position is unfavourably settled should not offset the related UTB in the table because the tabular reconciliation only includes unrecognized benefits.
In 20X2, a $400 thousand UTB liability should be recorded on the balance sheet because at that time Company A began utilizing the “as filed” 20X1 loss carryforward to reduce taxable income and thus pay less income tax than they would have had the original $1 million loss been determined to be capital in nature. For the tabular reconciliation, since the $400 thousand UTB was included in 20X1, no additional entry is necessary in 20X2. In addition, a DTA for the future deductible amount associated with the capital loss should continue to be recorded during 20X2 (and possibly beyond) even though, on an “as filed” basis, Company A utilized the loss carryforward on the 20X2 tax return.
It should be noted that in both 20X1 and 20X2, Company A must assess the realizability of the DTA based upon whether there is sufficient future taxable income of the appropriate character (i.e., future capital gains). Otherwise, a valuation allowance would be required against the DTA. In that case, the UTB amount would also be included in the disclosure required by ASC 740-10-50-15A(b) of UTBs that, if recognized, would affect the effective tax rate. In addition, respective disclosure of loss carryforwards should be provided on an ASC 740 “as-adjusted” basis.
Example 4
Background/Facts:
Company A has emerged, on the last day of its accounting and tax year, from a bankruptcy proceeding which resulted in a significant portion of the Company’s debt being cancelled. For tax law purposes, Company A does not have taxable income for the debt extinguishment but instead is required to reduce its income tax attributes and tax basis of property, subject to various computational rules. Company A would realize a permanent exclusion of taxable income (known as “black hole income”) to the extent its cancelled debt exceeds the reduction in tax attributes and other tax basis as required under the law.
Company A’s expected tax return position vis-à-vis the required reduction of its tax attributes/tax basis results in maintaining a significant amount of tax basis in various assets including equipment, plants and real estate. This tax return position would lead to realizing a larger “black hole” gain. However, there is uncertainty as to whether, upon examination by the taxing authority, the basis in such assets would be reduced by an amount greater than the Company is claiming in its tax return. The expected filing position is not more-likely-than-not sustainable based on technical merits and Company A is required to reserve the tax basis benefit consistent with ASC 740-10-25-6. Per ASC 740-10-25-6, an entity shall only recognize the financial statement effects of a tax position when it is more-likely-than-not, based on technical merits, that the position will be sustained upon examination.
Question:
How should Company A present and disclose the uncertain tax benefit related to the debt extinguishment?
Analysis/Conclusion:
ASC 740 acknowledges that a tax position recognized in the financial statements may also affect the tax bases of assets or liabilities and thereby change or create temporary differences (ASC 740-10-25-17). Accordingly, a taxable or deductible temporary difference is measured as a difference between the reported amount of an asset/liability in the financial statements and the tax basis as determined under the recognition and measurement principles pertaining to uncertain tax positions.
Therefore, in determining the temporary differences related to an asset, Company A would compare its carrying value as reported in its financial statements to the greatest amount more-likely-than-not to be sustainable upon an examination by the relevant tax authorities.
As discussed in ASC 740-10-45-11 through 45-12, a liability for unrecognized tax benefits should not be combined with deferred tax liabilities or assets, unless it arises from a taxable temporary difference. In Company A’s situation, the unrecognized tax benefit related to its expected tax filing position results in a taxable temporary difference. Therefore, the unrecognized tax benefit should be classified as a deferred tax liability. Furthermore, for U.S. public companies, the unrecognized tax benefit presented as a deferred tax liability should be disclosed in the tabular reconciliation of uncertain tax benefits consistent with ASC 740-10-50-15A. A disclosure is required beginning in the period in which the position (i.e., the debt extinguishment) is reflected in the financial statements (i.e., when it affects the measurement of a deferred tax liability).
Note: Company A would remeasure at each reporting period the taxable basis differences in the underlying asset consistent with the recovery of the asset for book purposes and adjust the deferred tax liability. A reclassification between deferred tax liability and a separate liability for unrecognized tax benefits would also be necessary to the extent the uncertain tax basis reduces income tax payable. In addition, interest on the potential tax underpayment would generally also be required as the uncertain tax basis is utilized.
15.5.1.5.2 Disclosure of Gross Unrecognized Tax Benefits
In circumstances where an unrecognized tax benefit in one jurisdiction would have an impact on a tax liability in another jurisdiction (such as a state unrecognized tax benefit affecting the amount of state taxes that would be deductible for U.S. federal purposes), the tabular reconciliation of unrecognized tax benefits should not include consideration of an unrecognized tax benefit’s effect in other jurisdictions. Indirect effects of uncertain tax positions on other jurisdictional tax calculations should be recorded in the financial statements. They should not be reflected in the tabular rollforward.
Example 15-5: Exclusion of Indirect Effects of Uncertain Tax Positions from the Tabular Disclosure
Background/Facts:
Company A has an uncertain tax position in State X of $1,000, which has not met the recognition threshold under ASC 740. If the position is not sustained, Company A will receive a $350 federal benefit for state taxes paid on $1,000.
Question:
Given the available facts, how should the tabular rollforward be presented?
Analysis/Conclusion:
In this case, only the $1,000 state unrecognized tax benefit should be included in the tabular disclosure.
For purposes of balance sheet classification, consistent with ASC 740-10-45-11, Company A should have a state liability for unrecognized tax benefits of $1,000 and a $350 federal deferred tax asset.
15.5.1.5.3 Interest and Penalties
Interest and penalties should not be included in the annual tabular reconciliation as unrecognized tax benefits, even if the accounting policy classifies interest and penalties as a component of income taxes.
15.5.1.5.4 Treatment of Deposits
If an advance deposit is made (regardless of whether it is refundable on demand or considered by the taxing authority as a payment of taxes), it should have no impact on the amount of unrecognized tax benefit that is reflected in the tabular reconciliation. This is because advance deposits are essentially equivalent to advance tax payments. As such, they should not be included as an offset to unrecognized tax benefits in the annual tabular reconciliation disclosure.
15.5.1.5.5 Required Information
ASC 740-10-50-15A(a) prescribes the following minimal line items (which can be further extended by the preparer):
Gross amounts of increases and decreases in unrecognized tax benefits as a result of tax positions taken during a prior period
Gross amounts of increases and decreases in unrecognized tax benefits as a result of tax positions taken during the current period
Amounts of decreases in the unrecognized tax benefits relating to settlements with taxing authorities
Reductions to unrecognized tax benefits as a result of a lapse of the applicable statute of limitations
15.5.1.5.5.1 The Gross Amounts of Increases and Decreases in Unrecognized Tax Benefits as a Result of Tax Positions Taken During a Prior Period
Amounts reported on this line represent an uncertain tax position taken in a prior year for which measurement has changed for one of two reasons: (1) the entity met one of the subsequent recognition thresholds in ASC 740-10-25-8, or (2) new information supported a change in measurement.
15.5.1.5.5.2 Increases and Decreases in Unrecognized Tax Benefits Recorded
for Positions Taken During the Year
To the extent that an uncertain tax position is taken during the year and the entity’s assessment of the amount of benefit to be recognized changes within the same annual reporting period, the tabular reconciliation should only reflect the net addition in existence at the end of the year when disclosing the gross amounts of increases and decreases in unrecognized tax benefits as a result of tax positions taken during the year. As we understand it, the FASB staff acknowledged that references to “decreases in unrecognized tax benefits” for this line of the tabular reconciliation should have been stricken from the guidance when the Board’s deliberations changed the tabular reconciliation from a quarterly disclosure to an annual disclosure. However, the FASB staff did emphasize that material changes in unrecognized tax benefits that occur during an interim period should be disclosed during the interim period and that an entity should not delay disclosure of material changes until the end of the annual reporting period.
15.5.1.5.5.3 The Amounts of Decreases in the Unrecognized Tax Benefits Relating to Settlements with Taxing Authorities
Certain settlements with taxing authorities may result in no cash payments (e.g., a taxing authority may concede a position taken on a tax return resulting in no cash payments to the taxing authority for that position). Only amounts paid or tax attributes (e.g., NOLs) used in lieu of payment should be included in this line item of the tabular reconciliation. A decrease in unrecognized tax benefits resulting from concessions or adjustments by the taxing authority should be reflected as a change to prior-period unrecognized tax benefits.
15.5.1.5.5.4 Reductions to Unrecognized Tax Benefits Resulting from a Lapse of the Applicable Statute of Limitations
Amounts reported in this line represent the tax benefits that were sustained by the entity because the taxing authority’s period of assessment has passed.
15.5.1.6 Unrecognized Tax Benefits That, If Recognized, Would Affect the Effective Tax Rate
ASC 740-10-50-15A(b) requires disclosure of the total amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate. That is, only unrecognized tax benefits that affect (if recognized) the tax provision within continuing operations should be disclosed. Certain unrecognized tax benefits may not affect the tax provision within continuing operations, such as (1) timing-related uncertainties (e.g., accelerated depreciation) (2) excess tax deductions from stock-based compensation recorded in equity under ASC 718, Compensation—Stock Compensation, and APB 25, (3) acquisition-related measurement period adjustments pursuant to ASC 805, and (4) measurement period adjustments occurring in connection with reorganizations in fresh-start balance sheets pursuant to ASC 852. To assist users of the financial statements, supplemental disclosures should be provided for resolutions of uncertain tax positions that, if sustained, would affect items other than the tax provision from continuing operations. A supplementary disclosure, for example, might specifically identify the amount of gross unrecognized tax benefits included in the ending balance, whose tax effects, if recognized in the financial statements, would be recorded in equity and/or goodwill.
As described in Section TX 15.5.1.5.2, the indirect effects in other jurisdictions should not be included within the tabular rollforward. We understand, however, that for purposes of applying the disclosure requirements specified in ASC 740-10-50-15A(b), one might consider the indirect effects in other jurisdictions.
15.6 Income Tax Related Disclosures for Stock Compensation
The following should be disclosed in relation to the tax effects of stock-based compensation awards:
The amount of cash resulting from the settlement of the awards, and the corresponding tax benefit that the entity realized for the current year.
The total compensation cost that the entity recognized in income, as well as the total recognized tax benefit for all income statements that the entity presented.
See Section TX 18.21 for a more detailed discussion of disclosures and for additional guidance on the presentation of tax effects relating to ASC 718.
15.7 Significant Risks & Uncertainties Disclosure
ASC 275, Risks and Uncertainties requires disclosures in annual and interim financial statements of risks and uncertainties (e.g., use of estimates) related to certain key information that help users in predicting future cash flows and results of operations. Although ASC 740-10-50-15(d) essentially codified ASC 275 for uncertain tax positions, the disclosures requirement in ASC 275 is still relevant guidance for other income tax matters, such as valuation allowances and indefinite reversal assertions for unremitted earnings of foreign subsidiaries. Additional disclosures may be required with respect to assumptions that management uses to estimate its balance sheet and income statement tax accounts. When it is at least reasonably possible that a material adjustment will occur in the near term (this is generally considered approximately one year), the financial statements should reflect this potential uncertainty along with a range of potential changes to its recorded amounts. This requirement is discussed in ASC 275-10-50-6 through 50-15, and an example relating to valuation allowances is offered in ASC 740-10-55-218 through 55-222.
As noted above, the threshold for disclosure is “reasonably possible,” indicating that probability is more than remote. The premise behind this threshold is that significant one-time charges or benefits, such as a change in the assessment of the need for a valuation allowance, should not surprise the reader of the financial statements. This is particularly important for public companies because of their quarterly reporting requirements. The more significant the change in estimate and the more time that elapses between the event and the filing date, the more difficult it may be for a company to justify that a significant one-time event was not reasonably foreseeable at the time of its most recent filing.
15.8 SEC Disclosures
15.8.1 Additional Footnote Disclosures
Several disclosures required by the SEC are not specifically required by ASC 740. They include the following:
The source of income (loss) before tax expense (benefit) must be classified as either foreign or domestic.
The amounts applicable to U.S. federal income taxes, to foreign income taxes, and to other income taxes must be stated separately for each major component of income tax expense (i.e., current and deferred).
The fact that an entity conducting business in a foreign jurisdiction has been granted a tax holiday from income taxes for a specified period must be disclosed. In such an event, an appropriately referenced note must (1) disclose the aggregate dollar and per-share effects of the tax holiday and (2) briefly describe the factual circumstances, including the date on which the special tax status will terminate (SAB Topic 11C).
These disclosure requirements apply not only to continuing operations, but also to total pretax income and total tax expense. However, question 7 of SAB Topic 6I indicates that “overall” disclosures of the components of total income tax expense (i.e., current vs. deferred and U.S. federal vs. foreign vs. other) are acceptable. It is not necessary to make such disclosures with respect to each of the different categories (continuing operations, discontinued operations, extraordinary items, etc.) in which income tax expense is reported.
15.8.2 Contractual Obligations Table
The SEC concluded that, in accordance with SEC Regulation S-K Item 303(a)(5), liabilities for unrecognized tax benefits should be considered when a registrant prepares the contractual obligations table.
There are various formats that those disclosures might follow. Deciding which of the various formats should be used is a matter of professional judgment. However, the ultimate goal of the disclosures is to provide transparent information that enables investors to understand the impact of uncertain tax positions on the company’s liquidity.
If a company can make reliable estimates about the periods in which cash outflows relating to its liabilities are expected to occur, it should include those estimates in the relevant columns of the contractual obligations table. For instance, any liabilities classified as a current liability in the company’s balance sheet should be presented in the “Less than 1 Year” column of the contractual obligations table.
If, however, a company cannot make reliable estimates of the cash flows by period, the company should consider alternative methods of conveying relevant information to investors. For instance, the company might consider including its liabilities in an “all other” column in the table (with a transparent note disclosure). Alternatively, the company might rely on a note disclosure alone (including quantitative information).
15.8.3 Interim Reporting (Form 10-Q Filings)
Companies are required to disclose in quarterly reports any material changes to contractual obligations that occur outside the ordinary course of business. The method by which any material changes are disclosed is a matter of professional judgment.
A company should evaluate whether the inclusion of liabilities for unrecognized tax benefits in its disclosures of contractual obligations represents a material change to its prior disclosures. If including the liabilities does, in fact, represent a material change, the company should use judgment to determine the appropriate means of conveying this information to investors. The SEC’s management discussion and analysis (MD&A) rules do not specifically require companies to include the contractual obligations table in quarterly reports. However, the inclusion of an updated table is one way to effectively disclose material changes. Another method provides in the contractual obligations disclosures a discussion of the impact of the liabilities. As noted above, the ultimate goal of the disclosures is to provide transparent information that enables investors to understand the impact of uncertain tax positions on the company’s liquidity.
15.8.4 Schedule II Requirement
In addition to the disclosure requirements mentioned, S-X Rule 5-04 requires that valuation allowance details be provided on Schedule II, as prescribed in Rule
12-09. If the information required by Schedule II is otherwise provided in the financial statements or notes, the schedule can be omitted.
15.8.5 MD&A Disclosures
SEC registrants must also make certain disclosures related to income taxes in the MD&A of SEC filings.
15.8.5.1 Effective Tax Rate
In their MD&A, registrants should explain the reasons for significant changes in the effective income tax rate from year to year and the effect that income tax payments would have on liquidity and capital resources.
In addition, qualitative disclosures related to an entity’s effective tax rate should be carefully considered in each period. For example, absent commentary to the contrary, a reader of the financial statements should be entitled to assume that an entity’s effective tax rate for the most recent periods will continue into the near-term future. If items impacting the effective rate in the current period will not recur in such a way that the expected tax rate will be substantially different going forward, MD&A disclosure of the one-time items is required. This will be the case regardless of whether the items are significant enough to require separate disclosure in the effective tax rate reconciliation.
15.8.5.2 Accounting Estimates & Contingencies
In December 2003, the SEC issued FRR 72 to remind companies of existing SEC guidance and to provide additional guidance, interpretation, and requirements related to MD&A disclosures, as specified in Items 303 of Regulations S-K and S-B. However, FRR 72 does not amend existing disclosure requirements and it provides interpretive guidance on three focused areas, one being critical accounting estimates. Although not specifically stated, we believe that this includes tax contingencies. The interpretation provides that the MD&A should, among other things, supplement the description of estimates already provided in the accounting policy section of the notes to the financial statements, including such factors as how the entity arrived at the estimate, how accurate the estimate/assumption has been, how much the estimate/assumption has changed from the past, and whether the estimate/assumption is reasonably likely to change in the future.
15.8.5.3 Realization of Deferred Tax Assets
The SEC requires certain disclosures with respect to deferred tax assets in certain circumstances. The following is a transcript of comments made by the SEC at the AICPA Conference on Current SEC Developments on January 12, 1993:
The SEC staff would insist that a registrant provide additional disclosures regarding the realization of its deferred tax asset in those situations in which the deferred tax asset comprises a significant portion of the registrant’s total assets and/or stockholders’ equity and it is not apparent that the registrant’s existing level of income would be sufficient to realize the deferred tax asset. If realization of a material deferred tax asset will require material improvements in profitability, or material changes in trends, or material changes in the relationship between reported pretax income and federal taxable income, or material asset sales or similar non-routine transactions, the staff believes that a discussion in MD&A of these factors is necessary. The staff believes that the registrant should provide sufficient disclosures in MD&A to inform the reader as to what factors and assumptions led management to arrive at its conclusion that the deferred tax asset would be realized in the future.
The staff recommended that the following disclosures be provided in MD&A:
1. A discussion of the minimum amount of future taxable income that would have to be generated to realize the deferred tax asset and whether the existing levels of pretax earnings for financial reporting purposes are sufficient to generate that minimum amount of future taxable income. If not sufficient, a discussion of the extent of the future increase in profitability that is necessary to realize the deferred tax asset, quantified to the extent possible, and the significant assumptions relied upon by management in concluding that it is more-likely-than-not that the results of future operations will generate sufficient taxable income to realize the deferred tax asset, for example, anticipated improvements in profitability resulting from improved gross margins, additional store openings, cost reduction programs, and corporate restructurings.
2. The historical relationship between pretax earnings for financial reporting purposes and taxable income for income tax purposes, including a discussion of the nature and amount of material differences between such amounts. A table reconciling pretax income to taxable income for each of the years for which financial statements are presented has been used to accomplish this objective.
3. A discussion of tax-planning strategies that would be available to generate future taxable income if the registrant were unable to generate sufficient future taxable income from ordinary and recurring operations.
4. The annual amounts of net operating loss carryforwards for income tax purposes that expire by year.
At the 1994 Conference, the staff added that “disclosures regarding significant deferred tax assets arising from deductible temporary differences such as OPEBs should include the expected timing of reversal of those temporary differences.” The staff recognized that estimates may be required since there are no actual expiration dates for the deductible temporary differences and that less precise disclosures would need to be accepted in certain circumstances. For example, disclosures regarding significant deferred tax assets arising from deductible temporary differences might provide annual reversals by year of significant deductible temporary differences that give rise to deferred tax assets for the first five years, followed by groupings for subsequent five-year periods.
15.9 Exemptions for Nonpublic Entities
Certain exceptions to the above requirements are made for nonpublic entities. A nonpublic entity does not need to numerically reconcile the statutory and effective rates or provide numeric information regarding the types of temporary differences and carryforwards that give rise to deferred tax assets and liabilities. However, in both cases, a nonpublic entity must disclose the nature of significant items. In addition, nonpublic and nontaxable entities are also exempt from disclosing the net difference between the tax bases and the reported amounts of assets and liabilities, a required disclosure for public nontaxable entities.