IT2013_1069_CH17_v2_P1_7-22

Chapter 17:
Accounting for Income Taxes in Interim Periods

Chapter Summary

ASC 740-270, Interim Reporting, prescribes an estimated annual effective tax rate (“ETR”) approach for calculating a tax provision for interim periods. Conventional wisdom might lead one to believe that using such an approach to record an interim period income tax provision simplifies the otherwise laborious process of computing a discrete tax provision for each interim period. However, accounting for income taxes in interim periods is far from simple. The ETR approach presents a number of unique complexities and challenges and, in certain circumstances, can lead to counterintuitive results. This chapter walks through some of the key considerations and complexities in accounting for income taxes during interim periods following this general outline:

The estimated annual effective tax rate approach should generally be used to determine the tax (or benefit) related to ordinary income, as defined (Section TX 17.2). Certain items do not meet the definition of ordinary income; the tax effects of such items should be computed and recognized as discrete items when they occur (Section TX 17.3).

There are limited exceptions to the use of the estimated annual effective tax rate approach (Section TX 17.2.2) and also limitations on the amount of benefits that can be recognized for losses, credits and rate differentials in loss periods (Section TX 17.2.1.3).

There are a number of additional situations that present unique challenges when accounting for income taxes in interim periods (Section TX 17.4 and Section
TX 17.5).



17.1 Method of Computing an Interim Tax Provision

ASC 740-270-25-2 provides the following guidance for calculating an income tax provision in an interim period:

The tax (or benefit) related to ordinary income (or loss) shall be computed at an estimated annual effective tax rate and the tax (or benefit) related to all other items shall be individually computed and recognized when the items occur.


17.1.1 Determining the Elements and Tax Effects of Ordinary Income

17.1.1.1 Definition of Tax (or Benefit) Related to Ordinary Income

Since the tax effects of current-year ordinary income receive different interim accounting treatment than the tax effects of other types of income during the same period, the definition of a tax (or benefit) related to ordinary income becomes important. ASC 740-270-20 defines these terms as follows:

a. Ordinary income (or loss) refers to income (or loss) from continuing operations before income taxes (or benefits) excluding significant unusual or infrequently occurring items. Extraordinary items, discontinued operations, and cumulative effects of changes in accounting principles are also excluded from this term. The term is not used in the income tax context of ordinary income vs. capital gain. The meaning of “unusual or infrequently occurring items” is consistent with their use in the definition of the term, “extraordinary item.”

b. Tax (or benefit) is the total income tax expense (or benefit), including the provision (or benefit) for income taxes both currently payable and deferred.

17.1.1.2 Items Excluded from the Definition of Ordinary Income

17.1.1.2.1 Significant Unusual or Infrequent Items

ASC 270-10-45-11A prescribes that “extraordinary items, gains or losses from disposal of a component of an entity, and unusual or infrequently occurring items shall not be prorated over the balance of the fiscal year.” Deciding whether events should be classified as unusual or infrequent can be challenging. The definition of “ordinary income (or loss)” in ASC 740-270-20 refers to the definition of the term “extraordinary item” in ASC 225-20-20, which provides the following:

Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates (see ASC 225-20-60-3).

Infrequency of occurrence. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates (see ASC 225-20-60-3).

While both of these criteria should be met to classify an event or transaction as an extraordinary item, only one of these factors is required for an item to be excluded from the estimated annual effective tax rate.

Additionally, consideration should be given to ASC 740-270-30-12 to 30-13, which provides that the tax effect of significant unusual or extraordinary items that are reported separately within income from continuing operations should be excluded from the estimated annual effective tax rate calculation and instead be recorded on a discrete basis in the period in which the item occurs. ASC 740-270-30-12 also prescribes discrete treatment for items that are required to be reported net of their related tax effect such as other comprehensive income, discontinued operations and extraordinary items.


Example 17-1: Impact of Nondeductible-Goodwill Impairment on Interim Period Tax Provisions

Background/Facts:

Company A has recorded a financial statement impairment of nondeductible goodwill during the second quarter.

Question:

Would the impairment of nondeductible goodwill be considered an unusual or infrequent item that requires discrete treatment, or should it be considered a component of the estimated annual effective tax rate, which requires recognition throughout the year?

Analysis/Conclusion:

ASC 740-270-30-4 through 30-8 indicate that the interim tax provision should be the estimated annual effective tax rate. This rate should then be applied to determine income taxes on a year-to-date basis. ASC 740-270-30-8 also states that, “in arriving at this estimated effective tax rate, no effect shall be included for the tax related to significant, unusual or extraordinary items that will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year.” These items should instead be recognized as a discrete tax event in the period of occurrence.

Judging whether a nondeductible-goodwill impairment should be classified as an unusual or infrequent item requires careful consideration of the relevant facts and circumstances. The definition of an “extraordinary item” in ASC 225-20-20 provides guidance for judging whether a transaction or event qualifies as unusual or infrequent. A history of goodwill impairments or a reasonable expectation that there will be impairments in the future would indicate that the impairment is not unusual and should therefore be included in the estimated annual effective tax rate (i.e., not treated discretely in the period). Conversely, in circumstances where there has been no history of goodwill impairments and there is presently no reasonable expectation of significant goodwill impairments in the future, the tax effect of the impairment might be able to be accounted for discretely in the period in which the impairment is recorded.

The following chart compares the year-to-date tax expense of a nondeductible-goodwill impairment classified as a discrete item and a nondeductible-goodwill impairment classified as an item that affects the estimated annual effective tax rate calculation. Company A projected $200 of book and taxable income and an ETR of 40 percent prior to the impairment. In the second quarter, Company A recorded an $80 impairment of its nondeductible goodwill.


1 Calculated as YTD tax expense on YTD book income using 40% effective rate, plus tax expense on goodwill impairment times 40% tax rate.

2 Revised effective rate is 66.7%—forecasted annual book income of $120 and tax expense of $80 on $200 taxable income.

3 YTD tax expense on YTD book income using 66.7% effective rate.

17.1.1.2.2 Extraordinary Items

ASC 225-20-20 defines the term extraordinary items as “events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence.” Thus, an item must satisfy both criteria (i.e., unusual and infrequent) to qualify as extraordinary while treatment as a discrete item for interim reporting purposes only needs to satisfy one of the criteria.


17.1.1.2.3 Discontinued Operations

See ASC 205-20-45-1 for a discussion of what constitutes a discontinued operation.

17.1.1.2.4 Cumulative Change in Accounting Principle

See ASC 250-10-45-3 through 45-7 for guidance on how to account for the cumulative effect of changes in accounting principles when an accounting pronouncement does not provide specific transition adjustments.


17.1.1.3 Limited Exceptions for Certain Items

Barring the exceptions presented below in Sections TX 17.1.1.3.1 through TX 17.1.1.4.8, Section TX 17.2.2, and Section TX 17.5.1, ASC 740-270 provides no latitude for treating any other tax effects of ordinary income on a discrete-period basis. Accordingly, the tax effects of items such as dividends-received deductions and capital gains rates on significant fixed asset dispositions that are not considered unusual or infrequent should be incorporated into the estimated annual effective tax rate rather than recorded discretely.

17.1.1.3.1 Tax-exempt Interest

While deliberating the accounting issues related to accounting for income taxes in interim periods, the FASB discussed the historical practice of excluding tax-exempt interest from ordinary income and effectively treating it as discrete income even though interest on tax-exempt securities often forms a portion of ordinary income of an entity that routinely invests in such securities.1 Despite this mention of recording the tax impacts of interest from tax-exempt securities as they are earned, the FASB decided not to provide specific guidance on this issue.

11 FIN 18, par. 80.

If not for the reference to the then common practice of excluding tax-exempt interest from the estimated annual effective tax rate calculation, tax-exempt interest would be treated like any other rate reconciling item related to current-year ordinary income. Because the FASB did not explicitly object to the exclusion of tax-exempt interest from the ETR calculation, we believe that including or excluding tax-exempt interest from the ETR calculation is acceptable as long as the approach is applied consistently.

17.1.1.3.2 Investment Tax Credits

ASC 740-270-30-14 provides guidance for handling the impact of investment tax credits when applying the estimated annual effective tax rate approach. Whether investment tax credits are included or excluded depends on the accounting treatment selected. ASC 740-270-30-14 states:

Certain investment tax credits may be excluded from the estimated annual effective tax rate. If an entity includes allowable investment tax credits as part of its provision for income taxes over the productive life of acquired property and not entirely in the year the property is placed in service, amortization of deferred investment tax credits need not be taken into account in estimating the annual effective tax rate; however, if the investment tax credits are taken into account in the estimated annual effective tax rate, the amount taken into account shall be the amount of amortization that is anticipated to be included in income in the current year (see ASC 740-10-25-46 and 740-10-45-28).

17.1.1.3.3 Leveraged Leases

ASC 740-270-30-15 states:

Further, paragraphs 840-30-30-14 and 840-30-35-34 through 35-35 require that investment tax credits related to leases that are accounted for as leveraged leases shall be deferred and accounted for as a return on the net investment in the leveraged leases during the years in which the net investment is positive and explains that the use of the term years is not intended to preclude application of the accounting described to shorter periods. If an entity accounts for investment tax credits related to leveraged leases in accordance with those paragraphs for interim periods, those investment tax credits shall not be taken into account in estimating the annual effective tax rate.

We believe that investment tax credits that arise from direct-financing leases and are recognized as additional return on investment should also be excluded.

17.1.1.3.4 After-tax Equity Pickup for Investees Owned 50 Percent or Less

It is typically appropriate to record equity in the net income of a 50-percent-or-less-owned investee based on its interim statements on an after-tax basis (i.e., the investee would provide taxes in its financial statements based on its own estimated annual effective tax rate calculation). For any incremental investor’s tax (e.g., the deferred tax liability for unremitted earnings), the incremental tax would not be calculated as part of the investor’s overall ETR calculation. Instead, this incremental tax would be calculated based on a separate ETR calculation (i.e., the amount of incremental tax expected to be incurred in the annual period divided by the estimated annual amount of equity method income).

17.1.1.4 Other Items That Do Not Represent Tax Effects Related to Ordinary Income

ASC 740-270-25-2 makes it clear that the only items that should be spread by means of the estimated annual effective tax rate approach are the tax effects of current-year ordinary income (or loss). As a result, many items resulting from actions that occurred during the year, but not representing tax effects related to current-year ordinary income, should be recorded discretely in the interim period in which they occurred (i.e., excluded from the ETR calculation). Examples of these items include the following:

Subsequent recognition, derecognition, or change in measurement for an uncertain tax position arising in prior periods due to a change in judgment or interpretation of new information (Section TX 17.1.1.4.1)

Interest and penalties recognized on uncertain tax positions (Section TX 17.1.1.4.2)

Change in tax law (Section TX 17.1.1.4.3)

Change in tax status (Section TX 17.1.1.4.4)

Certain changes in the realizability of deferred tax assets (Section TX 17.1.1.4.5)

Change in judgment regarding unremitted foreign earnings and other outside basis differences (Section TX 17.1.1.4.6)

Change in estimate related to a prior-year tax provision (Section TX 17.1.1.4.7)

17.1.1.4.1 Subsequent Recognition, Derecognition, or Change in Measurement for an Uncertain Tax Position Arising in Prior Periods Due to a Change in Judgment or Interpretation of New Information

As discussed in ASC 740-10-25-14 through 25-15, the existence of new information that results in a change in judgment that causes subsequent recognition, derecognition, or a change in measurement of a tax position taken in a prior period shall be recognized as a discrete item (including interest and penalties) in the period in which the change occurs. For example, if an event during an interim period (e.g., a court case or tax ruling related to another taxpayer with a similar exposure) prompts a change in the assessment of the sustainability of a tax position taken in a prior year (i.e., based on the technical merits of the tax position), the effect of the change should be recorded discretely in the period in which the assessment changes.

However, as discussed at ASC 740-270-35-6, if the assessment changes with respect to a current-year tax position, the new assessment should generally be incorporated into the revised ETR that will be applied to the year-to-date ordinary income and in each successive quarter (unless the tax uncertainty relates to a pretax item that was accounted for discretely, such as discontinued operations). The requirements for recording changes in unrecognized tax benefits in interim periods can be summarized as follows:


17.1.1.4.2 Interest and Penalties Recognized on Uncertain Tax Positions

ASC 740-10-25-56 requires that interest be accrued in the first period in which the interest would begin accruing according to the provisions of the relevant tax law. Therefore, interest expense should be accrued as incurred and should be excluded from the ETR calculation. ASC 740-10-25-57 indicates that a penalty should be recorded when a position giving rise to a penalty is taken or anticipated to be taken on the current year’s tax return.

17.1.1.4.3 Change in Tax Law

In accordance with ASC 740-10-25-47 through 25-48, ASC 740-10-45-15, and ASC 740-270-25-5 through 25-6, adjustments to deferred tax assets and liabilities as a result of a change in tax law or rates should be accounted for discretely in continuing operations at the date of enactment. Similarly, the effects of a retroactive change in tax rates should also be accounted for discretely in continuing operations in the interim period in which the law is enacted. However, the prospective effects of a change in tax law or rates on tax expense in the year of enactment should be reflected in the estimated annual effective tax rate calculation. See Section TX 7.4 (including Example 7-4) for more information on the accounting for changes in tax law.

17.1.1.4.4 Change in Tax Status

As specified in ASC 740-10-25-32 through 25-34, the effect of a voluntary change in tax status should be recognized discretely on (1) the date that approval is granted by the taxing authority or (2) the filing date, if approval is unnecessary. The entire effect of a change in tax status should be recorded in continuing operations in accordance with ASC 740-10-45-19. Chapter TX 8 offers more information on the accounting for changes in tax status.

17.1.1.4.5 Certain Changes in the Assessment of the Realizability of Deferred Tax Assets

As prescribed by ASC 740-270-25-7, the tax effect of a change in the beginning-of-the-year balance of a valuation allowance caused by a change in judgment about the realizability of the related deferred tax asset that results from changes in the projection of income expected to be available in future years should be recognized discretely in the interim period in which the change in judgment occurs. A change in judgement about the realizability of deferred tax assets resulting from changes in estimates of current-year ordinary income and/or deductible temporary differences and carryforwards that is expected to originate in ordinary income in the current year should be considered in determining the estimated annual effective tax rate. The change in judgment should not be recorded discretely in the interim period in which it changes. See Example 17-6 and Section TX 17.4.4 for additional information.

17.1.1.4.6 Change in Judgment Regarding Unremitted Foreign Earnings and Other Outside-Basis Differences

A company will sometimes change its intentions about whether it will indefinitely reinvest undistributed earnings of foreign subsidiaries or corporate joint ventures that are essentially permanent in duration and thus whether it will record deferred taxes on outside basis differences. In these situations, the tax effect of the change in judgment for the establishment/reversal of the deferred tax liability related to the outside basis difference that had accumulated as of the beginning of the year
should be recorded in continuing operations in the interim period during which the intentions changed. A portion of the outside basis difference that accumulated as
of the beginning of the year may include the effects of currency movements that
(1) had been previously recorded through a cumulative translation adjustment (CTA) as the company had already established a deferred tax liability or (2) were not recorded through CTA as the company did not recognize a deferred tax liability on the CTA portion of the outside basis difference. In either situation, the effect of that currency movement on the outside basis difference as of the beginning of the year is reflected in continuing operations in the period in which the change in judgment occurred. This treatment is consistent with ASC 740-30-25-19, which indicates that the tax effect of a subsidiary’s undistributed earnings (1) should be charged to expense in the period during which the circumstances change and (2) should not be recorded as an extraordinary item.

The tax effect of the change in intentions on unremitted earnings of the current year should be reflected in the determination of the company’s ETR. Accordingly, any tax effect related to currency movements associated with current-year unremitted earnings that increases or decreases the deferred tax liability would be attributed to CTA (i.e., a component of other comprehensive income) for the period. This is consistent with ASC 740-20-45-11(b), subject to the intraperiod allocation process in ASC 740-20-45. Chapter TX 12 offers a detailed discussion of intraperiod allocation.

17.1.1.4.7 Change in Estimate Related to a Prior-Year Tax Provision

As discussed in Section TX 17.1, the language in ASC 740-270-25-2, makes it clear that the estimated annual effective tax rate approach should only be used to record the tax effect of current-year ordinary income. A change in estimate in the current year that is related to a prior-year tax provision does not constitute a tax effect on current-year income. Therefore, the effects of this change should be recorded discretely in the period during which the change in estimate occurs. The next section presents guidance for determining whether a change in the prior-year tax provision is an error or a change in estimate.

17.1.1.4.8 Discerning an Error from a Change in Accounting Estimate in Income Taxes

The following guidance is intended to assist professionals with judgements as to when changes in tax positions reflected in prior periods or changes in income tax amounts accrued in prior periods constitute financial reporting “errors” rather than changes in estimate. The following circumstances are among those intended to be covered by this guidance:

The discovery that the tax reported in a prior year’s return was either understated or overstated (regardless of whether an amended return has been filed);

The discovery that a tax return or tax payment filing requirement was not met;

The discovery of misapplication of ASC 740 or related accounting principles; or

A change in the amount of tax expense or benefit initially recognized related to a prior reporting period (e.g., via a return-to-provision “true-up”).

Unless specified otherwise, all matters addressed in this section are subject to normal materiality considerations.

The ASC Master Glossary definition of the term change in accounting estimate indicates that a change in accounting estimate results from “new information.” In contrast, the ASC Master Glossary definition of the term error in previously issued financial statements indicates that errors result from “mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time the financial statements were prepared.”

As it relates to accruals for income taxes, we believe that, in general, an adjustment of a prior-period tax accrual that results either from new information (including a change in facts and circumstances) or later identification of information that was not reasonably “knowable” at the original balance sheet date and that results in improved judgment would lead to a change in estimate. However, an adjustment that arises from information that was reasonably “knowable” during the prior reporting period (or represents a reconsideration of the same information) may constitute “oversight or misuse of facts” and, therefore, may be an error. In this regard, consideration should be given to whether the information was (or should have been) “readily accessible” from the company’s books and records in a prior reporting period and whether the application of information commonly known by competent corporate tax professionals at that time would have resulted in different reporting.

Examples of Errors

The following would be examples of errors:

A tax accrual is intentionally misstated (without regard to materiality).

A mechanical error is made when calculating the income tax provision (e.g., if meals and entertainment expenditures were deducted twice instead of being added back to taxable income or if the wrong disallowance rate was applied).

Misapplications of ASC 740 and related accounting principles and interpretations are made. For example, the company failed to record a tax benefit or contingent tax liability at the balance sheet date that should have been recognized in accordance with such guidance considering the facts and circumstances that existed at the reporting date and that were reasonably knowable at the date the financial statements were issued.

The company chose to estimate rather than obtain an amount for tax provision purposes at the balance sheet date that was “readily accessible” in the company’s books and records, and the actual amount differs from the estimate. In assessing whether information was (or should have been) “readily accessible,” consideration should be given to the nature, complexity, relevance and frequency of occurrence of the item. In this regard, it would be expected that companies would develop internal control processes to properly consider relevant information relating to frequently occurring or recurring items that could be significant.

For example, a company would be expected to have an adequate internal control system to track meals and entertainment charges, to the extent such amounts create a material permanent difference in the company’s tax return. If there is a significant difference between the estimate made when closing the books and the actual amount reported on the tax return, this would seem to constitute an error. This is not to suggest that the level of precision is expected to be completely accurate or that all differences between estimates and actual amounts constitute errors. Rather, a relatively insignificant difference between an estimate and the actual amount provides evidence that the company’s control system is adequate and that such an adjustment should be treated as a change in estimate in the period identified.

Conversely, consider a company that had never before repatriated foreign earnings (and had not provided deferred taxes on such amounts in accordance with ASC 740-30-25-17). The company decides late in its fiscal year to repatriate some or all of the foreign earnings. To determine the financial statement impact of the planned repatriation, the company may need to perform complex “earnings & profits” (E&P) computations or assess other data that may only become available after year-end and take considerable time to complete (and thus would not be “readily accessible” as of the balance sheet date). To close its books on a timely basis, the company estimates certain amounts that are not readily accessible based on information available from the company’s books and records. In this case, assuming the company had a reasonable basis for its original estimates, we would be inclined to view any subsequent adjustment as a change in estimate. In this circumstance, to the extent amounts needing to be estimated were material, we would also expect disclosures (e.g., “early warning” disclosures prescribed by ASC 275-10-50-8 through 50-9) if it was reasonably possible that the estimates used could change within the next 12 months, such as when the E&P analysis was completed.

Distinguishing when information was (or should have been) readily accessible will often be judgmental and will be based on the facts and circumstances of each situation.

Examples of Changes in Estimate

The following circumstances would constitute changes in accounting estimate:

An event occurs that results in a changed judgment with respect to the sustainability of an uncertain tax position or an amount related thereto.

Examples of events are: (1) a settlement is reached with the taxing authorities related to a previously identified uncertain tax position; (2) a change in interpretation of tax law or new administrative ruling; (3) additional expert technical insight obtained with respect to complex, highly specialized or evolving areas of tax law interpretation and knowledge; and (4) additional information becomes known based on other taxpayers with similar situations that provides better insight into the sustainability of the uncertain tax position. For example:

The company, with the assistance of highly specialized tax experts, obtains a new insight or point of view in relation to the application of the tax law with respect to prior tax return positions involving nonrecurring or complex transactions or technical tax issues. Because of the level of sophistication and expertise required, and recognizing that insight with respect to complex tax laws is continually evolving both on the part of tax professionals and the taxing authorities, these circumstances would typically suggest a change in estimate rather than an error.

The company makes a retroactive tax election that affects positions taken on prior tax returns (as is sometimes permitted under the tax code), as long as the primary factors motivating such change can be tied to events that occurred after the balance sheet date. For example, based on subsequent-year developments, such as lower than expected operating results in succeeding periods, a company concludes that it is more tax efficient to deduct foreign income taxes paid than to claim a foreign tax credit for foreign taxes paid.

Due to a change in facts and circumstances, there is an economic basis to pursue a tax credit or deduction retroactively that was previously considered not to be economical. This is premised on the company having evaluated the acceptability of the tax position at a previous balance sheet date and having performed a reasoned analysis of the economics, and reaching a conclusion that it was not prudent to pursue such benefit. For example, a company considered the potential tax savings associated with pursuing tax credits for certain research activities. Based on the company’s lack of current taxable income, it concluded that the additional administrative burden of pursuing such credits was not economical. Then, in a subsequent period, based on a change in the company’s operating results and perhaps due to an increase in the amount of the potential credits, the company decided to put in place the necessary infrastructure to be able to claim the credit, including for retroactive periods.

Another example of a change in facts and circumstances might be new tax software becoming available that makes it economical to pursue a tax benefit.

To the extent it is concluded that a change in estimate has occurred, it should be noted that ASC 250-10-50-4 indicates that disclosure is required if the effect of the change is material.

17.2 Computing the Tax Provision Attributable to Ordinary Income

17.2.1 Estimated Annual Effective Tax Rate

17.2.1.1 Methodology

With limited exceptions, ASC 740-270 requires companies to calculate the estimated annual effective tax rate for current-year ordinary income, including both the current and deferred provisions determined under ASC 740. To project taxable income for the year, which is in turn used to estimate the annual provision for taxes currently payable, it is necessary to estimate temporary differences and rate differentials entering into the current provision. The temporary differences used to estimate the current provision are then included in the projected year-end temporary differences used to estimate the annual provision for deferred taxes, including any change in the valuation allowance. These estimates should be updated on each interim financial reporting date.

As a practical matter, however, there may be circumstances in which the estimated annual effective tax rate can be appropriately estimated by considering only rate differentials. These situations often involve temporary differences that are expected to have offsetting effects in the current and deferred provisions (i.e., the effect on the current provision would be equal in amount but opposite in direction to the effect on the deferred provision). If additional complexities arise (e.g., the enacted tax rate varies between years or a valuation allowance for beginning or ending deferred tax assets changes), separate estimates of the annual current and deferred provisions must typically be made to develop an appropriate estimated annual effective tax rate.


17.2.1.2 Best Current Estimate

17.2.1.2.1 General

The estimated annual effective tax rate should represent the best estimate of the composite tax provision in relation to the best estimate of worldwide pretax book ordinary income. The composite tax provision should include federal, foreign, and state income taxes, including the effects of (1) credits, (2) special deductions (e.g., Internal Revenue Code Section 199 deduction under the American Jobs Creation Act or percentage depletion), (3) capital gains taxed at different rates, and (4) valuation allowances for current-year changes in temporary differences and losses or income arising during the year. The estimated annual ETR is then applied to year-to-date ordinary income to compute the year-to-date interim tax provision on ordinary income. The difference between the year-to-date interim tax provision and the year-to-date interim tax provision as of the preceding interim period constitutes the tax provision for that quarter.


17.2.1.2.2 Treatment of Nonrecognized Subsequent Events on the ETR

If a significant pretax nonrecognized subsequent event occurs after the interim balance sheet date but before financial statement issuance, an important question arises: Should the company’s best current estimate of annual pretax ordinary income be updated for the nonrecognized subsequent event, or should the best current estimate only use information that existed as of the balance sheet date? For example, assume that, subsequent to the interim balance sheet date, a significant new customer contract was signed. Alternatively, assume a severe hurricane loss was suffered by an insurance company. In both instances, the subsequent event significantly changed the company’s current estimate of its annual pretax ordinary income and thereby its estimated annual effective tax rate.

ASC 740-270-35-3 indicates that, at the end of each interim period during the fiscal year, the estimated annual effective tax rate should be revised, if necessary, to reflect the entity’s best current estimate. Therefore, one could reasonably conclude that the company’s best current estimated annual effective tax rate should be based on information available prior to the date of issuance, even though some of that information might be about influential factors that did not exist or were not relevant until after the interim balance sheet date.

Conversely, AU Section 560.05 indicates that nonrecognized subsequent events should not result in the adjustment of the financial statements. If an entity were to incorporate a significant nonrecognized subsequent event into the development of an updated ETR, some of the subsequent event’s indirect effects would be recorded in the results up until the balance sheet date that preceded the nonrecognized event. Since the effects of nonrecognized subsequent events should not be reflected in the financial statements, one could reasonably conclude that the effects of a nonrecognized subsequent event should be excluded from the interim calculation of the ETR.

Given that either approach can be supported by a reasonable interpretation of existing guidance, we believe that both are acceptable. However, a company must choose one approach and consistently apply it as an accounting policy.

Companies that choose to consider all available information up until the issuance date should be careful to exclude items whose tax effects are required to be recognized discretely in the period that they occur, such as: (1) changes in tax laws or rates (as discussed in Section TX 7.4), (2) new information received after the reporting date related to the assessment of uncertain tax positions (as discussed in Sections TX 16.5.5 and TX 17.1.1.4), and (3) discontinued operations, extraordinary items, and other significant unusual or infrequent items (as discussed in Section TX 17.1.1.2.1).

When there is a significant time lag from the interim date to the date of the issuance of the financial statements (as may be the case with a company reporting on a prior interim period for the first time in connection with a registration statement), it may become increasingly difficult to assert that an event in the extended period should affect the estimated annual effective tax rate applied to the interim period. We generally believe that the delayed issuance of the financial statements should not result in a different assessment of the estimated annual effective tax rate than would have been the case had the financial statements been issued on a timely basis.

17.2.1.3 Limitation on Benefits of Losses, Credits, and Rate Differentials in Loss Periods

The ETR approach is modified by ASC 740-270-30-30 through 30-34, which limit the tax benefit recognized for a loss in interim periods to the amount that is expected to be (a) realized during the year or (b) recognizable as a deferred tax asset at the end of the year. Those limitations should be applied in determining both separate jurisdiction and worldwide estimated annual effective tax rates and the year-to-date benefit for a loss. We believe that those limitations also apply to rate differentials that would increase the effective benefit rate during loss periods.

In applying the guidance in ASC 740-270-30-30 through 30-34 related to the realizability of deferred tax assets and the need for a valuation allowance, the central issue that a company needs to consider is the valuation allowance that it expects to recognize at year-end, including any expected change in the valuation allowance during the year. The company cannot simply focus on the benefit of losses in the current year.

Example 17-2: Application of ASC 740-270-30-30 through 30-34: Loss Limitation When the Year-to-Date Loss Exceeds the Full-Year Expected Loss and Full Realization of the Tax Benefit of the Loss Is Assured

Background/Facts:

For the full fiscal year, an entity anticipates an ordinary loss of $100,000. The entity operates entirely in one jurisdiction, where the tax rate is 50 percent. A total of $10,000 in tax credits is anticipated for the fiscal year. The company does not anticipate any events that do not have tax consequences.

If there is a recognizable tax benefit for the loss and the tax credits pursuant to the requirements of ASC 740-10, the estimated annual effective tax rate that applies to the ordinary loss would be computed as follows:


The entity has the following year-to-date ordinary income and losses for the following interim periods:


The full tax benefit of the anticipated ordinary loss and the anticipated tax credits will be realized through carryback. The full tax benefit of the maximum year-to-date ordinary loss can also be realized through carryback.

Question:

Given these facts, how should the interim reporting guidance be applied?

Analysis/Conclusion:

Quarterly tax computations are as follows:


1 Because the year-to-date ordinary loss exceeds the anticipated ordinary loss for the fiscal year, the tax benefit recognized for the year-to-date loss is limited to the amount that would be recognized if the year-to-date ordinary loss were the anticipated ordinary loss for the fiscal year. The limitation is computed as follows:


Note: Example 17-2 was derived from ASC 740-270-55-16.

Example 17-3: Application of ASC 740-270-30-30 through 30-34: Loss Limitation When the Year-to-Date Loss Exceeds Full-Year Expected Loss and Partial Realization of the Tax Benefit of the Loss Is Assured

Background/Facts:

Assume that the same facts presented in Example 17-2 are applicable to this example except that it is more-likely-than-not that the tax benefit of the loss in excess of $40,000 of prior income available to be offset by carryback (i.e., $20,000 of tax at the 50 percent statutory rate) will not be realized. Therefore, the estimated annual effective tax rate is 20 percent (i.e., $20,000 of benefit that is more-likely-than-not to be realized divided by $100,000 of estimated fiscal-year ordinary loss).

Question:

Given these facts, how should the interim reporting guidance be applied?

Analysis/Conclusion:

Quarterly tax computations are as follows:


Note: Example 17-3 was derived from ASC 740-270-55-20.

17.2.2 Exceptions to the Use of the ETR Approach

ASC 740-270 requires the use of an estimated annual effective tax rate to compute the tax provision for ordinary income in all jurisdictions during an interim period. However, in determining that rate, there are two exceptions to the general rule that requires all jurisdictions (and all the tax effects on current-year ordinary income) to be included in the computation of the consolidated worldwide ETR.

If one of these two exceptions applies and one or more foreign jurisdictions are excluded from the computation of the worldwide ETR, the U.S. tax effects (e.g., remitted or unremitted dividend income and related foreign tax credits) of the operations in those foreign jurisdictions are also excluded. State and municipal income tax jurisdictions are subject to the same limitations as foreign jurisdictions with respect to what can be included in the consolidated worldwide ETR.


17.2.2.1 Jurisdictions with Pretax Losses for which No Tax Benefit
Can Be Recognized

When a company operates in a jurisdiction that has generated ordinary losses on a year-to-date basis or on the basis of the results anticipated for the full fiscal year and no benefit can be recognized on those losses, ASC 740-270-30-36(a) requires the company to exclude that jurisdiction’s income (or loss) from the overall ETR calculation. A separate ETR should be computed and applied to ordinary income (or loss) in that jurisdiction. In effect, any jurisdictions with losses for which no benefit can be recognized are removed from the base calculation of the ETR. Assuming the reason for no benefit is a full valuation allowance, the separate ETR for that jurisdiction would be zero.


Example 17-4: Treatment of Withholding Tax in an Interim Period Income Tax Calculation for an Entity with Operations in Multiple Jurisdictions

Background/Facts:

Parent has operations in Country A. Parent also has a wholly owned subsidiary (“Sub”) with operations in Country K. Upon repatriation of earnings, Parent will pay tax in both Country A and Country K on the earnings of Sub. Parent’s tax due to Country K will be paid by Sub on behalf of Parent in the form of a withholding tax for which Parent is the legal obligor. In the instant case, Parent does not consider the earnings of Sub to be indefinitely reinvested, and therefore, records a deferred tax liability on the outside basis difference in its investment in Sub. Such deferred tax liability would consider applicable tax in both Country A and K and would include withholding taxes in Country K as well as incremental taxes, net of realizable foreign tax credits, if any, in Country A.


To determine the tax provision in an interim period, ASC 740-270-30-36 typically requires the use of an overall (or worldwide) effective tax rate (ETR) applied to worldwide income. However, in certain circumstances, a jurisdiction will be excluded from the worldwide ETR calculation. ASC 740-270-30-36(a) requires that if an entity has a year-to-date ordinary loss or expects an annual ordinary loss in a separate jurisdiction for which the benefit will not be realized (i.e., a full valuation allowance will be recorded), then the interim tax provision is calculated separately for that jurisdiction, using the principles of ASC 740-270.

At the end of Q2, Sub has year-to-date ordinary income and anticipates ordinary income for the fiscal year. Parent’s operations in Country A have a year-to-date ordinary loss and an anticipated ordinary loss for the fiscal year. Parent has a full valuation allowance on its net deferred tax assets.

Question:

Should Parent’s withholding tax obligation to Country K related to Sub’s earnings be included in the worldwide ETR calculation?

Analysis/Conclusion:

We believe there are two acceptable alternatives, as long as the method chosen is consistently applied.

Alternative A: Include Parent’s obligation in Country K in the worldwide ETR (i.e., look to the tax obligations by jurisdiction). Under this view, the withholding tax is considered separately from Parent’s tax to Country A on the earnings of K.

Each component is analyzed as follows:

Country A (Parent)—Country A is excluded from the worldwide ETR calculation due to year-to-date ordinary loss for which no benefit may be recognized (i.e., a full valuation allowance is needed).

Country K (Parent)—Parent is recording withholding tax related to Sub’s earnings. Sub has year-to-date ordinary income and anticipates ordinary income for the fiscal year. This jurisdictional component is not in a year-to-date loss situation and should therefore be included in the worldwide ETR calculation.

Country K (Sub)—As stated above, Sub has year-to-date ordinary income and anticipates ordinary income for the fiscal year. Therefore, this jurisdictional component should be included in the worldwide ETR calculation.

Alternative A is supported by the jurisdictional discussion in ASC 740-270-30-36, which includes the following language, “an enterprise that is subject to tax in multiple jurisdictions pays taxes based on identified income in one or more individual jurisdictions….” This view is also supported by the general requirements of ASC 740-10-45-6 for financial statement presentation for income taxes by “tax-paying component of an enterprise within a particular tax jurisdiction.” In the case of Parent’s tax obligation to Country K, the identified income is the earnings of Sub on which the tax is levied, and the tax-paying component is Parent, the legal obligor.

Alternative B: Include Parent’s withholding tax to Country K in Parent’s separate income tax calculation and therefore exclude it from the worldwide ETR. Under this view, the withholding tax is considered a component of the measurement of Parent’s tax expense on its investment in Sub.

Each component is analyzed as follows:

Parent (Country A and K)—For the reasons previously discussed, Country A is excluded from the worldwide ETR calculation. Parent’s obligation to Country K would follow the treatment for Country A and also be excluded from the worldwide ETR calculation.

Sub (Country K)—For reasons previously discussed, this jurisdictional component is included in the worldwide calculation.

As discussed in ASC 740-10-55-24, the withholding tax due to Country K is merely a component of the Parent’s measurement of taxes on its investment in Sub. ASC 740-10-55-24 provides that measurement should be based on expectations regarding tax consequences (e.g., capital gains or ordinary income). The computation of a deferred tax liability for undistributed earnings based on dividends should reflect any related dividends received, deductions or foreign tax credits, and taxes that would be withheld from the dividend.

In measuring deferred taxes on Parent’s investment in Sub, Parent would incorporate withholding tax. The withholding tax would therefore be associated with Parent for purposes of calculating interim tax.

This analysis is further supported by ASC 740-270-30-36(b), which states that “the tax (or benefit) related to ‘ordinary’ income (or loss) in a jurisdiction may not be limited to tax (or benefit) in that jurisdiction. It might also include tax (or benefit) in another jurisdiction that results from providing taxes on unremitted earnings, foreign tax credits, etc.” While ASC 740-270-30-36(b) is not the exception being applied in the present fact pattern, it is related.

17.2.2.1.1 Zero-Rate Jurisdictions

ASC 740-270 does not specifically address whether a zero-rate jurisdiction should or should not be included in the ETR computation. As there is conceptual support for either inclusion or exclusion of a zero-rate jurisdiction, we believe this is an aspect of accounting for income taxes for which diversity in practice can be expected. The following are four acceptable approaches:

Approach A: Always exclude pre-tax ordinary income or loss from a zero-rate jurisdiction from the ETR computation. This view is premised on the theory that the income in a zero-rate jurisdiction is effectively tax-exempt. The exclusion of pre-tax income from a zero-rate jurisdiction is analogous to the optional treatment of tax-exempt income discussed in TX 17.1.1.3.1.

Approach B: Exclude pre-tax ordinary income or loss from a zero-rate jurisdiction from the ETR computation if there is a year-to-date loss in that jurisdiction. The rationale for this view is based on the notion that a loss ultimately will not provide a tax benefit. Support for this view can be found in ASC 740-270-30-36(a) which requires the exclusion of jurisdictions with year-to-date losses if no tax benefit can be recognized for the year-to-date loss or for an anticipated full-year loss.

Approach C: Exclude pre-tax ordinary income or loss from a zero-rate jurisdiction from the ETR computation only if a loss is anticipated for the full fiscal year. This view concludes that ASC 740-270-30-36(a) is not directly applicable because it addresses positive tax rate jurisdictions in circumstances where a loss would be offset with a valuation allowance. This view would not exclude income or loss when a year-to-date loss is anticipated to reverse in subsequent periods. This view in effect represents a modified analogy to the principle in ASC 740-270-30-36(a).

Approach D: Always include pre-tax ordinary income or loss from a zero-rate jurisdiction the ETR computation because the underlying principle in ASC 740-270 is that, absent a specific requirement or exception, all current-year ordinary income or loss should be included in the ETR computation. This view differentiates the exception in ASC 740-270-30-36(a) as only applying to taxable jurisdictions for which a valuation allowance may be necessary. This view is premised on the notion that the ETR approach is known to yield, at times, seemingly illogical results in particular periods, yet there are only two narrowly drawn exceptions to full-inclusion, both of which are described with reference to an entity that “is subject to tax.”

The approach used should be considered an accounting policy election to be applied consistently to all zero-rate jurisdictions of the reporting entity. If it is clearly evident that the approach applied to zero-rate jurisdictions has reporting consequences that would be significantly different than had one or more of the other acceptable approaches outlined above been applied, appropriate disclosure should be considered.

17.2.2.2 Jurisdictions for Which a Reliable Estimate Cannot Be Made

17.2.2.2.1 General Overview

ASC 740-270-30-36(b) provides the following two situations in which a company should exclude a jurisdiction from the overall computations of the estimated annual effective tax rate:

1. If a company operates in a foreign jurisdiction for which a “reliable estimate” of the annual effective tax rate in terms of the parent entity’s functional currency cannot be made.

2. If a reliable estimate of ordinary income for a particular jurisdiction cannot be made.

Presumably the first situation would arise when the exchange rate between the parent company’s functional currency and the foreign currency is highly volatile (this does not commonly occur in practice).

With respect to the second situation, the FASB acknowledged that determining whether an estimate is reliable requires the use of professional judgment and may involve the assessment of probability.2 For example, in some cases, a small change in an entity’s estimated ordinary income could produce a significant change in the ETR. In such cases, an estimate of the ETR would not be reliable if a small change in ordinary income were likely to occur.

2 FIN 18, par. 82.



Example 17-5: Interim Period Calculation of the ETR Involving a Jurisdiction That Anticipates an Ordinary Loss for the Fiscal Year

Background/Facts:

Company X operates in and is subject to tax in two different jurisdictions. Management has projected for the fiscal year that Jurisdiction A will have ordinary income, but Jurisdiction B will have an ordinary loss. Because Company X is a seasonal business, operating results are expected to vary from quarter to quarter.

Assume that the losses in Jurisdiction B will be benefited fully and that any resulting end-of-year deferred tax asset will not require a valuation allowance. Assume also that Company X is able to make reliable estimates of ordinary income and loss for Jurisdictions A and B.

The applicable tax rate for Jurisdiction A is 40 percent and the applicable tax rate for Jurisdiction B is 50 percent. No significant rate differentials are anticipated in either jurisdiction.

Company X develops for each jurisdiction the following budget of pretax income and loss and the related tax expense and benefit:


Based on the above forecasts, Company A determines that the estimated annual effective tax rate is negative 10 percent (i.e., $4 of total tax benefit on $40 of consolidated income). Assuming that the actual results mirror the projected results, application of the estimated annual effective tax rate as calculated would yield the following results:


Because the losses in Jurisdiction B are benefited at a higher tax rate than the income in Jurisdiction A is being taxed, Company X’s management believes that application of a global estimated annual effective tax rate produces counterintuitive results. For this reason, management proposes calculating a separate estimated annual effective tax rate for each individual jurisdiction (i.e., 40 percent for Jurisdiction A and 50 percent for Jurisdiction B). Management’s proposed approach would yield the following results:


Question:

Is the alternative approach proposed by Company X’s management acceptable?

Analysis/Conclusion:

No. If a company is subject to tax in multiple jurisdictions, ASC 740-270 requires that the interim period tax related to consolidated ordinary income be computed using one overall estimated annual effective tax rate.

The application of the estimated annual effective tax rate approach may produce a result that could appear illogical from a consolidated perspective. However, ASC 740-270 provides only two exceptions to the overall computation of the estimated annual effective tax rate, as described in TX 17.2.2.1 and 17.2.2.2.

17.2.2.2.2 Computing a Tax Provision When a Reliable Estimate Cannot Be Made

ASC 740-270-30-17 through 30-18 reads as follows:

Paragraph 740-270-25-3 requires that if an entity is unable to estimate a part of its ordinary income (or loss) or the related tax (or benefit) but is otherwise able to make a reliable estimate, the tax (or benefit) applicable to the item that cannot be estimated be reported in the interim period in which the item is reported. Estimates of the annual effective tax rate at the end of interim periods are, of necessity, based on evaluations of possible future events and transactions and may be subject to subsequent refinement or revision. If a reliable estimate cannot be made, the actual effective tax rate for the year to date may be the best estimate of the ETR.

This excerpt clarifies that the estimated annual effective tax rate is an estimate that is inherently subject to changes. However, this fact alone does not justify a departure from the ETR approach.

Whether a reliable estimate of ordinary income or loss or the related tax can be made is a matter of judgment. If management is unable to estimate only a portion of its ordinary income, but is otherwise able to reliably estimate the remainder, the tax applicable to that item should be reported in the interim period in which the item occurs. An estimated annual effective tax rate must be applied to the remainder of ordinary income and the related tax that can be reliably estimated.

17.2.2.2.3 Effects of “Naked Credits” on the Estimated Annual Effective Tax Rate

When a company is incurring losses and has a full valuation allowance, the increase of a deferred tax liability that does not serve as a source of income for the recognition of a deferred tax asset will trigger an estimated tax for the current year. The impact of this “naked credit” should be included in a company’s ETR calculation. This inclusion would be required whether the jurisdiction with the “naked credit” is included in an entity’s worldwide ETR calculation or excluded from the worldwide ETR calculation and treated as a separate jurisdiction with a stand-alone estimated annual ETR under ASC 740-270-30-36(a).

However, discrete treatment is appropriate when the annual estimate of the tax rate is not considered a reliable estimate. This may happen when a company determines a wide range of potential estimated annual effective tax rates because pretax income is at or near breakeven and it has significant permanent items such as the deferred tax effect from a “naked credit.” In such circumstances, consideration should be given to whether the company has the ability to estimate its ETR, given the range of possible outcomes. The inability to estimate the ETR in a jurisdiction would cause the tax provision for that jurisdiction to be calculated on a discrete basis under ASC 740-270-30-36(b).

17.3 Tax Effects Other Than the Tax on Current-Year Ordinary Income

ASC 740-270-25-2 requires that the entire tax (or benefit) related to all items other than the tax effect on ordinary income should “be individually computed and recognized when the items occur.”

Examples of these items include the tax effects related to discontinued operations, other comprehensive income, additional paid-in capital and items in continuing operations that represent tax effects not attributable to current-year ordinary income. The tax effects represented by these items should be computed and reflected in accordance with the intraperiod allocation rules discussed below in Section TX 17.4.

17.4 Intraperiod Allocation in Interim Periods

17.4.1 General Overview

ASC 740-270-45 indicates that the intraperiod allocation rules (ASC 740-20-45) should be used to allocate the interim provision throughout the interim financial statements. Although the “with-and-without” model is basically the same for interim and annual periods, as discussed in ASC 740-270-45-2, the allocation of tax expense or benefit for interim periods should be performed using the estimated fiscal year income and tax for “ordinary income (or loss)” as defined by the ASC Master Glossary and the year-to-date income and tax for (1) an infrequent, unusual, or extraordinary item, (2) the gain or loss on disposal of a discontinued operation, or
(3) another component of the financial statements (e.g., other comprehensive income). If more than one of the above items is present, the computation should reflect the order of precedence that will be assumed in annual financial statements. Thus, unusual or infrequent items that are included in continuing operations will ordinarily be considered before any items that are excluded from continuing operations.

If more than one item is excluded from continuing operations, the process outlined in ASC 740-20-45-14 should be used to apportion the remaining provision after the tax expense or benefit allocated to continuing operations is considered. This allocation process should be consistent with the process used in the annual calculation, which is illustrated in Chapter TX 12, Example 12-12.

17.4.2 Subsequent Revisions

Tax attributed to financial statement components that are reported in an early quarter can be subsequently revised to reflect a change in the estimate of tax related to annual ordinary income or changes in year-to-date income or loss in other components. ASC 740-270 requires the computation of the interim provision to be performed on a year-to-date basis. As a result, the tax provision for a given quarter equals the difference between the provision recorded cumulatively for the year (via the estimated annual effective tax rate approach) less the amount recorded cumulatively as of the end of the prior interim period. Changes in circumstances from quarter to quarter might make it necessary to record the tax effects in a financial statement category that differs from the one in which the company recorded the tax effects during a previous quarter. The goal of the ASC 740-270 model is to treat the interim periods as components of the current annual period. As a result, the intraperiod allocation, like the estimated annual effective tax rate, must be updated and recomputed each quarter.

17.4.3 Intraperiod Allocation That Reflects Discontinued Operations Prior
to the Date on Which They Are Classified as Held for Sale or Disposed of

Once operations are classified as discontinued, prior periods are restated to reflect the now discontinued operations as discontinued. With respect to operating results of discontinued operations prior to the date on which those operations are first reported as discontinued operations, ASC 740-270-45-6 through 45-8 provides detailed rules for taking the tax previously assigned to ordinary income and allocating it between the recomputed ordinary income and the discontinued operations. In addition, ASC 740-270-55-29 provides an illustration of accounting for income taxes applicable to income or (loss) from discontinued operations at an interim date. See Section TX 12.2.3.2.4 for a more detailed discussion about intraperiod allocation issues related to discontinued operations.

17.4.4 Changes in Valuation Allowance

The need for a valuation allowance must be reassessed at each interim reporting date. Pursuant to ASC 740-270-25-4, and depending on the circumstances that lead to a change in valuation allowance, the change may be reflected in the estimated annual effective tax rate or recognized discretely in the interim period during which the change in judgment occurred, or both.

Any change in valuation allowance that results from a change in judgment about the realizability of the related deferred tax assets resulting from changes in the projection of income expected to be available in future years is reported in the period during which the change in judgment occurs. No portion of the effect should be allocated to subsequent interim periods through an adjustment to the estimated annual effective tax rate for the remainder of the year.

The following changes in valuation allowance should be considered in determining the ETR for the year:

A change in the valuation allowance related to deductible temporary differences and carryforwards that are expected to originate in ordinary income in the current year.

A change in the valuation allowance for beginning-of-year deferred tax assets that results from a difference between the estimate of annual ordinary income (which includes the year-to-date amount) for the current year and the estimate that was inherent in the beginning-of-year valuation allowance.

If there is a reduction in the valuation allowance for beginning-of-year deferred tax assets that results from income other than ordinary income (e.g., discontinued operations), the benefit should be reflected discretely in year-to-date results (presuming, of course, that current-year continuing operations and projections of future income could not have supported the realization).


Example 17-6: Change in Assessment of the Realizability of Beginning-of-Year Deferred Tax Assets as a Result of Changes in Projections of Future Income

Background/Facts:

At the end of the second quarter, a company determines that future taxable income for the current year and for future years will be higher than estimated at the end of the previous year due to an increase in sales orders. This will permit a decrease in the valuation allowance against deferred tax assets related to net operating loss (NOL) carryforwards that existed at the beginning of the year.

The company has $3,000,000 of NOL carryforwards available at the beginning of the year. At that time, the enacted tax rate was 33.5 percent. Because of uncertainty related to realizability, management established a valuation allowance of $1,005,000 for the full amount of the deferred tax asset related to the NOL carryforward at the end of the prior year. Although the company broke even for the first three months of the current year, a second quarter increase in net income and sales orders has prompted the company to (1) revise its estimate of current-year income from zero to $200,000 and (2) change the expectation regarding income in future years to be sufficient to allow recognition of the entire deferred tax asset. This will permit a full reversal of the valuation allowance for NOL carryforwards that existed at the beginning of the year.

Question:

Should this change in judgment be recorded as a discrete event that is accounted for in the second quarter, or should the change be allocated to subsequent interim periods as part of the estimated annual effective tax rate calculation?

Analysis/Conclusion:

As indicated above, the decrease in the valuation allowance has two components:
(1) the portion related to a change in estimate regarding current-year income and
(2) the portion related to a change in estimate about future years’ income.

A company takes the first component into income by adjusting the estimated annual effective tax rate for the current year (i.e., spread over the third and fourth quarters through the revised ETR). The second component is taken into income as a discrete event in the second quarter.

As a result of revising the estimate of future profitability to reflect sales orders, the company calculates current-year income taxes as follows:


The required journal entry at the end of the second quarter would be:


The $938,000 would be accounted for as a discrete event in the second quarter. The tax benefit associated with the remaining valuation allowance of $67,000, along with a similar amount of tax expense tied to the reduction in the NOL deferred tax asset, would be released to income as profits are earned during the remainder of the year, including the second quarter. At the end of the year, the deferred tax asset account would have a balance of $938,000, and there would be no valuation allowance. The following is a summary of activity by quarter, which demonstrates the release of the valuation allowance.


The example above illustrates to the extent that (1) there is a change in assessment about the need for a valuation allowance and (2) an entity is expecting income during the current year that will allow for realization, the portion of the valuation allowance release attributable to current-year projected income will need to be held back and recognized throughout the year as the current-year income is earned.

Because the entity in Example 17-6 was projecting pretax profits of $200,000 and because the $200,000 of profits would allow for the realization of deferred tax assets, the valuation allowance release that is attributable to current-year income (in this case $67,000 [$200,000 x 33.5%]) will be released as the $200,000 is earned throughout the year. Absent the impact of the valuation allowance release tied to current year income, the portion of the second quarter year-to-date tax provision determined based on the ETR would have been $16,750. However, because the ETR calculation specifically includes the consideration of valuation allowance changes attributable to current-year income or loss, the ETR that will be used to calculate the second quarter provision is zero. The remaining $50,250 of valuation allowance release (i.e., $67,000 full-year expected release related to current-year income less $16,750 recognized in the second quarter) will be reflected in the financial statements as the remaining $150,000 of planned income for the year is earned in subsequent quarters.

17.4.4.1 Initial Recognition of Source-of-Loss Items

The initial recognition of source-of-loss items (see a discussion of source-of-loss items in Section TX 12.2.2.2.3.2) are generally excluded from recognition in income but rather recorded back to the source of the prior year loss/benefit. For example, the initial recognition of a tax benefit of a windfall tax deduction related to stock-based compensation would be recognized in additional paid-in capital. Accordingly, tax benefits related to source-of-loss items would not enter into the ETR calculation.

17.4.5 Exception to the Basic Intraperiod Allocation Model

ASC 740-20-45-7, which describes the exception to the basic “with-and-without” approach to intraperiod allocation, must also be considered in interim periods. If a company has a valuation allowance and expects (1) pretax losses from continuing operations and (2) income in other components of the financial statements, ASC 740-20-45-7 may have an effect on the presentation of the interim period financial statements and may possibly result in the reporting of a tax benefit (which would be incorporated in the estimated annual effective tax rate) in continuing operations, even though no such benefit would be computed using the basic “with-and-without” approach.

Example 17-7: Mechanics of Applying ASC 740-20-45-7 to Interim Periods

Background/Facts:

Assume the following:

There are only two categories of pretax income/loss (continuing operations and discontinued operations), which are summarized below for each interim period during the year.

Continuing operations includes no significant unusual or infrequent items.

There was a full valuation allowance at the beginning of the year, and a full valuation allowance is expected at the end of the year.

There are no permanent differences.


Question:

How should the tax provision be computed during interim periods?

Analysis/Conclusion:

As discussed in Section TX 12.3, the FASB concluded that all categories of income for the current period (e.g., discontinued operations and other comprehensive income), excluding continuing operations, should be considered to determine the amount of tax benefit that results from a loss in continuing operations and that should be allocated to continuing operations. To apply ASC 740-20-45-7 in an interim period, the estimated annual effective tax rate must reflect the effect of ASC 740-20-45-7 using the full-year plan for ordinary income and the year-to-date amounts for all other items.

Based on the amounts above, the estimated pretax ordinary loss for the full year is $40,000 and the year-to-date gain for discontinued operations is $20,000. Under the intraperiod allocation rules of ASC 740, the $20,000 of income from discontinued operations will allow the company to realize a benefit from $20,000 of current-year ordinary loss. Assuming a 40 percent tax rate, the company will realize a tax benefit of $8,000 on the ordinary loss, which will result in an estimated annual effective tax rate of 20 percent (tax benefit of $8,000 divided by the expected full-year ordinary loss of $40,000).

This calculation of the estimated annual effective tax rate to be applied in the interim period should be performed at each interim balance sheet date. The amount of tax expense (benefit) recorded in each period is presented in the table below. For simplicity’s sake, the example assumes no change in planned full year income.


Since the effect on ordinary income is accounted for through the ETR approach, and the tax in discontinued operations is recorded discretely in the period, the total tax provision for each quarter will not be zero (even though it will be at year-end). The amount recorded in discontinued operations will be $8,000, but the tax benefit on the year-to-date Q1 continuing operations loss of $10,000 is $2,000 (i.e., 20 percent ETR derived above multiplied by the $10,000 pretax loss). This is accomplished through the following entry:


The accrued income tax provision recorded in the balance sheet does not represent a deferred tax liability or income tax payable.

Assuming that the full-year plan for the year’s ordinary income did not change, the following cumulative entry would be recorded in the second quarter:


Assuming that the full-year plan for the year’s ordinary income did not change, the following cumulative entry would be recorded in the third quarter:


In this case, the application of the ETR approach would have resulted in the allocation of a net benefit of $12,000, which exceeds the benefit expected for the full year. Therefore, the amount recognized is limited to $8,000.

17.4.6 Tax Accounting Considerations of Stock-Based Compensation During Interim Periods

When an entity calculates its estimated annual effective tax rate, it should not anticipate or estimate the incremental effects of windfalls or shortfalls that may occur over the balance of the year. For example, if an option is due to expire in the current year, the entity should not anticipate that it will be exercised and that a windfall will be recognized, even though the fair value of the underlying stock exceeds the exercise price of the option. Similarly, if an entity had disqualifying dispositions for incentive stock options (ISOs) or employee stock purchase plans (ESPPs) in the past, it should not anticipate future disqualifying dispositions. Instead, the entity should recognize windfalls and shortfalls discretely in the period in which they occur.

For example, if an entity does not have a sufficient pool of windfall tax benefits at the beginning of the year, any shortfall should be recorded in the income statement in the period in which the shortfall occurred. If a windfall is recognized later in the year, the shortfall that was recognized earlier in the year should be reversed in the subsequent quarter to the extent that it can be offset against the windfall (because the pool of windfall tax benefits is determined on an annual basis).

Example 17-8 illustrates how an entity should record windfalls and shortfalls during interim periods.

Example 17-8: Windfalls and Shortfalls During Interim Periods

Assume the following:

The company has a calendar year-end.

No pool of windfall tax benefits is available at December 31, 20X8.

The company’s taxable income is sufficient for the stock option tax deductions to reduce income taxes payable.

The company has no other windfall or shortfall activity during the year.


1 The tax benefit is calculated by multiplying the intrinsic value of the option by the tax rate of 40 percent.

2 The deferred tax asset is calculated by multiplying the compensation cost by the tax rate of 40 percent.

Entities should also consider the guidance in ASC 718-740-25-10, which states that a windfall tax benefit should not be recognized until it reduces taxes payable. When applying this guidance on a quarterly basis, we believe that entities should consider their estimated annual income taxes payable. If an entity incurs a net loss for the period and experiences a windfall tax benefit in the early quarters of a fiscal year, the entity should still be able to recognize the windfall tax benefit from those exercises as long as the entity expects to have taxable income for the full year. We believe that the requirements of ASC 718-740-25-10 should be applied within the context of a fiscal year, not just an interim period. This is consistent with the requirement to determine the tax provision on an annual basis.

Example 17-9: Recognition of Prior Year Windfall Tax Benefits in Interim Periods

Background/Facts:

Company A, a calendar year-end public company, grants nonqualified stock option awards to its employees. In the past, a U.S. federal windfall tax deduction was generated (i.e., an excess tax deduction to Company A) as the intrinsic value of the options exercised exceeded the cumulative compensation cost for those awards. In accordance with ASC 718-740-25-10, none of the windfall tax benefits were recognized as an increase to additional paid-in capital (APIC) because Company A had a net operating loss carryforward (NOL) in prior years which resulted in the windfall deductions merely increasing the NOL instead of reducing taxes payable.

Company A has no valuation allowance on its deferred tax assets and forecasts, as of the first quarter, taxable income for the current fiscal year which will allow for utilization of all of the off-balance sheet NOLs that arose from the windfall deductions claimed in prior years. There are no unrecognized tax benefits for uncertainties related to the deductions.

Question:

When should Company A recognize the increase in APIC related to windfall tax benefits that are expected to reduce taxes payable in the current fiscal year?

Analysis/Conclusion:

We believe there is diversity in practice with respect to recognizing, in interim periods, windfall tax benefits that originated in prior years and are expected to reduce taxes payable in the current year. Two acceptable alternatives are as follows:

Alternative 1: Company A should recognize the prior year windfall tax benefits as the related income occurs during the current year. This view effectively assumes that estimated tax payments would generally be reduced by the windfall tax deduction at applicable quarterly intervals throughout the year. The windfall tax benefits should generally be sequenced as the last benefits to be recognized against year-to-date taxes payable. So, for example, if there were $120 of NOLs that included $20 of windfall tax deductions, and current full year income of $120 is expected to occur ratably ($30 per quarter), this would mean that no windfalls would be recognized in APIC until the fourth quarter. Recognizing windfall tax benefits on this basis appears consistent with the intent of ASC 718-740-25-10, which provides that the credit to APIC not be recognized until it reduces taxes payable.

Alternative 2: Company A should recognize the prior year windfall tax benefits that are expected to reduce taxes payable for the entire current year in the first quarter. This view is premised on the notion that the requirements of ASC 718-740-25-10 should be applied in the context of a fiscal year and is consistent with the general treatment of recording windfalls in APIC on a discrete basis in the interim period in which the windfall deduction occurs. In this case, since Company A is now in an annual period in which it anticipates being able to reduce taxes payable with NOLs that arose from windfall deductions, the prohibition on recognition of the windfalls in APIC no longer applies and the estimated amount of windfall benefits that will be used in the current year would be recognized in its entirety.

The view chosen represents an accounting policy that, once established, would be consistently applied. Company A should also consider the impact of the accounting policy on its statement of cash flows. ASC 230-10-45-14e requires that the windfall tax benefits from stock-based compensation awards be classified as cash inflows from financing activities while ASC 230-10-45-17c requires the same amount to be shown as cash outflows from operating activities.

Note: In cases where only a portion of the tax attributes will be used, the accounting policy elected by the company would determine the order in which the tax attributes are utilized. Section TX 12.2.2.2.3.3 indicates that either the with-and-without approach or the tax law ordering approach would be acceptable to determine the order in which tax attributes should be considered.

17.5 Other Complexities

17.5.1 Business Combinations

The acquisition of a business can significantly impact the acquiring company’s estimated annual effective tax rate. Because a business combination is a transaction that is not typically accounted for in periods prior to the acquisition date, no effect should be given to a business combination in the estimated annual effective tax rate before the interim period in which the business combination is consummated.

Beginning with the interim period in which the purchase is consummated, the estimated annual effective tax rate for the year would be calculated to reflect the expected results, including the results of the acquired company. That rate would be applied to the consolidated year-to-date ordinary income/loss to compute the year-to-date tax provision/benefit on ordinary income/loss.

Alternatively, a second acceptable approach would be to divide the annual period into pre-acquisition and post-acquisition periods and determine an estimated annual effective tax rate for each of the two periods. After the acquisition is consummated, the tax provision would be the sum of the tax provision for the pre-acquisition period plus the tax computed by applying the ETR for the post-acquisition period to the year-to-date, post-acquisition ordinary income. This method may not be appropriate if rate differentials that do not relate to the acquired operations occur disproportionately in the post-acquisition period.

Example 17-10: Application of the ETR Calculation When a Business Combination Impacts the Rate

Background/Facts:

Assume that a company has cumulative losses in recent years that result in a deferred tax asset with a full valuation allowance recorded against it. During the year, the company experienced losses of $1,000 in each of the first two quarters (Q1 and Q2). These losses cause an increase in the company’s net operating loss (NOL) carryforward. Consequently, the deferred tax assets and corresponding valuation allowance were increased by equivalent amounts. The company’s estimated annual effective tax rate was zero percent for both Q1 and for the six-month, year-to-date period ending in Q2.

On July 1, the company acquired the stock of another company in a non-taxable transaction. The business combination was accounted for under ASC 805, Business Combinations. As a result of the acquisition, the company has determined that it will be able to reverse its existing valuation allowance, as the taxable temporary differences relating to the amortizable intangible assets exceed the NOL carryforwards and are expected to reverse during the NOL carryforward period. Although the company expects to lose $750 for each of the remaining two quarters (Q3 and Q4), it will be able to recognize a deferred tax benefit of $600 [($750 x 2) x 40%] on such a loss because of the existence of its net deferred tax liability.

Accordingly, for some period of time subsequent to this acquisition, the company anticipates that its effective tax rate will be 40 percent, even though it expects to incur operating losses for the near term.

Question(s):

1. When should the business combination first impact the estimated annual effective tax rate calculation?

2. How should the release of the valuation allowance as a result of the business combination be recorded in the interim period financial statements?

3. How should the business combination be incorporated into the estimated annual effective tax rate calculation?

Analysis/Conclusion:

Question 1:

The acquisition of a business should first impact the estimated annual effective tax rate calculation in the period in which the business combination is consummated. Accordingly, in this example, while disclosure of the future impact may be necessary, the effects of the business combination should not be considered in the calculation of the income tax provision for the six months ended June 30. Rather, the impact should be reflected in the period ended September 30.

Question 2:

In accordance with ASC 805-740-30-3, the reduction of an acquirer’s valuation allowance as a result of a business combination is not accounted for as part of the business combination, but is recognized in the income tax provision (subject to intraperiod allocation as discussed in ASC 740-10-45-20). For purposes of this example, assume that the valuation allowance release should be recorded in continuing operations.

ASC 740-270 indicates that the estimated annual effective tax rate approach should be applied (with limited exceptions) to compute the tax effects related to ordinary income (or loss). However, ASC 740-270 indicates that ordinary income (or loss) excludes significant “unusual or infrequently occurring items” and provides that the tax effects of such items should not be pro-rated over the balance of the fiscal year. In this fact pattern, we believe there are two acceptable alternatives:

Alternative 1: In the period that the business combination is consummated, the acquired business should be incorporated in Company A’s estimated annual effective tax rate calculation—that is, to consider the inclusion of the expected results of Company B subsequent to the acquisition to represent a change in estimate regarding the future income of Company A. Under this view, the valuation allowance release would follow the general approach used when releasing a valuation allowance at an interim period as described in Example 17-6 in Section TX 17.4.4. Specifically, the decrease in the valuation allowance would comprise two components: (1) the portion related to a change in estimate regarding current-year income and (2) the portion related to a change in estimate about future years’ income. The portion of the valuation allowance release that relates to current-year income would be reflected in the estimated annual effective tax rate for the current year (i.e., it would be recognized through the remainder of the year). The portion of the valuation allowance release that relates to future years’ income would be recorded as a discrete item in the period of the business combination.

Alternative 2: Because a business combination is a transaction that cannot be anticipated in the estimated annual effective tax rate calculation prior to the acquisition date, a business combination, by its nature, could be considered an unusual or infrequent item as discussed in Section TX 17.1.2 and ASC 740-270-20. Under this view, the entire release of an acquirer’s valuation allowance as a result of a business combination would be recorded as a discrete item at the acquisition date.

When determining which alternative to apply, a company should consider the approach it will use for its interim tax provision calculations subsequent to the business combination (as discussed in question 3 below). The approach used for incorporating a business combination into the estimated annual effective tax rate calculation may influence the determination of which of the above alternatives to apply.

The alternative chosen is an accounting policy election that should be applied consistently. In addition, the company should provide transparent disclosures in the interim financial statements to enable readers to understand the impacts of the business combination and the related release of the valuation allowance.

In this example, because the company is forecasting losses for the remainder of the year, it does not matter which alternative is chosen because the results will be the same under either method (i.e., the full valuation allowance release will be reflected as a discrete item in the period of the business combination under either alternative). However, the approach adopted for incorporating the business combination into the estimated annual effective tax rate calculation will have an impact as demonstrated below.

Question 3:

A business combination can be incorporated into the ETR calculation in two ways:
(1) a pure ASC 740-270 approach or (2) a bifurcated rate approach.

A Pure ASC 740-270 Approach:

Under this approach, the tax provision/benefit for the interim period including the consummation date will include a catch-up for pre-acquisition interim periods.

Based on the above facts, under either Alternative 1 or Alternative 2, the estimated annual effective tax rate for the year, as of Q3, would be 17.1 percent. This would be computed as follows:


The year-to-date loss, as of Q3, would be $2,750 [($1,000 x 2) + $750]. The deferred tax benefit to be recognized as part of the estimated annual effective tax rate calculation would be $472 in Q3 ($2,750 x 17.1%) and $128 in Q4 ($750 x 17.1%). In addition, the release of the valuation allowance that was accounted for as a discrete item would provide a deferred tax benefit in Q3 (i.e., the period the business combination was consummated).

A Bifurcated Rate Approach:

Under this approach, in addition to the release of the valuation allowance that was accounted for as a discrete item in Q3 (i.e., the period the business combination was consummated) the deferred tax benefit of $600 would be recognized at the rate of $300 ($750 x 40%) during each of the last two quarters.

Example 17-11: Interim Period Tax Accounting for Acquisition-Related Transaction Costs

Background/Facts:

Company A, an SEC registrant, has incurred during the first interim period of the current year certain transaction costs (mainly legal and accounting) in connection with a planned acquisition of all of the stock of Company B, which is expected to close in the fourth quarter. Company A expects to incur additional accounting and legal fees in the remaining interim periods. These costs will be incurred regardless of whether the business combination is consummated; however, certain other costs, such as “success-based” fees payable to investment bankers, will only be incurred if the acquisition closes.

Company A follows an accounting policy under which it records the tax effects of transaction costs based upon an assumption that the business combination will not be consummated (presuming they would be deductible on that basis). Accordingly, it recognizes a U.S. federal deferred tax benefit in the period it incurs the costs and only revisits that accounting if and when the business combination is ultimately consummated (i.e., the first accounting alternative described in Section TX 10.4.6).

Question:

Company A has had several prior acquisitions and as a result considers acquisition-related costs to be a component of its ordinary income (i.e., the costs are not viewed as “unusual or infrequent”). Should Company A include the tax effect of all anticipated transaction costs in calculating its estimated annual effective tax rate (AETR) as of the end of the first quarter?

Analysis/Conclusion:

It depends. For purposes of calculating its AETR, Company A should include only the tax effects of transaction costs that are not dependent on successful completion of the acquisition. The tax effects of anticipated success-based fees should not be included since those fees are contingent on successful completion of a business combination. In general, no effect should be recognized in the financial statements for a business combination until the period in which the business combination occurs.

Note: We believe likewise that the anticipated tax benefit from success-based fees should not be included in the AETR calculation even when the entity elects an accounting policy that considers the likely form of a transaction were it to be consummated (i.e., the second accounting alternative described in Section TX 10.4.6).

17.5.2 Different Financial Reporting and Tax Year-End

If a corporation’s tax year-end date differs from its financial reporting year-end date, the basis for its tax computation and the application of the estimated annual effective tax rate approach in interim statements are impacted.

The essential question is this: Should the tax provision be based on the tax year or on the financial reporting year? In either case, the tax provision included in the annual financial statements will comprise:


If the tax provision is based on the tax year, the ETR calculation will spread the annual provision for the tax year to interim periods within that tax year, and the provision accrued at the financial reporting year-end will be an interim provision based on the estimated annual effective tax rate for the tax year that ends after the financial reporting year-end. If the tax provision is based on the financial reporting year, the provision accrued at the financial reporting year-end will be a discrete-period computation, and the tax credits and permanent differences recognized in that accrual will be those generated between the tax year-end date and the financial reporting year-end date. The ETR calculation in the latter case will be based on spreading the annual provision included in the financial reporting year’s income statement over the interim periods included within that year. It will also entail estimating at the interim periods of the financial reporting year (1) the provision for the tax year (if it has not occurred by the interim date) and (2) the results of the discrete computation at the financial reporting year-end.

The approach based on the financial reporting year is attractive because the credits and rate differentials recognized are those generated during the financial reporting year.

Since ASC 740 and the authoritative literature do not address how to account for the tax provision if a corporation’s tax year and financial reporting year do not coincide, we believe that both of the approaches described above are acceptable. See Section TX 10.5.3 for considerations in computing temporary differences as of an interim date.

Example 17-12: Calculation of an Income Tax Provision for Short-Period Financial Statements Due to a Change in Fiscal Year

Background/Facts:

On July 15, Company A sold 100 percent of the stock of Company B to an unrelated third-party. In its accounting for the acquisition, Company B will record its net assets at fair value in accordance with ASC 805, Business Combinations. For tax purposes, the net assets will be recorded at carry-over basis.

Company A has a December 31 year-end for both financial reporting and income tax purposes. Historically, Company B was included in the consolidated income tax return of Company A. After the sale, Company B changed its year-end to June 30 for both financial reporting and income tax purposes to coincide with its new parent’s year-end. Company A will be required to include the taxable income for Company B through July 15 in its tax return for the year-ended December 31.

In connection with the sale transaction, Company B is required to prepare stand-alone financial statements. Company B has historically calculated its income tax provision using the separate return method. Company B anticipates that it will file a registration statement in the near future and, therefore, is preparing its financial statements in accordance with SEC reporting requirements. Accordingly, the Company will be required to report audited results for the transition period from January 1—June 30 (see the SEC reporting requirements for transition periods at SEC 3185).

Question:

How should Company B calculate its income tax provisions for the six-month transition period ended June 30? In particular, (1) should the Company use an interim approach in accordance with ASC 740-270 or (2) should the Company use a discrete-period approach?

Analysis/Conclusion:

We believe there are two acceptable approaches:

Approach A: For the six-month period ended June 30, Company B could treat the period as an interim period and calculate its income tax provision using an estimated annual effective tax rate in accordance with ASC 740-270. The basis for this approach is that, as of June 30, there has been no change in the tax reporting period (that is, Company B’s tax year-end is still December 31). Accordingly, the income tax provision would be based on the tax reporting period.

Approach B: For the six-month period ended June 30, Company B could treat the period as a discrete period and calculate its income tax provision as if it would be filing a short-period return as of June 30. The basis for this approach is that, for financial reporting purposes, the six-month period ended June 30 is treated as a discrete period (i.e., a six-month annual period). Accordingly, the income tax provision would be based on the financial reporting period.

Under either approach, Company B would need to prepare footnote disclosures as of June 30 for audited financial statements as required by ASC 740 and Regulation S-X, Rule 4-08. Accordingly, if Approach A is selected, Company B would need to estimate its individual temporary differences using one of the methods described in Section TX Section TX 10.5.3, which provides guidance for determining temporary differences in an interim period.

17.5.3 When Disclosure of Components of Interim Tax Expense Is Required

If interim statements are used in lieu of annual statements (i.e., in a registration statement), companies need to disclose the components of interim income tax expense in the same way that companies present the disclosures required in annual statements by SEC FRP 204, Disclosures Regarding Income Taxes. To that end, companies must perform the following tasks:

Divide the aggregate interim income tax expense calculated using the estimated annual effective tax rate approach between jurisdictions.

Determine the current and deferred portions of the interim income tax provisions.

It is our view that allocating the computed interim tax to U.S. and foreign operations should usually be based on the ratio of each jurisdiction’s estimated tax to the consolidated worldwide tax used to calculate the worldwide estimated annual effective tax rate. In this situation, we would expect a company’s disclosure to explain how the interim disclosures are prepared differently than the year-end disclosures, which would also be presented.

17.6 Disclosures

Financial statement disclosures required during interim periods are generally prepared under the assumption that financial statement users have read or can access the audited financial statements for the preceding year. For this reason, tax-related disclosures are not expected to be as robust as the disclosures required at year-end.

SEC Regulation S-K, Item 303, requires that a company include in MD&A detailed disclosure of material changes in financial condition and the results of operations. If a company’s MD&A for the preceding annual period disclosed the company’s critical accounting policies, as required by FRR 60, Cautionary Advice Regarding Disclosure about Critical Accounting Policies, the disclosures need not be repeated in subsequent quarterly periods. However, if material changes have occurred, the discussion of critical accounting policies should be updated. A similar analysis is required under FRR 67, Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations.

Detailed footnote disclosure required by Regulation S-X, Rule 4-08 (h), and by other rules under Regulation S-X, do not apply to interim reporting on Form 10-Q. However, the SEC rules require companies to make sufficient disclosures to ensure that the financial information is not misleading to financial statement users. Material events that occur subsequent to the end of the most recent fiscal year should be disclosed.

If important developments occur during the year or if the amounts reported for the interim periods do not adequately represent future results, disclosure of these matters should be considered. Interim period disclosures about items associated with income tax often relate to the following:

Tax effects of significant unusual or infrequent items that are recorded separately or items that are reported net of their related tax effect (ASC 740-270-30-12)

Significant changes in estimates or provisions for income taxes (ASC 270-10-50-1(d)) (e.g., changes in the assessment of the need for a valuation allowance that occur during the period)

Significant variations in the customary relationship between income tax expense and pretax accounting income, unless they are otherwise apparent from the financial statements or from the nature of the entity’s business
(ASC 740-270-50-1)

Impact that recently issued accounting standards will have on the financial statements of the registrant when adopted in a future period (SAB No. 74)3

3 SAB 74 requires disclosure of the impact on financial position and the results of operations of accounting standards that have been issued but not yet adopted. The objectives of the disclosure should be (1) to notify the reader of the issuance of a standard that the registrant will be required to adopt in the future and (2) to assist the reader in assessing the impact that the standard will have on the registrant’s financial statements after it is adopted. See PwC SEC Volume 6200.21 for more details.

Material changes to (1) uncertain tax benefits (UTBs), (2) amounts of UTBs that
if realized would affect the estimated annual effective tax rate, (3) total amounts
of interest and penalties recognized in the statement of financial position,
(4) positions for which it is reasonably possible that the total amount of UTBs will significantly increase or decrease within the next 12 months and (5) the description of tax years that remain open by major tax jurisdiction