Excerpt from Accounting Standards Codification
4 Temporary differences
4.3 Scheduling the reversal of temporary differences Excerpt from Accounting Standards Codification Excerpt from Accounting Standards Codification
Income Taxes — Overall
Implementation Guidance and Illustrations 740-10-55-8
To the extent that evidence about one or more sources of taxable income is sufficient to eliminate any need for a valuation allowance, other sources need not be considered. Detailed forecasts, projections, or other types of analyses are unnecessary if expected future taxable income is more than sufficient to realize a tax benefit.
740-10-55-9
The terms forecast and projection refer to any process by which available evidence is accumulated and evaluated for purposes of estimating whether future taxable income will be sufficient to realize a deferred tax asset. Judgment is necessary to determine how detailed or formalized that evaluation process should be. Furthermore, information about expected future taxable income is necessary only to the extent positive evidence available from other sources (see paragraph 740-10-30-18) is not sufficient to support a conclusion that a valuation allowance is not needed. The requirements of this Subtopic do not require either a financial forecast or a financial projection within the meaning of those terms in the Statements on Standards for Accountants' Services on Prospective Financial Information issued by the Auditing Standards Board of the American Institute of Certified Public Accountants.
740-10-55-138
Temporary differences usually do not reverse in equal annual amounts as in the Example above, and a different average graduated tax rate might apply to reversals in different future years. However, a detailed analysis to determine the net reversals of temporary differences in each future year usually is not warranted. It is not warranted because the other variable (that is, taxable income or losses
exclusive of reversing temporary differences in each of those future years) for determination of the
average graduated tax rate in each future year is no more than an estimate. For that reason, an aggregate calculation using a single estimated average graduated tax rate based on estimated average annual taxable income in future years is sufficient. Judgment is permitted, however, to deal with unusual situations, for example, an abnormally large temporary difference that will reverse in a single future year, or an abnormal level of taxable income that is expected for a single future year. The lowest graduated tax rate should be used whenever the estimated average graduated tax rate otherwise would be zero.
Generally, ASC 740 does not require a detailed scheduling of the reversals of existing temporary differences. ASC 740-10-55-138 states that “a detailed analysis to determine the net reversals of temporary differences in each future year usually is not warranted. It is not warranted because the other variables (that is, taxable income or losses exclusive of reversing temporary differences in each of those future years)… is no more than an estimate.” ASC 740-10-55-8 states that “detail forecasts, projections, or other types of analyses are unnecessary if expected future taxable income is more than sufficient to realize a tax benefit.” However, assessing whether a valuation allowance is required for deferred tax assets or determining the applicable tax rate when phased-in rate changes are significant might require companies to determine the future reversal years of existing temporary differences. Scheduling also might be required to determine the classification of a deferred tax asset or liability when the deferred taxes are not related to a specific asset or liability on the balance sheet. However, in that case,
scheduling would only be required for the year following the balance sheet date to determine the current-noncurrent classification of deferred taxes on the balance sheet. See Chapter 18, Financial statement presentation, for a further discussion of classification considerations.
4.3.1 Determining reversal dates
Excerpt from Accounting Standards Codification
Income Taxes — Overall
Implementation Guidance and Illustrations 740-10-55-13
The particular years in which temporary differences result in taxable or deductible amounts generally are determined by the timing of the recovery of the related asset or settlement of the related liability.
However, there are exceptions to that general rule. For example, a temporary difference between the tax basis and the reported amount of inventory for which cost is determined on a last-in, first-out (LIFO) basis does not reverse when present inventory is sold in future years if it is replaced by purchases or production of inventory in those same future years. A LIFO inventory temporary difference becomes taxable or deductible in the future year that inventory is liquidated and not replaced.
The future years when temporary differences reverse generally are determined by the timing of the recovery of the related asset or settlement of the related liability;6 however, there are some exceptions (ASC 740-10-55-13). One exception would be the temporary difference related to LIFO inventory. The FASB believes that this temporary difference reverses when the inventory is liquidated and not replaced rather than when the inventory is sold and replaced by subsequent purchases or production.
The future years when temporary differences reverse may be known based on the transactions underlying the temporary differences. For example, the reversal of installment sales, prepaid
subscription revenues, and the deferred gain on a sale-leaseback transaction generally would reverse
6 See Section 4.3.2, Examples of temporary difference reversal patterns, for examples of reversal patterns for various temporary differences.
based on their respective contractual terms. However, for certain temporary differences, the future reversal dates will have to be estimated. Generally, estimates should be based on experience and other pertinent factors, including a company’s ability to control reversal of existing temporary differences. For example, the reversal of temporary differences related to warranty accruals would be based on warranty terms and past experience in incurring costs. The reversal of a temporary difference related to bad debt reserves should consider charge-off experience and estimates of when losses on specific loans or receivables will become deductible, as well as a company’s ability to apply tax-planning strategies to maximize the benefit of the charge-off.
The reversal periods of other temporary differences can be determined based on appropriate estimation techniques, considering the nature of the temporary differences. For example, a company’s lease portfolio might be comprised of a large number of individually insignificant contracts. If the contracts terms are similar, it generally would be appropriate to calculate the reversal of temporary differences for a representative sample of contracts and estimate the reversal of the aggregate temporary difference based on the calculated reversal patterns of the representative lease contracts.
For purposes of scheduling the reversal of assets and liabilities that are measured at their present values at the date of the balance sheet, the use of either the loan amortization or the present value method may be used. Under the loan amortization method, future payments (collections) would be presumed to relate first to interest and then to principal. The amount represented by the principal portion represents the amount of the temporary difference that is presumed to reverse. Under the present value approach, reversal would be presumed to occur based on the present value of future payments (collections).
4.3.2 Examples of temporary difference reversal patterns
Determining the reversal patterns of temporary differences, if necessary to do so, will require the use of estimates and judgments. The guidance in ASC 740 does not specify how different types of temporary differences should be scheduled to reverse, only that the method used should be systematic and logical.
A general approach to determining reversal dates for various types of temporary differences is summarized below. Qualified tax planning strategies also should be considered to change reversal patterns to reduce the amount of a valuation allowance for deferred tax assets.
• Allowance for bad debts/loan losses — Reversal periods for temporary differences should be estimated based on projected charge-offs related to existing receivables/loans. Future originating differences for expected additions to the allowance are considered only to the extent that future taxable income (exclusive of reversals of existing temporary differences) is considered as a source of taxable income in determining the deferred tax asset valuation allowance (see Section 14.4, Bad-debt reserves of savings and loan associations, for additional discussion).
• Capital leases — The net temporary differences related to a capital lease could be viewed as two separate temporary differences. From the standpoint of a lessee, a capital lease would be viewed as follows: a capitalized asset and a capitalized lease obligation, each with a tax basis of zero (assuming the lease is an operating lease for tax purposes). The capitalized leased asset would reverse based on the scheduled amortization for the asset. The capitalized lease obligation would reverse either based on i) the future years in which the principal amount of the obligation will be paid (referred to as the loan amortization method), or ii) the present value of the scheduled lease payments (referred to as the present value method). From the standpoint of a lessor, a sales-type or direct financing lease would be viewed as an investment (receivable) for financial reporting purposes with a zero tax basis and for tax purposes (assuming it is an operating lease for tax purposes) an asset subject to lease with a zero carrying value for financial reporting purposes. (See Section 3.2.1, Leveraged leases, for discussion of leveraged leases.)
• Company-owned life insurance — The cash surrender value of company-owned life insurance in excess of premiums paid is considered a temporary difference if the cash surrender value is expected to be recovered by surrendering the policy. That excess amount is not a temporary difference if the cash surrender value is expected to be recovered without tax consequence by holding the policy until the death of the insured. If the cash surrender value is expected to be recovered by surrendering the policy, companies should schedule reversal of the taxable temporary difference in the period that the policy is expected to be surrendered.
• Contingency accruals — Deductible temporary differences arising from accruals for losses under ASC 450 should be scheduled to reverse in period(s) in which the liabilities are anticipated to be settled.
• Deferred compensation — Deductible temporary differences arising from deferred compensation should be scheduled to reverse in the period principal payments of the liability give rise to tax deductions. Use of either the loan amortization or the present value method of determining the principal payments is appropriate.
• Depreciation — The reversal pattern of temporary differences related to depreciation should be scheduled whereby future-originating differences would not be scheduled. Alternatively, originating and reversing differences could be scheduled. Future originating differences and reversals for existing assets and expected additions would be considered to the extent that future taxable income (exclusive of reversals of existing temporary differences) is considered as a source of taxable income in determining the deferred tax asset valuation allowance (see Section 6.1, Sources of taxable income, for further discussion of sources of future taxable income).
• Indefinite lived intangible assets and tax deductible goodwill — Some intangible assets are amortized for tax purposes and only subject to impairment write-downs for financial reporting purposes. To the extent the book basis exceeds those assets’ (other than non-deductible goodwill) tax basis (that is, the intangible is amortized for tax purposes before an impairment write-down is recognized for book purposes), a deferred tax liability is recognized for financial reporting purposes, which will reverse when i) the asset is disposed, or ii) as impairment write-downs are recognized in earnings. By their nature, indefinite lived intangible reversal periods are indefinite (that is, the reversal of the deferred tax item cannot be scheduled in a particular period). (See Sections 4.2.6, Impact on deferred taxes of ability to delay payment, and 6.3.1, Limitations on taxable temporary differences related to indefinite lived assets as a source of future taxable income (Updated October 2011), for further discussion.)
• Installment sale receivables — Reversal should be scheduled based on contract terms.
• Amortizing intangible assets — Some intangible assets are amortized for book but not tax purposes.
Instead, tax deductions are permitted only when the assets are disposed of. Existing net deductible temporary differences for intangible assets generally should be scheduled based on the expected disposal dates.
• Inventories — LIFO basis differences — Reversal occurs when the inventory is liquidated and not replaced. The reversal does not occur if present inventory is sold in the future and replaced by purchases or production of inventory in those future years.
• Inventories — obsolescence reserves — Temporary differences for obsolescence reserves should be scheduled to reverse based on the estimated disposal dates of the obsolete inventory.
• Investments accounted for under the equity method — Temporary differences related to
investments accounted for by the equity method generally should be scheduled to reverse consistent with the portion of investment representing a temporary difference most likely would be recovered (i.e., by receipt of dividends or by sale of the investment). (See Sections 14.6, Investments in domestic subsidiaries, and 14.6.1.2, Outside –basis differences in equity method investees — Applicable rate, for further discussion.)
• Investment tax credits — basis reduction — Temporary differences resulting from ITC basis reduction provisions of the tax code should be scheduled to reverse as part of the depreciation temporary difference reversals. Scheduled tax depreciation should reflect lower tax deductions as a result of the ITC basis reduction. (See Section 4.2.8 Government assistance received (investment tax credits and government grants) (Updated October 2011), for further discussion.)
• Investment tax credits — deferral method — Deferred ITC (including amounts related to leases) is considered as a reduction of the financial statement asset cost, and any difference between the book and tax basis of the asset is considered a temporary difference. The temporary difference for deferred ITC would reverse as part of the depreciation temporary difference reversals, in the form of lower scheduled amounts of future book depreciation. (See Section 4.2.8, Government assistance received (investment tax credits and government grants), (Updated October 2011), for further discussion.)
• Land — Basis differences related to land should be scheduled to reverse based on the expected disposal date. Reversal generally would be scheduled in an indefinite future year for land held for operations.
• Pensions and Other Post-Employment Benefits (OPEBs) — A detailed analysis should be performed based on how and when the pension assets will be recovered or the pension (OPEB) liabilities will be settled (funded). (See Section 15.2.4, Deferred taxes for postretirement benefit plans, for further discussion.)
• Sales returns and allowances — Reversal should be based on estimated return patterns.
• Stock appreciation rights — Compensation expense recognized for financial reporting generally is not deductible for tax purposes until rights are exercised. Companies should schedule reversal in periods that employees are expected to exercise the rights, considering applicable contractual limitations.
• Stock options — Stock options may provide companies with a tax deduction as employees exercise options. Reversal of deductible temporary differences for accrued compensation expense should be scheduled to reverse in the period options are expected to be exercised. See Chapter 21, Share-based payment, for further discussion of the accounting for tax benefits of stock options.
• Vacation accruals — Reversal should be estimated based on plan terms and the likely date the existing accrual will be deductible.
• Warranty accruals — Reversal should be estimated based on contract terms and experience.