Accounting for Income Taxes (ASC 740):  Some Momentum toward Simplification

The designated body for establishing the accounting for income taxes (ASC 740) standards, the Financial Accounting Standards Board (FASB), is charged with establishing rules intended to give investors and other users of financial reports useful information for decision-making.

Unfortunately, the complexity of ASC 740 makes it difficult to hit this mark. Additionally, financial executives, with constrained budgets, often find it challenging to comply as intended.

Recently, however, the FASB has been meeting to discuss potential changes to ASC 740 and hopefully, to begin a longer-term process toward simplification.  The recent meetings have focused primarily on three areas: (1) share-based compensation, (2) intra-entity asset transfers and (3) balance sheet classification.

Share-based Compensation

Currently, the tax accounting rules for stock options or similar awards provide that an excess tax benefit (commonly referred to as a windfall benefit) is not recognized in the company’s financial statements until the company realizes a reduction in taxes payable. Further, the windfall benefit is recorded as an increase to additional paid-in-capital (APIC), rather than an income tax benefit from continuing operations. A windfall benefit occurs when the tax deduction is in excess of the share-based compensation expense recognized in the financial statements. This treatment, among other things, can create differences in tax attributes (e.g., net operating losses) reported on a tax return versus reported as a deferred tax asset in the financial statements. 

Additionally, a company must track its historic windfall benefits realized (windfall or APIC pool), to determine the financial reporting when the ultimate tax deduction for a share-based compensation award is less than the tax benefit previously recognized in its financial statements (commonly referred to as a shortfall).  When a shortfall occurs, it is recorded as a reduction to APIC to the extent a windfall pool exists, and any excess shortfall is a charge to income tax expense recorded in continuing operations.

The FASB proposal currently under consideration would require the recognition of all windfall benefits and all shortfalls within the income statement, with no impact on APIC. Further, the proposal would eliminate the existing prohibition on recognizing an excess benefit until a cash benefit is realized. The effect of these proposals eliminates the need to track the pool of windfall benefits.

The proposal would simplify the accounting and record keeping requirements related to share-based compensation; however, it will potentially introduce more volatility to a company’s effective tax rate from the recognition of windfalls and shortfalls in continuing operations. Finally, the board agreed to pursue the recommendation to eliminate an existing rule under U.S. GAAP that requires entities to list the excess tax benefits as a cash inflow within the financing activities section of the statement of cash flows. 

Intra-entity Asset Transfers

Currently, there is a prohibition on the recognition of deferred tax impacts on the intra-entity transfer of assets.  For financial statement purposes, the seller defers recognizing tax expense related to the transfer until the asset is depreciated, amortized or sold to a third party. For example, tax paid by a U.S. parent on the sale of assets to an affiliate in a different tax jurisdiction, is not reported as current tax expense. Instead, the exception results in another deferred charge or prepaid tax being recorded, which is then either amortized and included in the effective tax rate over future years as the asset is depreciated, or included in the effective tax rate when it is sold to a third party. 

This exception creates significant complexity as companies must separately track these asset transfers until the asset leaves the group. In an effort to simplify these rules, the FASB is proposing to eliminate this exception.  Therefore, recognition of the current and deferred income tax consequences of an intra-entity asset transfer is to be required when the transfer occurs.

The FASB decided on transition methods and effective dates and agreed to propose a modified retrospective transition approach and provide proper disclosure. The disclosure should include the nature and reason for the accounting change and the effects of the change on any financial statement line item and amounts for current period. The proposal, if ultimately adopted, would make U.S. GAAP consistent with IFRS for the treatment of intra-entity transfers.

The board agreed that if the guidance is finalized, the changes would be effective for financial reporting years beginning after December 15, 2016 (for public companies), and 2017 (for private companies). According to the FASB, early adoption would be permitted.

Balance Sheet Classification

The FASB has lastly focused its simplification efforts on balance sheet classification. Currently, the deferred taxes for each component of an entity are to be presented as a net current asset or liability and a net non-current asset or liability. The model requires deferred taxes to be classified based on the underlying asset or liability, instead of the expected reversal period in which cash taxes will be impacted. The FASB has acknowledged this requirement is both costly to apply and potentially misleading.

The FASB is proposing to require all deferred tax assets and liabilities to be classified as noncurrent. The FASB agreed to propose a prospective transition method and to require entities to provide proper disclosure. The disclosure should contain the nature and reason for the change in accounting principle. However, in lieu of disclosing the effect of the change on the balance sheet, the disclosure should note that the presented balance sheets are not comparable. The proposal, if ultimately adopted, would make U.S. GAAP consistent with IFRS related to classification.

The board agreed that if the guidance is finalized, the changes would be effective for financial reporting years beginning after December 15, 2016 (for public companies), and 2017 (for private companies). According to the FASB, early adoption would be permitted.

In Summary

These simplification proposals are a welcome effort by the FASB and if adopted, will provide some relief in dealing with the oftentimes burdensome compliance requirements under ASC 740.