ASC 740 inaccuracy remains a leading cause of company financial restatements and material weaknesses. ASC 740 governs how companies recognize the effects of income taxes on their financial statements under U.S. GAAP.
Mistakes in this area can be catastrophic to a company, not only due to the expenses related to financial restatements, but also due to the reputational and share impacts.
That is why it's imperative for tax professionals to get tax provision, which is key to achieving ASC 740 compliance, right the first time.
What is a Tax Provision?
The tax provision is part of the audited financial statements and therefore it impacts the company’s earnings and earnings per share. The tax provision is typically the most scrutinized process that the tax department undertakes. The CFO, CEO and audit committee all have an interest in understanding exactly what is driving the company’s tax rate and the significant components of the tax provision.
An income tax provision represents the estimated amount of income tax expense that a company is required to accrue under GAAP for the current year. This includes federal, state, local, and foreign income taxes. This means that for each financial statement year end, ASC 740 requires companies to calculate an effective tax rate and perform certain calculations to arrive at the full year current and deferred tax expense for each jurisdiction it does business in. The current expense will generally equal the estimated amount of tax owed to each jurisdiction, whereas the deferred taxes are tax impacts arising from future or past business activities based on the activities in the financial statement period. Deferred taxes generally relate to tax impacts arising from net operating losses, tax credits and other temporary differences, where the timing of the recognition of a deduction or income item for tax purposes differs from the timing that the item is recognized for GAAP purposes.
Ultimately, certain tax adjustments impact the ASC 740 calculation, but do not impact the tax rate. Since the tax rate impacts earnings, the types of tax adjustment that impact the rate get significantly more scrutiny than the those that do not.
Why is the provision process difficult?
Time Pressures
Time constraints are the top reason provision is such a challenging task. Since earnings announcements typically happen soon after year-end, tax departments only have a few days or weeks at most to perform the complex year-end provision calculations required under ASC 740. Getting started early is generally not feasible as pretax income is the starting point for the ASC 740 process.
Differences in Interim Periods vs. Year-End Reporting
Most financial statement processes can be optimized over time by adding incremental improvements each month-end or quarterly close. Due to the relatively short period of time in the process cycle, things that aren’t working well can be ironed out over the course of several months. This simply isn’t the case for tax provisions. Unlike other areas of the financial statements where the process of closing the books is fundamentally the same each quarter, ASC 740 specifically requires a different process for interim reporting.
For interim periods, companies are only required to calculate an estimated tax rate based on the company’s forecast of earnings. In other words, interim calculations are essentially estimates with much less detail and scrutiny than year-end reporting. While this makes for an easier process in the short-term, in the long-term, the annual cycle time makes year-end provision process improvements more difficult to achieve.
Inflexible Solutions
Last minute changes in year-end pretax income are common for large corporations. Unfortunately, changes in pre-tax income must be reflected in the tax provision and pushing them through the process efficiently and accurately can be a challenge. Comparative tax rate reporting is an essential element of control for these types of changes, but is often difficult to achieve in a manual spreadsheet environment or even with existing technology solutions.
Accounting, Tax and Technical Expertise are Musts
The tax provision process requires deep knowledge of both tax technical rules and the accounting rules under ASC 740. This means that practitioners need to keep up to date on legislation changes in the various jurisdictions in which their company operates in. In addition, knowledge of Federal tax law and potential future changes, like President Biden’s “Build Back Better Act” currently under consideration, is needed. Whether it is the Tax Cuts and Jobs Act (“TCJA”), Covid-related stimulus changes, or a future tax law act, tax planning in the wake of seemingly never-ending iterations on both the federal and state level takes an inordinate amount time.
Beyond just applying tax law to the company’s business outcomes, ASC 740 introduces concepts such as valuation allowances, uncertain tax benefits and permanent reinvestment that require their own complex technical analysis under GAAP. Provision calculations require in depth knowledge of both income tax technical rules in the various jurisdictions and a deep understand of ASC 740 as proscribed by the FASB.
Prior to the TCJA, generally, temporary items such as net operating losses (NOLs) and differences related purely to the timing of deductions and income items did not impact the rate. As such, the main focus of the provision process was on a much smaller set of items impacting the income tax rate. However, the TCJA introduced several concepts that changed the fundamental relationship between temporary items and the tax rate.
For example, the Global Intangible Low Tax Income (“GILTI”) rules introduced under the TCJA are a complex set of tax rules which may impose a U.S. tax on certain foreign operations. These rules also include potential deductions that may provide partial relief from the GILTI tax. However, that deduction is calculated based on the amount of taxable income for a given year. If income is relatively low or the company reports an NOL, the company may permanently lose the opportunity to claim the related deduction. In this case, temporary items which otherwise would not directly impact the income tax rate, may result in a rate impact indirectly due to their impact on the GILTI deduction.
There are other complex interactions between technical tax areas introduced by the TCJA such as the interaction between NOLs, interest disallowance rules under Section 163(j) and foreign derived intangible income (“FDII”). It is imperative that the tax professionals performing the provision calculations understand how these rules may interact with one another.
Cross-Functional Requirements Introduces Risk
For most large enterprises, the year-end calculation requires significant coordination with financial reporting and forecasting teams, foreign controllers and outside firms. Since this process only occurs once a year and is typically done in short timeframe, there are often training gaps, turnover issues and business changes – all of which introduce risk and the potential for material weaknesses.
Spreadsheet Reliance
It’s more important than ever to have strong effective processes for the parts of the provision process that can be automated. This often means utilizing the most sophisticated tools available. Yet, most companies still turn to spreadsheets to perform the majority of its tax provision work.
Tax professionals often like spreadsheets due to the high flexibility and ease of use. Ironically, that same flexibility is what creates risk due to incorrect formulas, version control issues and other typical spreadsheet pitfalls. In addition, spreadsheets do not easily adapt to business structure changes such as entering new jurisdictions or adding new legal entities.
The challenges outlined above are just a few of the reasons that income tax provision calculations are downright hard. Gathering and managing data, inflexible existing models and long software implementations only compound the issue.
The Best Defense is a Good Offense
Avoiding the negative consequences related to inaccurate tax provision calculations requires the right tax expertise and the right technology tools. Understanding the intricate requirements of ASC 740 is not enough. The sheer complexity and volume of data required to accurately calculate tax provision requires extensive accounting, technical and tax expertise and the most advanced tools available. Manual spreadsheets can help, but will likely become problematic at some point in the tax provision process. Even for companies in a loss position, or for private companies, preparing accurate annual and interim income tax provision mitigates the need to recreate data from prior years if the company later becomes profitable or decides to go public.
In light of another round of potential tax law changes under the Biden-Harris Administration, savvy finance and tax executives are proactively evaluating their ASC 740 and tax provision processes to ensure their team is equipped with the right expertise and tools to get the job done right. Having to restate financials or disclosure a material weakness is a painful process that executives want to avoid at all costs.
Nick Frank is a Product Lead with Bloomberg Tax & Accounting.