Case Studies for Book-Tax Differences in the Classroom

Editor: Annette Nellen, J.D., CPA

Financial accounting and tax professionals today face a bewildering maze of computational, disclosure, and reporting requirements related to income tax accrual. GAAP financial statements must comply with Accounting Standards Codification (ASC) Topic 740, Income Taxes (formerly FAS 109, Accounting for Income Taxes, and FIN 48, Accounting for Uncertainty in Income Taxes ), which requires accruals for the tax benefit (liability) of temporary book-tax differences and footnote disclosure of uncertain tax positions. In addition, the effective tax rate footnote must disclose the tax benefit (liability) of permanent book-tax differences. For corporate and passthrough entities with assets greater than $10 million, the IRS requires disclosure of both permanent and temporary book-tax differences on Schedule M-3. The IRS recently released a draft of Schedule UTP, Uncertain Tax Position Statement, which will also require corporate Schedule M-3 filers to provide a detailed analysis of current and prior tax year uncertain tax positions. These disclosure and reporting requirements raise questions as to how to most effectively cover book-tax differences in financial accounting and tax courses and how to prepare accounting graduates for this type of work in the profession.

The Challenge

While the basics of ASC Topic 740 principles are covered in intermediate accounting, the emphasis there typically is on financial reporting disclosure requirements rather than on the identification and measurement of book-tax differences, and those requirements are but one of many balance-sheet deferral items covered. Book-tax differences are usually covered in the second undergraduate tax course or in a graduate tax course, with primary emphasis on how to report such differences on Schedule M-1 or M-3, not on how to determine the deferred tax benefit or liability. Little attention is given to tax accruals for uncertain tax positions in either financial or tax accounting courses.

Spotty coverage of this sort can be traced to several difficulties. While the tax instructor likely is more comfortable working with technical tax content, the financial accounting instructor is likely more comfortable working with the footnote disclosures and may not be current on tax law. This is reflected in the coverage of book-tax differences in financial accounting and tax texts. While the typical financial accounting text has a chapter or two on tax accrual accounting, typically late in the book and too often omitted or shortchanged in the classroom, only a few of the major tax texts devote a chapter to this topic. In the collection PricewaterhouseCoopers Case Studies in Taxation , there are five full cases of varying difficulty that address book-tax differences on financial statements and/or tax returns, but only one case (Estabrook) reviews ASC Topic 740-10, FIN 48 adjustments.

With the likely implementation of the new Schedule UTP for all corporate Schedule M-3 filers, effective for the 2010 tax year, there is a new urgency to have more coverage of tax accrual in both financial and tax courses. The complexity of preparing realistic case studies dealing with uncertain tax positions cannot be underestimated, yet this seems to be the most practical way to tackle the problem. One starting point is Hennig, Raabe, and Everett, “FIN 48 Compliance: Disclosing Tax Positions in an Age of Uncertainty,” 39 The Tax Adviser 24 (January 2008), which illustrates various book-tax differences and how FIN 48 (now ASC Topic 740-10) applies to each difference. Still, the tax accrual for an uncertain tax position requires the exercise of professional judgment, which most students lack.

Thus, it would appear that the best way to teach the topic in an advanced tax course is to use the case method, in which the most basic book-tax differences are illustrated and the student is sequentially walked through tax accrual and ASC Topic 740-10 computation. The timing of this course puts the student close to graduation and entry into the profession, where the new graduate could quickly apply the information.

In this column, the authors use a multistep process to identify and explain:

• Tax accrual for a temporary difference for a deferred tax asset that is not an uncertain tax position;
• Computation of a valuation allowance when there is a more likely than not (MLTN) belief that the tax benefit will not be recognized in the future;
• Tax accrual for a temporary difference for a deferred tax liability that is an uncertain tax position;
• Tax accrual for a temporary difference for a deferred tax asset that is an uncertain tax position;
• Tax accrual for a permanent difference and computation of the effective tax rate;
• Accrual for an uncertain tax position when there is no book-tax difference; and
• Disclosures on Schedule M-3, Schedule UTP, and financial statements.

A Hands-on Solution

The authors have developed a case study that illustrates these steps. The following simplifying assumptions have been made:

• The taxpayer is a corporation with initial financial income of $11 million and an applicable federal tax rate of 35%;
• State and international taxes are not considered;
• Tax accrual is based solely upon current-year deductions;
• The appropriate unit of account is each separately identified transaction;
• The “true up” adjustments to the tax expense are included in the current year’s tax accrual; and
• ASC Topic 740-10 accruals for interest and penalties are ignored.

The case study is available online at http://tinyurl.com/C2C-OnlineCaseStudy.

Working Through the Case Study

Step 1: Tax accrual for a temporary difference for a deferred tax asset that is not an uncertain tax position (bad debt expense):

In the case study, Step 1 is illustrated with a bad debt expense. For financial accounting, the bad debt expense is the change in the beginning and ending allowances for doubtful accounts and is a contra-account to accounts receivable, while the tax deduction for bad debts is limited to those accounts that have been written off in the current tax year. If the addition to the allowance for doubtful accounts is $25,000 while the actual amount written off was $5,000, there is a temporary book-tax difference of $20,000, which results in a deferred tax benefit of $7,000 ($20,000 × 35%). The first journal entry in Exhibit 1 illustrates the tax expense when there are no book-tax differences, and the second entry illustrates how the book-tax difference for bad debts affects both the tax expense and the taxes payable, with the difference recorded as a deferred tax asset.

Step 2: Computation of a valuation allowance when there is a MLTN belief that the tax benefit will not be recognized in the future (net capital loss deduction):

Step 2 is illustrated by a net capital loss deduction. Assume the corporation has a net capital loss of $40,000. For financial accounting purposes, the capital loss is recognized in full in the year in which it occurred, while for tax accounting purposes, net capital losses can be carried back three years and forward five years to offset capital gains. Assuming that the corporation has recognized no capital gains in the prior three years, it must carry the loss forward, and the corporation recognizes no immediate tax benefit on its tax return. If it is more likely than not that the corporation will not have enough capital gains within the carryforward period, a valuation allowance, which is a contra-account to the deferred tax asset, must be established.

The valuation allowance is a nice segue into a discussion of ASC Topic 740-10 because it introduces the MLTN concept in a manner that is straightforward and easy to understand. Assume that management has made a probability distribution of the likelihood of the corporation utilizing the capital loss within the carryover period (see Exhibit 2). Based on this information, a valuation allowance would be established for 45% (1 – .55) of the deferred tax asset. The valuation allowance is recorded with the journal entry shown in Exhibit 3.

Step 3: Tax accrual for a temporary difference for a deferred tax liability that is an uncertain tax position (cost segregation and depreciation):

Step 3 introduces a book-tax difference that creates a deferred tax liability and also introduces the ASC Topic 740-10 concept of an uncertain tax position and how this affects tax accrual. Assume that the corporation acquired a building for use in its manufacturing process and it is depreciating the $5 million cost over 40 years using the straight-line method of depreciation for financial accounting. Also assume that for tax purposes a cost segregation study was performed that resulted in a significant portion of the cost being reclassified as personalty with useful lives of 15 and 20 years (Hospital Corp. of Am. , 109 T.C. 21 (1997)). The book-tax difference between the depreciation expense deducted on the financial statements ($125,000) and the tax return ($225,000) results in a deferred tax liability of $35,000 (($125,00 – $225,000) × 35%).

Based on the Cost Segregation Audit Technique Guidelines used by IRS agents, management believes there is an uncertain tax position regarding the full deductibility of the tax depreciation in the current year and recommends that the two-step process of ASC Topic 740-10-25 (recognition and measurement) be applied. Management has made a probability distribution of the likelihood of the deduction being allowed in full (see Exhibit 4).

While it is more likely than not that the position would be sustained on its technical merits upon IRS audit, the largest tax benefit that the taxpayer will likely realize is 75%, which is from the row of the table in which the cumulative probability first exceeds 50%. Thus, a portion of the deferred tax liability is reclassified as a tax liability arising from an uncertain tax position (Exhibit 5).

Note that this adjustment does not affect either the tax expense or the taxes payable; it simply reclassifies a portion of the deferred tax liability to an uncertain tax position liability.

Step 4: Tax accrual for a temporary difference for a deferred tax asset that is an uncertain tax position (contingent liability related to environmental contamination):

Step 4 builds upon the discussion of FIN 48 by illustrating the accrual for an uncertain tax position when the book-tax difference gives rise to a deferred tax asset. Assume that the corporation accrues an expense for a contingent liability arising from potential environmental contamination from the company’s manufacturing processes. Management believes it is more likely than not that the payment satisfying the judgment will be deductible. Since the payment will not be made until all legal appeals have been exhausted, which management expects to occur within three to five years, no deduction can be taken on this year’s tax return because the economic performance test of Sec. 461(h) has not been met. In addition, management believes that once the payment is made, a portion of the amount could be deemed to be a nondeductible capital expenditure (Sec. 263). Management has made a probability distribution of the likelihood of the deduction being allowed in full (see Exhibit 6).

While it is more likely than not that the position would be sustained on its technical merits, the largest tax benefit that the taxpayer will likely realize is 50%, which is from the row of the table in which the cumulative probability first exceeds 50%. Unlike the ASC Topic 740-10 adjustment for a deferred tax liability, the adjustment is made to a contra-account, much like the valuation adjustment, and increases the financial tax expense (see Exhibit 7).

However, there is a significant computational difference between the valuation allowance and the ASC Topic 740-10 adjustment. The valuation allowance uses the MLTN weighted average of 52%, while the measurement step of ASC Topic 740-10 uses the percentage in the first row in which the cumulative probability is greater than 50% is met. In this case the percentages are not significantly different. Given a different fact pattern, the percentages could be significantly different.

Step 5: Tax accrual for a permanent difference and computation of the effective tax rate (domestic production activity deduction):

Step 5 introduces the concept of a permanent difference. The domestic production activity deduction of Sec. 199 can be used because this deduction is never taken when computing financial net income. However, it does affect the effective tax rate as reported in the tax footnote. Management believes the IRS could take the position that the deduction is not allowable because of uncertainty about whether the income is from a qualifying domestic production activity. Management has made a probability distribution of the likelihood of the deduction being allowed in full (see Exhibit 8).

While it is more likely than not that the position would be sustained on its technical merits, the largest tax benefit that the taxpayer will likely realize is 85%, which is from the row of the table in which the cumulative probability first exceeds 50%. Thus, an additional tax expense is recognized for a tax liability arising from an uncertain tax position (see Exhibit 9).

Step 6: Accrual for an uncertain tax position when there is no book-tax difference (partnership loss):

Step 6 illustrates that ASC Topic 740-10 also applies to an uncertain tax position even when there is no book-tax difference. Assume that the corporation has a $100,000 ordinary loss deduction from a partnership. Management believes that the IRS could challenge the deductibility of a portion of the loss because the corporation is a limited partner, and the computation of its basis in the partnership interest includes a nonrecourse debt allocation (Sec. 752) and a special allocation of depreciation deductions that could potentially not meet the substantial economic effect test under Sec. 704(c) or the economic substance doctrine of Sec. 7701(o)(1)(D).

Management believes there is a reasonable basis for taking the deduction but lacks substantial authority for its position. Therefore, it must file Form 8275, Disclosure Statement, for the deduction. Management has made a probability distribution of the likelihood of the deduction being allowed in full (see Exhibit 10).

ASC Topic 740-10 requires accrual of a tax liability for an uncertain tax position for the entire amount of the tax because the MLTN threshold test is not met (see Exhibit 11 on p. 571).

Step 7: Disclosures on Schedule M-3, Schedule UTP, and financial statements:

Step 7 requires preparation of the Schedule M-3 and Schedule UTP tax forms and the financial statement disclosures. The Schedule M-3 disclosures for the transactions illustrated in the case are fairly straightforward and are summarized in (see Exhibit 12).

The Schedule M-3 disclosures for the current and noncurrent tax expense are more complex. (See sample Schedule M-3). The schedule is for 2009 because the 2010 forms are not yet available.) The current tax expense of $3,599,500 is reported on line 1 of Part III. Since the financial statements are prepared months before the tax return is filed, this number is at best an estimate of the taxes payable. When the tax return is filed, the difference between the estimated amount and the actual payable is a “true-up” adjustment that is made in the subsequent year. Since this is a concept that may be beyond the grasp of the typical tax student, the current tax expense and the taxes payable are the same.

The noncurrent tax expense of $43,050 reported on line 2 of Part III is the net of the tax accruals for the deferred tax assets/liabilities and the tax liability for uncertain tax positions, as summarized in Exhibit 13.

The Newest Development: Schedule UTP

The new Schedule UTP disclosures are more complex and are summarized in Exhibit 14 for each uncertain tax position. (See sample Schedule UTP).

It is interesting to note that the tax expense for the total amount of the item, not just the tax expense for the portion of the item that represents the uncertain tax position, is disclosed. While each book-tax difference was for $100,000, the FIN 48 accrual was less than the entire amount of the tax expense as is required by the form in every case but one. In a speech before the Tax Executives Institute on April 12, 2010, IRS Commissioner Douglas Shulman characterized the new disclosure initiative as a “reasonable approach” that will give the IRS the information needed “without asking taxpayers to divulge the strengths or weaknesses of their uncertain tax positions.”

The new schedule also applies to any accrual of a tax reserve in the financial statements, even if it is outside the FIN 48 framework. Thus, disclosures on Schedule UTP would also be required for transactions reported on Form 8275 to avoid tax penalties under the reasonable basis standard or on Form 8886, Reportable Transaction Disclosure Statement.

Conclusion

Pressures have been applied over the last decade to include more detailed financial statement disclosures of book-tax differences for all types of business entities. The challenge now is to add this perspective to an already “loaded” sequence of tax courses, such that a newly graduated tax professional can grasp technical tax matters and the interactions between financial and tax reporting functions. The IRS-mandated disclosure of book-tax differences on Schedule M-3 and the disclosures of some uncertain tax positions on Schedule UTP make it imperative that these topics be incorporated into the tax curriculum. A case study approach, as used by the authors and shared in some detail in this column, can facilitate this process. The authors welcome and appreciate comments and suggestions on how to incorporate this important topic into the tax curriculum.

EditorNotes

Annette Nellen is a professor in the Department of Accounting and Finance at San Jose State University in San Jose, CA. She is a former member of the AICPA Tax Division’s Tax Executive Committee and a current member of the AICPA Tax Division’s Individual Income Tax Technical Resource Panel. Cherie Hennig is a professor at the University of North Carolina–Wilmington. William Raabe is a professor of tax at Ohio State University in Columbus, OH. John Everett is a professor at Virginia Commonwealth University in Richmond, VA. For more information about this column, contact Prof. Hennig at cheriehennig@msn.com, Prof. Raabe at raabe@fisher.osu.edu, or Prof. Everett at jeverett@vcu.edu.