Constructing the effective tax rate reconciliation and income tax provision disclosure

By Allison L. Evans, CPA, Ph.D.

Editor: Annette Nellen, Esq., CPA, CGMA

While tax information on the financial statements presented under FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes, continues to be a focus of investors and analysts, tax issues also continue to rank as one of the largest causes for financial restatements. Audit Analytics reports that Topic 740-related issues were the second-highest cause of 2017 and 2016 financial restatements (tying with revenue recognition issues in 2017). Further, an analysis by PwC reveals that 22% of 2017 SEC income tax comment letters originated from the effective tax rate (ETR) reconciliation (see Stay Informed: 2017 SEC Comment Letter Trends: Income Taxes, available at www.pwc.com). Because tax practitioners often create or audit the income tax provision and related disclosures, it is important for tax students and professionals to understand how they are constructed.

Intermediate or advanced financial textbooks discuss temporary and permanent differences, deferred tax assets (DTAs), deferred tax liabilities (DTLs), and the corresponding journal entries. Tax textbooks often discuss book-tax reconciliations as they relate to Schedules M-1 or M-3 of Form 1120, U.S. Corporation Income Tax Return. However, coverage of the ETR reconciliation in either case is often high-level (or not covered at all), meaning many students enter the accounting profession without studying or preparing this important component of the financial statements.

This column walks the reader through a discussion of current and deferred tax expense as a bridge to ultimately preparing the rate reconciliation. It illuminates which book-tax differences do and do not affect ETR. Further, this column offers extensions to show how valuation allowances, differences in tax rates across time, and tax credits affect the ETR and how each item is presented in the rate reconciliation. After completing the basic exercises in this primer and the comprehensive examples in the accompanying Excel workbook, the reader will have a firmer grasp on what moves ETR, providing a better understanding of tax planning tools that affect not only tax dollars paid in various periods but also the tax disclosures on the financial statements.

As such, it can serve as an instructional supplement in both financial accounting and corporate tax courses. While Topic 740 applies to any entity that prepares financial statements under GAAP (including C corporations, flowthrough entities, and not-for-profits), this column focuses on publicly traded C corporations. Instructors may choose to assign the accompanying problems or to distribute the problems with solutions to serve as a study guide for the students.

Prerequisite knowledge

Since many tax and financial textbooks offer beneficial, in-depth analyses of common differences between financial and taxable income and how to prepare a book-tax reconciliation, this column assumes a base knowledge of common differences and whether they are temporary or permanent. Users will focus instead on how temporary and permanent differences relate to current and deferred tax expense and ultimately to the ETR calculation.

Which book-tax differences affect the ETR?

To best answer this question, this column considers two basic examples that also serve to review how to calculate current and deferred income tax expense. In Example 1, the company has one book-tax difference that is temporary in nature. In Example 2, another company has one book-tax difference that is permanent. Each corporation is a publicly traded, domestic corporation. Table 1 (below) illustrates the book-tax reconciliation for each company.

Table 1: Book-tax reconciliation


Example 1:
T Corp. begins operations in year 1. It earns $500,000 in revenues in year 1 and in year 2. It incurs $300,000 in ordinary, deductible expenses for its business each year. In year 1, T incurs a $10,000 short-term capital loss. It generates $10,000 of long-term capital gains in year 2.

Example 2: P Corp. begins operations in year 1. It earns $500,000 in revenues in year 1 and in year 2. It incurs $300,000 in ordinary, deductible expenses for its business each year. Each year, it also spends $10,000 for a life insurance policy on its CEO, which is not deductible for tax purposes.

Current and deferred components of the income tax provision (ASC Paragraph 740-10-50-9)

All entities are required to disclose the current and deferred income tax expense components of the total income tax provision from continuing operations. T and P will each calculate current tax liability and expense by multiplying taxable income by the 21% corporate tax rate enacted in the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. T will also record a DTA because the capital loss carryforward will cause taxable income to be lower in the future (relative to future financial income), as Table 1 illustrates. ASC Paragraph 740-10-10-3 requires T to measure its DTA using the currently enacted rate at which the temporary difference will reverse, which under the TCJA is also 21%. Therefore, T will record a year 1 DTA of $2,100 ($10,000 × 21%). To balance the entry, it will credit deferred income tax expense, creating a benefit for the same amount.

In year 2, T will reverse the DTA, which will generate a deferred tax expense that will increase total income tax expense by $2,100 that year. P will not have a deferred expense or benefit because it does not have any temporary differences. Table 2 (below) illustrates the income tax provision for T and P for federal purposes. (All journal entries corresponding to the tables in this column are found in the accompanying Excel workbook.)

Table 2: Required footnote disclosure for components of income tax expense


Calculating the ETR

ETR measures the size of the company's total income tax expense relative to its financial income. T and P will calculate ETR by dividing total income tax expense by pretax financial income from Tables 2 and 1, respectively. Table 3 (below) presents the resulting ETR.

An important point is illustrated by comparing the ETR for these two companies. It is a common misconception that all book-tax differences affect ETR. A comparison of T and P clearly shows this is not the case. As long as tax rates are constant over time, temporary differences do not affect ETR, which is why T's ETR of 21% equals the enacted statutory rate of 21%. Therefore, though accelerating deductions and delaying income are good tax planning strategies in terms of the time value of money and lowering the current-year tax liability, companies that care about the ETR disclosure will not find sufficient value in this approach.

Table 3. Computing ETR: Which difference type causes ETR to differ from the enacted rate?


Similarly, though having to wait to claim a loss is not ideal from a tax perspective, it will not affect the firm's ETR. It is therefore important for tax practitioners to have a clear understanding of a client's priorities (i.e., whether the client places more value on reducing its current tax liability or the ETR disclosed in the financial statements) before dispensing tax advice.

In contrast, permanent differences do affect the firm's ETR, though the effect may not always be beneficial. P Corp., for example, is suffering the effect of having a nondeductible expense. It incurs a relatively higher tax burden than a corporation that could deduct every dollar of expense, even if that deduction occurs in a future tax period. If P instead earned tax-exempt income (e.g., interest on tax-exempt bonds), its ETR would be lower than the statutory 21% rate. Tax credits, another useful ETR-reducer, are discussed on p. 606.

The ETR reconciliation

Basic requirements (ASC Paragraph 740-10-50-12)

Publicly traded entities must present a reconciliation of the company's income tax burden calculated at the statutory rate to its total income tax expense from continuing operations. The reconciliation may be disclosed as either a dollar amount or percentage (or both). As a dollar figure, the reconciliation begins from an as-if calculation, representing the tax burden as if every dollar of pretax financial income is taxable/deductible at the federal rate. The company must then show all significant reconciling items between that hypothetical number and its actual income tax expense for the year. If it is presented as a percentage, the company must reconcile from the federal statutory tax rate to its ETR.

To meet the significance disclosure requirement, corporations must separately disclose items that meet or exceed 5% of the tax at the statutory rate (SEC Regulation S-X, §210.4-08(h)(2)), meaning anything affecting ETR by at least 1.05%, using the 21% statutory rate enacted by the TCJA. (Private companies must disclose the nature of significant reconciling items, but they do not need to provide a numerical reconciliation, according to ASC Paragraph 740-10-50-13.)

To construct the rate reconciliation, T and P each begin by multiplying pretax financial income by the 21% current-year statutory tax rate (T, year 1: $190,000 × 21% = $39,900; T, year 2: $210,000 × 21% = $44,100; P, years 1 and 2: $190,000 × 21% = $39,900). T has no reconciling items in either year because it only has a temporary difference (meaning every dollar of revenue and expense will ultimately be taxed or deducted at 21% at some point in time, which is already embedded in the starting point of the rate reconciliation). Therefore, its ETR equals the 21% statutory rate. For P, tax savings that are lost because one expense is nondeductible equal $2,100 ($10,000 × 21%), which raises the corporation's tax burden by 1.1% ($2,100 lost tax deduction ÷ $190,000 pretax book income) and its ETR to 22.1% each year. Note that the income tax expense presented in the rate reconciliation for T and P equals the total income tax expense in Table 2. (See Table 4, below)

Table 4: Required ETR reconciliation disclosures, years 1 and 2


Effect of valuation allowance (ASC Paragraph 740-10-30-5(e))

A company must record a valuation allowance contra-asset if it is more likely than not that some or all of its DTAs will not be realized. While originating or reversing the DTA will not affect the company's ETR (assuming constant tax rates over time), creating or releasing the related valuation allowance will affect it. To illustrate, the following example adjusts the T fact pattern in Example 1 to incorporate a valuation allowance.

Example 1, adjusted: Based on all available positive and negative evidence, T's management in year 1 believes it is more likely than not that only one-fourth of the carryforward will be used within the five-year carryforward period allowed in Sec. 1212(a)(1)(B).

Because of this assessment, T will record a $1,575 valuation allowance ($10,000 carryforward × 21% × 75% not realizable), which increases its deferred income tax expense. Table 5 (below) illustrates T's year 1 provision and rate reconciliation, given this new assumption. Recording a valuation allowance reduces the $2,100 deferred tax benefit shown in Table 2 to only $525, and it also introduces a reconciling item to the rate reconciliation. Specifically, it raises the entity's tax burden by 0.83% ($1,575 increased expense ÷ $190,000 pretax book income). Please note that the addition of the valuation allowance does not rise to the level of significance per the SEC because it shifted the ETR by less than 1.05%, so it could be described as "other." Throughout this column, all line-item descriptions are retained for explanatory purposes.

Table 5: T Corp., year 1, assuming creation of valuation allowance


Given that T did use the full amount of the carryforward in year 2 (contrary to its assessment in year 1), it would reverse the valuation allowance in year 2 to create a deferred tax benefit of $1,575, and it would record the reversal of the DTA to create a deferred tax expense of $2,100. T's year 2 disclosures are presented in Table 6 (below). Even though the net effect is presented in the deferred provision, the full change in the valuation allowance is included in the rate reconciliation because, by construction, the reversal of a DTA does not affect ETR.

Table 6: T Corp., year 2, assuming creation of valuation allowance in year 1


Although creating or releasing a valuation allowance does not affect the liability on the current year's tax return, it directly affects the year's income tax expense on the income statement, and the results can be dramatic. General Motors, for example, reported the release of a $3.666 billion valuation allowance in 2015, which increased bottom-line earnings by the same amount. General Motors ultimately reported a total $1.897 billion income tax benefit that year (though the hypothetical income tax provision at the 35% federal statutory rate equaled a $1.933 billion expense), equating to an ETR of negative 32.9%.

Effect of differences in US tax rates over time

Because the starting point for the rate reconciliation assumes every dollar of pretax net income for financial purposes is taxed at the currently enacted federal rate (including items that will affect the tax return in a different year), if any item in year 1's pretax financial income is taxed or deducted in a period with a different rate, the rate differential will affect income tax expense and ETR in year 1. The rate differential essentially causes a temporary difference to have a permanent component.

To illustrate, assume T in the original example was not in its first year of existence when it generated the capital loss. It must carry the loss back three years before carrying the remainder forward five years (Sec. 1212(a)(1)). If T generates the loss in the 2019 tax year, for example, it will carry that loss back to 2016, 2017, and 2018, in that order, to offset capital gains in those years. Assume that T had reported an $18,000 capital gain in 2017 (and none in any other year) and paid tax on that gain at its pre-TCJA rate of 35%. T would file an amended 2017 tax return incorporating the $10,000 loss carryback to generate a $3,500 income tax refund in 2019 for the tax previously paid on the offsetting capital gain. It records the $3,500 refund receivable and a corresponding decrease to current income tax expense. Because the $10,000 capital loss in 2019's financial income generates an incremental $1,400 tax savings over the $2,100 benefit assumed in the starting point of the rate reconciliation, T reduces its 2019 ETR by 0.74% ($1,400 ÷ $190,000 pretax financial income). Table 7 (below) illustrates the result.

Table 7: T Corp., 2019, assuming carryback of capital loss to 35% tax year


Though the TCJA has made the 21% corporate tax rate permanent, it is possible that Congress could enact a new rate at some point in the future, so this column now returns to the original T fact pattern but assumes another future decrease in tax rates. If T knew in year 1 that the enacted tax rate for year 2 was being further reduced to 18%, for example, T would have created its DTA (and credited deferred tax expense) based on the 18% rate. Because T could not deduct the loss in year 1 at a 21% rate (which would have created $2,100 in tax savings), it would instead only be able to enjoy a tax savings of $1,800 in year 2. The balance sheet and income statement must reflect this $300 lost tax benefit ($10,000 × 3%) from carrying forward the loss into a year with a lower rate. Table 8 (below) presents the results assuming this future rate decrease. The reduced tax savings become a reconciling item in the rate reconciliation, increasing ETR by 0.16% in year 1 ($300 ÷ $190,000 pretax book income).

Table 8: Income tax disclosures assuming currently enacted statutory rates of 21% in year 1 and 18% in year 2


Effect of a tax rate change

In contrast to the preceding example, now assume that in year 1 the enacted tax rate effective for all future years was 21%. However, in year 2 Congress enacted a rate change, effective immediately, that decreased the statutory rate to 18%. When Congress enacts a tax rate change, whether it is effective in the current year or in a future one, entities must revalue their DTAs and DTLs in the period of enactment to maintain compliance with ASC Paragraph 740-10-10-3. The remeasurement will have a direct effect on the deferred income tax expense and thus will affect the ETR in the enactment year.

Table 9 (below) illustrates the income tax provision and rate reconciliation for T, given this fact pattern. The $2,100 deferred expense in year 2's provision reflects a $300 increase required to decrease the DTA because of the rate change ($10,000 temporary difference now reversing at a 3% lower rate) and the complete reversal of the DTA at year 2's 18% rate. The $300 increase to expense is a line item on the rate reconciliation. (Note that any valuation allowances related to DTAs will have to be revalued as well, and that adjustment will also affect income tax expense and the ETR. The accompanying Excel workbook includes a tab presenting Tables 8 and 9, incorporating the valuation allowance assumption in the adjusted example, as well as the associated journal entries.)

Table 9: Income tax disclosures assuming currently enacted statutory rate of 21% in all periods as of year 1 and a tax rate change to 18% enacted and effective in year 2


Comparing Tables 8 and 9 shows the difference between having foreknowledge of a difference in future tax rates versus reacting to a change enacted in the current year and having to adjust deferred tax balances. Taxpayers experienced the effects of this type of change firsthand in 2017 when Congress enacted a tax rate change as part of the TCJA to a flat 21% effective in 2018. Companies had to reduce their 2017 DTAs, any related valuation allowances, and their DTLs. However, instead of the hypothetical 3% decrease reflected in this column, corporations had a maximum decrease of 14%.

This adjustment caused those in a net DTA position (e.g., International Business Machines, Bank of America, and Ford Motor Co.) to experience a one-time increase to income tax expense and ETR, which negatively affected earnings. (To the extent that a company's DTAs are offset by valuation allowances, the overall effect on income tax expense is muted. Twitter, for example, offset over 88% of its 2017 DTAs with a valuation allowance, and Tesla's valuation allowance offset over 76% of its 2017 DTAs.) In contrast, companies that were in a net DTL position (e.g., Target, Dunkin' Brands Group, and Macy's) enjoyed a one-time discrete benefit to income tax expense and ETR from adjusting deferred tax accounts, which increased earnings in 2017. (Note the TCJA had other effects that are beyond the scope of this column.)

Tax credits

Similar to favorable permanent differences, taking advantage of a tax credit will not only yield permanent tax savings for the client, but it will also reduce the client's ETR. Specifically, a tax credit will reduce the current tax liability and the current income tax expense dollar for dollar. In returning to the original fact pattern in Table 1, if T and P are each entitled to a $500 nonrefundable credit in year 1, the entities would disclose the income tax provision and rate reconciliation shown in Tables 10 and 11 (below), respectively. Consequently, if a client wants tax planning advice that will reduce its ETR as well as its current-year tax liability, credits and permanent differences should be considered rather than temporary tax planning strategies.

Table 10: Effect of $500 credit on income tax provision in year 1


 

Table 11: Effect of $500 credit on effective tax rate reconciliation in year 1


Other common items in the ETR reconciliation

Foreign operations: Generating a portion of income in a foreign jurisdiction with a rate that differs from the 21% domestic rate (and that offers other tax incentives) will affect a corporation's ETR since the starting point of the rate reconciliation assumes a 21% tax rate on all financial income. Earning income in a jurisdiction with a higher (lower) tax rate will increase (decrease) the firm's ETR under the territorial system implemented by the TCJA. Other issues related to foreign income can also affect the ETR (e.g., base-erosion and anti-abuse tax (BEAT), global intangible low-tax income (GILTI), and foreign withholding taxes) but are beyond the scope of this column.

State income taxes, net of federal benefit: State income taxes represent an additional income tax burden beyond the federal 21% rate embedded in the starting point of the rate reconciliation. However, because state income taxes are deductible for federal tax purposes, only the net increase is shown on the rate reconciliation. For example, a company that pays $100 in state taxes can deduct that amount, which reduces its federal tax bill by $21. Therefore, only the incremental tax burden caused by the state tax ($79) would be reflected in the rate reconciliation.

Uncertain tax positions (ASC Paragraph 740-10-50-15): Companies are only allowed to recognize the benefit of tax positions they believe are more likely than not to be realized. These positions can stem from temporary or permanent differences and include decisions as to whether to file in a particular jurisdiction. (If a company does not file because it does not believe it needs to, it benefits from that decision and may be liable for repayment of tax if that decision later proves incorrect.) Even if a tax position's benefits are deemed more likely than not to be recognized, companies can claim in their financial statements only the amount that has more than a 50% cumulative probability of being sustained upon audit. Any benefits that are considered uncertain must be removed from income tax expense, which also affects the rate reconciliation. By extension, when such positions are settled with tax regulators or when the statute of limitation expires, income tax expense and ETR will also be affected.

Building knowledge for ETR reconciliations

After working through these exercises and the accompanying problems in the Excel workbook, users will have a fundamental understanding of income tax expense, its current and deferred components, and items that affect the ETR. They will be able to apply that knowledge to construct the income tax provision and ETR reconciliation. By doing so, they will have a better grasp of which tax planning techniques will also yield financial statement benefits and which items can change this year's ETR with no corresponding change to this year's tax return.

To accompany this analysis, instructors are encouraged to invite a tax practitioner into the classroom to discuss the importance of the income tax disclosures (and the potential costs if a company is required to restate its financial statements because of a Topic 740 error). The tax practitioner can expand on any of the other common reconciling items mentioned in this column and can address further issues encountered in practice, including provision-to-return adjustments after the tax return is filed.

 

Contributors

Allison L. Evans, CPA, Ph.D., is the EY Faculty Fellow and associate professor of accounting at the University of North Carolina Wilmington. Annette Nellen, Esq., CPA, CGMA, is a professor in the Department of Accounting and Finance at San José State University in San José, Calif., and is the chair of the AICPA Tax Executive Committee. For more information on this article, contact thetaxadviser@aicpa.org.

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