ASC 740 Income Tax Accounting Challenges in 2013 Tackling - - PowerPoint PPT Presentation

ASC 740 Income Tax Accounting Challenges in 2013

Tackling Valuations of Deferred Tax Assets, Tax Expense and UTP Reporting, and Other Issues

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TUESDAY, MAY 28, 2013

Presenting a live 110-minute teleconference with interactive Q&A Douglas Sayuk, Partner, Clifton Douglas, San Jose, Calif. Cindy Frank, Senior Director, Tax Process Efficiency and Technology, BDO USA, Phoenix Jeffrey Zawada, Director, FreedMaxick CPAs, Buffalo, N.Y . For this program, attendees must listen to the audio over the telephone.

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ASC 740 Income Tax Accounting Challenges in 2013 Seminar

Douglas Sayuk, Clifton Douglas douglas@cliftondouglas.com May 28, 2013 Cindy Frank, BDO USA cfrank@bdo.com Jeffrey Zawada, FreedMaxick CPAs jeff.zawada@freedmaxick.com

Today’s Program

Overview Of ASC 740 And Related Guidance [Cindy Frank] Specific Income Tax Accounting Issues, Best Practices [Douglas Sayuk, Cindy Frank and Jeffrey Zawada] Slide 8 – Slide 26 Slide 27 – Slide 96

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

OVERVIEW OF ASC 740 AND RELATED GUIDANCE

Cindy Frank, BDO USA

FAS 109/ASC 740 Objectives

Recognize:

1. The amount of taxes payable or refundable for the current year 2. Deferred tax liabilities and assets for the future tax consequences

9

Basic Principles

• A current tax liability or asset is recognized for the estimated

taxes payable or refundable on tax returns for the current year.

• A deferred tax liability or asset is recognized for estimated

future taxes created by temporary differences.

• The measurement of current and deferred taxes is based on the

provisions of the enacted tax law.

• Measurement of deferred tax assets is reduced if they will not be

recognized.

• These principles apply to domestic federal income taxes, and

foreign and state and local taxes that are based on income.

10

Components Of Income Tax Expense

Current income tax expense (benefit) +/- Deferred income tax expense (benefit) = Total income tax expense (benefit)

11

Current Income Tax Expense

This example replicates a typical tax return expense calculation and represents only the current portion of income tax expense. Without FAS 109/ASC 740 principles, our tax expense would be $520,000. Item Amount Pre-tax book income $1,000,000 Permanent differences 100,000 Financial taxable income $1,100,000 Temporary differences 200,000 Taxable income per return $1,300,000 Tax rate 40%

Tax liability (current portion of tax expense)

$520,000

12

Deferred Tax Expense

• SFAS 109 requires the balance sheet approach to compute

deferred taxes.

• To compute the deferred expense, you must compare the

beginning balance of temporary differences to their ending balance.

• Temporary difference treatment in FAS 109/ASC 740 smoothens
• ut the rate; there is no impact on book tax expense.

13

Components Of Total Expense

Permanent differences:

• Arise from income that is permanently non-taxable and

expense items are permanently non-deductible

• Affect either the financial statements or the tax

return, but not both

• Will always increase or decrease your effective tax rate
• Will either cost tax dollars or save tax dollars

14

Current Income Tax Expense

Item Amount Pre-tax book income $1,000,000

Permanent differences 100,000

Financial taxable income $1,100,000 Temporary differences 200,000 Taxable income per return $1,300,000 Tax rate 40%

Tax liability (current portion of tax expense)

$520,000

15

Permanent Differences

Item Amount Pre-tax book income $1,000,000 Permanent differences

• Meals and entertainment

50,000

• Fines and penalties

40,000

• Lobbying expenses

10,000 Total permanent differences $100,000

Financial taxable income

$1,100,000

16

Permanent Differences (Cont.)

Item Amount Permanent differences

• Meals and entertainment

50,000

• Fines and penalties

40,000

• Lobbying expenses

10,000 Total permanent differences $100,000 Tax rate 40%

Tax impact of permanent items

$40,000

17

Permanent Differences (Cont.)

Effective tax rate = 440,000/1,000,000 = 44% (this is a short method of testing the rate) Permanent differences will always affect your rate.

Item Amount Pre-tax book income $1,000,000 Tax rate 40% Expected tax expense $400,000 Tax related to permanent items 40,000

Total expected tax expense $440,000

18

Components Of Total Expense

Temporary differences:

• Will generally have no impact on your effective tax rate
• Are book/tax differences that will be deductible or

taxable in one or more future years

• Will either cost tax dollars or save tax dollars in the

current year, and will have the opposite effect in a future year

19

Current Income Tax Expense, Revisited

Item Amount Pre-tax book income $1,000,000 Permanent differences 100,000 Financial taxable income $1,100,000

Temporary differences 200,000

Taxable income per return $1,300,000 Tax rate 40%

Tax liability (current portion of tax expense) $520,000

20

Temporary Differences

Year-End 12/31/2011 Current Year Activity Year-End 12/31/2012 Bad debt reserve $300,000 $250,000 $550,000 Accrued bonus 200,000 (50,000) 150,000 Total change in temp differences $500,000 $200,000 $700,000 Tax rate 40% 40% 40%

Tax impact of temporary differences

$200,000 $80,000 $280,000

21

Temporary Differences (Cont.)

Entry to record impact of temporary differences

Debit Credit Deferred tax asset $80,000 Income tax expense $80,000

22

Remember Current Expense?

Item Amount Pre-tax book income $1,000,000 Permanent differences 100,000 Financial taxable income $1,100,000

Temporary differences 200,000

Taxable income per return $1,300,000 Tax rate 40%

Tax liability (current portion of tax expense)

$520,000

23

Journal Entries

Entries to record tax provision

Debit Credit Deferred tax asset $80,000 Income tax expense $80,000 Income tax expense $520,000 Current tax payable $520,000

24

Income Tax Expense

Income statement looks like:

Item Amount Deferred tax benefit (reduces tax expense $(80,000) Current income tax expense 520,000 Total income tax expense $440,000

25

Remember This Shortcut Method?

Item Amount Pre-tax book income $1,000,000 Tax rate 40% Expected tax expense $400,000 Tax related to permanent items 40,000 Total expected tax expense $440,000

Effective tax rate = 440,000/1,000,000 = 44% (this is a short method of testing the rate)

26

SPECIFIC INCOME TAX ACCOUNTING ISSUES, BEST PRACTICES

Douglas Sayuk, Clifton Douglas Cindy Frank, BDO USA Jeffrey Zawada, FreedMaxick CPAs

VALUING AND REPORTING DEFERRED TAX ASSETS

Calculating The Deferred Tax Asset

Deferred Tax Assets – General Approach Example Step 1: Identify temporary differences $3,000,000 Step 2: Identify NOL carryovers 7,000,000 Cumulative timing differences $10,000,000 Step 3: Determine applicable tax rate 40.00% Deferred tax asset before credits $4,000,000 Step 4: Identify tax credits 500,000 Step 5: Calculate gross deferred tax assets $4,500,000 Step 6: Value the deferred tax assets (2,500,000) Step 7: Calculate net deferred tax assets $2,000,000

In steps 5-7, current deferred tax assets/liabilities and non-current deferred tax assets/liabilities should be aggregated, for balance sheet presentation purposes.

29

Deferred Tax Assets: Specific Issues

I. Applicable tax rate A. Use enacted tax rate applicable when differences are expected to affect the taxes payable B. Consider effect of federal deductions for state taxes 1. Generally, this has the effect of reducing the state rate to 65% of the full amount (100% – 35% federal rate). 2. A few states permit a deduction for other state income taxes. C. Always use the regular tax rate, even when in an AMT situation D. Understand implications of tax holidays with limited durations II. Foreign branches A. Foreign DTAs result in a reduction to the future U.S. foreign tax credit. B. Thus, a DTL must be established for the future reduction to the FTC. C. This has the effect of eliminating a double-counting of branch DTAs.

30

Valuing The Deferred Tax Assets

I. Consider other DTA reductions prior to valuation allowance A. Worthless DTAs – Sect. 382 B. ASC 740-10 (FIN 48) DTA reductions (e.g., R&D credit reserves) II. Valuation allowance A. Remaining gross DTA subject to VA under more-likely-than-not standard B. While not a bright-line test, the prior three years of cumulative financial

• perations (pre-tax income +/- permanent items) is often considered strong
• bjective evidence.

C. Partial VAs based on forecasted future taxable income are not uncommon, but these can appear to distort the tax rate if sustained for multiple years. D. VA should be allocated pro rata between current and non-current DTAs (without netting of DTLs), regardless of the specific asset to which it is related.

31

Slide Intentionally Left Blank

Valuation Allowance Allocation

DTA/(DTL) DTA Ratio VA VA Allocated Classified Current DTA $2,000,000 20.00% $9,000,000 $1,800,000 Current DTL

• 0 -

n/a Total current DTA $2,000,000 $(1,800,000) $200,000 Non-current DTA $8,000,000 80.00% $9,000,000 $7,200,000 Non-current DTL $(1,000,000) Total non-current DTA $7,000,000 $(7,200,000) $(200,000) Total gross DTA $9,000,000 Valuation allowance (9,000,000) Net DTA $- 0 - 100.00% $- 0 - A B

A/(A+B) B/(A+B)

C

A+B+C

x x = =

General rules for classification: 1. Tracks balance sheet classification of underlying asset/liability (e.g., fixed asset DTAs are non-current) 2. Where not tied to an actual balance sheet account, based on when DTA is expected to reverse (i.e., less than one year is current, greater than one year is non-current)

33

DTA Movement Reconciliation: NOL Position

Gross Amount Applicable Rate DTA Pre-tax book loss $(10,000,000) n/a Perm differences 2,000,000 n/a Temp differences 3,000,000 40.00% 1,200,000 Taxable loss $(5,000,000)

• 40.00%

2,000,000 Tax credits 500,000 100% 500,000 Change to DTA $3,700,000 Gross Amount Applicable Rate DTA Pre-tax book loss $(10,000,000)

• 40.00%

$4,000,000 Perm differences 2,000,000

• 40.00%

(800,000) Tax credits 500,000 100% 500,000 Change to DTA $3,700,000

34

Return To Provision (RTP) Adjustment

• During the provision preparation, a comparison is performed to

identify any differences between the numbers used in last year’s tax provision and the amounts used on the tax return.

• Generally computed during Q3
• The differences are “trued up” as part of the tax provision

preparation process for the succeeding year.

35

Return To Provision (RTP) Adjustment

Adjustment resulting from the comparison of individual items included in the prior year provision to the final income tax returns

• Adjustments related to permanent items impact the current income

tax expense on the income statement

• Adjust deferred income tax asset/liability in succeeding year to reflect

impact of discrepancy on amount of tax paid in prior year

36

Change in Estimate

• Change in estimate when new

information ,not available when the provision was prepared, becomes available after the provision is completed.

Error

• Change can be attributed to

facts known or knowable at the time the provision was prepared.

• Incorrect computation
• Incorrect information used

during provision preparation

Return To Provision (RTP) Adjustment

37

Return 12/31/2011 Provision 12/31/2011 Difference * Tax Effected Pre-tax book income $1,000,000 $1,000,000 $0 $0 Meals and entertainment 50,000 40,000 10,000 4,000 Allowance for bad debts 60,000 80,000 (20,000) (8,000) Tax depreciation (300,000) (400,000) 100,000 40,000 Taxable income $810,000 $720,000 $90,000 $36,000

* Assume 40% federal and state statutory rate

Return To Provision (RTP) Adjustment

38

Debit Credit Current income tax expense $ 4,000 Deferred income tax expense 32,000 Income taxes payable $36,000

Entries to record tax provision true-up

ANALYZING AND REPORTING UNCERTAIN TAX POSITIONS

Uncertain Tax Positions: Brief Overview

I. Recognition: Determine whether position is sustainable on a more-likely- than-not basis (“on-off” switch) A. Based on technical merits B. Administrative practices and precedents II. Measurement: Calculate the expected benefit of the position, based on cumulative probability approach A. Benefit greater than 50% of being realized upon settlement B. Assume taxing authority has full knowledge of facts

• III. Unrecognized tax benefits (UTBs): Tax effect of UTPs

A. FIN 48 liabilities recorded on balance sheets B. Reduction of DTA (whether or not valuation allowance in recorded) C. Excludes interest and penalties and well as “indirect benefits”

40

Change In Recognition And Measurement

I. A change in recognition or measurement may occur when: A. Management changes its judgment on the position. B. The statute of limitations tolls. C. The position is effectively settled. II. Change in judgment A. Critical issue: Was there a change in fact or authority? B. A simple reassessment of existing facts can result in a restatement issue. C. Consistency must be maintained; significant consideration should be given to when establishing a methodology.

• III. Statute of limitations

A. Net operating loss and tax credit carrybacks/carryforwards B. Jurisdictional differences

41

Change In Recognition And Measurement (Cont.)

IV. Effective settlement A. A tax position is considered “effectively settled” when: 1. The taxing authority has completed its examination procedures. 2. The company does not intend to appeal or litigate any aspect of the tax position. 3. Possibility is remote that the taxing authority would examine or reexamine the tax position, assuming it has full knowledge of all relevant information. B. Examination closure: Key considerations 1. A tax position does not need to be legally extinguished, and its resolution need not be certain, in order to re-measure a tax reserve. 2. Consider whether the issue was specifically reviewed or examined 3. If not, is it remote the tax period will be re-examined? 4. Effective settlement may not affect the tax position in other years, especially where the issue was not reviewed or “horse-trading” occurred.

42

Common Unrecognized Tax Benefits

I. Transfer pricing A. Benefits and limitations of contemporaneous documentation B. Potential indirect effects – competent authority and withholding taxes II. State nexus/permanent establishment A. Consider taxing authorities’ administrative policies and practices on SOL B. Potential indirect effects – throwback and FTCs

• III. Foreign withholding taxes

A. Who is liable? Joint vs. separate liability B. Potential indirect effects – FTC (or deductions)

• IV. R&D credits

V. Anti-deferral provisions (Subpart F, Sect. 956, etc.)

43

Example Of Indirect Effects

Facts: A U.S. company determines that $100 of foreign taxes should have been withheld on royalty payment made to it by a foreign customer. The company determines that it has joint liability for payment of the tax in the foreign jurisdiction and that a reserve is required for this amount. However, the company concludes that it will also receive a $100 foreign tax credit for the taxes withheld, which it can use to offset U.S. taxes. Conclusion: Ignoring potential interest and penalties, this has no potential future net cash impact to the company, as the FTC will fully offset the foreign taxes paid. However, this must still be disclosed as a $100 UTB. The journal entries would be as follows:

• Dr. tax expense

$100

• Cr. FIN 48 reserve

$100 To record withholding tax reserve

• Dr. DTA

$100

• Cr. tax expense

$100 To record FTC DTA

44

Uncertain Tax Positions: Required Disclosures

I. All entities A. Interest and penalties 1. Classification 2. Current and cumulative amounts B. Reasonably possible increases or decreases in UTBs within next 12 months 1. Nature of uncertainty and potential event causing the change 2. Estimate of amount (or statement that cannot be reasonably estimated) C. Tax years that remain open to examination in major jurisdictions II. Public companies A. Tabular reconciliation of UTBs 1. Increases: Current year and prior year 2. Decreases: Settlements, tolling of statutes, changes in judgment B. Total amount of UTBs, if recognized, would affect the ETR.

45

FINANCIAL STATEMENT DISCLOSURES: OVERVIEW, ISSUES AND SEC COMMENTS

Reported, Discussed And Disclosed

Reported amounts

• Balance sheet presentation
• Income statement presentation
• Statement of cash flows (SFAS No. 95)
• Changes in equity, net of taxes

47

Reported, Discussed And Disclosed (Cont.)

Discussions

• MD&A (management discussions and analysis)
• Commission guidance regarding management’s discussion and analysis of

financial condition and results of operations:

• MD&A should be a discussion and analysis of a company’s business as

seen through the eyes of those who manage that business. Management has a unique perspective on its business that only it can

• present. As such, MD&A should not be a recitation of financial

statements in narrative form or otherwise uninformative series of technical responses to MD&S requirements, neither of which provides this important management perspective.

48

Reported, Discussed And Disclosed (Cont.)

Discussions (Cont.)

• Effective tax rate
• Forecasted rate for following year
• Critical accounting policies
• Liquidity
• Contractual obligations

49

Reported, Discussed And Disclosed (Cont.)

Disclosed

• Significant accounting policies
• Income taxes including, but not limited to:
• Components of income before taxes
• Income tax expense (domestic and/or foreign)
• Rate reconciliation (for public enterprise)
• Individual items in excess of 5%
• Components of net deferred tax asset/liability, valuation

allowances

• Certain information related to FIN 48 amounts

50

Disclosure Requirements

Financial statement presentation

• Classification
• Entities
• Jurisdictions

51

Disclosure Requirements (Cont.)

Financial statement disclosure

• Components of the net deferred tax asset or liability
• Information for certain deferred tax liabilities not recognized
• Components of income tax expense (continuing operations)
• Income tax expense or benefit allocated to continuing
• perations and separately allocated to other items
• Rate reconciliation (public enterprise)
• Certain carryforwards and certain valuation allowances
• Certain disclosures for members of a consolidated group

52

Disclosure Requirements (Cont.)

FIN 48 disclosure

• Policy on interest and penalty classification
• Tabular reconciliation
• Unrecognized tax benefit that, if recognized, would affect the effective

tax rate

• Total interest and penalties
• Unrecognized tax benefits – reasonable possible of significant change

in the next 12 months

• Nature of uncertainty
• Nature of even that could occur
• Estimate of range of possible change or a statement that an

estimate cannot be made

• Tax years open to examination

53

Disclosure Requirements (Cont.)

What to remember:

• Understand the netting rules when it comes to current and non-current

deferred tax assets and liabilities

• Understand how amounts are compiled and reported from different

jurisdictions

• Significant accounting policies related to tax should be disclosed (SFAS 109,

FIN 48, policies on interest and penalties).

• Components of income (from different jurisdictions)
• Components of expense (by jurisdiction, by classification)
• Rate reconciliation (dollars or percentages)
• Details for amounts > 5% of total for public companies
• Robust disclosures for estimates and changes in estimates (valuation

allowances, uncertain tax positions)

54

SEC Comments: Areas Of Focus

Management estimates and judgments

• Valuation allowances
• Basis for having or not having a VA
• Timing of recording changes
• Consistency with other forward-looking information
• FIN 48-related items
• Paragraph 21 disclosures
• Interest and penalty policy disclosures
• Disclosures and adjustments on adoption
• Timing of recording changes

55

SEC Comments: Areas Of Focus (Cont.)

Management estimates and judgments (Cont.)

• Adequacy of disclosure
• Rate reconciliation items
• Deferred tax assets and liabilities
• Uncertain tax positions
• Timing of reversal
• Expiration of NOLs in various jurisdictions
• Other
• Contingency obligations table

56

SEC Comments: Areas Of Focus (Cont.)

What to remember – SEC Comments

• SEC may ask for clarification related to management’s material

estimates and/or judgments.

• Changes in estimates should be well-documented.
• Responses to SEC comment letters are easier if the company has

documentation related to:

• Alternative views considered
• Company policies that provide guidance on estimates
• Criteria used in evaluation
• Consider information that could be important to the user of the

financial statements

57

Slide Intentionally Left Blank

DECIDING ON APPROPRIATE INTRA-PERIOD ALLOCATIONS

Intraperiod Tax Allocations

I. Income tax expense or benefit should be allocated among: A. Continuing operations B. Other components 1. Discontinued operations 2. Extraordinary items 3. Other comprehensive income 4. Items charged or credited directly to shareholders’ equity II. Steps in allocation process A. Step 1 - Calculate total tax expense B. Step 2 - Determine tax related to continuing operations C. Step 3 - Allocate remainder to other components (disc. ops, OCI, etc.)

60

Intraperiod Tax Allocations: Example

NOL Carryover w/ VA No NOL Carryover No VA NOL Carryover No VA Pre-tax Income – cont. ops $3,000,000 $3,000,000 $3,000,000 Pre-tax Income – disc. ops (1,000,000) (1,000,000) (1,000,000) Pre-tax income $2,000,000 $2,000,000 $2,000,000 NOL carryover (2,000,000)

• 0 -
• 0 -

Taxable income $- 0 - $2,000,000 $2,000,000 Tax rate 40.00% 40.00% 40.00% Total tax expense $- 0 - $800,000 $800,000 Related to continuing ops

• 0 -

1,200,000 1,200,000 Allocated to disc. ops

• 0 -

(400,000) (400,000)

A B A-B

$3MM x 40%=

Note: Net operating losses and other deferred tax assets are utilized before the impact of other components are considered.

Deferred benefit Current benefit 61

Application Of ASC 740-20-45-7

NOL Carryovers/Full Valuation Allowance Year X1 Year X2 Pre-tax income – cont. ops $(2,000,000) $2,000,000 Pre-tax gain/(loss) – OCI (AFS) 2,000,000 (2,000,000) Pre-tax income $-0- $-0- Tax rate 40.00% 40.00% Total tax expense $-0- $-0- Related to continuing ops (800,000)

• 0-

Allocated to disc. ops 800,000

• 0-

$(2MM) x 40%=

Note: Even though the two-year impact of the OCI gain/loss is $nil, the tax effect of the Year X1 application of this rule does not reverse out in Year X2. Rather, the disproportionate tax effects become lodged in OCI and only reverse under very limited circumstances.

Under this exception to the general rules, all components should be considered in determining the tax benefit resulting from continuing operations losses.

$2MM x 40%= No tax expense due to NOL C/F and valuation allowance 62

INTERIM PERIOD TAX COMPUTATION CALCULATIONS

Interim Period Tax Computation

I. Guidance A. ASC 740-270-25-2 1. The tax (or benefit) related to ordinary income (or loss) shall be computed at an estimated annual effective tax rate, and the tax (or benefit) related to all other items shall be individually computed and recognized when the items occur. 2. Ordinary income or loss a. Includes continuing operations before income taxes or benefit b. Excludes significant unusal or infrequently occuring items (rare) c. Excludes extraordinary items, cumulative effects of changes in accounting principles and discontinued

• perations

64

Interim Period Tax Computation (Cont.)

I. Calculation

• A. Caluclate estimated effective tax rate
• 1. Forecast annual pre-tax income by entity/tax filing

jurisdiction

• 2. Calculate current and deferred provisions
• 3. Consider federal, state and foreign
• B. Apply estimated effective tax rate
• 1. Multiply estimated effective tax rate by actual year-

to-date worldwide pre-tax income

• C. Layer on items recorded discretely

65

Interim Period Tax Computation (Cont.)

I. Items recorded discretely in the interim period A. Prior-year uncertain tax positions B. Current-year uncertain tax positions related to income excluded from the effective tax rate calculation C. Interest and penalties related to uncertain tax positions D. Change in tax law E. Change in tax status F. Changes in realizability of deferred tax assets G. Changes in judgment regarding APB 23 items (unremitted earnings of foreign subsidiaries and other outside basis items) H. Changes in estimates from prior-year provisions (provision to return adjustments)

66

Interim Period Tax Computation (Cont.)

I. Modification to estimated effective tax rate approach (ASC 740-270- 30-30 through ASC 740-270-30-34)

• A. Loss limitation (year-to-date loss exceeds the full-year expected

loss, and full realization of tax benefit is assured, i.e. no need for a valuation allowance)

• A. Recalculate tax based on year-to-date results

B. Good example: ASC 740-270-55-16 B. Loss limitation (year-to-date loss exceeds the full year expected loss, and partial realization of tax benefit is assured)

• A. Calculate estimated effective tax rate based on amount of

tax benefit assured B. Recalculate tax based on year-to-date results

• C. Good example: ASC 740-270-55-20

67

Interim Period Tax Computation (Cont.)

I. Example – ASC 740-270-55-16

Reporting Period Reporting Period Year-to- Date Overall Estimated Annual Effective Tax Rate Year-to- Date - Computed Year-to- Date - Limited Less Previously Reported Reporting Period First Qtr 20,000 20,000 60% 12,000

• 12,000

Second Qtr (80,000) (60,000) 60% (36,000) 12,000 (48,000) Third Qtr (80,000) (140,000) 60% (84,000) (80,000) (36,000) (44,000) Fourth Qtr 40,000 (100,000) 60% (60,000) (80,000) 20,000 Fiscal Year (100,000) (60,000) Year to date ordinary loss ($140,000 X 50%) (70,000) Estimated Tax Credits (10,000) (80,000) Ordinary Income Tax

68

Interim Period Tax Computation (Cont.)

I. Example – ASC 740-270-55-20 (overall ETR limited to partial unrealizable losses)

Reporting Period Reporting Period Year-to- Date Overall Estimated Annual Effective Tax Rate Year-to- Date - Computed Year-to- Date - Limited Less Previously Reported Reporting Period First Qtr 20,000 20,000 20% 4,000

• 4,000

Second Qtr (80,000) (60,000) 20% (12,000) 4,000 (16,000) Third Qtr (80,000) (140,000) 20% (28,000) (20,000) (12,000) (8,000) Fourth Qtr 40,000 (100,000) 20% (20,000) (20,000)

• Fiscal Year

(100,000) (20,000) Ordinary Income Tax

69

Interim Period Tax Computation (Cont.)

• C. ASC 740-270-30-36(a) – If a separate jurisdiction has year-

to-date ordinary loss or anticipates ordinary loss for the year, and no tax benefit can be recognized, then that entity should be excluded from the estimated effective tax rate calculation.

70

Interim Period Tax Computation (Cont.)

I. Example – ASC 740-270-55-39

Anticipated ordinary income for the fiscal year: In the United States 60,000 $ In Country A 40,000 Total 100,000 $ Anticipated tax for the fiscal year: In the United States ($60,000 at 50% statutory rate) 30,000 $ In Country A ($40,000 at 20% statutory rate) 8,000 Total 38,000 $ Overall estimated annual effective tax rate ($38,000 / $100,000) 38%

71

Interim Period Tax Computation (Cont.)

I. Example – ASC 740-270-55-40 – quarterly tax computation

Reporting Period United States Country A Total Year-to- Date Overall Estimated Annual Effective Tax Rate Year-to- Date Less Previously Reported Reporting Period First Qtr 5,000 15,000 20,000 20,000 38% 7,600

• 7,600

Second Qtr 10,000 10,000 20,000 40,000 38% 15,200 7,600 7,600 Third Qtr 10,000 10,000 20,000 60,000 38% 22,800 15,200 7,600 Fourth Qtr 35,000 5,000 40,000 100,000 38% 38,000 22,800 15,200 Fiscal Year 60,000 40,000 100,000 38,000 Ordinary Income Tax

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Interim Period Tax Computation (Cont.)

I. Example – ASC 740-270-55-41 – ordinary loss; realization not MLTN I. Country B history of losses, 40% rate, expected tax benefit will not be realized on these losses

Reporting Period United States Country A Country B Total Year-to- Date Overall Estimated Annual Effective Tax Rate Year-to- Date - Excluding Country B Less Previously Reported Reporting Period First Qtr 5,000 15,000 (5,000) 15,000 15,000 38% 7,600

• 7,600

Second Qtr 10,000 10,000 (25,000) (5,000) 10,000 38% 15,200 7,600 7,600 Third Qtr 10,000 10,000 (5,000) 15,000 25,000 38% 22,800 15,200 7,600 Fourth Qtr 35,000 5,000 (5,000) 35,000 60,000 38% 38,000 22,800 15,200 Fiscal Year 60,000 40,000 (40,000) 60,000 38,000 Note: Format above different than actual ASC 740-270-55-41 example Ordinary Income Tax 73

Interim Period Tax Computation (Cont.)

I. Example – ASC 740-270-55-41 – what if country B was included

Anticipated ordinary income for the fiscal year: In the United States 60,000 $ In Country A 40,000 In Country B (40,000) Total 60,000 $ Anticipated tax for the fiscal year: In the United States ($60,000 at 50% statutory rate) 30,000 $ In Country A ($40,000 at 20% statutory rate) 8,000 Total 38,000 $ Overall estimated annual effective tax rate ($38,000 / $60,000) 63.33%

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Interim Period Tax Computation (Cont.)

I. Example – ASC 740-270-55-41 – what if country B was included (Cont.) I. Country B history of losses, 40% rate, expected tax benefit will not be realized on these losses

Reporting Period United States Country A Country B Total Year-to- Date Overall Estimated Annual Effective Tax Rate Year-to- Date - Including Country B Less Previously Reported Reporting Period First Qtr 5,000 15,000 (5,000) 15,000 15,000 63.33% 9,500

• 9,500

Second Qtr 10,000 10,000 (25,000) (5,000) 10,000 63.33% 6,333 9,500 (3,167) Third Qtr 10,000 10,000 (5,000) 15,000 25,000 63.33% 15,833 6,333 9,500 Fourth Qtr 35,000 5,000 (5,000) 35,000 60,000 63.33% 37,998 15,833 22,166 Fiscal Year 60,000 40,000 (40,000) 60,000 37,998 Note: Format above different than actual ASC 740-270-55-41 example Ordinary Income Tax 75

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MERGER AND ACQUISITION TOPICS

Business Combinations: Key Steps

Step 1: Determine transaction structure (stock vs. asset acquisition)

• Stock – historical tax basis carryover; can lead to significant DTA/DTLs
• Asset – tax basis stepped up to FMV; DTA/DTL may be minimal

Step 2: Identify existing deferred tax assets and liabilities

• Typically, a short period cut-off provision is calculated.
• Consider the impact of stock awards and other non-recurring charges.
• When combined returns will be filed with the acquirer, the applicable tax rate

in valuing DTA/DTLs should be reassessed. Step 3: Calculate DTA/DTL from purchase accounting fair value adjustments

• In a stock transaction, every FV adjustment will result in a DTA/DTL. Non-

goodwill intangibles often result in a significant DTL.

• Consider the impact of an acquired DTL on the acquirer’s VA, as the benefit of

any release will be recorded to P&L.

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Business Combinations: Key Steps (Cont.)

Step 4: Evaluate deferred tax asset valuation

• Consider whether the combined operation’s financial position changes

the assessment of deferred tax asset utilization

• Changes to the acquired company’s VA are recorded in purchase

accounting, while the acquirer’s VA is recorded outside of purchase accounting.

• Also consider the need to write-off DTAs due to Sect. 382, SRLY or other

acquisition related limitations Step 5: Consider tax reserve needs

• Leverage off of conclusions reached in due diligence
• Consider the impact of indemnifications
• Continue to evaluate information available at the acquisition date during

the one-year measurment period

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STOCK AWARD ISSUES

Stock Awards

I. Guidance

• A. When the settlement of an award creates or increases a net
• perating loss
• A. This provides that the excess tax benefit and the credit to

APIC (and our APIC pool) for the windfall should not be recorded until the deduction reduces income taxes payable. B. ASC 718-740-25-10

• A. A share option exercise may result in a tax deduction before

the actual realization of the related tax benefit because the entity, for example, has a net operating loss carryforward. In that situation, a tax benefit and a credit to additional paid-in capital for the excess deduction would not be recognized until that deduction reduces taxes payable.

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Stock Awards (Cont.)

I. Result

• A. Net operating losses
• A. The deferred tax asset on the company’s net operating

losses will differ from the net operating losses actually

• n its tax return.
• B. The net operating losses relating to this windfall tax

benefit will have to be tracked separately.

• C. The net operating losses disclosed in the footnote should

be the actual net operating losses per the tax return.

• D. The footnote should also disclose the amount of benefit

still to be recorded in additional paid-in capital once the net operating loss carryforward is realized.

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Stock Awards (Cont.)

I. Accounting policy

• A. Generally two approaches allowed:
• A. With and without – results in windfall tax benefits

being realized last

• B. Tax law ordering – results in windfall tax benefit being

realized first (should be less complex)

• B. Election of method is an accounting policy that must be

applied consistently.

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Stock Awards (Cont.)

I. Examples I. Facts: NOL carryforward from prior years – actual per tax return $500,000 Deferred tax asset on NOL at 40% $200,000 Current-year taxable income (before excess tax deduction for stock-based comp) $600,000 Current-year excess tax deduction for stock based compensation $250,000

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Stock Awards (Cont.)

Example 1: No valuation allowance With and Without Without With Tax Law Ordering Taxable income before NOL and excess tax deduction 600,000 $ 600,000 $ 600,000 $ 600,000 $ Current year excess tax deduction for stock based compensation (250,000) $

• $

(100,000) $ (250,000) $ NOL Carryforward from prior years (500,000) $ (500,000) $ (500,000) $ (350,000) $ Taxable Income or NOL carryforward to next year (150,000) $ 100,000 $

• $
• $

Journal Entry Income Taxes Payable

• $
• $

Current Tax Expense 40,000 $ 100,000 $ Deferred Tax Expense 200,000 $ 140,000 $ Deferred Tax Asset (200,000) $ (140,000) $ Additional Paid-in Capital (40,000) $ (100,000) $ Memo Entry - Debit / (Credit) Deferred Tax Asset 60,000 $

• $

Additional Paid-in Capital (60,000) $

• $
• With and Without - memo entry to reflect the $150,000 excess tax deduction for which there has been no cash benefit yet received

Actual Remaining Net Operating Losses (150,000) $ (150,000) $ Deferred Tax Asset

• $

60,000 $ 0% 40%

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Stock Awards (Cont.)

Example 2: Full valuation allowance With and Without Without With Tax Law Ordering Taxable income before NOL and excess tax deduction 600,000 $ 600,000 $ 600,000 $ 600,000 $ Current year excess tax deduction for stock based compensation (250,000) $

• $

(100,000) $ (250,000) $ NOL Carryforward from prior years (500,000) $ (500,000) $ (500,000) $ (350,000) $ Taxable Income or NOL carryforward to next year (150,000) $ 100,000 $

• $
• $

Journal Entry Income Taxes Payable

• $
• $

Current Tax Expense 40,000 $ 100,000 $ Valuation Allowance 200,000 $ 140,000 $ Deferred Tax Asset (200,000) $ (140,000) $ Additional Paid-in Capital (40,000) $ (100,000) $ Memo Entry - Debit / (Credit) Deferred Tax Asset 60,000 $

• $

Additional Paid-in Capital (60,000) $

• $
• With and Without - Memo entry to reflect the $150,000 excess tax deduction for which there has been no cash benefit yet received

Actual Remaining Net Operating Losses (150,000) $ (150,000) $ Deferred Tax Asset

• $

60,000 $ Valuation Allowance

• $

(60,000) $

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CURRENT AUDITOR RED FLAGS

Current Auditor Hot Topics

I. PCAOB materiality guidelines II. Deferred tax asset disclosure A. Classification – current vs. non-current B. Stock-based compensation 1. Terminations and cancellations 2.

• Sect. 83(b) elections

C. Cost basis – fixed/intangible assets D. “True-up” impact – estimate vs. error III. Permanent reinvestment of foreign earnings rep under APB 23 A. Ability – sufficient cash to fund domestic operations B. Intent – established company policy; earnings need to fund operations C. Reasonable estimate of deferred taxes

88

Current Auditor Hot Topics (Cont.)

• IV. Valuation allowance
• A. Allocation between current and non-current assets
• B. Jurisdictional issues (e.g., cost plus entities)
• V. ASC 740-10 (FIN 48)
• A. Statute of limitation periods
• B. Disclosure regarding changes in next 12 months
• VI. Intraperiod tax allocations to OCI

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Current Auditor Red Flags

I. Effective tax rate reconciliation

• A. Foreign effective tax rate varies significantly from

statutory rate.

• II. Business combinations
• A. Contingent liabilities and consideration
• III. Deferred tax roll
• IV. Uncertain tax positions
• A. Inter-company transactions/transfer pricing
• B. Foreign audits

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RISK MITIGATION

Risk Mitigation

I. Valuation allowance documentation

• II. ASC 740-30-25-17 (APB 23) documentation
• III. Tax provision software
• IV. Department capability and internal controls

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Risk Mitigation (Cont.)

I. Valuation allowance documentation I. Four sources of taxable income

• A. Taxable income in carryback years

1. Consider character of income B. Future reversal of existing temporary differences 1. Consider timing of future reversals

• C. Tax planning strategies

1. Must be prudent and feasible 2. Must be something management wouldn’t ordinarily take 3. Must prevent deferred tax asset from expiring unused 4. Must result in the realization of a deferred tax asset

94

Risk Mitigation (Cont.)

I. Valuation allowance documentation (Cont.)

• D. Future taxable income exclusive of reversing

temporary differences and carryforwards

• 1. Three-year cumulative pretax book earnings
• 2. Forecast accuracy!!!
• 3. How many years of forecasted pre-tax income

would be needed to realize all of the deferred tax assets?

• 4. Document and consider company liquidity,

backlog, market trends, losses of significant customers, forecast divestitures, and expected restructuring or changes in operations.

95

Risk Mitigation (Cont.)

I. ASC 740-30-25-17 (APB 23) documentation A. Document policy of permanent reinvestment B. Consider all aspects of outside basis differences (unremitted earnings, cumulative translation adjustments, transactions with non-controlling shareholders and other comprehensive income) C. Document uses of excess cash at foreign subsidiary (working capital needs, capital expenditures, acquisitions, repay inter-company obligations, loan to

• ther foreign entities, etc.

D. Document or forecast need or lack thereof of cash at the parent company 1. Operations, debt service, acquisitions, capital expenditures, inter- company obligations E. Consider history of earnings remittances 1. Consider policy of not remitting past earnings F. Consider dispositions/available for sale entities

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