In theory, FAS 109, Accounting for Income Taxes, is easy. This accounting pronouncement requires entities to record income tax expense for domestic, foreign, state and local income. It also details how to account for different accounting methods between what is recorded for financial statement and income tax purposes. As a general rule, these differences between generally accepted accounting principles (GAAP, or commonly referred to as “book”) and tax are divided into two categories, either permanent differences or temporary differences.
Permanent differences are items that will never be the same for book and tax. A classic example of a permanent difference is expenses relating to meals and entertainment. One hundred percent of these expenses are reported for financial statement purposes, but as a general rule, only 50 percent of the deduction is allowed on the tax return. Companies never get the benefit of the remaining 50 percent, thus creating a permanent difference.
Temporary differences are those items that are reported at different times for book and tax, but at some point in the future, the same cumulative amount will be reported. The classic example of a temporary difference is depreciation. For example, a $1,000 asset might be depreciated for five years by using the straight-line method for GAAP; however, federal tax laws might mandate employing a useful life of seven years with a method of double declining balance. After the seven-year time period, both GAAP and tax will have a recorded cumulative depreciation expense of $1,000. During that seven-year time period, however, the cumulative amount will be different, thus creating a temporary difference.
An interesting thing to keep in mind about recording total tax expense under FAS 109 is that companies generally need only to be concerned about permanent differences. As a general rule, these are the only items that impact total tax expense. Temporary differences should have no impact on the total tax expense that is reported on the financial statements. Temporary differences that increase a company’s current expense should have a corresponding deferred benefit that, when netted together, will automatically equal zero.
The reality is that this accounting pronouncement is not easy. There are many exceptions to the general rule, both from a tax and GAAP perspective. In addition, both tax law and GAAP are always changing, so staying current and knowledgeable is required. When referring to tax law as it relates to FAS 109, the definition encompasses many areas such as federal tax, state tax (all 50 of them), taxation of local jurisdictions, international tax implications, among others.
So what can the preparer of tax provisions do during the preparation of this complex calculation? The answer is to keep the easy components of this process EASY. The following is a “top ten” list for simplifying tax provisions that I have compiled over the years. Some of these are best practices I have adapted from other sources.
1. All required information to prepare provision should be in “input format.” “Input format” requires using tabs or worksheets that require all the information needed to calculate the provision. Input tabs can be a very useful format versus input throughout the spreadsheet. Using input tabs helps ensure that the information required for the current period is updated and will allow you to update for changes. Modifications can include tax law changes as well as simple additions or deletions to your general ledger.
2. Shade areas required for input. When preparing the tax provision, only shaded areas require input, and data to calculate the provision should be included in the input tab only. Your preparer will know exactly where to put the necessary information, and before your detailed review, you can scan the input sheets to ensure that all the information has been entered correctly.
3. Consider automating as much as possible to avoid human input errors. Formulas should be used throughout the spreadsheet. The only “hard input” would be in the input tabs. Also consider using the “vlookup” function in Excel and import the entire trial balance.
4. Identify the source of information. General ledger accounts should be referenced and actual file names should be listed if the information comes from another system. Be as specific as possible — even if the location is in someone’s bottom desk drawer.
5. Maintain separate general ledger accounts for significant items and items used to calculate book/tax differences. This allows both the preparer to find the information easily and the reviewer to check it quickly. It also avoids the need to dig through accounts and have separate reconciliations.
6. On current provision, segregate book/tax differences between permanent and temporary. This segregation and classification allows the preparer and reviewer to do some quick checks for accuracy.
7. Use subtotals on current provision for permanent differences. As discussed earlier, the permanent differences should generally be the only items that impact total tax expense. By subtotaling these items, an effective tax rate reconciliation can be calculated and compared to actual expenses recorded to determine accuracy.
8. Use subtotals in current provision for temporary differences to easily tie out changes in the cumulative amount of temporary differences. The cumulative amount of temporary differences at the beginning of the year needs to be adjusted by all of the temporary differences that arose during the current year and for any prior year provision to return adjustments or “trueups.” Subtotals make it easier to ensure that all temporary differences included in the current year provision are also included in the cumulative amount of temporary differences at the end of the year. A common error is accidentally excluding a temporary difference that arose during the year from the cumulative amount of temporary differences at the end of the year. This would then cause an error in the calculation of deferred tax assets and liabilities as of the end of the year.
9. Roll deferred tax assets and liabilities just like any other balance sheet accounts. Start with the beginning of the year balances. Confirm that they agree to those reported in the prior year financial statements to ensure that any late journal entries from the prior year are reflected in the balances being rolled forward. Then add in current activity from the current provision, have a separate column for trueups, and cross-foot to arrive at the end of the year balances. Deferred taxes is an area that is often prone to many mistakes. Rolling forward the account from beginning to end of the year is a good method to help avoid errors.
10. Test accuracy of tax accounts through any changes in the “tax reserves for additional tax assessments.” This reserve is the item that most companies refer to as the “tax cushion.” In reality, it is the liability for tax exposures. Any differences in this reserve should be reconciled. If the reconciliation doesn’t work, it probably means an error exists somewhere else. Examples of these errors include incorrect posting of items or missed tax payments. I am a true believer that every process can be improved over time. If you are currently using an Excel spreadsheet to calculate your tax provision, I encourage you to try some of these suggestions to improve your process and to keep it simple.
The information contained herein is general in nature and is based on authorities that are subject to change. It is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the specific circumstances or needs, and may require consideration of non-tax and other tax factors. Contact Grant Thornton LLP or other Financial Institutions professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.