ASC 740 explained: A short guide to the accounting standard for income tax provisions

If your business pays income taxes and prepares GAAP financial statements, you need a way to reflect income taxes in your financials. This includes not just what you pay today, but also the tax effects of timing differences that will reverse in future periods.

Keep reading to learn about the ASC 740 accounting standard that helps guide that reporting, including what it is, how it works and why it matters.

What is ASC 740?

ASC 740 is the generally accepted accounting principles (GAAP) accounting standard that sets the ground rules for how your finance team should report the impact of income taxes on your company’s financial statements. This includes how your business should account for both current taxes and deferred taxes.

• If your business or organization follows GAAP in your financial reporting and pays income taxes at the federal, state or local level, your accounting team should generally be using ASC 740.
• ASC 740 is primarily used by C corporations, which pay entity-level taxes on business income. Pass-through entities like LLCs and S Corporations typically don’t pay federal income taxes at the business level, but they may have state taxes or other situations that require income tax reporting.
• In certain circumstances, nonprofit entities may also need to pay income taxes on unrelated business income and may use ASC 740 to guide their reporting on those payments.

How does ASC 740 impact your financial reporting?

ASC 740 affects both your income statement (tax expense) and balance sheet (deferred tax assets and liabilities). For leaders, it matters because the provision can materially impact reported earnings, lender covenant calculations and the story your financial statements tell.

For example, if your business is claiming a deferred tax asset as a result of a loss that is carried forward, ASC 740 gives your accounting team a framework for documenting that asset and demonstrating that you will have enough future income to make that asset realizable.

Because income taxes can be a significant line item, clear provision calculations and disclosures help stakeholders understand what is driving your effective tax rate and whether today’s tax expense differs from cash taxes paid.

Key components of documenting income tax provision under ASC 740

ASC 740 provides a framework to report various components of your business’s income taxes. These most commonly include current and deferred expenses, deferred assets or liabilities, valuation allowances and uncertain tax positions.

Current income tax expense

Your current income tax expense represents the income taxes payable (or refundable) based on the current year’s taxable income and tax law. It may differ from cash taxes paid during the year if you have estimated payments, refunds or prior-year true-ups.

Deferred income tax expense

Your deferred income tax expense refers to the future tax effects of timing differences between your financial statements and tax returns. In other words, this means the taxes you expect to pay or save later because book and taxable income do not line up in the current period.

Deferred tax assets

Deferred tax assets arise from deductible temporary differences and tax attributes that may reduce taxable income in future periods. These differences occur when an expense or loss is recognized in your financial statements before it becomes deductible on your tax return.

Common examples include net operating loss carryforwards, certain accrued expenses, and tax credit carryforwards. Deferred tax assets can help reduce future tax liabilities, but businesses must also evaluate whether those assets are likely to be realized in future periods.

Deferred tax liabilities

Deferred tax liabilities are the opposite of deferred tax assets. They also arise from timing differences, but these differences will increase taxable income in future periods. These differences typically occur when a tax deduction is recognized before the related expense is recognized in your financial statements.

One common example is accelerated tax depreciation, like bonus depreciation, which allows a business to deduct an asset more quickly for tax purposes than for book purposes. Deferred tax liabilities represent taxes that are expected to be paid in future years as those timing differences reverse and create taxable income.

Valuation allowances

Valuation allowances are contra-asset accounts recorded against deferred tax assets when management determines that it might not generate enough future taxable income to fully use those tax benefits. Under ASC 740, companies must evaluate whether deferred tax assets are more likely than not to be realized, based on factors like historical earnings, future income projections and the expiration of tax attributes.

Uncertain tax positions

Uncertain tax positions account for potential tax liabilities that may result from unclear tax guidance or a position taken that could result in additional payments or penalties being owed after challenge from the tax authority. This can be more relevant for SEC-regulated companies or companies that have multistate operations where state filing and nexus determinations are complex.

Common challenges in preparing income tax provisions under ASC 740

CFOs and accounting teams face certain challenges when reporting income taxes under ASC 740. These primarily involve issues around timing and stakeholder awareness.

Timing

Your accounting team has to prepare for a quick turnaround here. This is because tax calculations depend on finalized financial results and updated period-end information. That compressed timeline can strain internal resources, especially during quarter-end and year-end closes.

Stakeholder awareness

CFOs and other financial leaders within your business are typically skilled in many aspects of accounting, but income tax accounting can be specialized and may be handled less frequently. Without proper knowledge, ownership and review processes, this can lead to accuracy issues and incorrect filings, which can then compound over time and could require significant revisions.

Why accurate tax provisions matter for businesses

Income taxes can be a significant portion of your business expenses. That makes accurately reporting those expenses essential to your compliance responsibilities.

Regulators, especially, will watch you closely here, as they often see tax reporting as a hotspot. Because income tax accounting involves significant judgment and estimation, regulators and auditors scrutinize these areas closely.

When to outsource income tax provision services

In certain situations, it may make more sense to outsource your tax reporting to a more experienced accounting team rather than trying to tackle it in-house. For example, consider outsourcing under circumstances like:

• Growth: If your business is experiencing growth, creating new investments or developing new business structures, your taxes will get more complicated. You have to understand both GAAP accounting and tax accounting, which can get challenging for an internal accounting team.
• Acquisitions and restructurings: Deals can create new deferred taxes and purchase accounting adjustments, and they often require tighter documentation and coordination across finance and tax.
• Investor and lender expectations: If you have outside investors, audited financials or debt covenants, the provision may draw additional scrutiny. Extra review support can help improve consistency and documentation.
• Small internal team: If your internal accounting team is small, you may be able to make better use of their bandwidth and capabilities by having them focus on non-tax accounting and financial analysis.

ASC 740 tax provisions FAQs

Common questions about ASC 740 and income tax provisions include:

How often should income tax provisions be prepared?

Public companies generally are required to report financial statements quarterly and annually that include income tax provisions. Private companies typically report at least annually, but many calculate throughout the year to support interim financials and budgeting and to have a smoother year-end close.

What are the risks of incorrect income tax provisions?

Incorrect income tax provisions can lead to audit adjustments and, in some cases, restatements. This can be seen as evidence of a poor control environment.

How Wipfli can help

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