Simplifying the accounting for income taxes

The Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) 2019-12, Simplifying the Accounting for Income Taxes on Dec. 18, 2019. The ASU includes several provisions aimed at reducing complexity for financial statement preparers and increasing consistency and clarity for financial statement readers. 

The new guidance is effective for public business entities with fiscal years, and the related interim periods, beginning after Dec. 15, 2020. For other entities, the ASU is effective for fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 15, 2022. The guidance in the ASU may be adopted prior to the effective dates; however, companies must adopt all of the changes identified in ASU 2019-12 at the same time. The changes made by ASU 2019-12 are summarized as follows: 

Intraperiod tax allocation

The ASU removes the exception to the incremental approach for intraperiod allocation of tax expense when a company has a loss from continuing operations and income from other items that are not included in continuing operations, such as income from discontinued operations, or income recorded in Other Comprehensive Income. The general rule under ASC 740-20-45-7 is that the tax effect of pretax income or loss from continuing operations should be determined by a computation that does not consider the tax effects of items that are not included in continuing operations (the so-called incremental approach). Previously, companies could consider the impact on a loss from continuing operations of items in discontinued operations or other comprehensive income. However, under the amended guidance, companies should not consider the effect of items outside of continuing operations in calculating the tax effect on continuing operations.  

For example, a company with a loss in continuing operations but a gain from the increase in value of available-for-sale securities should no longer consider the effect of the gain in other comprehensive income when calculating income tax expense for continuing operations. Prior to the amendment, a loss company in a full valuation allowance, that would have otherwise recorded no tax benefit in this situation, would have recorded a tax benefit in continuing operations, offset by a tax expense in other comprehensive income. Under the amendment, a company with a loss in continuing operations that would not result in a tax benefit, due to a full valuation allowance, and a gain on discontinued operations would not consider the gain in determining the amount of benefit to recognize for the loss in continuing operations. 

The exception to the incremental approach was removed for a number of reasons. Included among those reasons were that some preparers and auditors had difficulty applying the exception, that the exception to the incremental approach creates counterintuitive outcomes because it results in a benefit being allocated to continuing operations with an offsetting expense in another component of income. In addition, users of financial statements and preparers indicated the exception is difficult to apply, is often overlooked, and does not provide any perceived benefit.

Interim provisions

The ASU includes two changes to interim accounting. The first amendment removes the exception to the general method for interim period calculations when the year-to-date loss exceeds the anticipated annual loss. Previously, the guidance limited the amount of benefit recorded in interim periods by determining a dollar amount limitation based on statutory rates for companies with a year-to-date ordinary loss and anticipated full-year ordinary loss. The benefit was limited to the benefit that could be realized by applying the statutory tax rate to the year-to-date loss, or the amount of benefit that could be recognized as a deferred tax asset. See the following example from ASC 740-270-55-16, where the stricken text shows the changes from ASU 2019-12:

The entity has ordinary income and losses in interim periods for the year to date. The full tax benefit of the anticipated ordinary loss and the anticipated tax credits will be realized by carryback. The full tax benefit of the maximum year-to-date ordinary loss can also be realized by carryback.

Under the prior guidance, the tax benefit for the third quarter above was limited to the year-to-date loss of $140,000 multiplied by the statuary tax rate of 50%, or $70,000, plus the estimated tax credits for the year, for a tax benefit of $80,000, while the effective rate computation would have resulted in a tax benefit for the quarter to date of $84,000.

The change above was made as the Board indicated that the exception is easily overlooked and therefore is prone to error.

The second change to interim provisions relates to changes in tax law. Under the new guidance, companies must reflect the effects of enacted tax law changes in the annual effective tax rate calculations in the interim period in which the law was enacted. Under the previous guidance, a mismatch could occur between current and deferred income taxes, whereby the impact on deferred balances was reflected prior to the inclusion of the rate change in the estimated AETR for changes enacted at the beginning of the year but not effective until mid-year. The ASU brings these points into conformity, making the enactment date the time to recognize the change for both the estimated AETR and deferred taxes.

Franchise taxes

The accounting for income taxes in jurisdictions with taxes partially based on both income and non-income measures (e.g. franchise taxes) posed significant headaches for companies. The amended rules greatly simplify the accounting by requiring companies to record deferred items at the statutory income tax rate in the jurisdiction, without regard for the effect of any potential taxes based on other non-income measures. Companies should record current taxes equal to the amount based on income in the period, recording any amount in excess of the income tax as a franchise tax (not as a component of income tax). 

Step up in goodwill

The guidance amends ASC 740-10-25-54 and now requires companies to determine whether a step up in the tax basis of goodwill relates to a previous business combination or is the result of a separate transaction. If the step-up relates to a previous business combination, the company should not record a deferred tax asset related to the goodwill, except to the extent that the newly tax-deductible goodwill exceeds the remaining balance of book goodwill. However, the company should record a deferred tax asset in instances where the step-up relates to a separate transaction. Factors that indicate that the step up in goodwill may be a separate transaction include:

• A significant lapse in time between transactions;
• The tax basis in new goodwill does not arise from settlement of liabilities of previous acquisition;
• The step-up is based on a valuation of the goodwill itself or a valuation of the business after the date of the business combination;
• The transaction resulting in step up requires more than a simple tax election;
• The entity incurs cash tax cost or sacrifices existing tax attributes to receive the step-up; or 
• The transaction resulting in the step-up was not contemplated at the time of business combination.

Foreign entity ownership changes

The ASU simplifies the accounting for income taxes for companies with a change in the percentage of ownership for foreign entities. Previously, where a company’s ownership of the foreign entity increased to require the company to consolidate the entity (rather than account for the entity using the equity method) the entity’s deferred tax liability was frozen, creating additional complexities. Similarly, when a company’s reduction in ownership caused a foreign entity to move from consolidation to the equity method, the guidance allowed companies to refrain from recording a deferred tax liability for the portion of basis differences for which the indefinite investment assertion had previously been made.

ASU 2019-12 removes these exceptions, outlined in ASC 740-30-25-15 and -16, and upon adoption, companies with ownership changes in foreign subsidiaries will follow the general rules for the recognition of deferred tax liabilities for equity investments and subsidiaries.

Separate company financials

Single-member limited liability companies that are disregarded for tax purposes generally are not severally liable for the taxes of its taxable owner. Therefore, some entities do not allocate the consolidated amount of current and deferred taxes to a single-member limited liability company that is disregarded from its owner, while other entities do. Under the amended guidance, companies that prepare separate financial statements for subsidiaries are not required to allocate tax expense to legal entities that are not subject to tax (e.g. disregarded single-member limited liability companies). However, companies may elect to allocate tax expense to these entities except where the entity is a partnership or other pass-through entity that is not wholly owned.

Effective date notes

While companies may adopt the changes outlined in ASU 2019-12 early, companies must adopt all of the guidance simultaneously. For those companies issuing interim financial statements, the adjustments shall be reflected as of the beginning of the annual period. 

Companies should reflect the adoption of the guidance in ASU 2019-12 as follows:

• Relating to separate company financials – on a retrospective basis for all periods presented in the related financials. 
• For foreign entity ownership changes – on a modified retrospective basis, recording a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption.
• Relating to franchise taxes – on a retrospective or modified retrospective basis.
• For all other adjustments – on a prospective basis. 

Takeaways 

The guidance in ASU 2019-12, Simplifying the Accounting for Income Taxes, covers a wide range of topics and makes several amendments that reduce complexities in the application of ASC 740. Companies should carefully evaluate each of the provisions identified above to ensure that all of the effects are identified prior to the adoption of the guidance.