The income tax provision is one of the few areas where the trial balance carries a number the client's tax software produced and nobody on the engagement can recompute from the ledger. A worked provision fixes that. Once the book-to-tax differences are sorted into temporary and permanent, the entries follow mechanically, and the auditor's recomputation takes an hour.
This guide runs a complete small provision, then a rate change, and lists the audit tests. For the wider private-company picture see /us/blog/asc-740-income-taxes-private-companies. Valuation allowances are in /us/blog/asc-740-valuation-allowance-assessment-evidence.
What is the five-step model?
ASC 740 splits tax expense into current and deferred components, computed separately, which add up to total expense. Deferred taxes use the asset and liability method, measured from the balance sheet.
- Identify temporary differences. Taxable differences create deferred tax liabilities. Deductible differences create deferred tax assets.
- Identify loss carryforwards and credits. Credits give a dollar-for-dollar benefit and are already tax-effected.
- Determine the applicable tax rate.
- Calculate deferred tax assets and liabilities. Multiply gross temporary differences and loss carryforwards by the rate. Do not multiply credits.
- Evaluate the valuation allowance for the deferred tax assets.
Permanent differences, such as nondeductible meals, never reverse. They change the effective rate but create no deferred balance.
Which tax rate applies?
The applicable rate is the enacted rate under current law that applies in the periods when the temporary differences are expected to reverse, and future changes are not anticipated (KPMG). It is not an effective rate. Where graduated rates are expected to be a significant factor, deferred taxes are measured at the average graduated rate expected in the reversal years. When that average would otherwise be zero, for example because the entity expects losses, the lowest graduated rate is used instead of zero (KPMG). State taxes are computed on the state rate applied separately to the state temporary differences, and a blended federal and state rate has to be supported and reassessed, not presumed.
Scheduling follows ground rules: use a systematic and logical method, and apply the same method to all temporary differences within a category.
Worked provision
An illustration with round numbers and a 21 percent rate, federal only. Pretax book income is $1,000,000. The book-to-tax reconciliation has three items:
- Tax depreciation exceeds book depreciation by $200,000. This is a taxable temporary difference.
- A warranty accrual of $50,000 is expensed for books but deductible only when paid. This is a deductible temporary difference.
- Nondeductible meals are $20,000. This is a permanent difference.
| Line | Amount |
|---|---|
| Pretax book income | 1,000,000 |
| Add: nondeductible meals | 20,000 |
| Add: warranty accrual (not yet deductible) | 50,000 |
| Less: excess tax depreciation | (200,000) |
| Taxable income | 870,000 |
| Current tax at 21% | 182,700 |
Deferred balances at year-end, assuming no opening balances:
| Item | Difference | Rate | Balance |
|---|---|---|---|
| Deferred tax liability, depreciation | 200,000 | 21% | 42,000 |
| Deferred tax asset, warranty accrual | 50,000 | 21% | 10,500 |
Deferred tax expense is $42,000 less $10,500, or $31,500.
| Account | Debit | Credit |
|---|---|---|
| Income tax expense, current | 182,700 | |
| Income tax expense, deferred | 31,500 | |
| Deferred tax asset | 10,500 | |
| Income taxes payable | 182,700 | |
| Deferred tax liability | 42,000 |
Proof: total expense is $214,200, which equals 21 percent of $1,020,000 (book income plus the permanent difference). The effective rate is 21.42 percent. The rate reconciliation shows the 0.42 point gap as the meals; see /us/blog/asu-2023-09-income-tax-disclosures-rate-reconciliation for the disclosure format.
What happens when the tax rate changes?
The effect of a change in tax law or rates on current and deferred tax balances is recorded in income from continuing operations in the period that includes the enactment date. That holds even when the deferred balances relate to items that were reported in discontinued operations, directly in equity or in other comprehensive income (KPMG). The rate used is the one in effect in the period the temporary difference is expected to reverse. If a rate cut applies to tax years beginning after a stated date, reversals scheduled before that date keep the old rate (KPMG).
An illustration, using a hypothetical enacted cut from 21 percent to 18 percent after the year above. Assume none of the differences has reversed and all reversals come after the effective date.
- Deferred tax liability: $200,000 x 18% = $36,000, a decrease of $6,000.
- Deferred tax asset: $50,000 x 18% = $9,000, a decrease of $1,500.
- Net decrease in the net liability: $4,500, a benefit.
| Account | Debit | Credit |
|---|---|---|
| Deferred tax liability | 6,000 | |
| Deferred tax asset | 1,500 | |
| Income tax expense, deferred (continuing operations) | 4,500 |
A law change also calls for a fresh look at the realizability of deferred tax assets. KPMG notes that an allowance cannot be released or withheld in anticipation of a future change in law or rates, because the effect is recognized in the period of enactment (ASC 740-10-35-4). If the change is enacted after year-end but before the statements are issued, its effect is not recognized at year-end, and significant effects not yet recognized are disclosed in the notes (KPMG). That ties to /us/blog/subsequent-events-type-1-type-2-asc-855.
Audit angle
What the auditor tests:
- The tax balance sheet. Obtain the book-to-tax reconciliation and agree the book side to the trial balance. Every line is classified temporary or permanent.
- Recomputation. Rebuild current tax from taxable income, and deferred balances from differences times the enacted rate. The proof that total expense equals the rate times book income plus permanent items catches most arithmetic errors.
- Roll-forward. Opening deferred balance, plus current-year movement, plus rate-change effects, to the closing balance. Agree each to the provision. See also /us/standards/book-tax-differences-schedule-m-1-m-2-m-3.
- Rates. Check that the enacted rate is used, not an effective rate, and that state rates are supported by apportionment.
- Scheduling. Where rates are graduated or changing, obtain the reversal schedule and the method, applied consistently.
- Valuation allowance and subsequent events. Test the allowance on the deferred tax assets, and search for law changes enacted after year-end.
Common misstatements: permanent differences booked as temporary, an effective rate applied to differences, rate-change effects booked in equity instead of continuing operations, a prior-year return-to-provision difference never trued up, and a missing deferred liability on accelerated depreciation.
Questions auditors ask
Do credits get multiplied by the rate?
No. Credits already give a dollar-for-dollar benefit, so they are recorded at face before any allowance.
Does the rate-change effect go through other comprehensive income if the underlying item did?
No. The effect on the deferred balance is recorded in continuing operations in the period of enactment.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- KPMG, Accounting for income taxes Handbook, July 2024 (applicable rate, graduated rates, effect of changes in law on continuing operations, enactment date, subsequent disclosure): https://kpmg.com/kpmg-us/content/dam/kpmg/frv/pdf/2024/accounting-for-income-taxes.pdf
- PwC Viewpoint, Income taxes guide, 4.2 Basic approach for deferred taxes: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/income_taxes/income_taxes__16_US/chapter_4_recognitio_US/42_basic_approach_fo_US.html
- PwC Viewpoint, Income taxes guide, 4.3 Applicable tax rate: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/income_taxes/income_taxes__16_US/chapter_4_recognitio_US/43_applicable_tax_ra_US.html
- PwC Viewpoint, Income taxes guide, 7.3 Accounting for changes in tax laws or rates: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/income_taxes/income_taxes__16_US/chapter_7_change_in__US/73_accounting_US.html
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