Definition
The effective tax rate is income tax expense divided by pre-tax income. The rate reconciliation starts with expected tax at the statutory federal rate (21% for C corporations) and adjusts for state taxes, permanent differences, credits, changes in valuation allowance, and rate changes, ending at reported expense. Public entities disclose a numerical reconciliation; other entities describe the nature of significant reconciling items. ASU 2023-09 adds specific rate reconciliation categories and disaggregated income taxes paid disclosures. It is effective for public business entities for annual periods beginning after December 15, 2024, and for all other entities for annual periods beginning after December 15, 2025. Entities other than public business entities give a qualitative description of the specific categories.
Why it matters in an audit or review
Auditors use the reconciliation as a reasonableness check: an unexplained gap often points to errors in deferred taxes, missed permanent items, or provision-to-return differences.
Example
(Illustrative) Pre-tax income is $500,000. Expected federal tax at 21% is $105,000. Add state tax net of federal benefit $20,000 and nondeductible meals $3,000, and subtract a $12,000 credit. Total expense is $116,000, an effective rate of 23.2%.
Common mistakes
- Plugging the reconciliation to get to expense.
- Not updating for the entity's actual blended state rate.
Sources
- FASB ASC 740-10-50, Income Taxes, disclosures including the rate reconciliation
- FASB ASU 2023-09, Income Taxes (Topic 740): Improvements to Income Tax Disclosures
- 26 U.S.C. 11(b), corporate income tax rate of 21 percent
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error