Current and deferred tax: the asset and liability method

• Compute current tax expense from taxable income and the enacted rate
• Compute deferred tax expense as the change in deferred tax assets and liabilities
• Apply the enacted-rate, no-discounting and noncurrent classification rules
• Explain why a provision with only temporary differences produces the statutory rate

Two pieces make the provision

ASC 740 comes from FASB Statement No. 109, and its arithmetic has not changed since 1992. Statement 109 paragraph 16 says it plainly: deferred tax expense or benefit is the change during the year in an entity's deferred tax liabilities and assets, and total income tax expense is the sum of deferred tax expense and income taxes currently payable or refundable.

So every provision has two parts:

• Current tax. The tax on this year's taxable income per the return (or the expected return), plus any adjustments to prior-year current taxes.
• Deferred tax. The change in the balance sheet amounts that represent future tax consequences of items already in the financial statements.

This is the asset and liability method. The balance sheet drives the income statement: you measure deferred tax balances at year end, compare them to the opening balances, and the difference (net of amounts that go to equity, OCI or acquisition accounting) is deferred tax expense.

The annual computation

Statement 109 paragraph 17 lays out the steps, applied separately for each tax-paying component in each tax jurisdiction:

1. Identify the types and amounts of existing temporary differences, and the nature, amount and remaining life of each operating loss and tax credit carryforward.
2. Measure the deferred tax liability for taxable temporary differences at the applicable rate.
3. Measure the deferred tax asset for deductible temporary differences and loss carryforwards at the applicable rate.
4. Measure deferred tax assets for each type of tax credit carryforward.
5. Reduce deferred tax assets by a valuation allowance if it is more likely than not (a likelihood of more than 50 percent) that some portion will not be realized.

The valuation allowance gets its own lesson: the four sources of taxable income.

Measurement rules that trip people up

• Enacted rates only. Paragraph 18 measures deferred taxes using the enacted rate expected to apply when the difference reverses. A proposed bill does not count. When a law changes, paragraph 27 requires the effect on deferred balances to go to income from continuing operations in the period that includes the enactment date.
• The federal rate. For a C corporation, 26 U.S.C. 11(b) sets the federal rate at 21 percent of taxable income. State taxes add their own rates (see the state taxes lesson).
• No discounting. Statement 109 prohibits discounting deferred tax assets and liabilities, even when reversal is decades away.
• Classification. ASU 2015-17 amended ASC 740-10-45-4 so that, in a classified balance sheet, all deferred tax liabilities and assets are noncurrent. Under ASC 740-10-45-6, deferred tax assets and liabilities (with any valuation allowance) are offset within a tax-paying component and jurisdiction, but never across components or jurisdictions.

How auditors use this structure

An auditor tests the provision as two separately supported numbers that must reconcile to one total:

• Current: tie taxable income to the prior-year return (through the return-to-provision true-up) and to the current-year book-to-tax schedule. The Schedule M-1 reconciliation workbook is the natural bridge.
• Deferred: roll forward each deferred balance from opening to closing, with the movement split among expense, equity, OCI and acquisitions. The deferred tax rollforward template is built that way.
• Proof: if the deferred rollforward does not explain the change in the balance sheet accounts, something is booked in the wrong place.

The common file error is a provision where deferred expense is plugged as total expense minus current expense. That hides errors in both pieces. Build each piece independently and make them prove to the total.

Building the provision for Ridgeback Tool & Die, Inc.