The interim tax provision and the estimated annual effective rate

• Compute a quarterly provision using the estimated annual effective tax rate
• Separate ordinary income from items taxed discretely
• Identify items always excluded from the annual rate
• Apply the ASU 2019-12 changes to interim tax accounting

The basic method

Interim tax accounting comes from APB Opinion No. 28 and FASB Interpretation No. 18, now ASC 740-270. Interpretation 18 paragraph 6 states the rule: tax on ordinary income is computed at an estimated annual effective tax rate, and tax on all other items is computed individually and recognized when the items occur.

Ordinary income (paragraph 5) is income from continuing operations before income taxes, excluding significant unusual or infrequently occurring items. Discontinued operations are also excluded. The term has nothing to do with ordinary income versus capital gain.

Paragraph 8 requires the entity to estimate its annual effective tax rate and revise it at the end of each interim period to its best current estimate. The rate reflects anticipated credits, foreign rates, capital gains rates and available tax planning. Paragraph 9 applies the rate to year-to-date ordinary income, and the quarter's tax is the year-to-date amount less amounts reported in prior quarters.

That cumulative approach matters. When the estimated rate changes in the third quarter, the catch-up for the first half lands in the third quarter. Nobody restates the first two quarters.

Discrete items

Items computed and recognized in the period they occur, outside the annual rate:

• Tax on significant unusual or infrequently occurring items and discontinued operations
• Changes in judgment about the realizability of beginning-of-year deferred tax assets (ASC 740-270-30-11)
• Effects of changes in tax laws or rates on deferred tax balances and on prior-year taxes (ASC 740-270-30-11 and 740-270-25-5)
• Changes in judgment on uncertain positions taken in a prior annual period (Interpretation 48 paragraph 13)
• Excess tax benefits and tax deficiencies on share-based awards (ASU 2016-09 requires these to be treated as discrete items in the period they occur)

What ASU 2019-12 changed

ASU 2019-12 changed two interim rules. It removed one exception and fixed the timing of the other:

• Year-to-date loss exceeding the expected annual loss. The old exception in ASC 740-270-30-28 capped the year-to-date benefit at the benefit determined from the year-to-date loss. ASU 2019-12 deleted that cap, so the general method applies: the estimated annual rate goes to the year-to-date loss, and the estimated annual benefit used in the rate is still limited by realizability. The year-to-date benefit can now exceed the benefit computed on the year-to-date loss alone.
• Enacted tax law changes (timing rule, not an exception). ASC 740-270-25-5 now requires the effect of a change in tax law on current-year taxes payable to be reflected in the annual rate computation beginning no earlier than the first interim period that includes the enactment date. The effect on deferred taxes is not spread through the rate; it is recognized in the period of enactment.

When the rate cannot be estimated

Interpretation 18 recognizes that a reliable estimate is sometimes impossible, such as near break-even, where a small change in forecast income produces a large change in the rate. In that case the actual effective rate for the year to date may be the best estimate of the annual rate. Document why a reliable estimate could not be made.

Audit and review focus

In an interim review, inquire how the rate was developed and compare it with the prior year and the forecast. In a year-end audit, the fourth quarter trues everything up, so the interim mechanics matter most to quarterly filers. Common problems:

• Discrete items buried in the annual rate, which spreads them across quarters
• A stale forecast that no one updated after a large customer loss
• Jurisdictions with losses and no benefit mixed into one blended rate

The interim provision workbook and interim calculator follow the year-to-date method. The Form 10-Q review guide covers the review engagement.

Second-quarter provision for Lakeshore Packaging Group, Inc.