ASC 740

What is ASC 740?

Accounting Standards Codification 740, also known as ASC 740, is a set of tax guidelines that dictates how public and private businesses must account for their income taxes on their financial statements under U.S. GAAP. ASC 740 includes not only the recognition but also the presentation, measurement, and disclosure of an entity’s income tax-related items. Taxes not covered by ASC 740 include payroll, sales and use, capital (equity)-based franchise, and value-added taxes (VAT). ASC 740 and its requirements can profoundly impact the income statement and how an entity reports its tax benefit or expense. It can also affect how liabilities and deferred tax assets are reported on the entity’s balance sheet.

ASC 740, created by the Financial Accounting Standards Board (FASB), incorporates much of the former FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 was issued in 2006 to remove inconsistencies and clarify how companies should account for uncertainty in income taxes reported in their financial statements.

Why is ASC 740 important?

ASC 740 is important because it helps ensure the accuracy of how companies account for and record income taxes in their financial statements. This information is valuable to shareholders, investors, or business partners when assessing corporate performance. Any inaccuracy in ASC 740 can be catastrophic for an organization, causing material weaknesses and financial restatements. Expenses related to financial restatements, as well as a drop in investor confidence and shareholder value, can prove costly to the economic health of a business.

Who is subject to ASC 740?

ASC 740 applies to all entities with income taxes, including public and private companies, non-profit organizations, and domestic and foreign entities. This guideline means income tax in any jurisdiction — federal, foreign, state, or local, including some franchises — is subject to ASC 740.

It is vital to be aware that, in some instances, even pass-through entities may be impacted by ASC 740. Since the tax consequences of transactions are “passed-through” to the owners, pass-through entities have not faced income tax. However, a growing number of states are implementing an entity-level income tax on pass-through entities, like partnerships, S Corporations, etc. In some instances, the pass-through entity tax (PTET) regime of certain states will fall within the scope of ASC 740. Unfortunately, making this determination can prove complex, given a lack of conformity among states.

Does ASC 740 apply to partnerships?

General and limited partnerships are excluded from ASC 740 tax provisions because the income taxes are attributed to the partners. However, in certain jurisdictions, partnerships represent taxable entities, meaning in those instances, ASC 740 would apply to tax based on income for that jurisdiction.

How do you account for uncertain tax positions?

ASC 740 provides standards for recognizing uncertain tax positions (UTP) in corporate financial reporting. According to ASC 740, a tax position is any position an entity takes in previously filed tax returns or anticipates taking on tax returns that have not yet been filed. If there is a 50% or less chance that the tax position would hold up if challenged by tax authorities, it is considered an uncertain position. In other words, the tax position fails to meet the more-likely-than-not standard.

Under ASC 740, the framework for determining and handling uncertain tax positions involves a multi-step process:

1. Inventory all tax positions for the current year and all open years for all jurisdictions.
2. Apply the "more-likely-than-not" (MLTN) threshold — or greater than 50% — and classify all tax positions as uncertain or routine business transactions.
3. Decide if the tax benefits from uncertain tax positions, as well as how much of those benefits, should be accounted for in the financial statements.

Examples of uncertain tax positions can include, but are not limited to:

• Uncertainty about the deductibility of a given amount.
• Uncertainty as to whether tax authorities will accept a particular transfer pricing methodology.
• Establishing whether a tax return should be filed in another state.

The uncertain tax position guidance contained within ASC 740 is notable as it requires organizations to track and disclose uncertain tax positions; however, for some, this may be a difficult balancing act.

Entities with uncertain tax positions, especially those with many uncertain tax positions, may raise a red flag among tax authorities, who could question the validity of the tax position taken on previously filed income tax returns. A large number of uncertain tax positions can also trigger an audit with the IRS.

Should an entity be found at fault and lose the challenge imposed by tax authorities, it could result in an elimination of deductions or an uptick in previously reported taxable income — which would then decrease net income reflected on the financial statements.

How do you calculate the ASC 740 income tax provision? 

Calculating the ASC 740 income tax provision involves determining and adding together the current and deferred income tax provisions.

The current income tax expense equates to the taxes reported on an entity’s current-year returns and any adjustments, if any, for prior-year returns. 

Use the following steps to estimate the company’s current income tax provision:

1. Begin with the company’s pretax GAAP income.
2. Determine permanent differences, which can be added or subtracted. Examples of permanent differences include but are not limited to, entertainment expenses and fines and penalties.
3. Identify temporary differences, which can be added or subtracted. Examining the current year's balance sheet and identifying differences between the GAAP calculations and the income tax calculations can help you determine temporary differences.
4. Deduct usable loss carryforwards.
5. Next, multiply this by the current statutory federal tax rate.
6. Deduct tax credit carryforwards, usable tax credits, and the benefit from current-year loss carrybacks to get the estimated income tax provision.

The deferred income tax expense — often the more complex part of the income tax provision — is the anticipated future tax expense stemming from activities in past or current periods. It focuses on the deferred effects of expenses, tax credits, net operating losses, and income.

What are the ASC 740 disclosure requirements? 

According to FASB’s proposed improvements to the disclosure requirements and rules for income taxes — finalized on August 30, 2023 — public entities must report under the new guidance for annual periods beginning after December 15, 2024. Privately held companies get an extra year. For these entities, the Proposed Accounting Standards Update (ASU) No. 2023-ED100, Income Taxes (Topic 740) Improvements to Income Tax Disclosures, is effective for annual periods beginning after December 15, 2025.

The new disclosure requirements include:

• Rather than a lump sum, entities must provide a breakout of the amounts paid for taxes between federal, state, and foreign taxing jurisdictions. 
• The rate reconciliation will require disaggregation into eight different categories, such as foreign tax effects, tax credits, and valuation allowances. The categories will be further disaggregated by jurisdiction and for amounts exceeding 5% of their domestic tax rate. 
• Companies will be required to disclose both the dollar amounts and percentages versus disclosing the rate reconciliation as either the dollar amounts or the percentages.

An important fact to point out is that the guidance does not require country-by-country disclosures. Previously, this was a point of confusion.