Financial reporting developments A comprehensive guide

Income taxes Revised September 2015

To our clients and other friends

This guide is designed to summarize the accounting literature related to accounting for income taxes.

Accounting Standards Codification Topic 740 includes financial accounting and reporting guidance for the effects of income taxes that result from an entity’s activities during the current and preceding years. It codified the guidance that was previously included in Statement 109, APB 23 and other FASB statements and EITF consensuses.

This publication has been updated for EY interpretative guidance through September 2015. We have updated and expanded our guidance covering a variety of topics including indefinite reinvestment assertions, disposal of tax-deductible goodwill and income tax allocation methods in the separate financial statements of subsidiaries. Updated and expanded sections are indicated in the respective heading as well as in Appendix D.

Excerpts from, and references to, the Accounting Standards Codification are contained within this guide. Guidance that may still be applicable but is based on non-authoritative standards not included in the FASB’s Accounting Standards Codification is included in an appendix.

EY professionals are prepared to help you identify and understand the issues related to income taxes. In addition, our audit and tax professionals would be pleased to discuss with you any other issues related to your tax and financial reporting needs.

Revised September 2015

Financial reporting developments: Income taxes | i

Contents

1 Introduction............................................................................................................... 1 2 Scope ........................................................................................................................ 5

2.1 General ................................................................................................................................. 5 2.2 State income taxes ................................................................................................................ 5 2.3 Partnerships and other flow-through entities ........................................................................... 6 2.4 Excise taxes — not-for-profit foundations ................................................................................. 6

3 Objectives and basic principles ................................................................................... 7 3.1 Basic approach ...................................................................................................................... 8 3.2 Exceptions to comprehensive accounting for deferred taxes .................................................. 10

3.2.1 Leveraged leases ........................................................................................................ 12 3.2.1.1 Leveraged lease tax credits as source of taxable income .............................. 12 3.2.1.2 Impact of change in effective tax rate ......................................................... 13 3.2.1.3 Impact of alternative minimum tax on leveraged lease

accounting ............................................................................................... 13 3.2.1.4 Leveraged leases acquired in business combinations .................................... 13

3.2.2 Intercompany transactions (updated October 2011, September 2013, September 2014 and September 2015) ....................................................................... 14

3.2.2.1 Measurement of prepaid tax on intercompany transactions .......................... 15 3.2.2.1.1 Consideration of NOLs and intercompany transactions

(updated September 2013) ............................................................... 15 3.2.2.2 Classification of prepaid tax on intercompany transactions ........................... 19 3.2.2.3 Impact of subsequent changes in tax rates on prepaid (accrued)

taxes attributable to intercompany transactions .......................................... 19 3.2.2.4 Changes in realizability of prepaid (accrued) taxes attributable

to intercompany transactions (updated September 2013) ............................ 19 3.2.2.5 Uncertain tax position considerations (updated September 2013) ................. 20 3.2.2.6 Business combinations (updated September 2014) ...................................... 20 3.2.2.7 Intercompany sale or transfer of an investment in a

consolidated entity (updated September 2014) ........................................... 21 3.2.3 Foreign currency differences ....................................................................................... 23

3.2.3.1 Nonmonetary temporary differences .......................................................... 23 3.2.3.2 Monetary temporary differences ................................................................ 24

3.2.3.2.1 Taxation of unrealized gains and losses .............................................. 25 3.2.3.2.2 Taxation of realized gains and losses .................................................. 25

3.2.3.3 Tax indexation of nonmonetary assets ........................................................ 26 3.3 Remeasurement in highly inflationary economies .................................................................. 26

3.3.1 Highly inflationary economy — change in functional currency ......................................... 28 3.3.2 General price-level changes — restatement of financial statements ................................ 28

4 Temporary differences ............................................................................................. 31 4.1 Temporary vs. permanent differences .................................................................................. 33 4.2 Identifying cumulative temporary differences ........................................................................ 34

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4.2.1 Temporary differences related to LIFO inventory .......................................................... 34 4.2.2 Temporary differences — change in tax method of accounting ....................................... 34 4.2.3 Tax-to-tax differences ................................................................................................. 35 4.2.4 Temporary differences related to state income taxes .................................................... 35 4.2.5 Different tax and fiscal year ends ................................................................................. 36

4.2.5.1 Payments to the IRS to retain fiscal year ..................................................... 36 4.2.6 Impact on deferred taxes of ability to delay payment..................................................... 36 4.2.7 Tax-planning strategies ............................................................................................... 37 4.2.8 Government assistance received (investment tax credits and government

grants) (updated October 2011 and September 2013) ................................................. 37 4.2.8.1 Scope (updated September 2013) .............................................................. 37 4.2.8.2 Investment tax credits ............................................................................... 39 4.2.8.3 Grant accounting (updated October 2011) .................................................. 40 4.2.8.4 Temporary differences related to government assistance received

(updated September 2013) .......................................................................... 40 4.2.8.5 Other considerations (updated September 2013) ........................................ 41 4.2.8.6 Investments in qualified affordable housing projects — subsequent to

the adoption of ASU 2014-01 (updated September 2014) ............................ 42 4.2.8.6.1 Overview (updated September 2014) ................................................. 42 4.2.8.6.2 Qualifying for the proportional amortization method

(updated September 2014) ............................................................... 43 4.2.8.6.3 Applying the proportional amortization method

(updated September 2014) ............................................................... 47 4.2.8.6.4 Investments in other tax credits (updated September 2014) ................. 50 4.2.8.6.5 Disclosure requirements for investments in qualified

affordable housing projects (updated September 2014) ....................... 50 4.2.9 Temporary differences — examples .............................................................................. 51 4.2.10 Temporary differences — financial services industry ...................................................... 52

4.3 Scheduling the reversal of temporary differences (updated September 2015) ........................ 53 4.3.1 Determining reversal dates .......................................................................................... 54 4.3.2 Examples of temporary difference reversal patterns ..................................................... 55 4.3.3 Change in method used to determine reversal pattern .................................................. 58

4.4 Basis differences without future tax consequences — permanent differences ........................... 58 4.5 Temporary differences without financial reporting asset or liability

(updated October 2011) ...................................................................................................... 59 4.6 Asset retirement obligations (updated September 2014) ....................................................... 59

5 Recognition and measurement .................................................................................. 63 5.1 Applicable tax rates ............................................................................................................. 64

5.1.1 Average graduated tax rates ....................................................................................... 65 5.1.2 Applicable tax rate to measure temporary differences related to

indefinite-lived intangible assets (updated September 2014) ......................................... 66 5.2 Enacted tax rate .................................................................................................................. 67 5.3 Dividends received deductions .............................................................................................. 67

5.3.1 Rate differential on distributed or undistributed earnings (including subsidiary dividend paid tax credits) (updated September 2013) ................................... 68

5.3.1.1 Consolidated financial statements (updated September 2013) ...................... 68 5.3.1.2 Separate financial statements of a subsidiary (updated September 2013) ..... 69

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5.3.2 Shareholders’ tax credits for dividends paid .................................................................. 71 5.4 Tax holidays ........................................................................................................................ 72

5.4.1 Applicable tax rate in a tax holiday period ..................................................................... 72 5.5 Alternative minimum tax ...................................................................................................... 73

5.5.1 Overview of the US corporate AMT system ................................................................... 75 5.5.2 Effect of the AMT on deferred tax calculations .............................................................. 76 5.5.3 Examples of AMT calculations and related tax provisions ............................................... 77

5.6 State and local income taxes ................................................................................................ 79 5.6.1 State applied vs. enacted tax rates ............................................................................... 80 5.6.2 Estimating deferred state income taxes ........................................................................ 80 5.6.3 Income apportionment (updated September 2014) ...................................................... 80 5.6.4 State taxes based on the greater of franchise tax or income tax .................................... 82

5.6.4.1 Revised Texas franchise tax ....................................................................... 84 5.6.4.2 Franchise tax effect on deferred state income taxes .................................... 85

5.6.5 State taxes based on items other than income .............................................................. 85 5.7 Special deductions ............................................................................................................... 86

5.7.1 Domestic production activities deduction ..................................................................... 87 6 Valuation allowances ................................................................................................ 89

6.1 Sources of taxable income .................................................................................................... 91 6.1.1 Liabilities for uncertain tax positions as a source of taxable income

(updated September 2013) ......................................................................................... 91 6.2 Appropriate character of taxable income .............................................................................. 92

6.2.1 Carryforwards that do not expire ................................................................................. 92 6.3 Future reversal of existing temporary differences (updated September 2015) ........................ 92

6.3.1 Limitations on taxable temporary differences related to indefinite-lived assets as a source of future taxable income (updated October 2011 and September 2014) ........................................................................................................ 93

6.3.2 Operating loss and tax credit carrybacks (updated September 2013 and September 2015) ....................................................................................................... 95

6.3.2.1 Availability of tax credits ........................................................................... 96 6.3.3 Tax benefit substitution vs. realization ......................................................................... 96

6.4 Tax-planning strategies ........................................................................................................ 98 6.4.1 Tax-planning strategies — optionality ............................................................................ 99 6.4.2 Tax-planning strategies — examples ............................................................................ 100 6.4.3 Consideration of significant expenses ......................................................................... 101

6.4.3.1 Classification of expenses to implement tax-planning strategies .................. 102 6.4.4 Tax elections............................................................................................................. 103

6.5 Future taxable income ........................................................................................................ 104 6.5.1 Consistency of assumptions and projections ............................................................... 104

6.5.1.1 Recovery of investments in subsidiaries .................................................... 104 6.5.1.2 Undistributed earnings of a foreign subsidiary ........................................... 105

6.5.2 Projections of future income ...................................................................................... 105 6.5.3 Originating and reversing temporary differences ........................................................ 106

6.6 Evaluation of positive and negative evidence ....................................................................... 107 6.6.1 Cumulative losses (updated October 2011) ................................................................ 108

6.6.1.1 Unusual, nonrecurring and noncash charges ............................................. 109 6.6.1.2 Emergence from bankruptcy .................................................................... 109

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6.6.2 Going concern opinion ............................................................................................... 110 6.6.3 Other negative evidence ............................................................................................ 110 6.6.4 Evaluation of operating loss and tax credit carryforwards ............................................ 110 6.6.5 Limitation of net operating loss carryforwards (updated October 2011

and September 2013) ............................................................................................... 112 6.6.6 Considerations for the release of a valuation allowance (updated October 2011) ........... 114

6.7 Available evidence ............................................................................................................. 115 6.8 Foreign tax credit carryforwards ......................................................................................... 116 6.9 Effect of Alternative Minimum Tax (AMT) on deferred tax assets .......................................... 116 6.10 Future tax benefits deemed worthless ................................................................................. 116 6.11 Valuation allowances in a business combination .................................................................. 116 6.12 Intraperiod tax allocations .................................................................................................. 117

6.12.1 Valuation allowances for certain debt and equity securities ......................................... 117 6.12.2 Valuation allowances for amounts recorded in other comprehensive

income related to postretirement benefit plans ........................................................... 118 7 A change in the valuation allowance ........................................................................ 119

7.1 General ............................................................................................................................. 119 7.2 Changes in valuation allowances — business combinations .................................................... 119 7.3 Valuation allowances for temporary differences related to undistributed

earnings of a foreign subsidiary .......................................................................................... 120 7.4 Intraperiod tax allocations .................................................................................................. 120

7.4.1 Valuation allowances for certain debt and equity securities ......................................... 120 7.4.2 Valuation allowances for amounts recorded in other comprehensive

income related to postretirement benefit plans ........................................................... 121 8 An enacted change in tax laws or rates ................................................................... 122

8.1 Changes in tax laws and rates ............................................................................................. 122 8.1.1 Regulatory changes akin to legislative changes ........................................................... 124

8.2 Enactment date ................................................................................................................. 124 8.2.1 Enactment date (United States) ................................................................................. 124 8.2.2 Enactment date (Australia) ........................................................................................ 125 8.2.3 Provisional measures ................................................................................................ 125

8.3 Effects of rate changes on deferred tax assets .................................................................... 125 8.4 Retroactive change in enacted tax rates .............................................................................. 127 8.5 Changes in tax rates following adoption of new accounting standards ................................... 130 8.6 Change in tax law or rates related to items not recognized in continuing operations .............. 131 8.7 Changes in tax accounting methods (updated September 2014) .......................................... 132

8.7.1 Discretionary change in tax accounting methods (updated September 2014) ............... 133 8.7.2 Nondiscretionary change in tax accounting methods ................................................... 135 8.7.3 Change in tax accounting methods due to change in tax law ........................................ 135 8.7.4 Implementing a change in tax accounting method (updated September 2014) ............. 135

8.8 Other discussions of the impact of changes in tax rates ........................................................ 137 9 Change in the tax status of an entity ....................................................................... 138

9.1 General (updated September 2013) .................................................................................... 138 9.2 Conversion of a partnership to a corporation (updated September 2013) ............................. 139

9.2.1 Outside basis considerations related to a conversion of a partnership to a corporation (updated September 2013) ..................................................................... 140

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9.3 Change in tax status as a result of acquisition (updated September 2013) ............................ 140 9.4 Change in tax status — subsequent event (updated September 2013) ................................... 140

9.4.1 Change in tax status — effective date versus financial reporting date (updated September 2013) ....................................................................................... 141

9.5 Built-in gains (updated October 2011) ................................................................................ 142 9.6 Upon consummation of initial public offering ....................................................................... 144 9.7 Loss of nontaxable status ................................................................................................... 145 9.8 REIT conversion (updated September 2013) ....................................................................... 145

10 Regulated entities .................................................................................................. 148 10.1 General ............................................................................................................................. 148 10.2 Regulatory-assisted acquisitions of financial institutions ...................................................... 149 10.3 Business combinations ....................................................................................................... 149 10.4 Impact of regulatory requirements ..................................................................................... 149

11 Business combinations ........................................................................................... 151 11.1 General ............................................................................................................................. 152 11.2 Tax effects of basis differences (updated September 2013) ................................................. 152

11.2.1 Changes in tax basis (updated September 2013) ........................................................ 153 11.2.1.1 Tax effects of obtaining a step-up in inside-tax basis of acquired

net assets (updated September 2013) ...................................................... 155 11.2.1.1.1 Tax effects of a post-acquisition merger

(updated September 2013 and September 2014) .............................. 155 11.2.1.2 Post-combination intercompany transactions

(updated September 2013) ...................................................................... 156 11.2.1.3 Post-combination intercompany transfers of acquired

intellectual property (updated September 2014) ....................................... 156 11.3 Identifiable intangible assets and goodwill (updated September 2014) .................................. 157

11.3.1 Nondeductible goodwill ............................................................................................. 158 11.3.1.1 Amortization of nondeductible goodwill after adoption of ASU

2014-02 (updated September 2014) ........................................................ 158 11.3.2 Nondeductible identified intangible assets .................................................................. 159 11.3.3 Purchase price allocation differences ......................................................................... 159 11.3.4 Tax-deductible goodwill (updated September 2014) ................................................... 159 11.3.5 Goodwill amortization and impairment allocation policies

(updated September 2014) ....................................................................................... 162 11.3.5.1 Financial reporting goodwill not amortized (updated September 2014)........ 163 11.3.5.2 Financial reporting goodwill is amortized .................................................. 165

11.3.6 Excess tax-deductible goodwill in pre-ASC 805 transactions ........................................ 168 11.3.7 Changes in acquirer’s valuation allowance as a result of a business

combination (updated September 2014) .................................................................... 169 11.3.8 Disposal of tax-deductible goodwill (updated September 2015) ................................... 171

11.4 Tax consequences of contingent consideration .................................................................... 174 11.4.1 At acquisition — taxable ............................................................................................. 175 11.4.2 Post acquisition — taxable .......................................................................................... 175 11.4.3 At acquisition — nontaxable ........................................................................................ 176

11.4.3.1 Deferred tax asset — outside basis difference............................................. 176 11.4.3.2 Deferred tax liability — outside basis difference .......................................... 176

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11.4.4 Post-acquisition — nontaxable .................................................................................... 177 11.4.4.1 Deferred tax asset — outside basis difference............................................. 177 11.4.4.2 Deferred tax liability — outside basis difference .......................................... 177

11.5 Deferred taxes for acquisition-related costs ......................................................................... 177 11.5.1 Excess tax basis over financial reporting basis ............................................................ 178 11.5.2 Excess financial reporting basis over tax basis ............................................................ 179

11.6 Deposit-based intangibles ................................................................................................... 179 11.7 Acquired research and development deferred tax liabilities .................................................. 179 11.8 Impairment of identifiable intangible assets and goodwill

(updated September 2014) ................................................................................................ 180 11.8.1 Impairment of tax-deductible goodwill (updated September 2014) .............................. 180 11.8.2 Impairment of nondeductible goodwill ........................................................................ 181

11.8.2.1 Allocation of subsequent impairments to deductible and nondeductible goodwill (updated September 2014) ................................... 181

11.9 Foreign currency temporary differences from “pushdown” adjustments ............................... 181 11.10 Effects of change in tax laws or rates subsequent to a business combination ......................... 183 11.11 Valuation allowance in a business combination .................................................................... 184

11.11.1 Changes in a valuation allowance established at the acquisition date ............................ 184 11.11.1.1 Pre-statement 141(R) business combinations ............................................ 184

11.12 Changes in a tax uncertainty established at the acquisition date ........................................... 185 11.12.1 Pre-Statement 141(R) business combinations ............................................................ 186

11.13 Effect of acquirer-specific attributes on measurement of acquired deferred taxes ................. 186 11.13.1 Valuation allowance for acquired deferred tax assets (updated September 2014) ........... 186 11.13.2 Apportioned tax rates................................................................................................ 187 11.13.3 Unborn foreign tax credits ......................................................................................... 188 11.13.4 Assertion regarding indefinite reinvestment (updated September 2013) ...................... 188

11.13.4.1 Deferred tax accounting on acquired outside basis differences in post-combination restructuring (updated September 2014) ....................... 189

11.14 Income tax effects of replacement awards classified as equity issued in a business combination ......................................................................................................... 190

11.14.1 Accounting for the tax effects of incentive stock options (ISOs) ................................... 191 11.15 Differences in measurement of deferred taxes in separate financial statements

of subsidiary ...................................................................................................................... 192 11.16 Tax effects of a business combination achieved in stages ..................................................... 193

11.16.1 Outside basis differences ........................................................................................... 193 11.16.1.1 Deferred tax liabilities for domestic subsidiaries acquired in stages ............. 194 11.16.1.2 Deferred tax liabilities for foreign subsidiaries acquired in stages ................ 195 11.16.1.3 Limitations on deferred tax assets for subsidiaries ..................................... 196

11.16.2 Inside basis differences.............................................................................................. 197 12 Noncontrolling interests ......................................................................................... 198

12.1 Reporting noncontrolling interests and income taxes in the consolidated income statement .. 198 12.2 Changes in ownership interest in a subsidiary other than in a business combination .............. 199

12.2.1 Decreases in a parent’s ownership interest in a subsidiary without loss of control ......... 199 12.2.2 Increases in a parent’s ownership interest in a subsidiary ............................................ 200 12.2.3 Other tax effects of change in ownership of subsidiary (updated October 2011) ........... 200 12.2.4 Loss of control of a subsidiary .................................................................................... 201

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13 Asset acquisitions .................................................................................................. 204 13.1 Asset acquisitions .............................................................................................................. 204

13.1.1 Asset acquired with tax basis greater than book basis ................................................. 206 13.1.2 Asset purchased for more than tax basis .................................................................... 207 13.1.3 Deferred credit from tangible asset acquisition ........................................................... 208 13.1.4 Deferred credit from the acquisition of assets recorded at fair value ............................ 209 13.1.5 Valuation allowance reduced due to acquired intangible asset ..................................... 209 13.1.6 Purchase of future tax benefits .................................................................................. 210 13.1.7 Transaction directly with a governmental taxing authority ........................................... 210

14 Foreign and domestic subsidiaries and US steamship entity temporary differences ..... 212 14.1 Introduction (updated September 2014) ............................................................................. 212

14.1.1 Six-step process to deferred tax accounting for outside basis differences (updated September 2014) ....................................................................................... 212

14.1.2 Exceptions to deferred tax accounting for outside basis differences (updated October 2011 and September 2014) ........................................................... 214

14.2 Investments in foreign subsidiaries ..................................................................................... 217 14.2.1 Foreign vs. domestic subsidiaries ............................................................................... 218 14.2.2 Investments that are essentially permanent in duration

(updated September 2014 and September 2015)....................................................... 219 14.2.2.1 Inside basis differences of foreign subsidiaries .......................................... 223

14.2.3 Partial reinvestment .................................................................................................. 225 14.2.3.1 Dividends (updated October 2011) ........................................................... 225

14.2.4 Other situations involving “indefinite reversal” ........................................................... 225 14.2.4.1 Change in status of foreign investees ....................................................... 225

14.2.5 Foreign equity method investees and corporate joint ventures .................................... 227 14.2.6 Exceptions to recognition of deferred taxes on undistributed earnings and

US possessions ......................................................................................................... 227 14.2.7 Foreign operational structures ................................................................................... 227

14.2.7.1 Branch offices (updated October 2011 and September 2013) .................... 227 14.2.7.2 Partnerships ........................................................................................... 230 14.2.7.3 Hybrid structures (updated September 2013) ........................................... 231 14.2.7.4 Subpart F income (updated October 2011) ............................................... 231

14.2.8 Deferred taxes allocated to translation adjustments .................................................... 232 14.2.8.1 Original investment not indefinitely reinvested .......................................... 234 14.2.8.2 Hedge of a net investment ....................................................................... 235

14.2.9 Applicability of ASC 740-30 exception to consolidated variable interest entities ........... 235 14.2.10 ASC 740-30 and acquisition accounting ..................................................................... 236 14.2.11 Consideration of unborn foreign tax credits (updated September 2013) ...................... 236 14.2.12 Advance corporate tax payments and refunds (UK) ..................................................... 237

14.2.12.1 Frequently asked questions ..................................................................... 237 14.3 Undistributed domestic earnings before 1992 ..................................................................... 238 14.4 Bad debt reserves of savings and loan associations .............................................................. 238 14.5 Statutory reserve funds of US steamship companies ............................................................ 239 14.6 Investments in domestic subsidiaries .................................................................................. 239

14.6.1 Basis differences with tax consequences .................................................................... 240 14.6.1.1 Outside basis differences in joint ventures ................................................ 241

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14.6.1.2 Outside basis differences in equity method investees — applicable rate (updated September 2013) ............................................... 241

14.6.2 Dividends received deduction..................................................................................... 242 14.6.3 Basis differences without tax consequences ............................................................... 242

14.6.3.1 Expected manner of recovery of investment .............................................. 243 14.6.3.2 Change in expected manner of recovery of investment............................... 243

14.6.4 Partnerships (updated September 2013) ................................................................... 244 14.6.5 State tax considerations for outside basis differences for investments in

domestic subsidiaries (updated September 2014) ....................................................... 245 14.7 Limitations on deferred tax assets (updated September 2014) ............................................. 245

14.7.1 Disposals and assets held for sale (updated September 2014) ..................................... 247 15 Intraperiod tax allocation ....................................................................................... 248

15.1 Income tax expense (benefit) allocated to continuing operations — the incremental approach (updated September 2015) ............................................................... 249

15.1.1 Tax effect of pretax income from continuing operations .............................................. 250 15.1.1.1 Exception to general principle of allocation to continuing

operations (updated September 2014 and September 2015) ...................... 251 15.1.1.1.1 Level of application (updated September 2013) ................................ 256

15.1.2 Changes in tax laws, rates or tax status ...................................................................... 257 15.1.3 Changes in the valuation allowance ............................................................................ 257 15.1.4 Tax benefit of dividends on shares held by ESOP ......................................................... 259

15.1.4.1 Tax benefit of dividends on allocated ESOP shares ..................................... 259 15.1.4.2 Tax benefit of dividends on unallocated ESOP shares ................................. 259

15.1.4.2.1 Unallocated shares accounted for under SOP 76-3 (non-authoritative).......................................................................... 259

15.2 Items charged or credited directly to shareholders’ equity .................................................... 260 15.2.1 Income taxes for debt and equity securities classified as available for sale .................... 261

15.2.1.1 Initial recognition of unrealized loss .......................................................... 263 15.2.1.2 Valuation allowances ............................................................................... 263

15.2.1.2.1 Deferred tax assets related to unrealized losses on debt securities ...... 265 15.2.1.2.2 Subsequent to initial recordation ...................................................... 267

15.2.1.2.2.1 Changes due to changes in portfolio value (updated October 2011) ....................................................................... 267

15.2.1.2.2.2 Reductions resulting from a change in judgment ........................ 269 15.2.1.2.2.3 Increases resulting from a change in judgment .......................... 270

15.2.1.3 Income tax rate changes .......................................................................... 270 15.2.1.4 Backward tracing of tax effects ................................................................ 270

15.2.2 Cumulative translation adjustment ............................................................................. 271 15.2.2.1 Foreign currency hedges ......................................................................... 272

15.2.3 Cash flow hedges ...................................................................................................... 272 15.2.4 Deferred taxes for postretirement benefit plans .......................................................... 273

15.2.4.1 Recognition of deferred taxes for activity in postretirement benefit plans .......................................................................................... 273

15.2.4.2 Valuation allowances ............................................................................... 273 15.2.4.2.1 Subsequent recognition of valuation allowance ................................. 274 15.2.4.2.2 Valuation allowance changes due to changes in amounts in other

comprehensive income related to postretirement benefit plans ........... 274

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15.2.4.2.3 Change in judgment resulting in decreased valuation allowance .......... 275 15.2.4.2.4 Change in judgment resulting in increased valuation allowance ........... 276

15.2.4.3 “Lingering effects” of changes in judgment on other comprehensive income ....... 276 15.2.4.4 Income tax rate changes .......................................................................... 276

15.2.5 Income tax consequences of issuing convertible debt .................................................. 277 15.2.5.1 Income tax consequences of issuing convertible debt with a

beneficial conversion feature ................................................................... 277 15.2.5.2 Income tax consequences of issuing convertible debt

instruments that may be settled in cash upon conversion (updated September 2014) ...................................................................... 279

15.2.6 Order of tax deductions for excess stock compensation — prior to application of ASC 718 .............................................................................................. 281

15.2.7 Tax effects of transactions among or with shareholders (updated October 2011 and September 2014) ....................................................................................... 282

15.2.7.1 Tax effects of spin-off transactions (updated October 2011) ...................... 284 15.2.7.2 Need for a valuation allowance by the subsidiary when there is a

spin-off transaction (updated October 2011) ............................................. 284 15.2.8 Tax benefits of pre-reorganization temporary differences and carryforwards ............... 285

15.3 Operating loss tax benefit — backward tracing prohibited ..................................................... 286 15.4 Intraperiod tax allocation examples ..................................................................................... 286

16 Reorganizations ..................................................................................................... 290 16.1 General ............................................................................................................................. 290 16.2 Bankruptcies (updated September 2014) ............................................................................ 290

17 Separate financial statements of a subsidiary .......................................................... 292 17.1 General ............................................................................................................................. 292 17.2 SEC staff position .............................................................................................................. 293 17.3 Carve-out financial statements ........................................................................................... 294 17.4 Other allocation methods (non-SEC filers) (updated September 2015) .................................. 295

18 Financial statement presentation and disclosures .................................................... 297 18.1 Balance sheet presentation (updated October 2011 and September 2015) .......................... 298

18.1.1 Offset of deferred tax assets and liabilities (updated September 2013 and September 2014) ..................................................................................................... 299

18.1.1.1 State and local income taxes and valuation allowance (updated September 2013) ...................................................................... 300

18.2 Disclosures about balance sheet accounts ........................................................................... 301 18.2.1 Components of balance sheet deferred tax amounts ................................................... 305 18.2.2 Net operating loss and tax credit carryforwards .......................................................... 305 18.2.3 Subsequent recognition of tax benefits....................................................................... 305 18.2.4 Indefinite reversal exceptions .................................................................................... 306 18.2.5 Other balance sheet-related disclosures ..................................................................... 306

18.3 Disclosures about income statement accounts .................................................................... 307 18.3.1 SEC staff position ...................................................................................................... 307

18.4 Disclosure of changes in tax laws or rates ............................................................................ 308 18.5 Interest and penalties due to taxing authorities ................................................................... 308 18.6 Professional fees ............................................................................................................... 308 18.7 Reconciliation to statutory rate .......................................................................................... 308

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18.8 Illustrative financial statement note disclosure (updated September 2013) ........................... 309 18.9 Management’s discussion and analysis — SEC staff positions ................................................ 311

18.9.1 Management’s discussion and analysis disclosure requirements .................................. 312 19 Accounting for uncertainty in income taxes ............................................................. 313

19.1 Introduction ...................................................................................................................... 313 19.2 Scope ................................................................................................................................ 313

19.2.1 Taxes within scope .................................................................................................... 314 19.2.2 Entities within scope .................................................................................................. 314

19.3 Unit of account .................................................................................................................. 314 19.3.1 Unit of account ......................................................................................................... 315 19.3.2 Consistency .............................................................................................................. 316 19.3.3 Attribution of income taxes to the entity or its owners ................................................ 316

19.4 Recognition ....................................................................................................................... 317 19.4.1 More likely than not ................................................................................................... 318 19.4.2 Examination by the taxing authority ........................................................................... 318 19.4.3 Evaluating the technical merits of individual tax positions ............................................ 318

19.4.3.1 Sources of authoritative tax laws (updated September 2014) ..................... 318 19.4.3.2 Tax opinions and levels of authority for a tax position

(updated September 2014) ...................................................................... 320 19.4.4 Administrative practices and precedents .................................................................... 321

19.4.4.1 Self-reporting obligation .......................................................................... 322 19.4.5 Disaggregation ......................................................................................................... 322 19.4.6 General reserves ....................................................................................................... 322 19.4.7 Tax indemnification agreements (updated October 2011) ........................................... 323

19.4.7.1 Tax indemnification agreements in a business combination (updated October 2011) .......................................................................... 323

19.4.7.2 Tax indemnification agreements in a spin-off transaction (updated October 2011) .......................................................................... 326

19.4.7.3 Other tax indemnification agreements (updated October 2011) .................. 327 19.4.8 Amended tax returns and tax refund claims (updated September 2014) ...................... 328

19.5 Measurement of tax positions ............................................................................................. 329 19.5.1 Measurement............................................................................................................ 329

19.5.1.1 Binary tax positions (updated September 2014) ........................................ 330 19.5.2 Highly certain tax positions ........................................................................................ 330

19.5.2.1 Documentation of highly certain tax positions ........................................... 331 19.5.3 Measurement of a tax position after an audit settlement ............................................. 331 19.5.4 Differences related to timing ...................................................................................... 332 19.5.5 Transfer pricing (updated September 2014) ............................................................... 334

19.6 Tax-planning strategies ...................................................................................................... 335 19.6.1 Tax-planning strategies ............................................................................................. 336

19.7 Subsequent recognition, derecognition and measurement ................................................... 336 19.7.1 Subsequent recognition ............................................................................................. 338

19.7.1.1 Effectively settled ................................................................................... 338 19.7.1.2 Change in assessment of technical merits ................................................. 339

19.7.2 Effect of completion of an audit on change in measurement ........................................ 339 19.7.3 Examples — various stages of an audit on recognition and measurement ...................... 340

19.7.3.1 Audit milestones ..................................................................................... 341

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19.7.3.2 Payment of taxes as prerequisite to petition a court (updated September 2014) ................................................................................... 343

19.7.4 Derecognition of a tax position ................................................................................... 343 19.7.5 New information vs. new evaluation ........................................................................... 343 19.7.6 Changes in judgment ................................................................................................. 343 19.7.7 Intraperiod tax allocation (updated September 2013) ................................................. 344 19.7.8 Subsequent events .................................................................................................... 346 19.7.9 Interim reporting ....................................................................................................... 347

19.8 Interest and penalties ......................................................................................................... 347 19.8.1 Interest .................................................................................................................... 347 19.8.2 Penalties .................................................................................................................. 348

19.9 Classification (updated September 2014)............................................................................ 348 19.9.1 Classification as current or noncurrent (updated September 2014) ............................. 350 19.9.2 Accounting policy election (updated September 2014) ............................................... 350 19.9.3 Interaction with ASC 718 .......................................................................................... 350 19.9.4 Presentation of an unrecognized tax benefit when a net operating loss

carryforward, a similar tax loss or a tax credit carryforward exists (updated September 2013 and September 2014)....................................................... 351

19.9.4.1 Subsequent to the adoption of ASU 2013-11 (updated September 2013 and September 2014) ....................................................................... 351

19.9.4.2 Prior to the adoption of ASU 2013-11 (updated September 2013) .............. 353 19.10 Disclosures ........................................................................................................................ 353

19.10.1 Disclosures under ASC 740 for uncertain tax positions (Illustration 19-5 updated September 2013) ........................................................................................ 355

19.10.2 Disclosure example ................................................................................................... 357 19.10.3 Interim reporting ....................................................................................................... 357

19.11 Implementation ................................................................................................................. 358 19.11.1 SEC shares views on the guidance in ASC 740 related to uncertainty in

income taxes adoption issues ..................................................................................... 359 Questions and interpretative responses ........................................................................................ 362

20 Interim reporting ................................................................................................... 364 20.1 Estimated annual effective tax rate ..................................................................................... 364

20.1.1 Nonrecognized subsequent events (updated September 2014) ................................... 366 20.2 Operations taxable in multiple jurisdictions .......................................................................... 367

20.2.1 Income tax effects of a change in an indefinite reinvestment assertion ......................... 368 20.2.2 Zero-rate jurisdictions (updated September 2014)...................................................... 369 20.2.3 Effects of deferred tax liabilities related to indefinite-lived intangible assets on

the estimated annual effective tax rate (updated September 2014) ............................. 369 20.3 Effect of new tax legislation (updated October 2011 and September 2015) .......................... 370 20.4 Computation of interim period tax (or benefit) ..................................................................... 373

20.4.1 Exception of general principle of allocating income tax (benefit) to continuing operations ................................................................................................ 376

20.4.2 Ability to estimate the annual effective tax rate .......................................................... 378 20.5 Reversal of taxable temporary differences .......................................................................... 379 20.6 Tax (or benefit) applicable to significant unusual or infrequently occurring

items, discontinued operations or extraordinary items (updated October 2011) .................... 380 20.6.1 Basis of tax provision (updated September 2013 and September 2015) ...................... 380

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20.6.2 Discontinued operations (updated October 2011 and September 2013) ...................... 384 20.6.3 Gain from the disposal of a component of an entity (updated October 2011) ................ 389

20.7 Using a prior-year operating loss carryforward (updated September 2013) .......................... 390 20.8 Examples ........................................................................................................................... 391

20.8.1 Estimated annual effective tax rate computation and effect of new tax legislation ........ 392 20.8.1.1 Calculation of first-quarter income tax expense ......................................... 392 20.8.1.2 Calculation of second-quarter income tax expense when a

change in tax rates occurs ....................................................................... 393 20.8.2 Accounting for income taxes if an “ordinary” loss is anticipated for the fiscal year ........ 394

20.8.2.1 Realization of the full tax benefit of losses when company has “ordinary” losses in all interim periods ...................................................... 394

20.8.2.2 Realization of the full tax benefit of losses when company has “ordinary” income and losses in interim periods and for the year-to-date period ........... 395

20.8.2.3 Partial realization of the tax benefit of losses when company has “ordinary” losses in all interim periods ...................................................... 396

20.8.2.4 Partial realization of the tax benefit of losses when company has “ordinary” income and losses in interim periods and for the year-to-date period (Illustration 20-10 updated October 2011) ................... 396

20.8.3 Accounting for income taxes upon the use of prior-year net operating loss carryforwards .................................................................................................... 397

20.8.3.1 Reversal of valuation allowance because of current-year ordinary income ... 397 20.8.3.2 Reversal of valuation allowance because of estimated

“ordinary” income in future years ............................................................ 398 21 Share-based payment ............................................................................................ 400

21.1 ASC 718 overview ............................................................................................................. 400 21.2 Tax effects of awards that normally result in a tax deduction ................................................ 401

21.2.1 Measuring deferred taxes for deductible awards ......................................................... 402 21.2.2 The effect on deferred tax assets of the IRC Section 162(m) limitation ......................... 403

21.2.2.1 Section 162(m)(6) limitations for certain health insurance providers ........... 404 21.3 Valuation allowances on deferred tax assets ....................................................................... 405 21.4 Realization of tax benefits .................................................................................................. 406

21.4.1 Tax deduction exceeds recognized compensation cost (updated September 2015) ....................................................................................... 407

21.4.2 Tax deduction is less than recognized compensation cost (updated September 2015) ....................................................................................... 407

21.4.3 Determining the pool of excess tax benefits ................................................................ 408 21.4.3.1 Entities to be included in the pool of excess tax benefits ............................. 410 21.4.3.2 Net unrealized excess tax benefits acquired in a purchase

business combination .............................................................................. 411 21.4.4 Determining when an excess tax benefit is realized and measuring the

excess tax benefit (updated September 2015) ............................................................ 411 21.4.4.1 Identifying and measuring deductions realized during the period

(updated September 2014) ....................................................................... 412 21.4.4.1.1 Aggregation of shortfalls and windfalls ............................................. 414

21.4.4.2 Identifying and measuring excess tax benefits in foreign jurisdictions .......... 415 21.4.4.3 Realization of tax benefits on awards subject to graded vesting .................. 415 21.4.4.4 Tax effects of liability awards and Section 83(b) elections .......................... 416

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21.5 Examples of the accounting for the tax consequences of non-qualified stock options ..................................................................................................................... 417

21.5.1 Tax deduction exceeds the amount of cumulative compensation cost recognized ............ 417 21.5.2 Tax deduction is less than the amount of cumulative compensation cost recognized ..... 419

21.6 Tax effects of awards that normally do not result in a tax deduction ..................................... 420 21.6.1 Accounting for a change in the tax status of an award (e.g., disqualifying disposition) ... 421

21.6.1.1 Modifications of incentive stock options .................................................... 422 21.7 Other issues ...................................................................................................................... 422

21.7.1 Income tax effects of replacement awards classified as equity issued in a business combination ................................................................................................ 422

21.7.2 Impact of research and development cost-sharing arrangements on deferred taxes .......................................................................................................... 423

21.7.3 Accounting for income tax benefits of dividends on share-based payments .................. 424 21.7.4 Accounting for payroll taxes on share-based payments (not subject to

ASC 740) .................................................................................................................. 426 21.8 Presentation ...................................................................................................................... 427

21.8.1 Balance sheet classification of deferred tax assets arising from share-based payments ........................................................................................................ 427

21.8.2 Presentation of excess tax benefits in the statement of cash flows .............. 427 21.9 Transition issues ................................................................................................................ 428

21.9.1 Deferred taxes in transition — Modified prospective transition ...................................... 428 21.9.1.1 Calculating APIC credits available for deferred tax asset write-offs .............. 430 21.9.1.2 Calculating the initial pool of excess tax benefits under the

original method ...................................................................................... 430 21.9.1.3 Calculating the initial pool of excess tax benefits under the

alternative method.................................................................................. 434 21.9.1.3.1 Initial pool calculation ..................................................................... 434 21.9.1.3.2 Subsequent recognition of tax benefits ............................................. 435

21.9.1.4 Calculating the initial APIC pool for companies that went public after 1994 ............................................................................................. 438

21.9.1.5 Summary of deferred tax effects under modified-prospective transition ...... 439 21.9.2 Deferred taxes in transition — prospective transition ................................................... 440 21.9.3 Accounting for valuation allowances on excess tax benefits recognized

prior to the adoption of ASC 718 ............................................................................... 440 A Abbreviations used in this publication ...................................................................... A-1 B Index of ASC references in this publication ............................................................... B-1 C Non-authoritative guidance ..................................................................................... C-1 C1 (Non-authoritative) Business combinations — prior to adoption of

Statement 141(R) ................................................................................................... C-2 C1.1 General — prior to adoption of Statement 141(R) .................................................................. C-2 C1.2 Tax effects of basis differences — prior to adoption of Statement 141(R) ............................... C-3 C1.3 Identifiable intangible assets and goodwill — prior to adoption of

Statement 141(R) ............................................................................................................... C-4 C1.3.1 Nondeductible goodwill — prior to adoption of Statement 141(R) ................................... C-4 C1.3.2 Nondeductible identified intangible assets — prior to adoption of

Statement 141(R) ...................................................................................................... C-5 C1.3.3 Purchase price allocation differences — prior to adoption of Statement 141(R) .............. C-5

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C1.3.4 Tax-deductible goodwill — prior to adoption of Statement 141(R) ................................... C-5 C1.3.5 Immediate recognition of tax benefits in a business combination — prior to

adoption of Statement 141(R) .................................................................................... C-7 C1.3.6 Negative goodwill — prior to adoption of Statement 141(R) .......................................... C-8 C1.3.7 Deposit-based intangibles — prior to adoption of Statement 141(R) ............................. C-11 C1.3.8 Acquired research and development deferred tax liabilities — prior to

adoption of Statement 141(R) .................................................................................. C-11 C1.3.9 Effect of acquirer-specific attributes on measurement of acquired

deferred taxes — prior to adoption of Statement 141(R) ............................................. C-12 C1.3.9.1 Apportioned tax rates — prior to adoption of Statement 141(R).................. C-12 C1.3.9.2 Unborn foreign tax credits — prior to adoption of Statement 141(R) ........... C-12 C1.3.9.3 Assertion regarding indefinite reinvestment — prior to adoption

of Statement 141(R) .............................................................................. C-13 C1.4 Impairment of identifiable intangible assets and goodwill — prior to adoption of

Statement 141(R) ............................................................................................................. C-13 C1.4.1 Impairment of tax-deductible goodwill — prior to adoption of

Statement 141(R) .................................................................................................... C-13 C1.4.2 Impairment of nondeductible goodwill — prior to adoption of

Statement 141(R) .................................................................................................... C-14 C1.4.2.1 Allocation of subsequent impairments to deductible and

nondeductible goodwill — prior to adoption of Statement 141(R) ................ C-14 C1.4.3 Foreign currency temporary differences from “pushdown” adjustments —

prior to adoption of Statement 141(R) ...................................................................... C-14 C1.5 Effects of change in tax laws or rates subsequent to a business combination —

prior to adoption of Statement 141(R) ............................................................................... C-16 C1.6 Valuation allowance in a business combination — prior to adoption of Statement 141(R) ....... C-17

C1.6.1 Acquired company tax benefits — prior to adoption of Statement 141(R)..................... C-17 C1.6.1.1 Subsequent recognition of acquired company deductible temporary

differences and carryforwards — prior to adoption of Statement 141(R) ..... C-18 C1.6.1.2 Decrease in valuation allowance established in a business

combination as a result of a change in tax law — prior to adoption of Statement 141(R) ................................................................ C-20

C1.6.2 Acquiring company valuation allowance reduced in a business combination — prior to adoption of Statement 141(R) ................................................ C-20

C1.6.2.1 Subsequent recognition of acquiring company deductible temporary differences and tax carryforwards — prior to adoption of Statement 141(R) ...... C-21

C1.6.3 Acquiring company valuation allowance increased in a business combination — prior to adoption of Statement 141(R) ................................................ C-22

C1.7 Post-combination net operating losses — prior to adoption of Statement 141(R)................... C-22 C1.8 Ordering pre and post acquisition tax benefits — prior to adoption of Statement 141(R) ........ C-23 C1.9 Tax benefits of non-qualified options issued in a purchase business

combination — prior to adoption of Statement 123(R) and Statement 141(R) ....................... C-25 C2 (Non-authoritative) Asset acquisitions — prior to adoption of Statement 141(R) ....... C-26

C2.1 Asset acquisitions — prior to adoption of Statement 141(R) ................................................. C-26 C2.1.1 Asset acquired with tax basis greater than book basis — prior to adoption

of Statement 141(R) ................................................................................................ C-27 C2.1.2 Asset purchased for more than tax basis — prior to adoption of

Statement 141(R) .................................................................................................... C-28

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C2.1.3 Deferred credit from tangible asset acquisition — prior to adoption of Statement 141(R) .................................................................................................... C-29

C2.1.4 Deferred credit from the acquisition of assets recorded at fair value — prior to adoption of Statement 141(R) ...................................................................... C-30

C2.1.5 Valuation allowance reduced due to acquired intangible asset — prior to adoption of Statement 141(R) .................................................................................. C-31

C2.1.6 Purchase of future tax benefits — prior to adoption of Statement 141(R) ..................... C-33 C2.1.7 Transaction directly with a governmental taxing authority — prior to

adoption of Statement 141(R) .................................................................................. C-33 C3 (Non-authoritative) income tax exposures (contingencies) — prior to adoption

of the accounting for uncertainty in income taxes in ASC 740-10 .......................... C-35 C3.1 Initial recognition of tax benefits — prior to adoption of FIN 48 ............................................. C-35 C3.2 Accounting for income tax exposures — prior to adoption of FIN 48 ...................................... C-36 C3.3 Recording an accrual for income tax exposures in the financial statements —

prior to adoption of FIN 48 ................................................................................................ C-38 C3.4 Interest — prior to adoption of FIN 48 ................................................................................. C-40 C3.5 Income tax reserves established in purchase business combinations — prior to

adoption of FIN 48 and Statement 141(R) .......................................................................... C-40 C3.5.1 Tax allocation uncertainties in a business combination — prior to adoption

of FIN 48 and Statement 141(R) ............................................................................... C-41 C3.5.2 Income tax uncertainties in a business combination — prior to adoption of

FIN 48 and Statement 141(R) ................................................................................... C-44 C3.5.3 Deferral of FIN 48 and adoption of Statement 141(R) for certain

nonpublic enterprises ............................................................................................... C-45 C3.6 Disclosure — prior to adoption of FIN 48 ............................................................................. C-46

C4 (Non-authoritative) Income taxes attributable to stock-based compensation arrangements — prior to adoption of Statement 123(R) .................... C-47 C4.1 General — prior to adoption of Statement 123(R) ................................................................ C-47

C4.1.1 APB 25 accounting — prior to adoption of Statement 123(R) ...................................... C-47 C4.1.2 Statement 123 accounting — prior to adoption of Statement 123(R) ........................... C-48 C4.1.3 Taxation of stock-based compensation arrangements — prior to adoption

of Statement 123(R) ................................................................................................ C-48 C4.2 Deferred taxes for stock-based compensation — prior to adoption of Statement 123(R) ........ C-49

C4.2.1 Tax deduction exceeds book expense — prior to adoption of Statement 123(R) ............ C-50 C4.2.2 Book expense exceeds tax deduction — prior to adoption of Statement 123(R) ............ C-51 C4.2.3 Nondeductible awards expensed for book — prior to adoption of

Statement 123(R) .................................................................................................... C-54 C4.2.3.1 Subsequent changes to the tax status of an award — prior to

adoption of Statement 123(R) ................................................................ C-55 C4.2.4 Rescissions of stock option exercises — prior to adoption of Statement 123(R) ............ C-56 C4.2.5 Subsequent changes in the fair market value of underlying stock — prior to

adoption of Statement 123(R) .................................................................................. C-56 C4.2.6 Expired unexercised options — prior to adoption of Statement 123(R) ......................... C-57

C4.3 Valuation allowance considerations — prior to adoption of Statement 123(R) ....................... C-57 C4.3.1 Recognition of a valuation allowance after initial recognition of deferred

tax assets attributable to excess tax deductions — prior to adoption of Statement 123(R) .................................................................................................... C-57

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C4.4 Other stock-based compensation arrangements — prior to adoption of Statement 123(R) ............................................................................................................. C-58

C4.5 Net operating losses utilized before current-year excess stock compensation tax deductions — prior to adoption of Statement 123(R) ...................................................... C-58

C4.6 Classification in statement of cash flows of the income tax benefit received for stock-based compensation — prior to adoption of Statement 123(R) .................................... C-60

C4.7 Tax benefits of non-qualified options issued in a purchase business combination — prior to adoption of Statement 123(R) and Statement 141(R) ....................... C-61

C4.8 Impact of stock compensation tax benefits on EPS computation — prior to adoption of Statement 123(R) ........................................................................................... C-61

C4.8.1 Computing the tax benefit component of the assumed proceeds — prior to adoption of Statement 123(R) .................................................................................. C-62

C4.8.2 Impact of valuation allowance on the tax benefit component of the assumed proceeds — prior to adoption of Statement 123(R) ....................................... C-65

D Summary of important changes ............................................................................... D-1

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Notice to readers:

This publication includes excerpts from and references to the FASB Accounting Standards Codification (the Codification or ASC). The Codification uses a hierarchy that includes Topics, Subtopics, Sections and Paragraphs. Each Topic includes an Overall Subtopic that generally includes pervasive guidance for the topic and additional Subtopics, as needed, with incremental or unique guidance. Each Subtopic includes Sections that in turn include numbered Paragraphs. Thus, a Codification reference includes the Topic (XXX), Subtopic (YY), Section (ZZ) and Paragraph (PP).

Throughout this publication references to guidance in the codification are shown using these reference numbers. References are also made to certain pre-Codification standards (and specific sections or paragraphs of pre-Codification standards) in situations in which the content being discussed is excluded from the Codification.

This publication has been carefully prepared, but it necessarily contains information in summary form and is therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. The information presented in this publication should not be construed as legal, tax, accounting, or any other professional advice or service. Ernst & Young LLP can accept no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. You should consult with Ernst & Young LLP or other professional advisors familiar with your particular factual situation for advice concerning specific audit, tax or other matters before making any decisions.

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Financial reporting developments Income taxes | 1

1 Introduction

Excerpt from Accounting Standards Codification Income Taxes — Overall

Overview and Background

740-10-05-1 The Income Taxes Topic addresses financial accounting and reporting for the effects of income taxes that result from an entity’s activities during the current and preceding years. Specifically, this Topic establishes standards of financial accounting and reporting for income taxes that are currently payable and for the tax consequences of all of the following:

a. Revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized in financial income

b. Other events that create differences between the tax bases of assets and liabilities and their amounts for financial reporting

c. Operating loss or tax credit carrybacks for refunds of taxes paid in prior years and carryforwards to reduce taxes payable in future years.

Generally, most items included in pretax income for financial reporting purposes also are included in taxable income in the same year when taxes are based on income. However, certain items are recognized for financial reporting purposes before or after they are recognized for tax purposes. Over time, these differences arise in one period, reverse in another period and eventually offset each other. In ASC 740, Income Taxes, these differences should be recognized based on the impact on taxes payable if the entity’s assets were converted to cash and liabilities settled at the amounts reported for financial statement purposes.

Illustration 1-1

Assume in Year 1 Company LML received a $100 payment for services to be rendered the following year, concluded one of its customers would not remit the $50 remaining balance due for services rendered during the prior year (and the receivable was written off in Year 4), and purchased an asset for $100 that was depreciable for financial reporting purposes over four years but the tax law allowed the asset to be depreciated over three years. The impact of these differences, as increases or (decreases) in financial reporting and taxable income, is as follows:

Year 1 book/tax

Year 2 book/tax

Year 3 book/tax

Year 4 book/tax

Total book/tax

Deferred revenue — recognized for book when earned, taxed when received — /100 100 / — — / — — / — 100 / 100 Bad debts — recognized for book when incurred, deducted when written off (50) / — — / — — / — — /(50) (50) / (50) Depreciation — 4-year life for book, 3-year life for tax (25) /(33) (25) / (33) (25) /(34) (25) / — (100)/ (100) Net book/tax differences (75) / 67 75 / (33) (25) /(34) (25) /(50) (50) / (50)

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1 Introduction

Financial reporting developments Income taxes | 2

Absent guidance to the contrary, companies might account for income taxes on an “as-paid” basis. That is, the income tax expense recognized in a given period would equal the amount payable to the taxing authority. Although this approach would be reasonable if all items of income and expense were treated the same for financial and tax reporting purposes, that is not the case with most companies applying generally accepted accounting principles. Thus recognition of income tax expense on an “as-paid” basis would not result in the recognition of all costs and benefits attributable to transactions recognized in the financial statements.

Illustration 1-2

Assume the same facts as Illustration 1-1, as well as the following:

• Company LML’s book income, before consideration of the items in Illustration 1-1, was $100 in each period.

• There are no other differences between the financial and tax reporting.

• The enacted statutory tax rate for all periods is 40%.

Under the as-paid basis, Company LML’s tax return statements would reflect the following:

Year 1 Year 2 Year 3 Year 4 Total Preliminary income $ 100.0 $ 100.0 $ 100.0 $ 100.0 $ 400.0 Tax impact of above items 67.0 (33.0) (34.0) (50.0) (50.0) Taxable income 167.0 67.0 66.0 50.0 350.0 Statutory tax rate 40% 40% 40% 40% 40% Current tax expense $ 66.8 $ 26.8 $ 26.4 $ 20.0 $ 140.0

Under the as-paid basis, Company LML’s financial statements would reflect the following:

Year 1 Year 2 Year 3 Year 4 Total Preliminary income $ 100.0 $ 100.0 $ 100.0 $ 100.0 $ 400.0 Book impact of above items (75.0) 75.0 (25.0) (25.0) (50.0) Pretax book income $ 25.0 $ 175.0 $ 75.0 $ 75.0 $ 350.0 Current tax expense (66.8) (26.8) (26.4) (20.0) (140.0) Net income (loss) $ (41.8) $ 148.2 $ 48.6 $ 55.0 $ 210.0

The as-paid basis does not accurately reflect the financial position or results of operations because a company would be subject to additional taxation if its assets were converted to cash and its liabilities extinguished at amounts reported in the financial statements. Thus, the FASB concluded income taxes should be provided in the income statement based on the taxes payable or refundable as if all of its assets were converted to cash and all of its liabilities were extinguished at their financial statement carrying amounts.

Under ASC 740, companies must defer the tax impact of items recognized in earnings or the income tax return, but not both. Thus, the income taxes payable due to differences in the timing of recognizing revenues and expenses for tax and financial reporting purposes (e.g., deferred revenue, recognition of bad debt expense for financial reporting but not tax purposes, depreciation of assets for tax purposes on an accelerated method relative to the method for financial reporting) create differences between the financial reporting basis and tax basis of those items.

1 Introduction

Financial reporting developments Income taxes | 3

Illustration 1-3

Assuming the same facts as described in Illustrations 1-1 and 1-2 above, Company LML would compute its deferred tax assets/(liabilities) and deferred tax benefit/(expense) as follows:

Year 1 Gross/DT

Year 2 Gross/DT

Year 3 Gross/DT

Year 4 Gross/DT

Deferred revenue 100.0 / 40.0 — / — — / — — / — Bad debts 50.0 / 20.0 50.0 / 20.0 50.0 / 20.0 — / — Asset, net of acc