ASC 740 and ASU 2023-09: The New Landscape of Income Tax Accounting

Introduction to ASC 740

ASC 740, Accounting for Income Taxes, provides the framework for the measurement, presentation, recognition, and disclosure of income taxes for entities preparing U.S. GAAP financial statements. It applies to both domestic and foreign entities subject to taxes based on net income. ASC 740 sets the guidelines to improve the accuracy of tax-related information in financial statements, which investors and stakeholders rely on to evaluate company performance, viability, and cash flow.

An income tax provision involves calculating and recording current and deferred income tax expenses or benefits in financial statements. The components include:

• Current tax expense (or benefit) and payable (or receivable),
• As well as deferred tax expense (or benefit) and deferred tax liabilities and assets.

Deferred taxes represent future tax impacts related to items recognized in financial statements. Both current and deferred taxes are measured based on enacted laws within a given jurisdiction. The total tax expense, which is the sum of current and deferred tax expenses or benefits, is reported and disclosed in financial statement tax footnotes and reconciled in the rate reconciliation.

The effective tax rate reconciliation analyzes items impacting the jurisdiction's statutory rate, such as the U.S. federal statutory rate of 21%. These items are identified and quantified as a percentage, with the total tax expense measured against financial statement income.

Recent updates: ASU 2023-09

In December 2023, the Financial Accounting Standards Board (FASB) issued ASU 2023-09, which changes the way income tax provisions are disclosed in financial statement footnotes. This update impacts all companies with income taxes and disclosure requirements.

For public companies, the change is effective for annual reporting periods beginning after December 15, 2024. For other businesses, it’s effective for reporting periods beginning after December 15, 2025.

Enhanced footnote disclosure requirements

The changes introduced by ASU 2023-09 aim to provide more transparency to investors but also increase the complexity and burden of footnote preparation for many companies. The enhancements require additional disclosure of information related to the reconciliation of the effective tax rate to statutory rates for federal, state, and foreign income taxes.

The standardization of categories in the rate reconciliation supports consistent reporting and comparative analyses. The changes also eliminate disclosures for unrecognized tax benefit balance changes and cumulative unrecognized deferred tax liabilities.

New disclosure requirements

The new tabular rate reconciliation and cash taxes paid disclosures have a conservative threshold, requiring separate line-item reporting for previously combined items. Pre-tax income or loss from continuing operations must be disclosed separately for foreign and domestic categories. Income tax expense and taxes paid are reported separately in federal, state, and foreign categories. This disaggregation aims to segment data into smaller specified categories, providing clarity and revealing trends.

Differences for public business entities (PBEs) and non-PBEs

There are differences in rate reconciliation disclosure requirements for public business entities (PBEs) and non-PBEs. A PBE is an entity meeting any one of five specific criteria, including being required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements. For PBEs, the new annual rate reconciliation will have eight specific, predefined categories presented in tabular format:

1. State and local income tax, net of federal income tax effect
2. Foreign tax effects
3. Effect of changes in tax laws or rates enacted in the current period
4. Effect of cross-border tax laws
5. Tax credits
6. Changes in valuation allowances
7. Nontaxable or nondeductible items
8. Changes in unrecognized tax benefits

These categories must be reported in both numerical amounts and percentages. Items not fitting into predefined categories must be disclosed separately if their effect exceeds 5% of the amount computed by multiplying income (or loss) from continuing operations before tax by the applicable statutory income tax rate.

Items within certain categories, such as cross-border tax laws, tax credits, and nontaxable or nondeductible items, must be disaggregated by nature. Foreign tax effects must be disaggregated by jurisdiction and nature. Items not fitting any of the eight categories must be disaggregated by nature.

For the state and local category, PBEs must provide a qualitative description of the jurisdictions contributing to the majority of the category's effect. PBEs must also explain individual reconciling items, including their nature, effect, and significant year-over-year changes. Non-PBEs are not required to present numerical reconciliation of categories but must provide qualitative disclosures and detailed explanations of differences between statutory and effective tax rates.

Income taxes paid disclosure

Both PBEs and non-PBEs must disclose income taxes paid (net of refunds received) disaggregated by federal, state, and foreign taxes. These must be disaggregated by individual jurisdictions equal to or greater than 5% of total income taxes paid (net of refunds received) on an annual basis.

Key takeaways

Entities with income tax reporting and disclosure requirements should begin planning and reviewing their current tax provision and footnote disclosure processes. The enhanced reporting required for PBEs effective for tax reporting year 2025 and non-PBEs for 2026 necessitate more granular data collection to comply with new reporting requirements and consider comparative disclosures including prior periods.

How CLA can help with ASC 740 and ASU 2023-09

With changing regulations and increased oversight, tax provisions can be hard to keep up with. We can help review your financial statements so they accurately account for differences between accounting standards and tax regulations.