So in previous episodes, you’ve spoken about how the income tax provision is calculated, but we haven’t gone into much detail about where the provision is reported. That is forms 10-K and 10-Q for US public companies. What are these forms used for exactly? What do they contain and what are the differences between them?
Yeah, I think first off when you reference form 10-Q and form 10-K, I just want to clarify that these are US regulatory filings for US public companies. And the majority of, I think, what we’re going to be talking about today will be focused on interim or quarterly reporting and the tax provision calculations with regard to quarterly, and then we’ll compare and contrast annual – but really from a US perspective and before diving into the details surrounding this US reporting, I did want to just know, as an aside that foreign companies also may have a quarterly or interim financial statement filing requirements as well. And however one thing to note is, these generally aren’t required by the international standards, by IFRS, and are really subject to individual country requirements. And for the most part, these individual countries actually don’t require detailed reporting for the quarters.
So some foreign companies still do have to complete financial statements on the quarters and some of these will include some tax provision calculations. However, typically these are more for internal purposes or some other purposes outside of regulatory requirements.
So therefore this is kind of all to say that interim or quarterly reporting while still certainly applicable in some cases to foreign countries, it’s really more of a focus in the US than it is abroad. So I just wanted to give that caveat.
And then further to that point, when we talk about the 10-Q and the 10-K, these are truly US public company reports. US private companies generally have similar financial statement filings on both a quarterly and annual basis. And they generally hold many of the same traits as these forms that we’re talking about today, but these are a bit less detailed and less stringent for the most part.
So with both of those asides, let’s shift over to your specific question regarding what are the 10-Q and what are the 10-K and what do they contain? So first off the 10-Q and 10-K are both regulatory filings required of US publicly traded companies by the SEC, so by the Securities and Exchange Commissions.
The 10-K is the annual. So 10-K is the annual report generally containing 12 months, a full year of activity, while 10-Q is the quarterly report, which includes year-to-date information for each quarter – so quarters one through three. So just, if we take a quick example, if we had a calendar year company, they would have three 10-Qs during the year.
The first one would be January 1st to March 31st, that would be Q1. The second quarter would cover January 1st, so back to the beginning of the year, all the way to June 30th. So it is a year to date kind of report. And then the last one would cover January 1st to September 30th. So that would be Q3. And that would cover the full nine months of Q3. So full year to date.
And then obviously, the 10-K, the annual report would cover the full year, January 1st to December 31st. So you could see that the reporting, you know, basically builds upon each other. Each quarter builds upon the next, and you will get to this cumulative reporting where you go from three months to six months to nine months. So ultimately the 12 months, the full boat in the 10-K. So now that we have some background as to the timeframe covered for each of these types of reports, let’s double click on this for a second and break down what exactly goes into these reports.
And we could start with the 10-K first, which is really the more detailed report with the two.
So the 10-K, holistically, is really a great resource to just learn about a company, both from a business perspective and obviously taking it to their financials. It’s just a wealth of information.
And this generally starts with an overview of the business. So providing a summary of the product lines or service offerings of a business, providing some background on that subsidiaries, its organizational structure.
It also gets into the company’s history, its accounting policies; and you’ve recent transactions like an acquisition or a disposition; its risk factors, its legal proceedings; pretty much everything that you would want to know about a company is kind of in this overview of the business, in terms of the background of the company. And then kind of following this informational component, typically the 10-K we’ll go ahead and dive into a section called MD&A, or management discussion and analysis. And this is really an area where management can kind of tell their story of the company and how it is performing.
So this is really a tax provision podcast, so we’re obviously very focused on tax here. So, one thing to note is a big piece of the MD&A section, at least as far as income tax is concerned, is this is the area where management generally explains what impacted their income tax position in a material way, what their rate drivers are. So what’s driving their effective tax rate up or down, how did that ETR change quarter over quarter, year over year. So [you’re] providing the trend analysis.
So this is the section where management really gets to discuss that and really gets to explain how their income taxes and changed over time and why that was, and then after this section, the MD&A section, it’s really the meat of the 10-K.
So really the bulk of what we’re going to be talking about today is the next section, which is the financial statements. And we talked a little bit about this on previous episodes, but we have income statement, the balance sheet, the cashflow statement – the core financials that every company has to reckon with. And we’ve talked about those a good deal, but in terms of tax it really comes down to the provision for income tax on the income statement.
And then on the balance sheet, it comes down to the deferred tax asset or liability, and then the income tax receivable or payable, which we covered a pretty good detail on previous episodes, but in terms of tax, that’s really what goes into those main financial statements. Obviously there’s a lot of detail related to non-tax items like revenue, other expenses, other assets, other liabilities that go into those schedules as well.
But then after you have the core financial statements, or what all companies will do, is they’ll provide these lengthy notes for the financials, which are really supplementary statements and schedules kind of breaking down the numbers in these main schedules.
And just kind of focusing on tax for a moment, income tax is always allocated as own note, or footnote as people call them. So this footnote generally consists of a breakdown of the provision for income taxes or total income tax expense on the income statement. It separately states out the current portion and the deferred portion. Remember we talked about, current plus deferred equals total tax provision…
And then it breaks it out by where the expense is actually allocated, to what jurisdictionally. So if it’s a US company, they’ll look at the federal. So looking at the US federal, it’ll look at the US states – how much sector spends is allocated the federal and how much is allocated to the states, and then how much goes to foreign. So it’ll break it out into those three categories.
And then we’ll go ahead and look at the different tax asset or liability on the balance sheet and it’ll show the material items that make up that figure. So what goes into that deferred tax asset liabilities on a more granular level.
Then we’ll dive into a rate reconciliation. So we talked a little bit about a rate rec on a previous episode, but this is really walking from the US statutory rates – so 21 percent for a US corporation to a company’s effective tax rate or ETR. So that’ll be an important part of the tax footnote as well.
And then finally, typically, the footnote will also include a table breaking down any uncertain tax positions or UTPs a company accrue. And these are items that are not more likely than not to be sustained by taxing authorities like the IRS upon an audit. And we’ll get into UTPs and UTVs a little bit more on it on a future episode, and we talked a little bit about that in the past as well.
So that’s really the 10-K as a whole, and as mentioned, it’s really quite detailed and includes a lot of narrative in addition to a really thorough numerical component and lengthy footnote schedules, including all of the tax components that we just talked about.
So that’s a 10-K and then on the other side of the coin, we have the 10-Q, or the interim or quarterly filing, and this is really much simpler and much less detailed.
So these interim reports generally only focus on the financials themselves. It’ll have some MD&A section management discussion it’ll have any key changes that happen during the quarter, any key changes to accounting principles or other important disclosures of that nature, but they don’t include the kind of detailed footnotes and disclosures as in the annual filing. So it’s really a lot simpler.
And when we think about tax specifically, while the discussion in the MD&A section is generally still present describing kind of the changes to the ETR and a high-level analysis of that nature, the detailed tax footnote seen in the annual report is really nowhere to be found. So instead, the quarterly filings will either have a very slimmed down footnote without any breakout of the deferred tax assets, or liabilities, or any rate reconciliation. Actually, some companies won’t even have a tax footnote, in all the quarters, if there’s really nothing material to disclose there.
So that’s one big difference on the tax side, and then another difference to dimension here between the 10-K and the 10-Q is the tank. You actually includes unaudited financial statements, and this is really quite different from the audited financial statements within a 10-K. So on the quarters, financial auditors – [CrossBorder Solutions is] a public accounting firm, or you think about Big Four public accounting firms, or mid-sized public accounting firms, or small ones – they don’t actually audit the components of the financial statements on the quarters, they merely review it.
So they have that term ‘review’ and what this means is they essentially make sure the numbers are reasonable analytically. So as opposed to truly agreeing all of the details to what’s called substantive evidence, they’re really just looking analytically and saying, “Does this all make sense? Does this all kind of jive together?”
And then finally the last major difference to note here between the annual and the quarterly is really the timing, the timing of the filings. This does vary by size of the company, but for the biggest of the biggest companies, the 10-K is required to be filed within 60 days of a company’s year end. So if we have a calendar year company with a 1231 year end, it would be due by basically the end of February. And then while a 10-Q must be filed within 40 days of the quarter – so you could see the 10-Q is a quicker turnaround than the annual – and that’s really because it’s a simpler, less detailed report.
Of course, now forms 10-K and 10-Q are annual and quarterly reports that tell us about who a company is and how they’ve been doing, and part of the reports is the provision for income tax. Let’s take a step back here and recap what the annual tax provision is itself as well as the quarterly.
If you want to break that down, Howard.
Yeah, so that’d be kind of a definition in hand that you’ve laid out. When we think about back to a core definition of a tax provision, it’s really a calculation of all of the income tax components of a financial statement. And we just discussed the detail related to tax that goes into the form 10-K. And you could probably imagine that the steps to actually calculating annual provision would have to result in essentially providing all this detail that we talked about. And on a previous episode, we broke down all the steps of the annual provision process, and we discussed that the main components of this are really the current provision. So that’s where a company bridges their accounting income to their taxable income. And that’s a really similar to a tax return.
So it’s basically estimating what your current year tax liability is going to be, very similar to a tax return where you finalize it.
And then there’s the deferred provision element, which is where a company really accounts for the future tax benefits for liabilities resulting from temporary or timing differences, net operating losses, or credits and attributes of that sort.
And then finally, the rate reconciliation where companies really bridge the gap between the statutory tax rate, or 21 percent in the US, and the effective tax rate.
So those were the main core components that go into the annual provision process. And then of course, on top of these key components, there is the data gathering component on the front end, right? So you have to get the trial balance, get all the supporting financial calculations. And then obviously, you run the calculations and then you have the data synthesizing on the back end, where you create your journal entries and ultimately a textbook, which is kind of the end result and that’s what we just discussed.
So that’s a high-level [overview of] what you have to do in an annual provision process. It all comes down to those core fundamental provision calculations. The current, deferred, and the rate rec.
So we’ve focused on the annual process in the previous episodes. Let’s home in on the quarterly process in the standard methodology used to calculate it. Can you tell us what the typical standard methodology is?
The general rule under US GAAP, and IFRS too, is to do what is known in the US as a FIN 18 approach – and this is also referred to as an estimated annual effective tax rate, or an EAETR approach.
And this FIN 18 really gets its name from the old US tax provision standard prior to ASC 740. And this approach is really a far simpler method in calculating tan annual provision. And that really makes sense given the differences between the 10-K and the 10-Q detail, which we covered a bit earlier. So at its core, I think there’s really four basic steps when it comes down to the FIN 18 approach.
So first, and really most importantly, a company calculates its estimated annual effective tax rate or this EAETR and this step is really key and fundamental. And we’ll get into exactly what this means in a moment.
So after you have your EAETR in hand, then secondly, you would apply this rate to your actual year to date pre-tax income results. So your actual year to date accounting income before income tax, and that would yield you your actual year to date tax expense. You take that EAETR, you multiply it by your actual year to date pre-tax book income, and now you’re at your actual year to date tax expense.
So I think that is fairly straightforward, so far at least.
But then this next step is where it gets a little bit confusing because what you have to do here is layer in something called discreet items. And we’ll get into exactly what these are a little bit later as well. But once these are layered in the discreet items, this will lead you to actually calculating your actual year to date affect the tax rate.
And you would do that by taking your actual year to date tax expense after you consider these discreet items, and then you would divide it by your actual year to date pre-tax book income.
So, it’s basically a lot of math here, but this element of discreet is a little bit quirky and it only is applicable in the quarter. So we’re going to talk about exactly what that means shortly.
But after you do this, once you go into the actual year to date ETR and your actual year to date tax expense, you would take this actual year to date tax expense. After the discreets, you would subtract it by the actual year to date expense incurred in previous quarters. That result would be the incremental year to date tax expense that needs to be recorded for this particular quarter through a journal entry.
So you’re really looking at year to date – you calculate this actual year to date expense number – and then you back out the year to date expense booked previously, in previous quarters, to get with the incremental journal entry is for this quarter.
And like I said, we’re going to break down each of these steps in detail in a minute. But just to start, when we think about this process, just as a whole, it really all hinges around this concept of the estimated annual effective tax rate.
So this is calculating an estimated ETR for the whole year, even though the quarters are completed before the full year is over. So it’s a little bit tricky to grasp that concept, but in Q1, Q2, and Q3 companies are estimating their ETR for the entire year. The whole entire year they’re estimating their ETR for.
So they’re not just going through an actual year to date approach where they’re just looking at actual year to date data, but instead they’re working with projected data for the full year, the entire year, or all 12 months of the year.
And this estimated annual effective tax rate is calculated by taking estimated annual tax expense and dividing it by, once again, estimated annual pre-tax book income.
So it’s really the same formula as the actual effective tax rate, which to remember is just total tax expense divided by pre-tax book income, but you’re layering in this projection element, this estimated annual element to it.
And the question is, why is this the case? Why can’t companies just kind of take the actual year to date numbers like they do a year-end and calculate their provision that way? And the logic is really that since tax is assessed based on annual or full year earnings, as in when a company files a tax return, it’s really an annual exercise because these companies really need to look at the quarterly provision the same way. So as if tax will be assessed on this annual basis, because that’s really how it is assessed.
So, and it really is important because some companies have different earnings cycles throughout the year. So, you know, utilizing projections kind of smooths this out and gets to a more realistic income number that the actual annual tax would be assessed on. And probably the easiest way to understand this is the real quick example. So if we took a retail company, does the majority of their sales around the holiday season, they may have relatively flat income for the first half or the first three quarters of the year. But then at the end of the year in December when the holidays hit, they’re in a significant income position they really have a boom in business in that last month of the year.
And that significant income is ultimately what they’re going to be taxed on. They’re going to be taxed on their full year earnings. That’s sort of why you need companies need to do this exercise and why it’s based on the annual four year number is because ultimately the tax results are going to be dictated by the full year results. And it wouldn’t really be accurate to be looking at tax on a quarter-by-quarter basis.
And before diving into those next steps of the process, you mentioned an estimated annual pretax income and estimated annual income tax expense as the two key metrics going into calculating the estimated annual effective tax rate.
Can you provide some more details on that? How are these two items determined?
Yeah. The estimated annual pretax income is generally based on management forecasts. The tax department usually gets these from the FP&A, or financial planning and analysis group, or just the finance group in general. And as noted, this forecast really should be up to date. And so generally it is updated each quarter and the tax group must request a new forecast every quarter.
And just as a sidebar, some companies actually may update their forecast a lot more often than that. Some update it on a almost daily or weekly basis. So the tax department really needs to constantly be monitoring this, making sure that we’re kind of working with the latest when they’re doing their quarterly provision.
And then meanwhile, the estimated annual pretax income, but estimated annual tax expense is generally calculated by starting at this projected pre-tax book income for the year, and then layering in projected permanent differences – once again, for the year – and then multiplying this by a tax rate. And then you layer in your tax credits or any other tax effected adjustments to get to an estimated annual tax expense.
And once again, these tax credits and other tax effected adjustments, that’s all projected for the year as well. So everything that we’re talking about is really estimated annual numbers up until this point. And you know, one really important thing to note is in this FIN 18 approach, generally companies are not nearly as focused on their deferred tax asset or liability profile as they are at year end. In fact, since temporary differences don’t impact the effective tax rate, don’t impact the ETR as we have discussed on previous episodes; generally, these are not even computed and updated on a quarterly basis. Instead companies really home in and focus on their ETR and the drivers have such like a permanent differences is tax credits, as we just discussed.
And generally, from a temporary difference perspective, usually they will just throw in a high-level estimate number instead of provision, or really not even worried about it at all. So that’s just really an important practical point and one that I do want to emphasize is another really core difference in looking at the quarterly or the interim provision versus the annual. And one that really saves companies a ton of time, not having to deal with all the intricacies of temporary differences on the quarters.
In which case, I think it’s time to re-introduce our audience to a very concrete sounding, acronym — or abbreviation, if you will, EAETR that’s the estimated annual effective tax rate. And we’re going to use that to shorten things up as we go along.
Now that we’ve been through the EAETR, the estimated annual effective tax rate, and understand what goes into that – tell us about the other steps in the quarterly process. What comes next after calculating the EATER.
After you calculate this metric, the EAETR, but just kind of a mouthful – after you calculate that, you need to apply that against the actual year to date pre-tax book income and that gives you the actual year to date income tax expense for the particular quarter that you’re in.
So if you’re in Q3, we’re talking nine months of year to date activity. If you’re in Q2, it would be six months. And then if you’re in Q1, that would be three months.
So now that you have this kind of actual year to date income tax expense in-hand, which we just arrived at using the forecasted rate times the actual year to date income; you have these results, the actual year to date income tax expense. But one thing that’s really important to note here is up until this point, we haven’t considered extraordinary or unusual items.
So this EAETR approach does not include any extraordinary or unusual items that occurred during the year and are kind of not part of normal business operations. So instead these are completely excluded from this EATR, completely excluded from your estimated annual effective tax rate, and it’s layered into the actual tax expense separately. So really important to note that, that the EAETR doesn’t include these kinds of special items that aren’t really regular or normal business operations. And the way you kind of do layer in these extraordinary items is through this mechanism of a discreet item.
So as mentioned, these discreet items are really extraordinary or unusual items and the way you account for them is you fully account for them in the period incurred. So very different than being included in the EAETR and being kind of spread out more evenly throughout the whole year. It’s really included just in that period, just in that quarter that it incurred.
So just a few examples of discreet items to maybe shed a little bit of color on the concept: So one, and we’ve talked a little bit about this on a previous episode, but I think we get into it more on a future one as well – but one is the excess tax benefit on non-qualified stock options are ‘non quals’, and this is also known as a windfall.
So that’s one item that is generally a discreet item, kind of an event that is extraordinary and unusual. It’s something that shouldn’t be built into the estimated annual effective tax rate, because it’s unusual. It doesn’t happen the same way, in the same kind of nature every year, every quarter. Another one is the impact of changes in tax law or a tax rate change. So once again, this isn’t something that is kind of normal business operations. This is very different. This is kind of an unusual item.
Another one is the return-to-provision impact. So we talked about the true-up or return-to-provision, where you look at your prior provision and your prior year return, and then you true that up under next year’s provision for the difference. And that’s usually run through as a discreet as well. And that’s both on the federal side, the state side, and then ultimately the international side too.
And that’s because it’s really kind of like a one-time event in the year, and doesn’t really factor into the kind of normal business operations. So that’s just some examples of discreet items. And once we layer these discreet items in, we get to our adjusted year to date income tax expense and that’s all-in through the entire year up until this point.
So it’s always, you know, year to date, income tax expense, as opposed to just for a particular quarter, you know, we’re not looking at just Q3. We’re looking at the first of the year, all the way to the end of Q3. So for a calendar year, we’re looking at [January 1st] to [September 30th], as opposed to just looking at [July 1st] to [September 30th]. It’s a full year, year to date.
And then we would take the actual year to day tax expense after we consider all these discreet items, which we just talked about, and then you would divide it by the actual year to date pre-tax book income, to give us our finally actual year to date effective tax rate figure.
And while the EAETR is really important in looking at interim, this metric is also very important: this actual year to date effective the tax rate, which includes the impact of discreet items. That’s also another really important metric for companies to look at as well, because that’s truly their effective tax rate, all-in with everything included – even those unusual items, even the discreets.
So finally, once you have this actual year to date effective tax rate, or your all-in number; and you have your actual year to date tax expense, which is how you get to it. As I mentioned before, you would subtract out any tax expense you’ve kind of accrued in previous quarters to figure out exactly what you need for this quarter to accrue, to book as a journal entry for this particular quarter.
So once again, the quarters are really all focused on year to date information. So you’re not just looking at the quarter in a vacuum, you’re looking at everything that happened, up until the end of the quarter. And then you need to book an incremental tax expense or tax benefit for that quarter. You need to back out everything else that happened in quarters previous.
So if you’re in Q3, you would need to back out, what’s been booked in Q2 to see what the incremental amount of tax you need to book to your financial statements and [what] your trial balance is.
So those four steps of calculating the EAETR, applying it to actual year to date results, layering in discreet items, and then backing out previously recorded quarterly expense to get to this quarter’s tax expense makes sense.
Now is there any circumstance where possibly not all entities in a consolidated group would use this estimated annual ETR approach? Could some companies have to deal with leaving some entities out?
Yeah, so there’s really two key exceptions to kind of using this EAETR, this estimated annual effective tax rate approach. This would be where certain entities are excluded and kind of just treated separately from the EAETR calculation, but it’s the first is a circumstance where there are jurisdictions that company operates in that have pre-tax losses.
So they’re not an income position, they’re in a loss position. And in this loss position, they’re not able to recognize any tax benefit. So they’re not able to benefit from these losses to save on any tax or offset any income.
And this is generally due to these jurisdictions being in a full valuation allowance position. So we talked a little bit about valuation allowances in previous episodes, but this is a mechanism [where] if you’re not more likely than not to recognize your deferred tax assets, to benefit from your deferred tax assets to recognize a benefit in the future from these DTAs then you have to offset it with a valuation allowance.
And basically, if you’re in these jurisdictions with these losses where you’re never going to recognize a benefit, this would generally happen if you expect these jurisdictions to continue in losses and never to reverse to income where you could carry forward that loss and offset that income’s reduced tax. If you’re in that sort of position, then generally, this would be a circumstance where you have to exclude that particular jurisdiction, the entities in those jurisdictions, from your EAETR.
So that’s number one. Then number two is this could also happen where you need to exclude certain entities, certain jurisdictions from this EAETR, if you can’t reliably estimate pretax income or loss for the year for these particular jurisdictions or particular entities. So if for some reason, the country that you’re looking at is in a situation where they just can’t project out their results for the year.
This would be another situation where they simply can’t use the EAETR approach for these particular entities in these jurisdictions, because well, they simply can’t make the correct projections. And that could be for several reasons, maybe the business is just fluctuating so heavily that you just have no idea what the results are going to be in the future. So that’s another example.
And in this case if this occurs where entities are excluded from the EAETR, what you would do is you would have their actual results – the actual year to date pre-tax income and their actual year to date income tax expense – included within the calculation after the application of the core estimated annual effective tax rate.
So you would calculate your estimated annual effective tax rate, you would apply that to the income of all the entities that need to go into that calculation, you wouldn’t consider these kinds of jurisdictions that really need to be excluded; and then you would layer in their income and their expense – so basically this calculation after you compute this ETR. So you’d be basically layering-in an additional step to our four step process that we talked about before.
And I understand there is another quarterly provision methodology as well. Why is that and how does this one compare to the FIN 18 approach?
The other kind of potential approach on a quarterly or an interim provision is to basically do it in the same fashion as an annual provision. And that’s where you’re not using projections and you’re just using actual year to date income to compute your effective tax rate and your tax expense.
So it really basically is the same process as a full year provision, which we talked about a little bit earlier and covered in detail on previous episodes. And certain companies will use this kind of what I like to call a full blown provision methodology for a variety of reasons. So there’s a bunch of reasons that companies would potentially do this. And while it’s not technically correct methodology as a general rule, there are exceptions that would actually make this a requirement. So it would actually mean that a company needs to do this.
And one of the reasons it’s having an inability to forecast an effective tax rate, and we alluded to this a little bit for specific jurisdictions or specific entities before, but basically this analysis of – if you are unable to forecast an effective tax rate, if you’re unable to make projections – it’s really a facts and circumstances based analysis. And typically a sensitivity analysis is utilized to determine if reasonable changes to a forecast would cause maybe disproportionate changes to the effective tax rate. And this could happen in the case where pre-tax book income or the denominator in the ETR calculation is breakeven. So your pre-tax booking commons is basically breakeven.
But then you have really material, permanent differences or other rate drivers that cause major changes to your tax expense. So that effected the numerator but not the denominator. And what that could potentially do is cause huge swings to the rate, given a really small denominator run by breakeven.
Let’s just say it’s a dollar if you have changes to the numerator, it’s going to cause massive swings to the estimated annual effective tax rates. So this could be a potential reason why you wouldn’t be able to use that EAETR approach and you just kind of need to use actual data just like you would at year end.
So what are the practical differences between how companies do quarterly versus annual provisions?
We touched on some of these, but just to kind of summarize and ring fence this just at a high level: First off, interim or quarterly provisions are much quicker, they’re much easier do and just take less time.
Second, these interim provisions generally don’t include tracking exact amounts of deferred tax assets and liabilities and therefore, exact amounts of temporary differences that go with them. And hence, this is one of the reasons why, they’re really much quicker.
So the focus of quarterly is really on the material, permanent adjustments, and then other rate drivers. So things like credits as well. And it really focuses in on the income statement as opposed to the balance sheet – really honing in on the effective tax rate, as opposed to those items on the balance sheet, like the deferred tax asset or liability.
Then remember that while year end everything must be truly correct and scrutinized by a full audit. Auditors are only conducting an analytical review on the quarters. So the numbers still need to be materially correct, but the auditors are looking at it from a much different perspective, much different lens.
So for this reason, the focus is really on the income statement. The focuses really on the effective tax rate and it really shifts away from the deferred tax assets and liabilities. Like it is a really big focus on year end.
So listeners of this podcast have heard you advocate for using tools like software to assist in calculating the income tax provision. I’m wondering how specifically can tools beyond Excel assist with the calculations needed for the quarterly provision’s estimated annual ETR and a follow up for companies who already may be using software. Are there ways to use it that you think are being underutilized or overlooked?
Yeah, so I think in this case software – we could talk about some obvious features of software – but first, it’s great to import pre-tax book income. It could also pull in other projected figures like permanent differences or tax credits. And then, what it could even do is, besides kind of importing news projected numbers, it could even pull numbers from a previous year and pull those into a current quarter to kind of automate those.
And oftentimes that happens if the figure is not that material or a company doesn’t expect a particular adjustment – let’s say a particular permanent adjustment – to change from last year to this year. It may just use the same number as last year. So for more immaterial items, this is very common and software could really help do that kind of in an automated fashion as opposed to having to do that manually in Excel.
Another really good function of a very efficient and fully functional quarterly software is it’s really a great tool to easily exclude particular entities from that EAETR the estimated annual effective tax rate calculation, which is really much harder to do in Excel.
So we talked about those exceptions, which may call for excluding certain entities from this estimated annual effective tax rate approach. And this is really difficult to do in Excel, particularly if you have dynamic data changing from quarter to quarter, or if you have an entity that needs to be excluded that wasn’t excluded in the past or vice versa – an entity that previously was excluded that now needs to be brought back in. [It’s] really difficult to kind of look at that dynamic data in Excel and update that in real time and update the way the calculations are working in there, but in software it really could be as easy as, they say, a check box.
So, I think this is often an area that people kind of overlook in Excel because it’s really difficult to manually track. And then even in certain software on the market, it’s really not built for this functionality of excluding certain entities from this estimated annual effective tax rate calculation either. So often people kind of just ignore it and it really could be material to your ETR and to your operation. So it’s important to kind of get that right.
And then the last point with regards to software in particular is we talked about quarterly [and] the fact that you have less time to work with your quarterly provision than your annual, and the fact that it’s a really quick process. Some days some companies will only have, a day or two to kind of turn around their interim provision. Some companies I’ve even seen only have a couple hours to turn around their interim provision from the time they get their trial balance from the accounting department.
So you really want to be assured that your calculations are working correctly, that all your numbers are flowing and you know, there’s no issues with errors in the workbook, and no issues with any of the core calculations occurring behind the scenes. And that’s what software really provides assurance with. A good software will be able to kind of calculate these things for you. Obviously the user will always need to be there to kind of review their work, but a good software will kind of take a lot of the burden off you and can kind of assure that the data is in a controlled environment. And you’re able to kind of move through quickly with accurate calculations.