Lindsay Haskell and Dan DeLau take a closer look at unraveling errors and changes in estimates for accurate financial reporting. Discover how companies navigate the intricacies of income tax provision processes, governed by ASC 740, to ensure precise representation of their financial positions. Learn about the critical role of return to provision adjustment and the nuances between errors and changes in estimates, vital for maintaining compliance and transparency.

By Lindsay Haskell and Dan DeLau

In the realm of financial reporting, companies must diligently adhere to accounting standards to ensure accurate representation of their financial positions. The income tax provision process, governed by Accounting Standards Codification (ASC) 740, plays a pivotal role in this endeavor.

One critical aspect of this process is the return to provision adjustment, a measure that companies must employ to refresh current year income tax expense and deferred balances based on any difference between an amount included in the prior year tax provision as compared to the actual amount reflected on the company’s prior year income tax return.

The return to provision analysis ensures that the current year financial statements accurately reflect the current tax position. It is an essential component of a company’s income tax provision process, allows for adjustments for permanent and temporary differences, and will identify differences that were the result of changes in estimates or potentially, the correction of an error. 

Difference Between Error and Change in Estimate

It is crucial to distinguish between errors and changes in estimates in the context of return to provision adjustments. An error is a mistake in the recognition, measurement, presentation, or disclosure of financial information that was not intentional. On the other hand, a change in estimate results from new information or changed circumstances altering previous assumptions without any indication of error.

To illustrate the return to provision adjustment, consider IRC Section 174 regarding research and development (R&D) costs. Effective Jan. 1, 2022, a provision of the Tax Cuts and Jobs Act (TCJA) requires all Companies to capitalize and amortize IRC Section 174 expenses. Historically, companies have had the option of deducting Sec. 174 expenses in the year incurred or capitalizing and amortizing the costs over five years. However, the new TCJA provision eliminates this option and will require:

  • Sec. 174 expenses associated with research conducted in the United States to be capitalized and amortized over a five-year period beginning with the midpoint of the taxable year in which the expenses are paid or incurred.
  • Sec. 174 expenses associated with research outside of the United States to be capitalized and amortized over a 15-year period beginning with the midpoint of the taxable year in which the expenses are paid or incurred.

Now, imagine a scenario where a company, for tax provision purposes, relied on Section 41 Qualified Research Expenses as identified for R&D Credit tax purposes. This indicated $5 million should be capitalized, resulting in a net increase to book income of $4.5 million (capitalize R&D of $5 million and deduct $500 thousand in current year R&D amortization).  However, after the provision was completed and when additional time allowed, a deeper analysis of actual Section 174 R&D costs indicated that $7 million should have been capitalized, resulting in a net increase to book income of $6.3 million (capitalize R&D of $7 million and deduct $700 thousand in current year R&D amortization). 

The difference between the amount determined during the prior provision process versus the amount determined during the prior tax return process needs to be adjusted in the current year provision analysis, resulting in a return to provision adjustment to the related deferred tax asset.  Additionally, the return to provision adjustment needs to be explained as a change in estimate or the correction of an error.

A change in estimate results from new information whereas an error reflects the misapplication of information. In our example, relying on Section 41 Qualified Research Expenses resulted in a practical estimate as part of the tax provision calculation. However, Section 174 includes both direct and indirect R&D costs while Section 41 allows for only direct R&D costs.

A simple explanation is to look at wages. Under Section 174 the company capitalizes wages including benefits, taxes, and time off. Section 41 includes direct wages only. At the time of the tax provision analysis, if the company relied on Section 41 direct costs but included an estimate of indirect costs, then to true up that estimate at the time of the tax return, this would result in a change in estimate. However, if the company failed to identify any indirect costs and only included Section 41 direct costs in its Section 174 analysis, this situation is an error and if material, may result in a restatement of the financial statements.

The Takeaway

The return to provision adjustment is an integral part of a company’s income tax provision process under ASC 740, and understanding the difference between errors and changes in estimates is crucial.  The above example highlights the necessity for a return to provision adjustment, ensuring transparency and compliance with accounting standards. Companies must remain vigilant in their adherence to these standards to maintain financial integrity and facilitate informed decision-making, with particular focus on avoiding errors in the provision calculation.

To continue the discussion, please contact Lindsay Haskell at TaxOps.

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