Day 1 - Reference Guide

Day 1 – Reference Guide Corporate Tax & Accounting – Basic Framework

© Shamen Dugger, Esq., CPA 8/21/13 Basic Framework

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CONTENTS

Introduction 2

I. Framework Level 1 - General Ledger (GL) Analysis/Preparation 4

A. Appreciate the Importance of Journal Entries

B. Reveal the Client’s Story for the Period

C. Prepare/Review the General Ledger

II. Framework Level 2 - Trial Balance (TB) Analysis/Preparation 9

A. Identify Applicable Financial Statements Based on Account Type

B. Note Book/Tax Differences

C. Prepare/Review the Trial Balance

III. Framework Level 3 - Financial Statement (FS) Analysis/Preparation 12

A. Understand the Financial Statement Interplay

B. Prepare/Review the Income Statement

C. Prepare/Review the Balance Sheet

IV. Framework Level 4 - Basic Tax Provision Analysis/Preparation 15

A. Understand Basic Tax Provision/ASC 740 Concepts

B. Build Six Basic Tax Provision Schedules - Federal

C. Build Six Basic Tax Provision Schedules - State

V. Framework Level 5 - Basic Tax Return Analysis 32

A. Understand How the Federal 1120 Reflects the Provision/Source Data

B. Understand How the California 100 Reflects the Provision/Source Data

VI. Framework Level 6 - Impactful Written/Verbal Communication 35

A. Use the Framework for Impactful Written/Verbal Communication

B. Examples of Effective Communication Using the Framework

VII. Framework Level 7 – Consulting/Specialty Work Interplay 38

VIII. Leveraging the Framework to Accelerate Learning/Understanding 41

A. New Technical Developments

B. Client Assignments of Greater Complexity

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INTRODUCTION

For over seventeen years I have observed, participated in, and taught various trainings in corporate

tax and accounting. Although the trainings themselves were excellent and extensive providing

knowledge and insight on various corporate tax and accounting related topics, they fell short in

three primary areas: 1) effectively transitioning new hires to real world client work; 2) mitigating

attrition caused by a disconnect between established expectations and employees’ perceived ability

to obtain necessary training to meet those expectations; 3) efficiently increasing core corporate tax

and accounting knowledge for non-core corporate tax and accounting professionals.

So why the shortfall? In my opinion, the answer is that traditional training efforts, though

admirable and appreciated, lack meaning. In more precise terms, the trainings lack a specific

framework that systematically connects employees to new concepts and more complex client

assignments.

For example, consider new hire trainings. Typically, these trainings are intensive week or

two week long sessions consisting of a variety of topics. One day may focus on ASC 740/tax

provisions, the next on corporate returns, and the other days on a range of subjects from

written/verbal communication to specialty areas. While there is no question that this is excellent

training, the hurdles are 1) How does a new hire translate this material to real world client

assignments and 2) How does a new hire retain such valuable information post-training? Without

a framework showing how each training is interrelated and impacts the big picture of corporate tax

and accounting, both hurdles become challenging to overcome. But apply the correct framework,

and new hires can hit the ground running with their acquired skills using them to complete a variety

of client assignments and, not only retain the information provided, but add layers of complexity

to this tangible foundation.

Let’s review the same new hire training delivered using the framework. Under this

scenario, before we delve into the intricacies of corporate tax and accounting, we would establish

meaning for the new hires by explaining the big picture of this area of knowledge. The framework

begins with ingraining in employees the importance of understanding the meaning behind the

corporate tax concepts they are applying. A basic general ledger and trial balance are prepared to

show employees how these documents tell the story of what happened during the period to the

company and how such events impact the company’s goals in terms of its development stage. An

income statement and balance sheet are then prepared using the general ledger/trial balance data

to show employees the financial statement impacts from these transactions and how the income

statement and balance sheet are interrelated. Employees are then shown how these source

documents are used to prepare six basic tax provision schedules (taxable income, deferred

inventory, current/deferred tax calculation, rate reconciliation, tax account rollforward, financial

statement/footnote impacts). The relationship between the tax provision and federal/state income

tax returns is then emphasized as employees see how tax return forms reflect elements of the tax

provision and other source data. Finally, employees are shown how they can communicate the

results of their efforts effectively in verbal or written form by simply following the framework,

i.e., telling the story of the company’s key transactions during the period, their financial statement

impacts, and the resulting tax provision and return impacts. For additional clarity, the framework

is illustrated as follows:

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In comparison, the new hire training provided via the framework mitigates the hurdles of

traditional training by first establishing for new hires the big picture from which all their client

assignments and subsequent layers of complexity can be understood. When a new hire returns and

is assigned a tax provision to complete, he can consult the framework to first obtain an

understanding of the client’s development stage and key transactions during the period via

requesting the general ledger and trial balance. The basic tax provision schedules taught through

the framework also act as a foundation in preparing or rolling forward the tax provision assigned.

More importantly, utilizing the framework, the employee is now empowered to exceed

expectations by inquiring whether any tax return preparation will be involved and communicating

effectively verbally or in writing the results of such assignment.

Such newfound confidence also permeates into the new hire’s ability to understand and

apply greater levels of complexity, as well as new developments. Regular in-house training

sessions on tax specialties or new legislation/accounting pronouncements resonate more as the

new hire runs the information through the framework noting any impacts to the general ledger/trial

balance, financial statements, tax provision, and tax returns. He also now combs this new

information for client impacts, which he can confidently communicate verbally or in writing to

management or the clients themselves, thereby furthering his ability to meet and potentially exceed

expectations.

Am I suggesting that traditional training programs need to be overhauled? No. Merely

adding a one day framework course will provide employees the structure they need to better apply

and retain traditional training.

My hope is that this book will serve as a step by step guide in implementing your own

corporate tax and accounting framework to improve the success of your employees and, ultimately,

of your business.

Shamen Dugger, Esq., CPA

August 2013

http://shamendugger.com/wp-content/uploads/2013/07/framework1.png

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FRAMEWORK LEVEL 1

GENERAL LEDGER (GL) ANALYSIS/PREPARATION

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A. Appreciate the Importance of Journal Entries

The starting point in creating a meaningful training framework is preparing and understanding a

basic general ledger made up of journal entries reflecting transactions for the period. The general

ledger is the starting point because such document is the basis for comprehending company

activities from a real world perspective. Without first acknowledging what has transpired within

a company over the period under review, it is challenging to comprehend and connect with the

related tax and accounting impacts.

B. Reveal the Client’s Story for the Period

For example, our client is Joe & Linda’s Cupcake Corporation (JLCC), a home-based startup C

corporation domiciled in California with no employees and only in state operations. Before

considering the general ledger, think through the real world transactions JLCC might have at this

Year 1 startup stage of development. Such transactions likely include:

Capital contributions from Joe and Linda to start the business;

Equipment purchases to produce the cupcakes;

Baking supplies purchases to produce the cupcakes;

Website design costs to market the cupcakes;

Business meals and entertainment;

Sales revenue.

Now consider what the related journal entries would be for such transactions to better

understand the accounts impacted and their related financial statements. It is important to note

that, although journal entries can be challenging especially for tax professionals without extensive

accounting experience, they become more intuitive when prepared from a real world perspective.

For example, think about the capital contributions transaction. In this case, what is

occurring? Joe and Linda are contributing cash to JLCC. What accounts are impacted? Cash is

an asset and capital contributions are equity, both reflected on the balance sheet. Therefore, our

related journal entry for this transaction is:

Dr. Cash (asset) XXXXX

Cr. Capital Contribution (equity) XXXXX

Consider now the equipment purchase. In this case, what is occurring? JLCC is spending

cash to obtain equipment. What accounts are impacted? Cash is an asset and equipment is an

asset, so both are balance sheet accounts. We also know that equipment typically is depreciated

over its useful life for book purposes. Depreciation is an expense account reflected on the income

statement and accumulated depreciation is a contra asset account reflected on the balance sheet.

Therefore, our related journal entries for this transaction are:

Dr. Equipment (asset) XXXXX

Cr. Cash (asset) XXXXX

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Dr. Depreciation (expense) XXXXX

Cr. Accumulated Depreciation (contra asset) XXXXX

The baking supplies, website design, and meals and entertainment expenses are all simply

cash outlays for expense items. Cash is an asset reflected on the balance sheet and the remainder

are expense accounts reflected on the income statement. Therefore, our related journal entries for

these transactions are:

Dr. Baking Supplies (expense) XXXXX


Dr. Website Design (expense) XXXXX


Dr. Meals & Entertainment (expense)XXXXX


Consider the sales revenue. In this case, what is occurring? JLCC is receiving cash and

recording sales revenue or deferred revenue (if delivery of the cupcakes is not anticipated until

post-Year 1). Cash is an asset reflected on the balance sheet, sales are revenue reflected on the

income statement, and deferred revenue is a liability reflected on the balance sheet. Therefore, our

related journal entries are:


Cr. Sales (revenue) XXXXX


Cr. Deferred Revenue (liability) XXXXX

C. Prepare/Review the General Ledger

Now that we have a good understanding of the likely transactions JLCC should have reflected on

the Year 1 general ledger and we know the balance sheet and income statement accounts likely

impacted, we will review JLCC’s actual Year 1 general ledger to verify our accuracy.

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Based on our review of the actual general ledger, we were quite accurate with our

transaction analysis. But how does this exercise improve our abilities to complete client

assignments and retain information so we can ultimately meet our goals? The answer is that this

exercise assists in developing a real world connection out of abstract tax and accounting concepts.

Transaction Dr. Cr.

Initial Investment in Business

Cash (asset) 20,000

Capital Contribution (equity) 20,000

Stove Purchase (5 yr. useful life)

Equipment (asset) 10,000

Cash (asset) 10,000

Baking Supplies Purchase

Supplies (expense) 5,000

Cash (asset) 5,000

Website Development

Contractor (expense) 2,000

Cash (asset) 2,000

Advance Payment for Wedding Order

Cash (asset) 5,000

Deferred Revenue (asset) 5,000

Payment for Same Day Party Order

Cash (asset) 2,000

Sales (revenue) 2,000

Company Marketing

Meals & Entertainment (expense) 1,000

Cash (asset) 1,000

First Year Stove Depreciation

Depreciation (expense) 2,000

Accumulated Depreciation (contra asset) 2,000

Check 47,000 47,000 √

GENERAL LEDGER - YEAR 1

Joe & Linda's Cupcake Corporation

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The exercise helps to understand that the general ledger is not just some form of source data to use

in completing an assignment, but rather it represents actual real world transactions that have

meaningful impacts on the client and its financial statements. The exercise also is useful in

demystifying documents and concepts that seem intimidating on first glance, but when addressed

intuitively in their basic form are not as daunting as originally thought.

Going forward, tax practitioners can use this first step of the framework to dissect and

understand any client transactions at any level of complexity. When faced with a new client,

practitioners can go through a similar exercise to understand what the potential transactions of that

client at that particular development stage are in reality. In addition, as new transactions occur,

practitioners can analyze the transactions in terms of their related journal entries and financial

statement account impacts. Practitioners also can better understand new tax and accounting

developments through the framework of their related journal entries and financial statement

account impacts.

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FRAMEWORK LEVEL 2

TRIAL BALANCE (TB) ANALYSIS/PREPARATION

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A. Identify Applicable Financial Statements Based on Account Type

Meaningful corporate tax and accounting training is enhanced through using the general ledger

prepared in the first level of the framework to produce the related trial balance. Through such

preparation and analysis tax practitioners understand that the trial balance is merely the ending

balance in each account within the general ledger and is typically organized by financial statement

(i.e., income statement accounts combined and balance sheet accounts combined). This

information is important as it is the foundation of financial statement preparation and a

comprehension of how financial statements interrelate. It also is important as a starting point for

tax provision preparation in noting the accounts that are permanent or temporary book/tax

differences.

As with the general ledger, consider conceptually what the trial balance will look like

before actually viewing the trial balance, beginning with the income statement accounts.

Reviewing the general ledger, the only revenue account is sales, which is not a substantial amount

and, upon a high level review, is not enough to offset the many expense accounts for the period.

Therefore, even without the actual trial balance, it is evident from a high level analysis that JLCC

likely incurred a loss for Year 1.

Now consider the balance sheet accounts conceptually. JLCC’s asset accounts are cash,

equipment, and accumulated depreciation (contra asset account). JLCC’s only liability account is

deferred revenue and only equity account is the original capital contribution. We know from basic

accounting rules that assets less liabilities equal owner’s equity, so we test our results. We can

quickly sum the assets of $17,000 and subtract the $5,000 liability resulting in the necessary

owner’s equity of $12,000. However, our owner’s equity is reflecting $20,000. The differential,

we recall, must be our net income for the period per our income statement accounts, which a quick

calculation of revenue less expenses yields the $(8,000) loss differential. Viewed another way,

JLCC’s assets of $17,000 are produced by a combination of liabilities ($5,000) and owner’s equity

($12,000 = $20,000 capital contribution less $8,000 loss for Year 1).

B. Note Book/Tax Differences

At this stage, it also is recommended that the trial balance accounts be reviewed for permanent and

temporary book/tax differences that will be important in calculating the tax provision. The only

account that is a permanent difference is meals and entertainment, and the only temporary

differences are deferred revenue and depreciation. We will review such tax provision concepts in

further detail later in our framework analysis. For now, it is simply important to note that in

preparing or reviewing a trial balance, this is an excellent time to note book/tax differences.

C. Prepare/Review the Trial Balance

Now that we have a good understanding of the likely income statement and balance sheet account

impacts to the trial balance, as well as the potential book/tax differences, we will review JLCC’s

actual Year 1 trial balance to verify our accuracy. (It is important to note that net income is not a

trial balance account, but the result of all revenues less all expenses. At year end, all revenue and

expense accounts are closed out with the resulting net income [or loss] transferred to the balance

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sheet as part of owner’s equity to ultimately be absorbed into retained earnings [or accumulated

deficit]. Balance sheet accounts, on the other hand, are not closed out and remain at year end to

be carried over to Year 2.)1

As with the general ledger, our trial balance conceptual analysis was pretty accurate

compared to the actual trial balance reinforcing that financial documents are merely a reflection of

real world transactions and can be more effectively understood and prepared from that vantage

point. In addition, our conceptual analysis brought real world application to basic corporate tax

and accounting concepts in terms of the relationship between the income statement and balance

sheet, as well as the fact that assets are produced by a combination of liabilities and owner’s equity.

Finally, our analysis denoted how typical trial balances are organized separately by income

statement and then balance sheet accounts facilitating transaction analysis and financial statement

preparation.

The trial balance preparation exercise also sets the stage for tax related work. The

importance of evaluating trial balance accounts for book/tax differences was emphasized for later

tax provision/return preparation.

In terms of better meeting and potentially exceeding expectations, the process to apply in

any client assignment or new development is beginning to form via the framework. The starting

point always is understanding the assignment or new development in terms of its real world

application, i.e., in terms of its journal entry/general ledger impacts and ultimately its financial

statement account impacts via the trial balance. From this foundation, tackling client assignments

of various complexity levels becomes more constructive and manageable.

1 Key: BTD = Book/Tax Difference; ND = No Difference; TD = Temporary Difference; PD = Permanent Difference; FS = Financial Statement;

IS-R = Income Statement Revenue Account; IS-E = Income Statement Expense Account; BS-A = Balance Sheet Asset Account; BS-CA =

Balance Sheet Contra Asset Account; BS-L = Balance Sheet Liability Account; BS-EQ = Balance Sheet Owner’s Equity Account

BTD FS Account Dr. Cr.

ND IS-R Sales 2,000

ND IS-E Supplies 5,000

ND IS-E Contractor 2,000

PD IS-E Meals & Entertainment 1,000

TD IS-E Depreciation 2,000

ND BS-A Cash 9,000

ND BS-A Equipment 10,000

TD BS-CA Accumulated Depreciation 2,000

TD BS-L Deferred Revenue 5,000

ND BS-EQ Capital Contribution 20,000

Check 29,000 29,000 √

TRIAL BALANCE - YEAR 1


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FRAMEWORK LEVEL 3

FINANCIAL STATEMENT (FS) ANALYSIS/PREPARATION

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A. Understand the Financial Statement Interplay

After analyzing and preparing JLCC’s general ledger and trial balance, you already should know

the results of your financial statement preparation. This is one of the most important aspects of

going through such exercises as you now understand that to really meet/exceed expectations, you

need to be on the alert for inaccuracies in such source documents, especially as you delve into

corporate tax and accounting work. Always make sure your trial balance net income ties to net

income per your income statement, which ties to net income for the period within owner’s equity

on the balance sheet. This is a common issue in completing corporate tax and accounting work

(especially tax provisions) as you may have older versions of the trial balance or financial

statements that do not tie.

B. Prepare/Review the Income Statement

In our example, per the trial balance, we determined that JLCC likely would generate a loss for

income statement purposes as expenses exceeded revenue for Year 1. In addition, in evaluating

our balance sheet accounts per our trial balance, the requisite amount to complete our assets =

liabilities plus equity equation had to be an $(8,000) loss. Per the following income statement, our

calculations were correct and JLCC did generate an $(8,000) loss for Year 1.

C. Prepare/Review the Balance Sheet

Our example, per the trial balance, also concluded that assets of $17,000 were generated by JLCC

incurring a liability of $5,000 and owner’s equity of $12,000 ($20,000 capital contribution - $8,000

Year 1 loss). Per the following balance sheet, our calculations were correct as JLCC’s assets of

$17,000 are equivalent to JLCC’s liabilities and owner’s equity of $17,000.

Income

Sales 2,000

Total Income 2,000

Expense

Supplies 5,000

Contractor 2,000

Meals & Entertainment 1,000

Depreciation 2,000

Total Expense 10,000

Net Income/(Loss) (8,000)


Income Statement

For the Period Ending December 31, Year 1

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A review of our trial balance, income statement, and balance sheet reflects that our net

income amounts tie throughout at an $(8,000) loss. If ever these amounts do not tie out, then we

know our calculations are inaccurate or we are using an outdated version. And, of course, we

know that in order to meet/exceed expectations, we need to alert our team or supervisor of such

inaccuracy/inconsistency immediately.

In addition, now that the financial statements are complete, you can further meet/exceed

expectations by stepping back from the details and evaluating such results from a common sense

perspective, i.e., do such results make sense based on our understanding of JLCC’s facts and

circumstances and what tax related impacts may occur?

Here is an example. This is JLCC’s first year of business, so loss generation is not

surprising or uncommon. Due to JLCC’s limited domestic activity in California and loss

generation, the tax provision is expected to be $nil for federal purposes and the $800 minimum tax

for California purposes. Federal and state deferred tax assets consisting primarily of net operating

losses will be tracked for future use in the income tax footnote, but not reflected on the balance

sheet as it is not more likely than not (>50%) that JLCC will recognize these tax benefits. A

valuation allowance has been established to offset these deferred tax assets until company

management determines that the positive evidence of recognizing such benefits exceeds the

negative evidence to such an extent that meets the requisite threshold for release. The federal

income and California income/franchise tax returns are expected to reflect the tax provision results.

All favorable small business elections will be evaluated and claimed as deemed appropriate by

company management.2

2 Concepts included in this example will become clearer upon working through the remaining exercises and examples in this reference book.

Assets

Cash 9,000

Equipment 10,000

(Less A/D) (2,000)

Total Assets 17,000 √

Liabilities & Owner's Equity

Liabilities

Deferred Revenue 5,000

Equity

Capital Contribution 20,000

Net Income - Year 1 (8,000)

Total Liabilities & Owner's Equity 17,000 √


Balance Sheet

December 31, Year 1

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FRAMEWORK LEVEL 4

BASIC TAX PROVISION ANALYSIS/PREPARATION

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A. Understand Basic Tax Provision/ASC 740 Concepts

Now that we have completed our source documents (general ledger, trial balance, and financial

statements), we can transition to corporate tax work beginning with tax provision analysis and

preparation. But before we tackle tax provision exercises, it is important to step back and evaluate

in real world terms what specifically we are trying to accomplish in preparing a tax provision. For

simplicity, we will first focus only on JLCC’s federal tax provision evaluating state related impacts

later in this section. Also, although federal corporate income tax rates vary depending on levels

of taxable income, we will assume a federal rate of 35% for instructive purposes.

What is a company’s tax provision exactly? It is current tax expense for the period plus

the change in deferred tax assets/liabilities (i.e., deferred tax benefit/expense) for the period.

Current tax expense is relatively straightforward as it is pre-tax book income (per the trial balance

and income statement) multiplied by the applicable statutory tax rate. Therefore, in JLCC’s case

focusing solely on federal income tax, current federal tax expense is the $(8,000) pre-tax book loss

multiplied by our assumed statutory corporate federal income tax rate of 35%, which equates to a

$(2,800) tax loss/benefit on pre-tax book income.3

How then is deferred federal tax expense calculated? Let’s start with some background.

In a perfect world, current federal tax expense for book/financial statement purposes would equal

federal income taxes payable per the applicable federal 1120 corporate income tax return. In

JLCC’s case, the related journal entry to book the current federal income tax benefit and refund

(assuming for illustrative purposes that federal losses are refundable) would be:4

Dr. Income Tax Payable (Refund) $2,800

Cr. Income Tax Expense (Benefit) $2,800

Once the federal return was filed and associated refund received, a subsequent journal entry

would be recorded to reverse the taxes payable/refund account and debit cash for the refund

receipt:

Dr. Cash $2,800

Cr. Income Tax Payable (Refund) $2,800

Deferred taxes/benefits arise because our perfect world scenario where book/financial

statement tax expense/benefit equals return tax payable/refund typically does not occur in the real

world. The variance is driven by differences in the computation of income/loss for book/financial

statement purposes under generally accepted accounting principles (GAAP) and the computation

of income/loss for tax return purposes under federal and state tax statutes, regulations, and case

law (foreign as well). These “book/tax differences” fall into two categories: permanent and

temporary. Permanent differences are variations between GAAP and tax that will never reverse,

whereas temporary differences are such variations that will reverse over time and ultimately have

the same impact for book/financial statement and tax return purposes. These temporary

3 Alternative minimum tax and other current tax impacts may affect current tax expense, which will be addressed later in this section. 4 Note that if, instead of loss/refund generation, JLCC had generated Year 1 income producing a federal corporate income tax expense of $2,800,

the journal entry would be reversed to debit income tax expense and credit income tax payable. Once the tax payment was made, income tax payable would be debited and cash credited.

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differences drive deferred taxes/benefits because as they reverse they result in deferred tax expense

or benefit depending on whether the difference was a deferred tax liability or asset.

It also is important to note that permanent and temporary differences can be either items of

revenue/income or expense/deduction. For example, interest on municipal bonds is a permanent

book/tax difference relating to revenue/income that is includible as revenue for book purposes but

is not includible in income for tax purposes. As this permanent difference will never reverse and

is favorable from a tax perspective in that it will never be included in income, it is considered a

“good perm.” On the other hand, penalties are a permanent book/tax difference relating to

expense/deduction that are expensed for book purposes but not deductible for tax purposes. As

this permanent difference will never reverse and is unfavorable from a tax perspective in that it

will never be deductible from income, it is considered a “bad perm.”

Temporary differences emerge as items of revenue/income or expense/deduction as well,

but typically are more challenging as their reversals over subsequent periods must be tracked and

accounted for properly. Temporary differences can result in either deferred tax assets (DTA) or

deferred tax liabilities (DTL).

A DTA exists when more income is recognized for tax return purposes than book/financial

statement purposes (e.g., deferred revenue where income is recognized upon receipt of cash for

tax return purposes but only upon performance/delivery for book purposes) or when less deduction

is recognized for tax return purposes than book/financial statement purposes (e.g., estimated costs

that are expensed immediately for book purposes but not until fixed for tax purposes). In both of

these DTA scenarios, as the temporary difference reverses over time book/financial statement

income will increase without a commensurate increase in taxable income per the tax return, i.e.,

more income was recognized for tax return purposes than book/financial statement purposes. A

typical DTA journal entry would be:

Dr. Deferred Tax Asset $1,000

Dr. Income Tax Expense $1,000

Cr. Income Tax Payable $2,000

In our DTA sample journal entry, we see that more tax has been recognized per the return

than the books/financial statements. As the DTA reverses, the journal entry will reflect a reduction

in the deferred tax asset and an increase in income tax expense. Such reversal leads to increased

income tax expense on the income statement, which reduces net income for the period (or increases

net loss). This reduced net income (increased loss) transfers over to the balance sheet in terms of

reduced owner’s equity for the period, and ultimately reduced retained earnings (or increased

accumulated deficit). A typical DTA reversal journal entry would be:


Cr. Deferred Tax Asset $1,000

Temporary differences also can result in deferred tax liabilities. A deferred tax liability

exists when more revenue is recognized for book/financial statement purposes than tax return

purposes (e.g., percentage of completion revenue recognition for book purposes but completed

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contract for tax purposes) or when less expense is recognized for book/financial statement

purposes than tax return purposes (e.g., accelerated tax depreciation under MACRS but slower

straight line depreciation for book purposes). In both of these DTL scenarios, as the temporary

difference reverses over time taxable income per the tax return will increase without a

commensurate increase in book/financial statement income, i.e., more income was recognized for

book/financial statement purposes than tax return purposes. A typical DTL journal entry would

be:



Cr. Deferred Tax Liability $1,000

In our DTL sample journal entry, we see that more tax has been recognized per the

books/financial statements than per the tax return, which results in a deferred tax liability. As the

DTL reverses, the journal entry will reflect a reduction in the deferred tax liability and an increase

in taxable income per the tax return. A typical DTL reversal journal entry would be:

Dr. Deferred Tax Liability $1,000


B. Build Six Basic Tax Provision Schedules - Federal

Now we will apply these tax provision concepts to calculate JLCC’s Year 1 federal tax provision

through building JLCC’s six basic tax provision schedules. The first basic tax provision schedule

is the taxable income calculation. This schedule begins with pre-tax book income/loss and adjusts

for permanent and temporary differences to arrive at taxable income.

The book/financial statement loss of $(8,000) is multiplied by the federal corporate income

tax rate of 35%. Therefore, JLCC’s current federal income tax benefit is $(2,800) for

book/financial statement purposes.5 Considering the book/tax differences of $500 meals and

entertainment addback, $5,000 deferred revenue addback, and $(3,000) depreciation reduction,

JLCC’s net income per the tax return is $(5,500), which results in federal income tax payable per

the federal income tax return of $(1,925), i.e., $(5,500) x 35% federal statutory rate. Therefore,

our related journal entry is:6

Dr. Deferred Tax Asset $875

Dr. Income Tax Payable (Refund) $1,925


The federal net operating loss is not refundable but can be carried forward to offset future

taxable income. Therefore, the federal net operating loss becomes a DTA. Thus the corrected

related journal entry is:

5 The federal current tax expense calculation may change upon further evaluation within the current/deferred tax expense calculation schedule

reviewed later in this section. Alternative minimum tax and various other modifications may impact overall current federal tax expense. 6 Note that the $875 DTA per the journal entry ties to the tax effected book/tax differences, i.e., 35% x ($500 + $5,000 + $(3,000)) = $875. Also note that the $500 permanent book/tax difference will not result in a DTA and is included for illustrative purposes only.

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Company management determines that due to JLCC’s first year of operations, loss

generation, no specific projections of profitability in the near future, and no taxable income

generating strategies on the horizon (in other words, negative evidence outweighs the positive

evidence), it is not “more likely than not” (>50% probability) that JLCC will recognize such DTA.

Therefore, a valuation allowance has been established so that JLCC does not reflect the related

$(2,800) tax benefit from Year 1 on the income statement and also does not recognize the related

DTA on the balance sheet. The rationale for establishing such valuation allowance is to prevent

financial statement distortion from recognizing an income statement tax benefit that may, in

actuality, never be recognized due to the failure to generate taxable income. The same rationale

applies to the balance sheet in that DTA are not reflected as JLCC is uncertain whether these will

ever be recognized, so, in actuality, JLCC cannot say the DTA are a true asset at this stage of the

Company’s development. The related journal entry to establish the valuation allowance is:


Cr. Valuation Allowance $2,800

Once JLCC meets the more likely than not threshold for DTA recognition, the valuation

allowance can be released with the following journal entry:

Dr. Valuation Allowance $2,800


It is important to proceed with caution whenever considering valuation allowance release

because the result typically is recognition of a large tax benefit on the income statement increasing

net income, which can result in earnings volatility and swings in earnings per share.

Following is an illustration of JLCC’s Year 1 federal taxable income calculation:

20

Now that we have completed the taxable income calculation schedule, we need to prepare

our second basic tax provision schedule, which is deferred inventory to track movement in JLCC’s

DTA, DTL, and related valuation allowance for Year 1.

Since our deferred tax expense/benefit for the period is based on our changes in the DTA

and DTL accounts from one period to the next, we must calculate what these changes are for Year

1. To accomplish this, we simply list separately all our accounts that reflect DTA and DTL. In

JLCC’s case, we have two DTA accounts, deferred revenue and net operating loss carryforwards,

and one DTL account for depreciation.

Our calculation begins with the cumulative timing difference (CTD) at the beginning of

the period, adjusts the beginning amount for current period timing differences, and sums those two

amounts to obtain the cumulative timing difference at the end of the period. This ending CTD

amount is tax effected using the applicable rate anticipated at the time of reversal, which in our

case we will assume is a 35% federal corporate income tax rate.

In JLCC’s case, this is Year 1, so no beginning CTD balance exists. Our current period

timing differences for each account can be obtained from JLCC’s taxable income calculation

FSR

Pre-Tax Book Income/(Loss) (8,000) 35% (2,800)

Permanent Differences

Meals & Entertainment 500

Temporary Differences

Deferred Revenue - Book 5,000

Deferred Revenue - Tax -

Depreciation Expense - Book 2,000

(Bonus) Depreciation Expense - Tax 5,000

Taxable Income/(Loss) (5,500) 35% (1,925)

Dr. Deferred Tax Asset 700 DTA for Dep and Def Rev

Dr. Income Tax Payable 1,925 NOL

Cr. Income Tax Expense 2,800 (tax benefit)

NOTE: Doesn't tie due to permanent difference.

175 Difference


Tax Provision - Federal Taxable Income Calculation

Year Ending December 31, Year 1

21

schedule. Per that schedule, our current period timing differences are $5,000 for deferred revenue,

$(3,000) for depreciation, and $5,500 for the Year 1 federal net operating loss carryforward.

Summing our $nil beginning CTD balances and our current period timing differences, we obtain

the CTD ending balances for Year 1. Tax effecting the ending CTD balances provides our

respective DTA and DTL balances, which are categorized according to the anticipated reversal

period as current for a year or less and non-current for more than one year. Total DTAs are then

netted against any DTLs to obtain Gross DTA (or Gross DTL if DTL>DTA), as illustrated by

JLCC’s Year 1 Deferred Inventory Schedule below.

Per the schedule, our deferred inventory changed during Year 1 from $nil at the beginning

of the year to gross DTA of $2,625. Therefore, JLCC generated a deferred tax benefit of $(2,625).

Technically, this means JLCC’s total Year 1 tax provision is the current tax expense of $nil plus

the Year 1 change in gross deferred tax assets of $(2,625) resulting in an overall deferred tax

benefit of $(2,625) for JLCC’s Year 1 tax provision. However, due to the established offsetting

valuation allowance, the deferred tax benefit of $(2,625) cannot be recognized resulting in a $nil

tax provision for Year 1.

It is important to cross check our DTA/DTL analysis with our taxable income calculation

to ensure accuracy. Per the related journal entry in our taxable income schedule, the difference

between book/financial statement income and taxable income per the tax return is a $700 DTA,

which ties to the sum of JLCC’s deferred revenue DTA of $1,750 and depreciation DTL of

$(1,050). The federal net operating loss carryforward DTA of $1,925 ties to our journal entry as

well. The $175 journal entry differential is due to the disregarded meals and entertainment

permanent difference of $500 ($500 x 35% = $175).

The third basic tax provision schedule is the current/deferred tax expense calculation.

Although it already has been determined that both federal current and deferred tax expense are $nil

for Year 1, there may be other calculations impacting these amounts. Alternative minimum tax,

state taxes, ASC 740-10 liabilities, and foreign calculations all could impact JLCC’s

current/deferred tax expense in future periods.

CTD @ 1/1/Year 1 Current TD CTD @ 12/31/Year 1 Applicable Rate Current Non Current

Deferred Revenue - 5,000 5,000 35% 1,750

Depreciation Expense - (3,000) (3,000) 35% (1,050)

Total Temporary Differences - 2,000 2,000 1,750 (1,050)

Federal Net Operating Loss - 5,500 5,500 35% 1,925

Total Deferred Tax Assets - 10,500 10,500 35% 3,675

Less Deferred Tax Liabilities - (3,000) (3,000) 35% (1,050)

Gross Deferred Tax Assets - 7,500 7,500 35% 2,625

Valuation Allowance - (7,500) (7,500) 35% (2,625)

Total Net Deferred Tax Assets / (Liabilities) - - -


Tax Provision - Federal Deferred Inventory Calculation


22

Following is a sample federal alternative minimum tax calculation for JLCC:

The fourth basic tax provision schedule is the rate reconciliation. The importance of this

schedule is to identify for readers the drivers of any differences between the statutory tax rate and

the respective tax expense/benefit at that rate, and the effective tax rate with corresponding tax

provision.

In JLCC’s case, the federal statutory corporate income tax rate is 35%, which on a pre-tax

book loss of $(8,000) generates a book tax benefit of $(2,800). However, as we determined from

our previous schedules, JLCC’s tax provision for Year 1 is $nil with an effective tax rate of 0%

($nil tax provision divided by $8,000 pre-tax book loss). What is driving this difference, i.e., what

is reducing JLCC’s 35% federal statutory rate to an effective tax rate of 0% and JLCC’s $(2,800)

federal book tax benefit to $nil?

Stepping back and observing from JLCC’s previous three schedules what is driving the

difference between tax expense for book purposes and that for tax return purposes, we know that

permanent and temporary book/tax differences are driving such differential. Specifically, we

know that one meals and entertainment permanent difference addback is reducing JLCC’s book

loss by $500 and JLCC’s book tax benefit by $175. Therefore, this difference likely is reducing

JLCC’s statutory rate towards the effective tax rate. In addition, we know that three temporary

Pre-Tax Income (8,000)

Permanent Differences 500

Temporary Differences 2000

Federal TI before NOL (5,500)

NOL Utilization/Generated 5,500

Federal Taxable Income 0

Regular Tax Rate 35%

Regular Federal Income Tax 0

Federal TI before NOL (5,500)

AMT Adjustments 0

Projected AMTI before AMTNOL (5,500)

AMT NOL Utilization/Generation 5,500

Projected AMTI before Exemption 0

Exemption 0

Federal Projected AMTI 0

Federal AMT Tax Rate 20%

Federal Tentative Minimum Tax 0

Total Current Federal Tax Expense 0


Tax Provision - Federal Current/Deferred Tax Expense Calculation


23

book/tax differences are impacting JLCC’s book loss and statutory rate. The deferred revenue

addback of $5,000 and unutilized federal net operating loss of $5,500 are reducing JLCC’s book

loss by such amounts, and, accordingly, the book tax benefit by $1,750 and $1,925. These

differences are likely reducing JLCC’s statutory rate towards the effective tax rate. JLCC’s

$(3,000) additional depreciation deduction for tax purposes is increasing JLCC’s book loss by such

amount and book tax benefit by $(1,050). This difference is likely increasing JLCC’s effective

tax rate towards the statutory rate.

Let’s review JLCC’s actual rate reconciliation to evaluate our analysis.

Per the rate reconciliation, our analysis is correct in that the primary drivers reducing our

35% federal statutory rate and corresponding $(2,800) book tax benefit to 0% and $nil,

respectively, are movements in the deferred tax accounts offset by valuation allowance. It is

important to note that the respective rate impact for each book/tax difference is obtained by

dividing its tax effected impact by pre-tax book income (e.g., meals and entertainment tax effected

impact of $175 divided by pre-tax book income of $(8,000) equals a rate impact of -2%). It also

is important to ensure the correct tax rate is applied. JLCC’s example is straightforward as only

federal corporate income tax is being considered. However, once state and foreign impacts are

included, applicable tax rates become more complex.

JLCC’s fifth basic tax provision schedule is the tax account rollforward. This schedule

compares what a company has booked for tax related accounts per the general ledger/trial balance

for a period with the amounts for those same accounts per our tax provision analysis. Any

differences between the amounts booked by the company and our analysis result in adjusting

journal entries. These entries are provided to the company to incorporate into the general ledger,

which flow through to the trial balance, and ultimately impact the financial statements where

applicable and the income tax footnote to the financial statements.

Pre-Tax Book Income (8,000)

Federal Statutory Rate (8,000) 35% (2,800) 35%

Permanent Items

Meals & Entertainment 500 35% 175 -2%

Valuation Allowance Movement

Federal Net Operating Loss 5,500 35% 1,925 -24%

Deferred Revenue 5,000 35% 1,750 -22%

Depreciation (3,000) 35% (1,050) 13%

Annual Provision - 0%


Tax Provision - Federal Rate Reconciliation


24

In JLCC’s case, what tax related accounts have been included in our analysis? As we only

are focusing on federal corporate income tax for this example, we need only consider related

federal tax accounts. Federal Tax Expense represents our book/financial statement tax account,

while Federal Tax Payable represents our tax return account. JLCC also has DTA and valuation

allowance accounts, which should be noted.

In JLCC’s case, does the general ledger or trial balance indicate that JLCC has booked any

amounts in the company’s tax-related accounts? Based on our source data preparation, the

company has not booked any amounts in such accounts or even established the accounts.

Therefore, the general ledger amounts for JLCC’s tax-related accounts should be $nil. Per our tax

provision preparation and analysis, both federal tax expense and federal tax payable are $nil due

to loss generation/valuation allowance offset and the fact that federal net operating losses per

federal tax law are not refundable but must be carried back or forward accordingly. JLCC

generated a net DTA but that amount is offset by valuation allowance, resulting in a $nil DTA

account balance and a valuation allowance account balance of $2,625. Therefore, JLCC’s

adjusting journal entry for Year 1 is:


Cr. Valuation Allowance $2,625

These results are reflected in JLCC’s following tax account rollforward:

Again, it is important to note that the respective DTA amounts are not reflected on the

balance sheet in Year 1 due to the offsetting valuation allowance, but are merely disclosures

included in the income tax footnote to the financial statements.

The final tax provision schedules are the financial statement impacts and the income tax

footnote preparation. As discussed previously, there are no financial statement impacts due to a

$nil federal tax provision and full valuation allowance offsetting the net DTA. Only the income

tax footnote to the financial statements must be prepared.

Following is a sample Year 1 income tax footnote for JLCC:

Offset by VA

Federal Tax Expense Federal Tax Payable Deferred Tax Asset Valuation Allowance

General Ledger 0 0 0 0

Our Analysis 0 0 0 2,625

Adjusting Journal Entry 0 0 0 2,625


Tax Provision - Federal Tax Account Rollforward Calculation


25

C. Build Six Basic Tax Provision Schedules - State

In JLCC’s case, in addition to a federal tax provision, we also must compute a state tax provision

for California as nexus exists with this State. More specifically, JLCC has minimum connections

with California in terms of property, payroll, and sales located/occurring within the State.7

JLCC’s state tax provision calculation is much the same as the federal tax provision

calculation. Specifically, we begin with the same taxable income calculation where the

book/financial statement loss of $(8,000) is multiplied by the California corporate

income/franchise tax rate of 8.84% net of the federal benefit from the state income tax deduction

on the federal return, i.e., 8.84% x (1-35%) = 5.75%. Therefore, JLCC’s current state income tax

expense is $(460) for book/financial statement purposes.8 Considering the same book/tax

differences we computed in our federal calculation, JLCC’s net income per the tax return is

$(5,500), which results in state income tax payable per the California return of $(316), i.e., $(5,500)

x the state rate of 5.75%. Therefore, our related journal entry is:


Dr. Income Tax Payable (Refund) $316

Cr. Income Tax Expense (Benefit) $460

7 It is important to note that state income tax nexus has a broad reach such that any JLCC connections outside of California with other states could potentially have created a filing requirement and calculation of the related tax provision/ASC 740 impacts. 8 As with the federal current tax expense calculation, the state current tax expense calculation may change upon further evaluation within the

current/deferred tax expense calculation schedule reviewed later in this section. State alternative minimum tax, apportionment, modifications from federal tax law, and various other modifications may impact overall state current tax expense.

Income Taxes

The tax effects of temporary differences and carryforwards that give rise to significant portions of the deferred tax assets are as follows:

Year Ended 12/31/Year 1Deferred Tax Assets

Accruals and Reserves $1,750Net Operating Loss Carryforward $1,925_Total Deferred Tax Assets $3,675

Deferred Tax Liabilities $(1,050)__Gross Deferred Tax Assets $2,625Valuation Allowance $(2,625)

Total Net Deferred Tax Assets / (Liabilities) $0

No tax benefit has been recorded through December 31, Year 1 due to a history of operating losses and a full valuation allowance has been provided.

As of December 31, Year 1, the Company had net operating loss carryforwards of $1,925 available to reduce future taxable income, if any, for federal income tax purposes. The federal net operating loss carryforwards will begin to expire in Year 21.

Current federal tax laws include provisions limiting the annual use of net operating loss and tax credit carryforwards in the event of certain defined changes in stock ownership. Accordingly, the annual use of the Company's net operating loss and credit carryforwards may be limited. Management believes that no limitation exists on which to utilize its tax attributes.

Effective Year 1, the Company adopted an accounting pronouncement that requires financial statement effects of an uncertain tax position to be recognized when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. The Company does not have any uncertain tax positions at this time.

26

As with the federal net operating loss, the state net operating loss is not refundable but can

be carried forward to offset future taxable income. Therefore, as with the federal net operating

loss, the state net operating loss becomes a DTA. Thus the corrected related journal entry is:



Since this is JLCC’s first year of operations, Company management arrives at the same

conclusion regarding recognition of the state-related DTA as with the federal DTA. Company

management determines that due to JLCC’s first year of operations, loss generation, no specific

projections of profitability in the near future, and no taxable income generating strategies on the

horizon (in other words, negative evidence outweighs the positive evidence), it is not “more likely

than not” (>50% probability) that JLCC will recognize such DTA. Therefore, a valuation

allowance has been established so that JLCC does not reflect the related $(460) tax benefit from

Year 1 on the income statement and also does not recognize the related DTA on the balance sheet.

The rationale for establishing such valuation allowance is to prevent financial statement distortion

from recognizing an income statement tax benefit that may, in actuality, never be recognized due

to the failure to generate taxable income. The same rationale applies to the balance sheet in that

DTA are not reflected as JLCC is uncertain whether these will ever be recognized, so, in actuality,

JLCC cannot say the DTA are a true asset at this stage of the Company’s development. The related

journal entry to establish the valuation allowance is:

Dr. Income Tax Expense $460

Cr. Valuation Allowance $460

Once JLCC meets the more likely than not threshold for DTA recognition, the valuation

allowance can be released with the following journal entry:

Dr. Valuation Allowance $460


It is important to proceed with caution whenever considering valuation allowance release

because the result typically is recognition of a large tax benefit on the income statement increasing

net income, which can result in earnings volatility and swings in earnings per share.

Following is an illustration of JLCC’s Year 1 state taxable income calculation:

27

JLCC’s state tax provision for Year 1 is current state tax expense of $nil plus deferred state

tax expense of $nil. California does, however, impose an $800 minimum franchise tax, which will

be recorded outside of the tax provision as beyond the purview of ASC 740 as it is a tax that is not

based in income.

State deferred tax inventory is prepared much like the federal deferred tax inventory

reflecting the same book/tax differences at the 5.75% California rate. The net state DTA is offset

by valuation allowance, so the change in deferreds during Year 1 from $0 to $431 results in no

deferred tax expense or benefit for Year 1.

Following is an illustration of the state deferred inventory calculation:

SSR

Pre-Tax Book Income/(Loss) (8,000) 5.75% (460)

Permanent Differences

Meals & Entertainment 500

Temporary Differences

Deferred Revenue - Book 5,000

Deferred Revenue - Tax -

Depreciation Expense - Book 2,000

(Bonus) Depreciation Expense - Tax 5,000

Taxable Income/(Loss) (5,500) 5.75% (316)

Dr. Deferred Tax Asset 144 DTA for Dep and Def Rev

Dr. Income Tax Payable 316 NOL

Cr. Income Tax Expense 460 (tax benefit)

NOTE: Doesn't tie due to permanent difference.

29 Difference


Tax Provision - State Taxable Income Calculation


28

JLCC’s current/deferred tax expense calculation is $nil per our previous analysis.

However, there are circumstances where additional analysis will be required to determine these

amounts. For example, some states, like California, impose alternative minimum tax and state

modifications from federal tax law. In addition, although in JLCC’s case California apportionment

is 100% because all JLCC activities occur within California, this likely will change in the future

as JLCC expands property, payroll, sales, and other economic connections into various state

jurisdictions (foreign as well, which will be explored in subsequent framework guidebooks). Such

expanding state activities also will require review of a state’s tax regime to determine whether

such regime falls within the purview of ASC 740, which only covers income based taxes meaning

tax calculations where items of income/gain are offset by items of expense/loss. Taxes falling

outside this definition will require evaluation as to whether they should be properly accounted for

within the tax provision or outside of the tax provision under income from continuing operations.9

Such determinations are important as taxes included as part of continuing operations can impact

operating income, which is a key variable considered by investors in evaluating financial results,

i.e., if the tax was considered part of the tax provision then the tax would not impact operating

income directly, just indirectly as part of overall net income for the period.

JLCC’s rate reconciliation remains the same basic calculation as for federal purposes, but

now includes the state related components. The book income tax expense (benefit)/statutory rate

now includes both the federal and state amounts of $(2,800) and $(460), respectively. Such total

tax benefit is now adjusted to the actual $nil tax provision and 0% effective tax rate by including

the state net operating loss and applying the combined federal/state statutory rate to permanent and

temporary differences. As with the federal rate reconciliation, the primary drivers from the

statutory blended rate of 40.75% to the 0% effective tax rate is JLCC’s inability to recognize the

related federal and state tax benefits due to the application of an offsetting valuation allowance

9 The Texas Margin Tax is a good example of a tax not solely based on income, thereby requiring further analysis as to whether it is properly

accounted for under ASC 740. The Texas tax is typically based on 1% of the lesser of 70% of revenues or 100% of gross receipts after deductions for compensation or cost of goods sold. Although this taxing regime has an ASC 740 income based component in that part of the

calculation involves items of revenue less items of expense, it also includes a component that is simply based on a percentage of revenues, which

does not fall under the ASC 740 definition of an income based tax. The authorities have determined that the Texas Margin Tax is covered by ASC 740, but it is a good example of how complex this determination can become.

CTD @ 1/1/Year 1 Current TD CTD @ 12/31/Year 1 Applicable Rate Current Non Current

Deferred Revenue - 5,000 5,000 5.75% 288

Depreciation Expense - (3,000) (3,000) 5.75% (173)

Total Temporary Differences - 2,000 2,000 288 (173)

Federal Net Operating Loss - 5,500 5,500 5.75% 316

Total Deferred Tax Assets - 10,500 10,500 5.75% 604

Less Deferred Tax Liabilities - (3,000) (3,000) 5.75% (173)

Gross Deferred Tax Assets - 7,500 7,500 5.75% 431

Valuation Allowance - (7,500) (7,500) 5.75% (431)

Total Net Deferred Tax Assets / (Liabilities) - - 5.75% -


Tax Provision - State Deferred Inventory Calculation


29

absorbing such benefits. In other words, the total federal/state book tax benefit of $(3,260) cannot

be recognized on the income statement because there is much uncertainty surrounding whether

JLCC will ever be able to utilize such benefits to offset taxable income, which would be distortive

to the financial statements.

Following is an illustration of this calculation:

In practice, a company’s rate reconciliation may reflect a slight differential. Typically, this

differential is due to rounding so it is important to carry out decimal places accordingly and link

amounts throughout the calculation, rather than hard coding data. If a company’s differential is

more substantial, likely the issue is a missing book/tax difference item, applying an incorrect tax

rate, or reflecting an amount incorrectly as a negative or positive number.

JLCC’s tax account rollforward also remains much the same as federal, but with state tax

impacts included. JLCC’s tax accounts expand from a federal focus to a federal and state focus,

including state income tax expense, state income tax payable, state franchise tax expense, and state

franchise tax payable. JLCC’s deferred tax accounts and valuation allowance also may be broken

out into federal and state components, but for illustrative purposes such amounts will be combined

within the same accounts.

Following is an illustration of JLCC’s tax accounts including both federal and state

considerations:

Pre-Tax Book Income (8,000)

Federal Statutory Rate (8,000) 35.00% (2,800) 35.00%

State Statutory Rate (8,000) 5.75% (460) 5.75%

Permanent Items

Meals & Entertainment 500 40.75% 204 -2.55%

Valuation Allowance Movement

Federal Net Operating Loss 5,500 35.00% 1,925 -24.06%

State Net Operating Loss 5,500 5.75% 316 -3.95%

Deferred Revenue 5,000 40.75% 2,037 -25.47%

Depreciation (3,000) 40.75% (1,222) 15.28%

Annual Provision - 0%


Tax Provision - Federal/State Rate Reconciliation


30

The related adjusting journal entry that will be sent to JLCC management for inclusion in

the general ledger/trial balance and ultimately the financial statements is for the $800 California

minimum franchise tax as follows:

Dr. Franchise Tax Expense $800

Cr. Franchise Tax Payable $800

In Year 1, net income per the income statement will be reduced by this amount and the

respective liability reflected on the balance sheet. Once payment of this amount is made with the

applicable California extension or return, the payable will be reversed as follows:

Dr. Franchise Tax Payable $800

Cr. Cash $800

Although JLCC’s net DTA increased accordingly for state purposes, the same uncertainty

exists regarding DTA recognition thereby requiring establishment of an offsetting valuation

allowance. Therefore, the DTA account remains at $nil with an increase in the valuation allowance

account from the federal amount of $2,625 to include the state amount of $431 for a total valuation

allowance of $3,056 at the end of Year 1. The associated journal entries are:


Cr. Income Tax Expense $431

Dr. Income Tax Expense $431

Cr. Valuation Allowance $431

It is important to ensure JLCC’s tax account rollforward results tie back to the taxable

income calculation. JLCC’s taxable income calculation for state purposes reflected a net DTA of

$460, comprising of a state net operating loss of $316 and other deferreds of a net DTA of $144.

The $460 less the tax effected permanent adjustment of $29 results in JLCC’s calculated net DTA

of $431 reflected in the journal entry and subsequent calculations.

The financial statement impact is an $800 California minimum franchise tax that will be

accounted for as part of continuing operations outside the tax provision as franchise tax is beyond

the purview of ASC 740 as it is not based on income per the ASC 740 definition. As discussed,

this may not be an optimal result as net income from continuing operations is reduced, which is a

key indicator of future performance for investors. Had the franchise tax been included in the tax

provision, this amount would not have reduced net income from continuing operations directly but

only indirectly in the overall net income calculation per the income statement. Net state DTAs are

Offset by VA

Federal Tax Expense State Tax Expense Franchise Tax Expense Federal Tax Payable State Tax Payable Franchise Tax Payable Deferred Tax Asset Valuation Allowance

General Ledger 0 0 0 0 0 0 0 0

Our Analysis 0 0 800 0 0 800 0 3,056

Adjusting Journal Entry 0 0 800 0 0 800 0 3,056


Tax Provision - Federal/State Tax Account Rollforward Calculation


31

not reflected in the balance sheet as they are offset by valuation allowance, but are disclosed in the

financial statements income tax footnote as follows:

Income Taxes

The tax effects of temporary differences and carryforwards that give rise to significant portions of the deferred tax assets are as follows:

Year Ended 12/31/Year 1Deferred Tax Assets

Accruals and Reserves $2,038Net Operating Loss Carryforward $2,241___Total Deferred Tax Assets $4,279

Deferred Tax Liabilities $(1,223)__Gross Deferred Tax Assets $3,056Valuation Allowance $(3,056)

Total Net Deferred Tax Assets / (Liabilities) $0

No tax benefit has been recorded through December 31, Year 1 due to a history of operating losses and a full valuation allowance has been provided.

As of December 31, Year 1, the Company had net operating loss carryforwards of $1,925 and $316 available to reduce future taxable income, if any, for federal and California income tax purposes, respectively. The federal and California net operating losscarryforwards will begin to expire in Year 21.

Current federal and California tax laws include provisions limiting the annual use of net operating loss carryforwards in the event of certain defined changes in stock ownership. Accordingly, the annual use of the Company's net operating loss carryforwards may be limited. Management believes that no limitation exists on which to utilize its tax attributes.

Effective Year 1, the Company adopted an accounting pronouncement that requires financial statement effects of an uncertain tax position to be recognized when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. The Company does not have any uncertain tax positions at this time.

32

FRAMEWORK LEVEL 5

BASIC TAX RETURN ANALYSIS

33

A. Understand How the Federal 1120 Reflects the Tax Provision/Source Data

Now that JLCC’s source documents, financial statements, and basic tax provision schedules are

prepared, the necessary documents exist to prepare JLCC’s corporate federal income (Form 1120)

and California income/franchise (Form 100) tax returns. The most effective means of

understanding such tax return preparation, including all the accompanying schedules and

statements, is by learning such preparation through the framework.

Peruse the basic first five pages of a Form 1120. The fact that should jump out at you is

that you have seen all this data they are requesting before. In fact, you just prepared it. Take page

1 of the 1120. It is simply an extended version of the federal taxable income calculation you

prepared as the first of your six basic federal tax provision schedules. Simply return to the general

ledger and pinpoint items of income and deduction for tax purposes. Our total income for page 1

purposes will be $7,000, i.e., the $2,000 Year 1 sale plus the $5,000 cash received for Year 2

delivery. Expenses for page 1 will be the $5,000 bonus depreciation, plus the $500 50% meals &

entertainment, plus the additional $7,000 of typical expenses for website design and baking

supplies. Therefore, page 1 of JLCC’s 1120 will reflect our taxable income/(loss) of $(5,500), i.e.,

$7000 income less $12,500 in deductions.

We also know that, based on our deep understanding of JLCC’s facts and circumstances,

Page 2/Schedule C Dividends and Special Deductions does not apply to our single entity,

California based startup business. Pages 3 and 4 Schedules J and K also are not significant to

JLCC’s startup development stage, so we merely run through the calculations to obtain $nil tax for

Schedule J and respond accordingly to the Schedule K questions. Page 5 includes three schedules,

which are familiar to us. Schedule L is simply the beginning and ending balance sheet per the

books, which we already prepared for year end and know that JLCC’s beginning balance for these

sections is $nil as this is Year 1 for the Company. Schedule M-1 is a reconciliation of

income/(loss) per the books with income per the return, which we know is our first basic tax

provision schedule, i.e., JLCC’s taxable income calculation. Here we simply fill in the blanks with

our tax provision taxable income schedule beginning with JLCC’s book loss of $(8,000). Items 2

and 3 are $nil but item 4 is our $5,000 deferred revenue addback. Item 5 we know is our $500

meals & entertainment addback. Item 7 is $nil and item 8 is our additional depreciation deduction

of $(3,000). The result is a loss per our federal return of $(5,500), which ties to our tax provision

taxable income schedule. The M-2 Schedule reflects our only retained earnings of Year 1’s

$(8,000) book loss and original $20,000 capital contribution, which reflects the equity amount in

the balance sheet we prepared.

Beyond the five basic Form 1120 pages, we are required to include other applicable

schedules and attachments. In JLCC’s case, for example, a schedule for depreciation (Form 4562)

likely will be required to provide additional details to the IRS. A statement electing bonus

depreciation also may be required. Other schedules, elections, and statements may apply, but a

high level review indicates the federal return for JLCC’s Year 1 is relatively straightforward.

34

B. Understand How California 100 Reflects the Tax Provision/Source Data

JLCC also must file Form 100 for California C corporations, but such task is simplified because

California tax laws mimic federal tax laws in many respects. California state income/franchise tax

begins with JLCC’s federal taxable income/(loss) amount of $(5,500). Various state adjustments

(e.g., differences between federal and state depreciation laws) are made to the federal amount to

arrive at taxable income/(loss) after state adjustments. The applicable state apportionment factor

is applied to this amount resulting in California taxable income. The remaining schedules in the

basic five-page California Form 100 reflect much of what was included on the federal return (e.g.,

Schedule L balance sheet, Schedule M-1 Book/Tax Reconciliation, and Schedule M-2

Unappropriated Retained Earnings Reconciliation). This is why typically the federal return (or

portions thereof) must be attached to state returns, including California. As with the federal return,

additional schedules, elections, and statements may apply, but a high level review indicates the

California return for JLCC’s Year 1 also is relatively straightforward.

The main point with respect to return preparation is not to underestimate the difficulty

involved in actual federal/state corporate income/franchise tax return preparation, but to highlight

that the basic mechanics of the federal/state returns reflect the source data and basic tax provision

schedules prepared, thereby simplifying and making greater sense of the return preparation

process. In addition, now that it is understood how the tax returns fit within the overall framework,

the impact of source document and tax provision changes on the tax returns are better understood

and anticipated as well.

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FRAMEWORK LEVEL 6

IMPACTFUL WRITTEN/VERBAL COMMUNICATION

36

A. Use the Framework as a Blueprint for Effective Written/Verbal Communication

Effective verbal and written communication skills do not come from innate talent, rather they are

both learned skills that improve with practice. The difficulty lies in how exactly to practice such

skills relative to corporate tax and accounting and apply them to the myriad of real world

assignments. Here again, the basic corporate tax and accounting framework offers a solution.

The framework acts as a blue print for all forms of verbal and written communication

regardless of the setting. For example, in JLCC’s case an associate working on the engagement is

asked by a manager to draft a client letter on the engagement status. It is recommended that the

associate request a sample firm client letter to ensure proper formatting, font, letterhead, etc., but

after that the letter is drafted using the framework. The opening paragraph provides background

on the project, which is simply a reflection of the big picture framework, i.e., completing provision

and return based on the source documents prepared or provided. The second paragraph provides

JLCC’s tax provision results and the rationale behind such results. The third paragraph addresses

JLCC’s anticipated tax return results and the rationale behind those results. The final paragraph

includes any additional critical information, which in JLCC’s case is the upcoming project

completion process. Typical salutations, enclosures, and copies to third parties are included as

necessary.

B. Examples of Effective Communication Using the Framework

Using the basic framework, a client letter as follows can be prepared:

Good Tax, Inc. 999 West Drive

Silicon Valley, California 90000

February 1, Year 2

Mr. Joe Smith

President

Joe & Linda’s Cupcake Corporation

333 Oak Drive

Silicon Valley, California 90000

Mr. Smith:

The purpose of this correspondence is to provide a status report on the corporate tax project (the

“project”) Good Tax, Inc. is in the process of completing for Joe & Linda’s Cupcake Corporation

year ended December 31, Year 1 activity. As established in our agreement dated January 20, Year

2, such project primarily includes Year 1 tax provision and return preparation.

Our preliminary analysis results in a $nil tax provision with a corresponding 0% effective tax rate.

This outcome primarily is driven by the substantial expenses required in this inception year leading

to overall loss generation, as well as the establishment of a valuation allowance to offset all

deferred tax assets resulting from the related tax benefits as recognition of such benefits does not

meet the requisite more likely than not threshold.

We anticipate that the federal income and California income/franchise tax returns will reflect the

tax provision results with no federal income tax and only the $800 California minimum tax due.

Requisite extensions are being prepared and will be filed by the March 15, Year 2 due date. We

will contact you in the next two weeks with any additional information requirements to complete

the filings.

Once the project is complete, we will schedule a meeting to review the deliverables with you, and,

upon your approval, store the documents on our secure on-line file room accessible via the

following link and password: www.goodtax.com, Cupcakes001!.

Please do not hesitate to contact me at 000-000-0000 with any questions regarding the project.

Sincerely,

Joe Williams

Joe Williams

Director – Good Tax, Inc.

cc: Mrs. Linda Smith, Vice President – Joe & Linda’s Cupcake Corporation

37

This same approach can work in drafting an email, presentation, speaking during a meeting,

handling a client phone call, or even preparing a client deliverable. In every one of these scenarios

the framework provides the overall big picture of what is being accomplished for the client, the

detailed transactions via the source data that are impacting the results, the specific tax provision

results and respective drivers, and the specific tax return results and respective drivers.

38

FRAMEWORK LEVEL 7

CONSULTING/SPECIALTY WORK INTERPLAY

39

Specialty consulting tax work performed by tax specialists in the areas of state tax, international

tax, transfer pricing, and special projects (e.g., research credit studies, IRC §§ 382/383 reviews)

are important to core corporate income tax compliance as they provide the detailed source

documentation that is used in preparing tax provisions and returns. Therefore, although such tax

specialists are not required to be experts in core tax compliance, it is important that they understand

the core tax compliance impacts of their specialty work.

For example, a research credit specialist can prepare a research credit analysis

exceptionally well and secure millions in federal and state research credits for a company,

including substantial supporting documentation. However, unless the research credit specialist

also has a good comprehension of the core corporate income tax compliance impacts of claiming

such research credits, these tax benefits may be diluted or altogether lost due to provision/return

impacts.

Perhaps the company has a full valuation allowance due to a history of consistent losses,

which prevents the company from recognizing such benefits on the financial statements, as

follows:

Dr. Deferred Tax Asset XXXXX

Cr. Income Tax Expense XXXXX

Dr. Income Tax Expense XXXXX

Cr. Valuation Allowance XXXXX

Perhaps the company is limited by IRC §§ 382/383 in its ability to utilize such credits and

they must be written off, as follows:

Dr. Valuation Allowance XXXXX

Cr. Deferred Tax Asset XXXXX

Perhaps the ASC 740-10 uncertain tax position reserves create an unwanted liability on the

company’s balance sheet, as follows:

Dr. Income Tax Expense XXXXX

Cr. ASC 740-10 Liability XXXXX

Perhaps such liability results in earnings volatility once the uncertain tax position is

effectively settled and a substantial tax benefit is recognized, as follows:

Cr. ASC 740-10 Liability XXXXX

Dr. Income Tax Expense (Benefit) XXXXX

And what if the uncertain tax position is not effectively settled, then the company must

reimburse the federal/state government for whatever portion of the credit was monetized plus

interest and potentially penalties (bad permanent difference), as follows:

40

Dr. ASC 740-10 Liability XXXXX

Cr. Cash XXXXX

Dr. Interest (Expense) XXXXX

Cr. Cash XXXXX

Dr. Penalties (Expense) XXXXX

Cr. Cash XXXXX

Perhaps this research credit uncertain tax position leads to the company for the first time

having to file a Schedule UTP with its federal/California returns, which results in higher potential

for audit and increased audit scrutiny. And how much additional time/cost will the company incur

quarterly/annually to substantiate and carry forward such benefits?

There are a host of considerations that a research specialist should take into account before

recommending a research credit study to a company as the potential tax savings may be diluted or

eliminated altogether due to tax compliance concerns. More importantly, securing such benefits

may result in unwanted financial statement and/or tax return impacts that dwarf the estimated

savings opportunity.

The framework provides enough big picture information in terms of corporate tax and

accounting mechanics to assist specialists in accelerating the learning curve with respect to core

corporate income tax compliance without trying to become experts. In addition, this knowledge

improves the credibility of the specialist potentially increasing their marketability based on such

heightened expertise. They also may feel more empowered in terms of the core tax compliance

process, rather than an outside player that simply completes studies and moves on. They are a

trusted advisor, not just in terms of their specialty expertise, but in terms of how that expertise

impacts the bottom line.

41

LEVERAGING THE FRAMEWORK TO ACCELERATE

LEARNING/UNDERSTANDING

42

A. Accelerate Understanding of Technical Developments

Now that you understand the basic corporate tax and accounting framework, how do you use the

framework to accelerate learning curves in your daily work activities/client and class assignments?

The two primary areas for acceleration are: 1) assimilating new corporate tax and accounting

developments and 2) tackling assignments of greater complexity.

Regarding new developments, the framework can be used to more efficiently sift through

extensive data on new accounting pronouncements and tax laws. For example, consider the

Foreign Account Tax Compliance Act (FATCA) that should take effect some time during 2014.

There is a tremendous amount of information on this new legislation, but you cannot realistically

review and know everything about FATCA, nor do you need to know everything. The more

effective way to understand FATCA is through the framework. Beginning with any journal

entry/general ledger impacts of FATCA, determine what exactly FATCA’s impacts are from a real

world perspective and what the legislation is attempting to accomplish. Then consider the trial

balance impacts of FATCA in terms of what financial statement accounts are impacted and

whether any book/tax differences result. Using this source data, determine the financial statement,

tax provision, and tax return impacts from FATCA. Using the framework, summarize this data

into a quick memo and practice verbally discussing FATCA from this blueprint in training

sessions, with internal management, and with clients. This is the most efficient means of extracting

salient aspects of a new corporate tax law/accounting pronouncement to determine any client

impacts and communicate effectively on the topic.

B. Accelerate Ability to Complete More Complex Work

Regarding tackling assignments of greater complexity, the framework is an excellent blueprint to

use as every client assignment, every corporate tax responsibility, and every class project always

follow the basic framework. For example, an associate receives an assignment from management

to prepare an amended return for a client. The associate is new and has never prepared an amended

return, so where to start? Always start from the framework as it walks the associate through asking

the correct questions to better understand the project/expectations, what information will be needed

to complete the assignment, and additional commentary that shows the associate is thinking

beyond the assignment to other potential concerns/opportunities the client may have relative to the

amended return.

Working through the framework, the associate begins with the related journal

entries/general ledger impacts because some change in the basic accounts is driving the need for

the amended return. Once the employee understands the change/real world drivers of the amended

return, the impacted trial balance accounts can be reviewed and any book/tax differences or

changes to such differences identified. Financial statement impacts, tax provision impacts, and

the resulting amended return can be identified prompting further questions for management. For

example, if the request is for an amended federal return, do any state returns dependent on federal

taxable income require amending as well? Are the financial statement impacts merely footnote

disclosures or do they impact the financial statements as well? Are these financial statement

impacts immaterial? If the amended return(s) result in greater federal/state tax liability, are there

any offsets to such increase via tax net operating loss/credit carryforwards or other tax strategies?

43

What should be included in the deliverable; is there a sample to follow? Many more questions can

emanate from the basic framework, but you see how using the framework as a guide to accomplish

new levels of complexity can be helpful and assist in meeting/potentially exceeding project

expectations.

44

Visit us at shamendugger.com or contact us directly at 408-398-0815 for more

information on the corporate tax and accounting framework or to schedule our one-

day framework training course.

All information presented in this reference guide is for educational purposes only

and should not be relied upon as accounting, legal, or tax advice of any kind.

Shamen Dugger, LLC, its employees, and assigns, assume no liability with respect

to the information contained within this reference guide. Please consult your tax

advisor before making any decisions relative to the contents of this reference guide

and/or in utilizing the information herein for any purpose.

© Shamen Dugger, Esq., CPA Day 1 – Basic Framework

Day 1 - Reference Guide

Documents

framework level

specific framework

various corporate tax

basic tax provisionasc

tax provisions

noncore corporate tax

basic tax return analysis

big picture of corporate