Chapter 14:
Income Taxes & Financial Accounting
Income tax allocation
MACR system
SFAS no. 109
Investment tax credit
Empirical research
Income Tax Law of 1913
Established income as a basis for taxation
Since income for tax purposes was defined
differently than income for accounting
purposes
Resulted in many items being recognized in
different time periods for tax and book
purposes
Efforts to synchronize tax and book accounting
go back to the 1930s
Income Tax Allocation
Made necessary by the timing differences
between when a revenue or expense item
reaches the published financial statements
as opposed to when it appears on the tax
return
tax expense is based on the published
before-tax income figure
Income Tax Allocation
Comprehensive Allocation: as long as
timing differences arise
tax allocation must take place,
despite the possibility of relevant circumstantial
differences
Permanent differences between published
statements and tax returns are not subject to
the allocation process
Intrastatement or Intraperiod
Tax Allocation
items are shown net of the tax effect
prior period adjustments
extraordinary items
changes in accounting principle
operations of discontinued segments
balance of the total tax expense figure then
appears below net income before income
taxes and extraordinary items
Timing Differences
Referred to as temporary differences
Tax liability would be greater than tax expense
where
revenues are recognized for tax purposes earlier than
for published reporting purposes
expenses are recognized more rapidly on the financial
statements than on the tax return
Tax expense is greater than tax liability when
either revenues are recognized more slowly or
expenses more rapidly for tax purposes than for
book purposes
Depreciation
Using straight line for book and accelerated
for tax purposes creates
timing differences for a non-growth company
a potentially permanent deferral for a growthtype company
Federal government uses accelerated
depreciation to stimulate economic growth
Orientations to Income Tax Allocations
No allocations...tax is a distribution of income
New form of equities...tax allocation is in effect an
investment in the firm by government
Net-of-tax method...adjust book depreciation; tax
expense = tax liability
Partial allocation...only those credits expected to
be paid in foreseeable future are recorded
Discount deferred tax liabilities
Modified Accelerated Cost Recovery System
Came about in 1986 tax act
Eliminates concept of useful depreciable
life
Uses six classes of capital assets with
prescribed lives
Salvage values not considered
Eliminated IRS-corporation controversies over
useful lives
Class (Years)
Type of Asset
3
Short-lived special mfg tools & handling devices
5
Cars, light trucks & certain mfg equipment
7
Most heavy mfg equipment
10
Includes RR track, electrical generating...
15
Includes gas pipelines and nuclear plants
20
Includes sewer pipes and phone cables
SFAS No. 96 (December 1987)
Kept comprehensive income tax orientation
of APB Opinion No. 11, but substituted a
liability (asset-liability) approach in place of
the deferred approach of APB Opinion 11
Dissatisfaction with the conservative
recognition of deferred tax assets in SFAS
No. 96 led to its replacement by SFAS 109
SFAS No. 109
Carryback of deferred tax assets and the allowed
carryforward against deferred tax liabilities of
future years
Allows recognition of deferred tax assets if
realization is “more likely than not”
Restores a consistency between deferred tax assets
and liabilities
Current or noncurrent designation is derived from
the classification of the related asset or liability
Net Operating Losses
SFAS No. 96 also took a negative view of
treating tax-loss carryforwards as assets like
its predecessor, APB Opinion No. 11
SFAS No. 109 took a complete turnaround
on booking tax-loss carryforwards from its
two predecessors. Tax-loss carryforwards
will now be booked subject to the same
valuation allowance for deferred tax assets.
Empirical Research
Beaver and Dukes
Ayers
Espahbodi, Espahbodi,
and Tehranian
Cheung, Krishnan, and
Min
Givoly and Hayn
Chaney and Jeter
Investment Tax Credit (ITC)
First enacted in 1962.
Provisions of the law have changed several
times.
As a tool of macroeconomic policy, the ITC
is seen as a means of stimulating investment
and, thus, fighting recession in the short run
and combating inflation over the long run.
Tax Reform Act of 1986 eliminated ITC
Interpretations of the ITC Transaction
Reduction of the cost of the asset.
Allocation by means of a deferred
investment credit account.
Capital donated by the government.
Flow through (immediate recognition of all
benefits taken in the year of acquisition).
Improving Accounting Standards
Deferred tax assets and liabilities should be
discounted to their present value.
Discount rate for deferred tax liabilities should be
for a loan of similar duration, repayment schedule,
and risk undertaken by the lender.
Deferred tax assets, a single rate might be
prescribed since the government is the payer.
since the firm’s risk is low, the rate should be
determined based on a very high quality
investment having a very low rate of risk.
Chapter 14:
Income Taxes & Financial Accounting
Income tax allocation
MACR system
SFAS no. 109
Investment tax credit
Empirical research