Accounting for Income Taxes
I.
Overview – Accounting for income taxes involves both intraperiod and interperiod tax allocation.
Intraperiod allocation matches a portion of the provision for income tax to the applicable components
of net income and retained earnings. Income for federal tax purposes and financial accounting income
frequently differ. Income for federal tax purposes is computed in accordance with the prevailing tax
laws, whereas financial accounting income is determined in accordance with GAAP. Therefore, a
company’s income tax expense and income taxes payable may differ. The incongruity is caused by
temporary differences in taxable and/or deductible amounts and requires interperiod tax allocation.
II.
Intraperiod Tax Allocation – Intraperiod Tax Allocation involves apportioning the total tax provision for
financial accounting purposes in a period between the income or loss from:
a. Income from continuing operations
b. Discontinued operations
c. Extraordinary items
d. Cumulative effect of an accounting change
e. Other comprehensive income
i. Pension Adjustment
ii. Unrealized gain/loss on available for sale security
iii. Foreign translation adjustment
f. Components of stockholders’ equity
i. Retained earnings for prior period adjustments and
ii. Items of accumulated (other) comprehensive income
g. General Rule – Any amount not allocated to continuing operations is allocated to other income
statement items, other comprehensive income, or to shareholders’ equity in proportion to their
individual effects on income tax or benefit for the year. Such items (discontinued operations,
extraordinary items, etc.) are shown net of their related tax effects. The amount of income tax
expense (or benefit) allocated to continuing operations is the tax effect of pretax income or loss
from continuing operations plus or minus the tax effects of change in:
i. Tax laws or rates,
ii. Expected realization of a deferred tax asset, and the
iii. Tax status of the entity.
III.
Comprehensive Interperiod Tax Allocation – Income Tax Return vs. Financial Statements
a. Objective – the objective of interperiod tax allocation is to recognize the amount of current and
future tax related to events that have been recognized in financial accounting income.
i. Current Year Taxes:
1. Payable (liability) or
2. Refundable (asset)
ii. Future Year Taxes:
1. Deferred tax liability, or
2. Deferred tax asset (benefit)
b. Differences – There are two types of differences between pretax GAAP financial income and
taxable income. All differences are either permanent differences or temporary differences.
i. Permanent Differences
1. Permanent differences do not affect the deferred tax computation. They only
affect the current tax computation. These differences affect only the period in
which they occur. They do not affect future financial or taxable income.
2. Permanent differences are items of revenue and expense that either:
a. Enter into pretax GAAP financial income, but never enter into taxable
income (interest income on state or municipal obligations) or
b. Enter into taxable income, but never enter into pretax GAAP financial
income (dividends received deduction).
ii. Temporary Differences
1. Temporary differences affect the deferred tax computation.
2. Temporary differences are items of revenue and expense that may:
a. Enter into pretax GAAP financial income in a period before they enter
into taxable income.
b. Enter into pretax GAAP financial income in a period after they enter into
taxable income.
c. Comprehensive Allocation – The asset and liability (sometimes referred to as the Balance Sheet
Approach) method is required by GAAP for comprehensive allocation. Under comprehensive
allocation, interperiod tax allocation is applied to all temporary differences. The liability method
requires that either income taxes payable or a deferred tax liability (asset) be recorded for all
tax consequences of the current period.
i. Temporary differences are recognized for GAAP purposes before or after they are
recognized for tax purposes; the related income tax effect will be recognized for GAAP
purposes before or after it is recognized for tax purposes.
1. Items that are first recognized for tax purpose will eventually be recognized for
GAAP purposes (or vice versa), therefore, the differences are temporary and will
eventually “turn around”
2. These temporary differences affect future periods and require that:
a. A liability (for future taxable amounts), or
b. A benefit (for future deductible amounts)
c. These should be recognized in the financial statement until the
difference turns around completely.
d. Accounting for Interperiod Tax Allocation
i. Total income tax expense (GAAP income tax expense) or benefit for the year is the sum
of:
1. Current income tax expense/benefit, and
2. Deferred income tax expense/benefit.
ii. Current income tax expense/benefit is equal to the income taxes payable or refundable
for the current year, as determined on the corporate tax return for the current year.
iii. Deferred income tax expense/benefit is equal to the change in deferred tax liability or
asset account on the balance sheet form the beginning of the current year to the end of
the current year (called the “Balance Sheet Approach”).
IV.
Temporary Differences – Temporary differences are the differences between the tax basis of an asset
or liability and its reported amount in the financial statement that will result in taxable or deductible
amounts in future years when the reported amount of the asset or liability is recovered or settled,
respectively.
a. Transactions That Cause Temporary Differences – There are four basic causes of temporary
differences which reverse in future periods.
i. Revenues or gains that are included in taxable income, after they have been included in
financial accounting income.
ii. Revenues or gains that are included in taxable income, before they are included in
financial accounting income.
iii. Expenses or losses deducted from taxable income, after they have been deducted from
financial accounting income.
iv. Expenses or losses deducted for taxable income, before they are deducted from
financial accounting purposes.
b.
c.
d.
e.
v. Additional causes of temporary differences are:
1. Differences between the financial reporting and tax basis of assets and liabilities
arising in a business combination accounted for as a purchase.
2. Differences in the tax basis of assets due to indexing, whenever the local
currency is the functional currency.
Deferred Tax Liabilities and Assets Recognition
i. Deferred Tax Liabilities – Deferred tax liabilities are anticipated future tax liabilities
derived from situations where future taxable income will be greater than future
financial accounting income due to temporary differences. All deferred tax liabilities are
recognized on the balance sheet.
ii. Deferred Tax Assets – Deferred tax assets arise when the amount of taxes paid in the
current period exceeds the amount of income tax expense in the current period. They
are anticipated future benefits derived from situations where future taxable income will
be less than future financial accounting income due to temporary differences.
iii. Valuation Allowance (Contra Account) – If it is more likely than not that part or all of
the deferred tax asset will not be realized, a valuation allowance is recognized. The net
deferred tax asset should equal that portion of the deferred tax asset that, based on
available evidence, is more likely than not to be realized.
Enacted Tax Rate – Measurement of deferred taxes is based on the applicable tax rate. This
requires using the enacted tax rate expected to apply to taxable items (temporary differences)
in the periods the taxable item is expected to be paid (liability) or realized (asset).
Adjustment for Changing Tax Rates – The liability method requires that the deferred tax
account balance (asset or liability) be adjusted when the tax rates change. Thus if future tax
rates have been enacted, not just proposed or estimated, the deferred tax liability and asset
accounts will be calculated using the appropriate enacted future effective tax rate.
i. Treatment of Changes
1. Changes in tax laws or rates are recognized in the period of change (enactment).
a. The amount of the adjustment is measured by the change in applicable
laws/rates applied to the existing deferred tax account.
b. The adjustment enters into income tax expense for that period as a
component of income from continuing operations.
2. Change in the Valuation Allowance
a. A change in circumstances that causes a change in judgment about the
ability to realize the related deferred tax asset in future years should be
recognized in income from continuing operations in the period of the
change.
3. Change in the Tax Status of an Enterprise
a. An entity’s tax status may change from taxable to nontaxable
(corporation to partnership) or from nontaxable to taxable (SCorporation to C-Corporation).
b. At the date a nontaxable entity becomes a taxable entity, a deferred tax
liability or asset should be recognized for any temporary differences.
c. At the date a taxable entity becomes a nontaxable entity, any existing
deferred tax liability or asset should be eliminated (written off).
d. The effect of recognizing or eliminating a deferred tax liability or
deferred tax asset should be included in income from continuing
operations in the period of the change.
Net Temporary Adjustment (From Beginning Balance) – The deferred tax account is adjusted
for the change in deferred taxes (asset or liability), due to the current years events. The income
f.
tax expense/benefit – deferred is the difference between the beginning balance in the deferred
tax account and the properly computed ending balance in the account.
Balance Sheet Presentation
i. Deferred tax liabilities and assets should be classified and reported as a current amount
and a noncurrent amount on the balance sheet.
1. Deferred tax items should be classified based on the classification of the related
asset or liability for financial reporting. For example:
a. A deferred tax asset that relates to product warranty liabilities (accrued
expenses) would be classified as “current” because warranty obligations
are part of the current operating cycle.
b. A deferred tax liability that relates to asset depreciation (fixed assets)
would be classified as “noncurrent” because the related assets are
noncurrent.
2. Deferred tax items not related to an asset or liability should be classified based
on the expected reversal date of the temporary difference. Such items include:
a. Deferred tax assets related to carry forwards
b. Organization costs expensed for GAAP financial income (no asset) but
deducted in later years for tax purposes
c. Percentage completion method used for contracts for GAAP financial
income (no asset or liability) but completed contract method used for
tax purposes.
3. All deferred tax assets and liabilities classified as current must be offset (netted)
and presented as one amount (a net current asset or a net current liability).
4. All deferred tax liabilities and assets classified as noncurrent must be offset
(netted) and presented as one amount (a net noncurrent asset or a net
noncurrent liability).
5. Any valuation allowance for a deferred tax asset should be allocated pro rata to
current and noncurrent deferred assets.
V.
Permanent Differences – A permanent difference is a transaction that affects only income per books or
taxable income, but not both. Income tax expense for a period is calculated only on taxable items. For
example, tax-exempt interest (municipal and state bonds) is included in financial income, but is excluded
in computing income tax expense. In effect, permanent differences create a discrepancy between
taxable income and financial accounting income that will never reverse.
a. No Deferred Taxes – Because they do not reverse themselves, no interperiod tax allocation is
necessary for permanent differences. The income tax provision for financial accounting
purposes is computed on the basis of pretax book income adjusted for all permanent
differences.
b. Examples – Permanent differences are either (a) nontaxable, (b) nondeductible, or (c) special
tax allowances. Examples are:
i. Tax-exempt interest (municipal, state)
ii. Life insurance proceeds on officers key man policy
iii. Life insurance premiums when corporation is beneficiary
iv. Certain penalties, fines, bribes, kickbacks, etc.
v. Nondeductible portion of meal and entertainment expense
vi. Dividends received deduction for corporations
vii. Excess percentage depletion over cost depletion
VI.
Operating Losses – Under the present law, an operating loss of a period may be carried back two years
and forward twenty years and be applied as a reduction of taxable income in those periods as permitted
by the tax laws. An election must be made in the year of loss to either (1) carryback the portion of the
loss that can be absorbed by the prior years’ taxable income, and carry-forward any excess, or (2)
carryforward the entire loss. Taxable income and financial accounting income will differ for the periods
to which the loss is carried back or forward.
a. Operating Loss Carrybacks – The tax effect of any realizable loss carryback should be recognized
in the determination of the loss period net income. A claim for refund of past taxes is shown on
the balance sheet as a separate item from deferred taxes. This income tax refund receivable is
usually classified as current.
i. Tax carrybacks that can be used to reduce taxes due or to receive a refund for a prior
period are a tax benefit (asset) and should be recognized (to the extent they can be
used) in the period they occur.
b. Operating Loss Carryforwards – If an operating loss is carried forward, the tax effects are
recognized to the extent that the tax benefit is more likely than not to be realized.
i. Tax carryforwards should be recognized as deferred tax assets (because they represent
future tax savings) in the period they occur.
1. NOL carryforwards should be “valued” using the enacted (future) tax rate for
the periods they are expected to be used.
2. Tax credit carryforwards should be “valued” at the amount of tax payable to be
offset in the future.
3. The deferred tax asset will reduce tax payable in a future period.
4. The tax benefit would reduce the net operating loss of the current period.
VII.
Interperiod and Intraperiod Disclosures
a. Balance Sheet Disclosures
i. The components of a net deferred tax liability or asset should be disclosed, including the
total of:
1. All deferred tax liabilities
2. All deferred tax assets
3. The Valuation allowance for deferred tax assets
ii. Other balance sheet disclosures include:
1. The net change during the year in the total valuation allowance, and
2. The tax effect of each type of temporary difference and carryforward that is
significant to the deferred tax liability of asset.
b. Income Statement Disclosures
i. The amount of income tax expense (or benefit) allocated to continuing operations and
the amounts separately allocated to other items must be disclosed.
ii. The significant components of income tax expense attributable to continuing operations
must be disclosed. These include:
1. Current tax expense or benefit
2. Deferred tax expense or benefit
3. Investment tax credits
4. Government grants
5. Benefits of NOL carryforwards
6. Tax expense allocated to shareholders equity items
7. Adjustments of deferred taxes from changes in tax laws or rates
8. Adjustments of the beginning of the year deferred tax asset valuation due to
changes in expectations
iii. The tax benefit of an operating loss carryback or carryforward should be reported in the
same manner as the current year source of income or loss that gave rise to the benefit
recognition.
iv. Recognition of income tax expense attributable to continuing operations and the
amount of income tax expense that would have resulted from applying the statutory
rate to pretax income from continuing operations should be presented.