Rules for Computing Income
The rules for computing income for
financial statement purposes do not
correspond to the rules for
computing income for taxation
purposes.
Rules for Computing Income
Book Income
Ô
GAAP
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Rules for Computing Income
Book Income Ô
Taxable Income Ô
GAAP
IRS
Rules for Computing Income
Book Income Ô
Taxable Income Ô
GAAP
IRS
The differences between the two may be
temporary differences or
permanent differences
Temporary Differences
¦Temporary differences that will
cause taxable income to be higher
than book income in future periods
give rise to a deferred tax liability.
¦Temporary differences that will
cause taxable income to be lower
than book income in future periods
give rise to a a deferred tax asset.
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Temporary Differences
¦Future taxable amounts.
• Revenue accrued before taxed.
• Expenses deducted before accrued.
¦Future deductible amounts.
• Revenues taxed before accrued.
• Expenses accrued before deducted.
Permanent Differences
Because permanent differences
between book income and taxable
income do not reverse and are not
offset by corresponding differences
in subsequent periods, they do not
give rise to deferred tax assets or
deferred tax liabilities.
Liability Approach
¦Deferred income tax liabilities
¦Deferred income tax assets
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Accounting for Income Tax
Procedures
¦Calculate the future taxable amounts
and/or future deductible amounts.
¦Calculate deferred tax liability
¦Calculate deferred tax asset
¦Calculate the valuation allowance
¦Prepare the proper journal entry
The journal entry accomplishes
three things:
¦Records income taxes payable or
income tax refund receivable.
¦Increases or decreases deferred tax
liability, deferred tax asset, and/or
valuation allowance to amounts at
balance sheet date.
¦Records income provision for
income taxes as a “plug” figure.
Change in Enacted Tax Rate
¦A change in effective tax rates is
reflected in the financial statements
of the year of enactment.
¦This is accomplished by applying the
new rate to cumulative temporary
differences.
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Valuation Allowance
¦ The FASB requires that firms with deferred
income tax assets assess the likelihood that
these assets may not be fully realized in future
periods.
¦ If it is more likely than not (>50%) that some
portion of the benefit will not be realized in its
entirety, a deferred tax asset valuation allowance
is required.
¦ The valuation allowance should be sufficient to
reduce the deferred tax asset to the amount that
is more likely than not to be realized.
Net Operating Losses
¦ Companies that experience operating
losses for tax purposes may elect one of
two options
• Both carryback and carryforward
• Only carryforward
¦ Most firms will elect the first option
¦ The carryback period is two years and the
carryforward period is twenty years
Footnote Disclosures
¦Footnotes disclose the portion of the
provision for income taxes that is
currently payable and that which is
deferred.
¦Footnotes provide a reconciliation
between the provision for income
taxes and income taxes determined
by applying the federal statutory rate
to income before income taxes.
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Tax Policy Decisions
The divergence between the statutory
rate and the effective tax rate arises
from two types of tax policy
decisions
• The tax jurisdiction in which the firm
chooses to operate
• Special characteristics of the income tax law
Analytical Insights
¦Increases in balances of deferred tax
liabilities may signal a decrease in
earnings quality.
¦Decreases in balances of deferred
tax assets may signal a decrease in
earnings quality.
Interfirm Comparability
The deferred tax portion of the income
tax footnote can be used to undo
differences in financial reporting
choices across firms.
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Earnings Conservatism Ratio
Pre-tax book income
EC =
Taxable income per tax return
Earnings Conservatism Ratio
¦EC ratios close to one indicate
relatively conservative financial
reporting. The lower the ratio, the
more conservative the reporting.
¦Increases in EC ratios from year to
year suggest adoption of more
aggressive reporting practices.
Earnings Conservatism Ratio
¦ EC ratio comparisons for a single
company over time can be misleading if
the tax law has changed over the period of
comparison
¦ Comparisons across companies should
be made cautiously
¦ LIFO layer liquidations are not captured by
the EC ratio
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