Chapter 18
Accounting for Income Taxes
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A company’s effective tax rate is its income tax expense divided by pretax financial income.
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The statutory tax rate is the tax rate set in the
Internal Revenue Code.
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Because of tax strategies, companies recognize revenues and expenses for financial reporting purposes at a different point in time than for income tax purposes.
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(Slide 1 of 2)
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Income tax expense determined under GAAP is normally not equal to the amount of income tax paid as determined by the Internal Revenue Code (IRC).
The measurement and timing differences between a corporation’s financial and tax accounting can be categorized into three groups as follows:
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Temporary difference: A corporation reports some items of revenue and expense in one period for financial accounting purposes, but in an earlier or later period for income tax purposes. This results in deferred tax assets and liabilities.
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Permanent difference: Some items of revenue and expense that a corporation reports for financial accounting purposes are never reported for income tax purposes under the Internal
Revenue Code.
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 Some items that are allowable deductions for income tax reporting do not qualify as expenses under GAAP.
Operating loss carrybacks and carryforwards: When a corporation reports an operating loss in a given year, the tax code allows the corporation to carry back the loss to offset taxable income reported in previous years, or carry forward the loss to offset future taxable income.
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These operating losses will result in tax refunds in the case of operating loss carrybacks and deferred tax assets in the case of operating loss carryforwards.
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Causes of Differences between Financial Reporting Determination of
Income Tax Expense and Tax Reporting of Income Tax Paid
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A temporary difference is measured as the difference between the tax basis of a corporation’s asset or liability for income tax purposes and the reported amount (i.e. book value) of the asset or liability in its financial statements.
Sometimes called timing differences because of the different time periods in which the differences affect pretax financial income and taxable income.
Interperiod income tax allocation is the allocation of a corporation’s total income tax obligation as an expense to various accounting periods.
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(Slide 2 of 6)
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The temporary differences will result in a deferred tax liability when future taxable income will be greater than future pretax financial income (triggering the obligation to pay a greater amount of tax in that future period).
The temporary differences will result in a deferred tax asset when future taxable income will be less than future pretax financial income (triggering tax savings in that future period).
A corporation’s temporary differences generally relate to its individual assets and liabilities and may be classified into four groups, as shown on the following four slides:
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(Slide 3 of 6)
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(Slide 4 of 6)
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(Slide 5 of 6)
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(Slide 6 of 6)
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(Slide 1 of 3)
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The main questions that accounting authorities have had to face in determining how to account for income taxes involves the following issues:
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Do temporary differences create tax-related assets and liabilities? If so, do they require interperiod allocation or not?
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When applying interperiod tax allocation, what tax rate should be used?
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In addressing these issues, the FASB first identified two objectives of accounting for income taxes:
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A corporation should recognize the amount of its income tax payable or refund for the current year.
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(Slide 2 of 3)
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A corporation should recognize deferred tax liabilities for future taxable amounts, and deferred tax assets for future deductible amounts, so that the balance sheet recognizes the future tax consequences that will arise from all past transactions, events, and arrangements that it has reported in its financial statements or income tax returns.
In order to accomplish these objectives, the FASB concluded that a comprehensive asset and liability approach was necessary.
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The comprehensive asset and liability approach is the recognition of a tax asset or liability when there are timing differences between the accounting value and tax value of an asset or liability.
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(Slide 3 of 3)
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To implement the objectives, the FASB listed four principles that a corporation is to apply to account for its income taxes. A corporation must:
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Recognize a current tax liability (asset) for its estimated income tax payable (refund) on its income tax return for the current year
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Recognize a deferred tax liability or asset for the estimated future tax effects of each temporary difference
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Measure its deferred tax liabilities and assets based on the provision of the enacted tax law; the effects of possible (but not yet enacted) future changes in tax laws or rates are not anticipated
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Reduce the amount of deferred tax assets, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
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(Slide 1 of 2)
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The following three characteristics of a liability were established in FASB Statement of Financial Accounting
Concepts No. 6:
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It is a responsibility of the corporation to provide economic benefits to another entity that will be settled in the future.
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The responsibility obligates the corporation, so that it cannot avoid the future sacrifice.
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The transaction or other event obligation of the corporation has already occurred.
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(Slide 2 of 2)
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Deferred tax liabilities meet the first characteristic because:
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The deferred tax consequences stem from the tax law and are a responsibility to the government
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Settlement will involve a future payment of taxes
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Settlement will result from events specified by the existing tax laws
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They meet the second characteristic because income taxes will be payable when the temporary differences result in taxable amounts in future years.
The third characteristic is met because the events that resulted in the deferred tax liability have already occurred.
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(Slide 1 of 2)
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The three characteristics of an asset are:
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It is reasonably expected to provide future economic benefits for the company.
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The company has obtained the rights to the benefits and controls other entities access to it.
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The transaction, arrangement, or event resulting in the company’s right to or control of the benefit has already occurred.
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The deferred tax asset consequences of temporary differences of a corporation that will result in economic benefits from deductible amounts in the future years meet these characteristics of an asset.
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(Slide 2 of 2)
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Deferred tax assets meet the first characteristic because the deductible amounts in future years will result in reduced taxable income and will provide future economic benefits to the company through reduced taxes paid.
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The second characteristic is met because the corporation will have an exclusive right to the reduced taxes paid.
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The third characteristic is met because the events that resulted in the deferred tax asset have already occurred .
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After a corporation has identified a future taxable or deductible amount, it measures the temporary difference to record the amount of the deferred tax liability or deferred tax asset to report in its financial statements.
The marginal tax rate is the enacted income tax rate expected to apply to the last dollar of taxable income.
If there is sufficient uncertainty about a corporation’s future taxable income, the FASB decided that the corporation must establish a valuation allowance.
A corporation must recognize a valuation allowance if, based on available evidence, it is more likely than not that the deferred asset will not be realized.
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(Slide 1 of 2)
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To measure and record the amount of its current and deferred income taxes, a corporation completes the following steps:
Step 1. Apply the Internal Revenue Code to determine the company’s taxable income and income taxes payable for the year by applying the applicable tax rate to the current taxable income.
Step 2. Identify the temporary differences and classify each as either a future taxable amount or a future deductible amount.
Step 3. Measure the year-end deferred tax liability for each future taxable amount using the applicable tax rate.
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(Slide 2 of 2)
Step 4. Measure the year-end deferred tax asset for each future deductible amount using the applicable tax rate.
Step 5. Reduce deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that some or all of the year-end deferred tax assets will not be realized in tax savings in future years.
Step 6. Record the income tax expense (including the deferred tax expense or benefit), income tax payable, change in deferred tax liabilities and/or deferred tax assets, and change in valuation allowance (if any).
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The steps listed in the two previous slides are illustrated above.
The corporation determines the income tax payable as follows:
Taxable Income × Current Tax Rate = Income Tax Payable
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When a change in the income tax laws or rates occurs, a corporation adjusts the deferred tax liabilities and assets for the effect of the change.
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(Slide 1 of 2)
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Earlier, a permanent difference was defined as the difference between a corporation’s pretax financial income and taxable income in an accounting period that will never reverse in a later accounting period.
The differences arise because the U.S. Congress sets economic policies and establishes provisions of the tax code that impose a tax burden on, or provide, a tax subsidy to, a particular segment of the economy.
There are three types of permanent differences between a corporation’s pretax financial income and taxable income.
These differences are illustrated in the next slide.
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(Slide 2 of 2)
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Permanent differences affect either a corporation’s reported pretax financial income or its taxable income, but not both.
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Permanent differences cause a company’s effective tax rate to be different than the tax code or statutory tax rate.
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The effective tax rate is income tax expense divided by pretax financial income.
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The statutory tax rate is the tax rate set by the Internal
Revenue Code.
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Operating loss carryback: Occurs when a corporation reports an operating loss for income tax purposes in the current year and carries this loss back to offset previous taxable income.
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The corporation may first carry a reported operating loss back two years (in sequential order, starting with the earliest of the two years
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Operating loss carryforward: Occurs when a corporation reports an operating loss for income tax purposes in the current year and carries this loss forward to offset future taxable income.
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A loss may be carried forward for up to as many as 20 years and offset the loss against taxable income, if there is any
The corporation then pays lower income taxes in the future based on lower future taxable income
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The FASB considered two conceptual issues related to accounting for operating loss carrybacks .
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Should a corporation recognize the tax benefit of an operating loss carryback as a retroactive adjustment to tax expense in a prior period or as an adjustment to tax expense in the current period?
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Should the corporation incurring the operating loss recognize a current receivable for the tax benefit of the carrybacks?
The FASB concluded that a corporation must recognize the tax benefit of an operating loss carryback in the period of the loss as an asset (current receivable) on its balance sheet and as a reduction of the tax expense which reduces the loss on the income statement.
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(Slide 1 of 2)
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The FASB considered two conceptual issues relating to an operating loss carryforward that arises because a corporation either has no prior taxable income or its prior taxable income is not enough to absorb the entire operating loss carryback.
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Should a corporation recognize the tax effect of an operating loss carryforward in the current period or in the future when it is realized?
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How should the corporation report the tax effect of an operating loss carryforward on the financial statements?
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(Slide 2 of 2)
The FASB concluded that to comply with GAAP for the financial reporting of operating loss carryforwards, a corporation must recognize the tax benefit of an operating loss carryforward in the period of the loss as a deferred tax asset.
However, the corporation must reduce the deferred tax asset by a valuation allowance if, based on the available evidence, it is more likely than not that the corporation will not realize some or all of the deferred tax asset.
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Intraperiod income tax allocation is the allocation of a corporation’s total income tax expense for a period to the various components of income that are reported in the income statement, comprehensive income, and/or the statement of shareholders’ equity.
GAAP requires intraperiod income tax allocation be applied to income (or loss) related to:
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Discontinued operations
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Extraordinary items
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Retrospective adjustments
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Prior period adjustments
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Gains and losses included in other comprehensive income
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A corporation must report its deferred tax liabilities and assets in two classifications:
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Net current amount
Net noncurrent amount
A corporation must:
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Separate its deferred tax liabilities into current and noncurrent groups
Separate its deferred tax assets into current and noncurrent groups
Combine (net) the deferred tax asset and liability amounts in the current groups
Combine (net) the deferred tax asset and liability amounts in the noncurrent groups
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(Slide 1 of 2)
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GAAP requires that the notes to the financial statements (or directly on the statements themselves) disclose:
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For net deferred tax liability or asset:
 Causes of the deferred tax assets and liabilities
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Total deferred tax liabilities
 Total deferred tax assets
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Total valuation allowance
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For income tax expense:
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Amount of income tax expense or benefit allocated to continuing operations, discontinued operations, extraordinary items, retrospective adjustments, prior period adjustments, and gains and losses included in other comprehensive income
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Significant components of income tax expense related to continuing operations for the year
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(Slide 2 of 2)
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For the provision for income taxes and the effective tax rate, companies also disclose:
 U.S. federal income tax amount and the statutory rate
 Amounts of income tax expense attributable to states and foreign countries
 Other effects impacting the effective tax rate for the period
The intraperiod allocation of income taxes on the face of a corporation’s income statement (and schedule of retained earnings within the statement of changes in shareholders’ equity or comprehensive income) partially satisfies the preceding disclosures requirements.
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Companies and the IRS often disagree on:
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Whether certain types of transactions trigger taxable income or tax deductions
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The period in which the amount should be taxed or can be deducted
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The amount of the income or deduction, if any
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The company must first determine whether to recognize an uncertain tax position by evaluating whether the tax position is
“more likely than not” of being upheld during a tax audit, based on the technical merits of the position.
If a tax position meets the recognized criteria, the second step is for the company to measure the tax benefit as the largest dollar amount that is above the “more likely than not “threshold.”
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