FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:
TEXT AND CASES
11TH EDITION
RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 12
ACCOUNTING FOR
INCOME TAXES
Introduction

Income taxes are an
expense

Consistent with



The proprietary theory
Definition of comprehensive income
Accounting for income taxes is a controversial
issue
Historical Perspective




Income taxes first became a significant
issue because of the emerging facilities
exception during World War II
ARB No. 23
 Required the allocation of some deferred income taxes
 Did not provide clear measurement guidelines
The allocation of income taxes to the periods impacted is termed
interperiod tax allocation
APB Opinion No. 11
 Extended interperiod tax allocation to all timing differences
 Criticism because resulting balance sheet items did not reflect future tax
consequences
 Result


FASB Statement No. 96
Later FASB Statement No. 109 (See FASB ASC 740)
The Income Tax Allocation Issue
The objective of
financial accounting
SFAC No. 1


Provide information about the
amount and timing of future
cash flows
Most economic events have tax cash flow consequences
These cash consequences are reported on tax returns in
accordance with the Internal Revenue Code (IRC)
The Income Tax Allocation Issue

The goal of the IRC is to raise revenue to run the government
and in some cases to regulate the economy

These same economic events are reported for financial
accounting purposes under GAAP
The Income Tax Allocation Issue



The goals of the IRC and GAAP sometimes result in reporting
revenues and expenses in different accounting periods creating
an originating difference
In subsequent years these differences will reverse creating a
reversing difference
This issue is termed the income tax allocation issue
Revenue
2010
Expense
2011
Permanent Differences

Permanent differences are differences between taxable
income and financial accounting that will never reverse


Federal economic policy
Or to alleviate a provision
of the IRC that falls too
heavily on one segment
of the economy
Financial
income
Taxable
income
Permanent Differences

Occur because provisions
of the IRC

Financial
income

Taxable
income
Exempt certain types of
revenue from taxation
Or prohibit the deduction of
certain expenses
Types of Permanent Differences

Revenue recognized for
financial accounting
purposes that is never
taxable


Taxable
income
Interest on municipal bonds
Expenses recognized for financial accounting purposes
that are never deductible for tax purposes


Financial
income
Life insurance premiums
Income tax deductions that do not qualify as expenses
under GAAP
Temporary Differences

Temporary differences



Will reverse in a subsequent period
Some temporary differences are timing differences
Others occur because of different measurement bases
Temporary Differences



Create timing differences
Result in assets and liabilities
having differing bases for financial accounting
and taxation purposes
Originating differences when they reverse
create


Taxable amounts
Deductible amounts
Temporary Differences

Categories of timing differences


Current financial accounting income exceeds
current taxable income
Current financial accounting income is less
than current taxable income
Additional Temporary Differences
1
2
3
4
5
Reduction in the tax basis of depreciable assets
because of tax credits
The ITC accounted for by the deferred method
Foreign operations for which the reporting currency is
the functional currency
An increase in the tax basis of assets because of
indexing for inflation
Business combinations accounted for by the
purchase method
Net Operating Losses



Occurs when tax deductions are
greater than taxable income in a
period
IRC allows for these losses to be
carried back two years and
forward twenty years
Should the benefits of NOL’s be
recognized?
Conceptual Issues



Allocation versus Nonallocation
Comprehensive versus Partial allocation
Discounting deferred taxes
Alternative Interperiod Tax
Allocation Methods

Deferred method


Asset/liability method


Uses rates in effect when
difference originates
Uses rates expected to be in effect when the difference reverses
Net of tax method


Use one of the above methods to adjust balance sheet items that
caused the temporary difference
e. g. depreciable assets
FASB Dissatisfaction With the
Deferred Method


APB Opinion No. 11 required the use of
the deferred method
Did not meet SFAS No. 6 definition of
assets and liabilities
Measurement and Reporting
Under SFAS No. 96

Required the asset/liability approach
to allocation



Deferred tax liability
Deferred tax asset
SFAS No. 96


Limited the recognition of deferred tax assets
created by NOLs
Zero future income assumption
Business Dissatisfaction With
SFAS No. 96


The cost of scheduling necessary under its
provision
Loss of deferred tax assets under zero future
income assumption
SFAS No. 109



Board remained committed to the asset/liability
method
Allowed for the separate recognition and
measurement of deferred tax assets and liabilities
without regard to future income considerations
More likely than not criteria for deferred tax assets
rather than zero future income assumption
Determining Deferred Asset and
Liability Balances
1
2
3
4
5
Identify temporary differences, NOL
carryforwards, and unused tax credits
Measure the total deferred tax liability by
applying the expected tax rate to the future
taxable amount
Measure the total deferred tax asset by
applying the expected future rate to future
deductible amounts and NOL carryforwards
Measure deferred tax assets for each type of
unused tax credit
Measure the valuation allowance based on
the more likely than not criterion
The Valuation Allowance


There may be insufficient future
taxable income to derive the
benefit from a deferred tax asset
Use allowance to reduce the
deferred tax asset to amount
expected to be realized under the
more likely than not criterion
Do Assets and Liabilities Created by SFAS No.
109 Meet the Definitions in SFAC No. 6?


Deferred tax liability - meets the three
characteristics of liabilities
Deferred tax asset - meets the three
characteristics of assets
Financial Statement Disclosures



Income statement
Balance sheet
SEC disclosure requirements
FIN No. 48 (ASC 740): Accounting for
Uncertainty in Income Taxes – an
Interpretation of FASB Stmt No. 109

Tax contingencies too flexible



Used to manipulate earnings
Reporting & disclosure of tax positions
lacked transparency
FIN 48 establishes proper
accounting treatment for uncertain
tax positions.
FIN No. 48: Accounting for Uncertainty in
Income Taxes – an Interpretation of FASB
Stmt No. 109

Evaluation of tax position is a 2-step
process


Recognition
Measurement
Financial Analysis of Income Taxes

Disclosure requirements allow
financial statement users to make
better decisions including:
1
2
3
Assessing the quality of earnings
Assessing future cash flows
Calculation of actual tax rates
Financial Analysis of Income Taxes

The footnotes provide information on:
1
2
3
Information on the amount of taxes that would be
paid at the federal statutory rate and the amount
actually paid
Changes in the deferred tax asset and liability
accounts
Information concerning income tax carrybacks and
carryforwards
Financial Analysis of Income Taxes

The earnings conservatism ratio
Pretax accounting incomea
Taxable income
aIn
the event a company reports material permanent income tax
differences, the amount of these differences adjusts the numerator.
Financial Analysis of Income Taxes
Earnings conservatism ratios for Hershey and Tootsie
1.20
1.00
1.00
0.80
1.00
1.00 1.00
1.00
1.00
0.60
0.40
0.20
0.00
2009
Hershey
2010
Tootsie Roll
2011
IAS No. 12:
Accounting for Taxes on Income



Amended in 1996 to require the liability
(asset/liability) method
Quite similar to U.S. GAAP, as outlined in
SFAS No. 109
Considering other issues:
1
2

Do tax consequences of recovery amounts of assets and
liabilities depend on the manner of recovery?
Disclosure of reconciliation between income tax expense
and accounting profit
March 2009: Exposure draft of revised IAS
No. 12


Attempt to alleviate differences
At present the income tax project is inactive.
End of Chapter 12
Prepared by Kathryn Yarbrough, MBA
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written consent of the copyright owner is unlawful. Request
for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or
resale. The Publisher assumes no responsibility for errors,
omissions, or damages, caused by the use of these programs or from
the use of the information contained herein.