Accounting for Income Taxes
Financial statements are prepared using Generally Accepted Accounting Principles – GAAP and tax returns are filed using the Internal Revenue Code. The financial statements prepared with GAAP present the income tax expense whereas the consequence of preparing tax returns with Internal Revenue code is income tax payable. The amount of income tax expense and income tax payable is usually different which is caused by various factors. These factors may be of temporary or permanent nature and include differences which relate to deferred tax liabilities, deferred tax assets, valuation allowance, tax rate changes and operating losses. The types and nature of these differences are discussed throughout this essay.
Causes of Deferred Tax Liabilities
Deferred tax liabilities are the amounts taxable in future and are caused by various temporary differences which include recognizing revenues earlier in the income statement than the tax returns and recognizing expenses at a later stage than the tax returns. The most common temporary difference that causes deferred tax liabilities is the calculation of depreciation by different methods. The straight line method is used in the GAAP financial statements whereas the depreciation on tax returns is usually accelerated depreciation.
Another factor is the recording of prepaid expenses in the tax returns and presenting them as expenses in the GAAP income statement. The temporary difference due to recognition of revenues is caused by early recognition of total revenue from installment sales of assets and the company uses installment sales method for tax returns. Gain on assets based on fair value is also realized in the GAAP income statement while this gain is recognized on the tax returns when the asset is sold. This difference of recognizing gains also results in a deferred tax liability (Mulford & Comiskey, 2005).
The amounts needed to record periodic income taxes include the income tax expense from the GAAP income statement, income tax payable amount from the tax returns and the difference as a deferred tax asset or liability. The deferred tax liabilities or assets are gradually decreased when the company starts paying off the tax liability or deducting the deferred tax asset amount.
Causes of Deferred Tax Assets
Deferred tax assets are the deductible amounts from taxes in the future of a business. The causes of deferred tax assets include differences caused by recognizing expenses earlier in GAAP income statement and recognizing revenues earlier in the tax returns. These differences include recognition of accrued expenses in the GAAP financial statements such as rent, utility and salaries.
Recognized losses which arise due to fair value or the calculation of inventory by lower of cost or market value in the shareholders’ income statement also cause differences in income tax expense and tax payable. The recognition of advance revenues received in the tax returns and not in the shareholders’ income statement also results in differing tax amounts and causes deferred tax assets (Financial Accounting Standards Board, 1992).
The valuation allowance account is created to record changes in deferred tax assets when there is a probability that these assets will not be realized. The amount of deferred tax assets which do not have a probability of realization are transferred to the valuation allowance account. The total valuation allowance recognized is disclosed in the balance sheet of the company. The total changes in the valuation account are also disclosed in the balance sheet.
Deferred tax assets are a result of the temporary differences in the income tax expense on the GAAP income statement and taxes payable on the tax returns and these deferred tax assets are tax deductible in the future. This implies that the recognition of valuation allowance account also affects the effective tax rate of the company as it increases the income tax expense when deferred tax assets are not recognized (Mulford & Comiskey, 2002).
Permanent Differences and Deferred Taxes
Unlike temporary differences permanent or non-temporary differences do not result in deferred tax assets or liabilities. The amounts of permanent differences are recorded in only one set of records; only in GAAP income statement or the tax returns. The permanent differences though do not have any deferred tax consequences but the effective tax rate of the company is affected.
The tax exempt revenues included in the income statement decrease the effective tax rate while expenses which are not tax deductible increase the effective tax rate. Tax-free revenues such as interest on non-tax bonds and non-tax deductible expenses such as government fines are included in the shareholder’s income statement but are not included in tax returns which result in permanent differences and do not increase or decrease deferred tax assets or liabilities.
Affect of Tax Rates on Deferred Taxes
The change in tax rates affect the measurement of deferred taxes as the change in tax rates have to be revealed in the readjustment of deferred tax assets and liabilities. The change in tax rates have to be implemented immediately after the enactment of law regarding tax rates regardless of the official enforcement of law. The deferred tax assets and liabilities increase or decrease due to this change in the tax rates. If a company reports deferred tax assets on its statements the increase in tax rates would decrease the income tax expense whereas if the company has deferred tax liabilities the increase in tax rates would increase the income tax expense of the company (White, Sondhi, & Fried, 2002).
Income Taxes with Multiple Temporary Differences
Usually there are more temporary differences in large organizations and the income tax expense amounts are calculated with the existence of these multiple differences in mind. When multiple temporary differences exist in a company the income tax expense is calculated based on the nature of these differences. The differences which result in future taxable amounts are grouped together and the same is applied on differences which result in future tax deductible amounts. The net of tax deductible amounts are multiplied with the tax rate to arrive at the total amount of deferred tax assets while the taxable amounts are multiplied with the tax rate to calculate deferred tax liabilities.
Recognition of Carry-forward and Carry-back Operating Loss
Operating loss carry-forward and operating loss carry-back are used to reduce taxable income in future years or receive income tax refunds from previous years. Carry-forward operating loss is used to compensate for future taxable income and it yields a lower amount of tax payable. Carry-back operating loss is used to compensate taxable income from previous years to get reimbursement on the income taxes paid by the company. Carry-forwards are reported as deferred tax assets in the balance sheet whereas carry-backs are recorded as income-tax refund receivable on the assets side of the balance sheet.
Reporting of Deferred Tax Assets and Liabilities
Deferred tax amounts of assets and liabilities are classified by companies as current or non-current with respect to the nature of the related assets and liabilities. The company should report these deferred tax assets and liabilities in the classified balance sheet according to the nature of relevant assets and liabilities. The disclosures related with deferred tax assets and liabilities include total of all deferred tax assets and liabilities, recognized amount of valuation allowance, any changes in the valuation account and the estimated effect of temporary differences on the tax of the company (Whittington & Delaney, 2007).
Uncertainty in Income Taxes
The decisions made and steps taken for the measurement of various revenues and expenses may result in varying amounts represented on the tax returns. This representation though in good faith may be subject to change if the IRS challenges the presentation and the calculation criterion becomes invalid. In order to correctly account for uncertainties in tax decisions, companies follow a two step procedure. The first step involves the reflection of tax benefits in financial statements only if there is more than 50 percent chance that the benefits will sustain in the future. The second step entails that the amount of tax benefits disclosed should be the highest benefit the company would get after 50 percent benefit is realized.
Intra-period Tax Allocation
Intra-period tax allocation means the allocation of current year taxes across various parts of financial statements. The tax expenses are shown in various parts of the income statement and balance sheet with a representation of net effect of taxes on the company. Income from continuing and discontinued operations and extra ordinary items are included in the intra-period tax allocation.
Financial Accounting Standards Board. (1992, February). Summary of Statement No. 109. Retrieved July 5, 2009, from Fasb.org: http://www.fasb.org/summary/stsum109.shtml
Mulford, C. W., & Comiskey, E. E. (2002). The Financial Numbers Game. New Jersey: John Wiley & Sons, Inc.
Mulford, C., & Comiskey, E. E. (2005). Creative Cash Flow Reporting. New Jersey: John Wiley and Sons, Inc.
White, G. I., Sondhi, A. C., & Fried, D. (2002). The Analysis and Use of Financial Statements. New Jersey: John Wiley & Sons, Inc.
Whittington, O. R., & Delaney, P. R. (2007). Wiley CPA Examination Review: 2007-2008 Set. New Jersey: John Wiley & Sons, Inc.