Accounting for Icome tax

Most accountants agree that corporate income tax is an expense. Treating income
tax as an expense is required under current generally accepted accounting
principles (GAAP).

The income tax allocation issue

The objectives of accounting for income tax are to recognize the amount
of tax payable or refundable for the current year and to recognize the future tax
consequences of temporary differences as well as net operating losses ( NOLs)
and unused tax credit. To facilitated discussion of the issues raised by the concept
of inter period tax allocation, we first examine the nature of difference among
pretax financial income, taxable income, and NOLs.

Permanent and temporary difference

Difference between pretax financial accounting income and taxable
income are either permanent or temporary. Temporary difference between pretax
financial accounting income and taxable income affect two ore more accounting
periods and thus are the focus of the income tax allocation issue. Permanent
differences do not have income tax allocarion consequences.

Permanent differences
There are three types of permanent difference :

1. Revenue recognized for financial accounting reporting purpose that is

never taxable.

Examples inclued interest on municipal bonds.

2. Expense recognize for financial accounting reporting purposes that are

never deductible for income tax purposes.

Example is life insurance premiums on employees.

3. Income tax deductions that do not qualify as expenses under GAAP.

Example : the special dividen exclusion.

Permanent difference affect pretax financial accounting income or taxable

income but not both. A corporation that has nontaxable revenue or additional
deductions for income tax reporting purposes will report a relatively lower taxable
income as compared to pretax financial accounting income than it would have if
these items where not present, where as a corporation with expenses taht are nit
tax deductible will report a relatively higher taxable income.

Temporary difference
Temporary difference between pretax financial accounting income and
taxable income raise because the timing of revenues, gains, expenses, or losses in
financial accounting income occurs in different period from taxable income. This
timing diffirences result in assets and liabilities having different bases for
financial accounting purpose than for income tax purposes at the end of a given
accounting period.

Timing difference may be classified into two broad categories :

1. Current financial accounting income exceed current taxable income.

a. Revenue or gain are included in financial accounting income prior to

the time they are included in taxable income.

b. Expense or losses are deducted to compute taxable income prior to the

time they are deducted to compute financial accounting income.

2. Current financial accounting income is less than current taxable income :

a. Revenues or gains are included in taxable income prior to the time they
are included in financial accounting income.

b. Expenses or lossses are deducted to compute financial accounting

income prior to the time they are deducted to determine taxable
income.

Additional temporary differences

1. Reduction in the tax basis of depreciable asstes because of tax credits.

2. The ITC accounted for by the deffered method.

3. Foreign operations for which the reporting currency is the functional

currency.

4. An increase in the tax basis of assets because of indexing for inflation.

 5. Business combinations accounted for by the purchase method.

Net Operating Losses

A NOL occurs when the amont of total tax deductions and losses is
grearter than the amount of total taxable revenues and gains during and
accounting period. A NOL carryback is applied to the taxable income of the three
preciding years in reverse order begining with the earliest year and moving
foward to the most recent year. If unused NOLs are still available, they are
carriedfoward for up to 15 years to of set any future taxable income. NOL
carrybacks are currently realizable and are recorded for financial accounting
purpose as reductions in the current period loss.

Allocation vs nonallocation
Advocates of nonallocation argue as follow:

1. Income taxes result only from taxable income.

2. Income taxes different from other expense ; therefore , allocation in a

manner similiar to other expenses is not relevant.

3. Income tax are levied on total taxable income, not on individual items of
revenue and expenses.

4. Interperiod tax allocation hides an economic difference between a

company that employs tax strategies that reduce current tax payament and
one that does not.

5. Reporting a companies income tax expenses at the amount paid or

currenly payable is a better predictor of the companies future cash
outflows. Because many of the deffered tax will never be paid, or will be
paid only in the distant future.

6. Income tax allocation entails and implisit forecasting of fututre profits.

7. There is no present obligation for the potensial or future tax consequences

of pesent or prior transactions because there is no legal liability to paid tax
until on actual future tax return is prepare.

8. The accounting record keeping and procedure involving interperiod tax

allocation are too costly for the puported benefit.

Advocates of allocation argue as follows:

 1. Income taxes result from the incurence of transaction and events.

2. Income taxes are an expense of doing busnisses and should involved the
same accrual, defferal, and estimation concepts that are applied to other
expenses.

3. Difference between the timing of revenues and expenses do result in

temporary difference that will reverse in the future.

4. Interperiod tax allocation makes a companies net income a more useful

measure of its long term earning power and avoids periodic income.

5. Nonallocation of a companies income tax expenses hinders the prediction

of its future cash flows.

6. A company is a going concern and income taxes that are currently deffered
will eventually be paid.

7. Temporary difference are asociated with future tax consequence.

Comprehensive vs partial allocation

Advocated of comprehensive allocation raised the following arguments :

1. Individual temporary difference do reverse.

2. Accounting is primarily historical.

3. The income tax effects of temporary difference should be reported in the

same period as the related transaction and events in pretax financial
accounting income.

4. Accounting result should not be subject to manipulation by management.

Advocate of partial allocation raised the following arguments:

1. All groups of income tax temporary difference are not similiar to certain
other groups of accounting items, such as accounts payable.

2. Comprehensive income tax allocation distors economic reality.

3. Assessment of a companys future cash flows is enhanced by using the

partial allocation approach.

4. Accounting result should not be distorted by the use of a rigid, mechanical

approach, such as comprehensive tax allocation.
Alternative interperiod tax allocation methods
a. The deferred method

The deffered method of income tax allocation is an income satatement

approach. It is based on the concept that income tax expense is related to
the period in which income is recognized. The deffered method measure
income tax expense as though the current period pretax financial
accounting income is reported on the current years income tax return. The
deffered tax account balance is reported in the balance sheet as a deffered
tax credit or deffered tax charge. Under the deffered method, the deffered
tax amount reported on the balance sheets is the effect of temporary
differences that will reverse in the future and that are measure using the
income tax rate and laws in effect when the difference originated. No
adjusment are made to deffered taxes for changes in the income tax rates
or tax laws that occur after the period of origination.

Agruments in favor of the deferred method of the interperiod tax allocation

include the following:

- The income statement is the most important financial sattement,

and matching is a critical aspect of the accounting process. Thus, it
is of little consequence that deferred taxes are not truee assets or
liability in the conceptual sence.

- Deferred taxes are the result of historical transaction or event that

created the temporary differences. Since accounting reports most
economic event on an historical cost basis, deferred taxes should
be reported in a similiar manner.

- Historical income tax rates are veriable. Reporting deferred taxes

based on historical rates increase the reability of accounting
information.

b. The asset or liability method.

The asset or liability method of income tax allocation is balance sheet

oriented. The intent is to accrue and report the total tax benefit or tax
payablr that will acctualy be realized or assessed on temporary differences
when they reverse. A temporary difference is viewed as giving rise to
either a tax liability that will be paid in the future at the than current tax
rates.
 Agrument in favor of the asset/liability method of interperiod tax
allowance include the following :

- The balance sheet is becoming a more important financial

statement.

- As discussed earlier, reporting deferred taxes based on the

expected tax rates is conceptually more sound because the reported
amount represent either the likely future economic sacrifice (future
tax payment) or economic benefit (future reduction in taxes).

- Deferred taxes may be the result of historical transaction, but, by

definition, they are taxes that are postponed and will paid (or
reduce taxes) in the future at the future taxes.

- Estimated are used extensively in accounting.

c. The Net of Tax method.

The net of tax method is more a mothod of disclosure than a different

method of calculating defferd taxes. Under this method, the income tax
effects of temporary difference are computed applying either the deffered
method or the asset or liabiliy method. The resulting defferd taxes,
however, are not seperatly disclosed on the balance sheet. Instead, under
the net of tax method the tax aset or tax liability are treated as adjustment
of the accounts to which the temporary difference relate. Two alternatives
exceed for disclosing the perodic income tax expense on the income
satement under the net of tax method:

1. The tax effects of temporary difference are included in the total

income tax expense.

2. Income tax expense is reported at the same amount as current income

taxes payable, and the tax effects of temporary differences are
combined with the revenue or expense items to which they relate.

FASB dissatisfaction with the Deferred Method

The deffered method was prescribed by APB opinion no 11 in 1982, the
FASB, prompted by cricticisms and concern voiced in the literature and letters to
the board regarding the deffered method, began to consider accunting for income
taxes. In SFAC no 6, the FASB indicated that deffered income tax amount
reported on the balance sheet did not meet the newly established definitions for
asset and liabilities. After weighing the various arguments in favor of
nonallocation and interperiod income tax allocation, the comprehensive and
partial income allocation approaches, and the deffered, asset/liability, and net of
tax method of applying income tax allocation, in 1987 the FASB released SFAS
no 96, which concluded that :

1. Interperiod income tax allocation of temporary differences is appropriate.

2. The comprehensive allocation approach should be applied.

3. The asset/ liability method of income tax allocation should be used.

Deferred Tax Liability and Deferred Tax Asset Characteristic by

SFAC no 6.
3 characteristic of deferred tax liability :

- It must embody a present responsibility to another entity that involes

settlement by probable future transfer or use of asset at a spesificied or
determinable date, on occurrence of a special event, or on demand.

- The responsibility obligates the entity, leaving it little or no discretion to

avoid the future sacrifice.

- The transaction or event obligating the entity has already happened.

3 characteristic of deferred tax asset :

- It must embody a probable future benefit that involves a capacity to

contribute to future net cash inflow.

- The entity must be able to obtain the benefit and control other entities
acces to it.

- The transaction or other event resulting in the entity right to or control the
benefit must already have occurred.

Business Distatisfaction with SFAS no 96

After SFAS no 96 was issued, and prior to its mandatory implementation
date, many businesses expressed concern regarding the effect the standard would
have on their financial statements and the cost that would be inccured in
implementing the standart. These objections became so widespread that the
implementation date was first postponed from 1988 to 1989 and later from 1989
to 1991.
Prior to the effective date of SFAS no 96, the FASB received :

1. Requests for about 20 different limited-scoope amendments to its

provisions.

2. Many requests to change the criteris for recognition and measurement of

the deffered tax asset to anticipate, in certain circumtances, the tax
consequences of future income.

3. Request to reduce the complexity of scheduling the future reversals of

temporary differences and considering hypothetical tax planning
strategies.

SFAS no 109
The FASB was convinced by the critics of SFAS no 96 thet deferred tax
assets should be treated similarly to deferred tax liability and that the scheduling
requirements of SFAS no 96 were often too complex and costly. However, the
board did not want ti return to the deferred method and remained commited to
asset / liability method. SFAS no 109 respond to these concern by allowing the
separete recognition and measurement of deferred tax assets and liabilities without
regard to future income considerations, using the average enacted tax rates for
future years.

These requirements result in the following more simplified series of steps for
determining deferred tacx liability and asset balances :

1. Identify temporary differences, NOL carryback, and unused tax credits.

2. Measure the total deferred tas asset tax liability by applying the expected
tax rate ang future taxable amounts.

3. Measure the total deferred tax asset by applying the expected future tax
rate to futuredeductible amounts and NOL carryfowards.

4. Measure deferred tax assets for each type of unused tax credit.

5. Measure the valuation allowance based on tha above more likely than not
criterion.

The Valuation Allowance

Because there are may be insufficient future taxable income to actually
dereive a benefit from a recorded deferred tax asset, SFAS no 109 requires a
valuation allowance sufficient to reduce the deferred tax asset to the amount that
is more likely than not to be realized. The more likely than not criterion is a new
measurement yardstick for the FASB. AS a practical matter, use of this criterion
would both of the following results :

a. Recognition of a deferred tax asset if the likehood of realizing the future

tax benefit is more than 50 percent (the affirmative judgment approach).

b. Recognition of a deferred tax asset unless the likehood of not realizing the
future tax benefit is more than 50 percent (the impairment approach).

SFAS no 109 cited the following as possible sources of taxable income

( affirmative evidence) that may enable the realization of deferred tax assets :

1. Future reversals of exiting taxable temporary diferrences.

2. Future taxable income exclusive of taxable temporary difference and

carryovers.

3. Taxable income in the current or prior years to which deductible amounts

resulting from temporary differences could be carrieed back.

4. In order to prevent a NOL or tax credit carryover from expiring, prudent

and feasily tax planning strategies that an enterprise ordinarily might not
take may be employed to:

- Accelerate taxable amounts againts which to applly carryfowards.

- Change the character of taxable or deductible amounts from ordinary

income or loss to capital gain or loss.

- Switch from tax-exempt to taxable investments.

SFAS no 109 stressed that the exercise of judgment is necessary to determine

whether a valuation allowance should be reported and, if so, the level of
impairment of the deferred tax asset that is more likely than not to occur. On the
negative evidence (potensial impairment) might include the following :

a. A history of NOL or tax credit carryfowards expiring unused.

b. Anticipated losses ( by a presently profitable enterprise).

c. Unsettled circumstances that may adversely affect future operations and

profits.

d. A carryover period that is so brief that it would limit realization of

deferred tax benefit if :
 - A significant deductible temporary difference is expected to reverse in a
single year or

- The business operating cycle is traditionally cyclical.

This type of negative evidence shoula be weighed against poitive evidence such
as:

1. Existing contracts or sales backlog.

2. Significant appreciation of an assets value over its tax basis.

3. A strong earning history ( exlusive of the NOL deductible temporary

difference) coupled with evidence that the loss is an aberration rather than
a continuing condition.

Shift in Interpretation of future tax consequences

In requiring the separate measurement of deferred tax liability and
deferred tax assets and the reduction of deferred tax assets by the valuation
allowance, the resulting balance sheet amount would not reflect the effects of
netting deductible amounts againts taxable amounts or the certain guarantee of
realization for deferred tax assets that would have occurred under SFS no 96. In
short, the SFAS no 109 provisions introduced different levels of certainly
regarding expected future cash flows. As the result, the FASB reexamined
whether the resulting deferred tax liability and deferred tax assets fit the
definitions of liabilities and assets found in SFAC no 6.

The Characteristic of Deferred Tax Liability and Deferred Tax Asset Based
on SFAS no 109.

Deferred tax liability characteristic :

1. It must embodies a present obligation to the enterprise to settle by

proobable future transfer or use of assets upon the occurrence of a
specified event, or on demand.

2. The enterprise is obligated and has little or no discretion to avoid future

sacrifice, is also met.

Deferred tax asset characteristic:

1. It must embodies a capacity to contribute directly or indirectly to

enterprise future net cash inflows.
 2. The enterprise can obtain the benefit and can control other access to it.

3. the transaction or event that resulted in the enterprise obtaining the right to
control the benefit has already occurred.

Financial Statement Disclosure

Several disclosure issues a rise in connection with the reporting of income taxes
on financial statements.

Income Statement Presentation and Related Disclosures.

The potrayal of effects of taxation on major segments of income

statements and on items carried directly to retained earnings is enhanced by
allocating the income tax expense for a period among these items. The allocation
of income tax within an accounting period is termed intraperiod tax allocation.

SFAS no 109 also requires disclosure of the significant components of income tax
attribute to income from continuing operations. These components included :

1. The current provision (or benefit) for income taxes.

2. Deferred tax expense or benefit (exclusive of items 3-8 listed below).

3. Investment tax credits.

4. Goverment grants (to the extent taht they reduce income tax expense).

5. The benefits of operating loss carryfowards.

6. Tax expense that result from allocations of tax benefit to balance sheets in
a business combination.

7. Adjustment to theh deferred tal liability or asset for enacted changes in tax
laws or change in the tax status of the reporting entity.

8. Adjustment of the begining balance of the valuation allowance because of

a change in circumtances that cause a change in judgment about the
realizability of the related deferred tax asset.

Balance Sheet Presentation and Related Disclosures.

The current provision ( or benefit) in the balance sheet as a current liability

or asset. Deferres tas balance are reported as assets and liabilities. They are
classified as the net current amount and the net noncurrent amount. A deferred tax
assets or liability are related to an asset or liability if a reduction of the asset or
liability will cause the temporary difference to reverse. A deferred tax asset or
liability is not related to an asset or liability, including deferred tax assets created
by NOL or tax credit carryfowards, is classified as a current or noncurrent
according to the expected reversal date of temporary difference.

SEC Disclosures Requirement

The securities nd exchange comission (SEC) has adopted disclosure requirements

for corporations is issuing publicly traded securities. The disclosures required
included:

1. A reconciliation of the difference between income tax expense and the

amount of tax expense that would have been reported by applying the
normal rate to reported income for the company. This requirement
highglights the special provisions of the tax code that benefied the
company.

2. The amount of any temporary difference that is due to the defferal of

investment tax credits ( when and if the ITC is applicable).

These requierment are intended to provide information to investors and other

on the effective tax rates of corporations.

Financial Analysis of Income Taxes

Taken together, the SEC and SFAS no 109 financial statement disclosure
requirments allow investors, kreditors and other users of financial information
to make better decisions spesivicaly:

1. The quality of earnings can be assessed because special situation that give
rise to one time earnings or highlighted.

2. Future cash flow can be more easly assessed because reversals of defrred
tax asset and liability are highlighted.

3. Goverments regulation of the economic is enchanced because it is easier to

calculate actual tax rate.

The footnotes to a companies financial statement provide informantion that

can be used to analysed its income tax amounts. Specificaly most companies
will disclose

a. Information on the amount of tax that would be paid atthe federal satutory
raid and the amount acctualy paid.
 b. Changes in the defrred tax asset and liability accounts.

c. Information concerning income tax carryback and carryfowards.

International Accounting Standart.

The IASC’s discusion of accounting for ibcome tax is contained in IAS no
12, “accounting for tax on income.” In 199, this statement was revised to
reduce the number of options companies have when accounting for deferred
taxes. The IASC is currently considering some addtional issues such a whether
the tax concequences of recovering the carrying amount the certain asset and
liabilities may depend on tha manner of recovery or settlement. If so, deferred
tax assets and liability will be measured on the basis of the tax manner of
recovery of settlement. A requirement to disclose a reconciliation between tax
expense and accounting profit is also being considered. The FASB staff did
not undertake a comprehensive review of the resived IAS no 12 because the
ISAC was still in the process of developing the new standard when the FASB
study was published.