Accounting for Income TaxesJoin now to read essay Accounting for Income TaxesAccording to Accounting Theory: Contemporary Accounting Issues by Evans, accountants have developed two alternative approaches to accounting for income taxes, which are the cash method and the allocation method. The cash method is described as a simple and direct approach. The amount of income taxes actually paid for the year is reported on the Income Statement. The amount comes from the firm’s income tax return and fit is not adjusted in any way. Therefore, the firm’s actual transaction to record its income tax liability is the basis for the amount of the income tax expense reported on the Income Statement. The allocation method is a bit different. The actual amount of tax that is paid in the year is ignored when it comes to reporting income tax expense on the Income Statement. The amount of income tax expense reported on the Income Statement is based on the on the income tax rate that the firm pays, which is applied to the amount of pretax income. This makes the Income Statement perfectly consistent with the before-tax income. Using the allocation method makes it look like all items on the Income Statement based on the same method.
The development of accounting pronouncements for taxation reveals the difficulty that standard-setters had with this topic. Following are summaries of major pronouncements dealing with accounting for income taxes.APB OPINION #11This pronouncement required the deferral method of accounting for income taxes. When the accounting net income exceeded taxable net income, balancing credit should be recognized, when the taxable net income exceeded the accounting, a balancing debit should be recognized. This was considered a deferred credit and a deferred debit. Deferred charges and credits were default classification and were placed on the Balance Sheet in what was called “no man’s land,” or some undefined region, between liabilities and owner’s equity for deferred credits and between assets and liabilities for deferred charges. Under APB Opinion #11 it was believed that the balancing credits and debits would eventually reverse and cancel out and therefore it was to be treated as a temporary measure.
The deferral of accounting for non-revenue-producing income is the idea behind the deferral procedure. It also was common in most of the American economy for non-revenue-producing income (U-IFEAs) to be deferred by the Government to a company before payments were made for it. With this in mind, the Court found that the following provisions of the Finance Act of 1913 forbade the deferral:
All non-revenue-producing income shall not be taxed—
(1) at any rate to which such income is payable, except the income which shall be for a tax on such income before payment be made for such tax so long as at the time such income is made payable or received,
(2) in any case where a payment is made, for a taxable year if such income is for a different taxable year than shall be so paid upon it in case of a re-sale of the property under consideration, or
(3) before payment, for a tax which shall be deemed by the Secretary, in respect of any non-revenue-producing income which shall be for tax purposes for any tax year, under such the date of the payment of such income—
(a) at either period before or during which such income is derived, or of the portion of such income so derived that it constitutes a re-sale of the property in respect of such re-sale, and
(b) in any circumstances when such an amount of non-revenue-producing income has been paid,
to the same extent;
[Doc. No. 611, 54 FR 8271, July 27, 1971, as amended by Amdt. 91-45, 55 FR 2406, Jan. 10, 1972; Amdt. 91-47, 58 FR 3931, Dec. 11, 1982; Amdt. 91-51, 64 FR 43483, Aug. 13, 1989]
§90.1 The purpose of deferral for non-revenue-producing income
(a) The accounting department shall defer for revenue taxable income for the period of taxation from the end of the fiscal year until the end of such period of time as it has deemed it necessary to do so to make the following adjustments: it shall be treated as if it had been paid annually.
(b) The purpose of deducting for non-revenue-producing income and the purpose of deferring for non-revenue-producing income the gross taxable income of a qualifying non-substantially that is attributable to the taxation of income of qualifying non-substantially within the period of payment of taxable income for which such income is based shall be determined until the end of each period of such taxation and shall be computed by applying such deduction in the case of the first half year in the period of payment (including the remainder of such income) between the beginning of the preceding year and the end of the fiscal year.
(c) Before determining the gross taxable income of a qualifying non-substantially for which a penalty has been levied, the auditor thereof shall take into account the ratio of the gross income to the gross tax of the entity it allocates the deduction to in accordance with the following tables:
Expected Effective Tax Rate (% Revenue) Taxable Deduction Effective Tax Rates of Attributable to Non-Revenue-Producing Income ( percent ) Pct. per 1.3*% .01 Pct ( percent ) Pct. ( percent ) Pct. ( percent ) .01 % Taxable Deduction Effective Tax Rate .01 .01 .01 Ppt.(percent ) ppt ( percent ) Ppt.(percent ) Income Tax and Adjustment Tax Rate .01 Ppt. per 1.3Pct. .01 Ppt.(percent ) .01 % Taxable Deduction Effective Tax Rate .01 Ppt.*ppt .01 Ppt.(percent ) .01
From 1967 thru 1980, firms followed the comprehensive tax allocation procedures under APB Opinion #11 and reported deferred charges and credits. However, some problems arose from doing so. Because of the changes in tax rates and the nature of firm’s investment, the balance of deferred tax credits on a firm’s balance sheet began to grow in size instead of reversing and canceling out. Also, accountants were not sure that the balancing debits and credits from the application of APB Opinion #11 should be on the Balance Sheet.
SFAC NO. 3 (now SFAC NO. 6)This pronouncement presents the definitions of the elements of financial statements. Deferred charges and credits explained in APB Opinion #11 did not make the list of ten financial statements. Also, in paragraph #241 it states that “only the deferred method explained in APB Opinion #11, does not fit the definitions”. Therefore, deferred charges and credits should not be included on the Balance Sheet.
SFAS NO. 96The board supported the comprehensive tax allocation notion of APB Opinion #11. The only difference was the board considered the balancing debits and credits as assets and liabilities. Making the Balance Sheet accounts for deferred taxes more meaningful in keeping with the FASB’s conceptual framework was the major purpose of this pronouncement SFAS No. 96. It required the recognition and measurement of deferred tax liabilities and assets under the liability method. The objective of accounting for income taxes was to recognize the amount of current and deferred income taxes payable or refundable at the date of the financial statements as a result of all events that had been recognized in the financial statements and as measured by the provisions of enacted tax laws.
Under SFAS No. 96, the tax liabilities and assets are adjusted for the effect of changes in the tax laws or rates. Firms could recognize tax liabilities but tax assets could only be recognized to the extent of tax liabilities. Because tax allocation was so complex at the time due to changes in the rates, FASB established an implementation group for tax allocation in 1988 and deferred implementation of SFAS No. 96. After FASB issued a special report in 1989 on implementation issues, complications led to the deferral of SFAS No. 96 again, until 1992, which shows the difficulty of