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According 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-setter s had with this topic. Following are summaries of major pronouncements dealing with accounting for income taxes.
APB OPINION #11
This 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.
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. 96
The 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 obtaining a resolution on tax allocation issues.
SFAS NO. 109
FASB issued this statement to replace the complex SFAS No. 96 which was concerned with the recognition of deferred income taxes. SFAS No. 109 requires that deferred tax liabilities for all taxable temporary differences and deferred tax assets for all deductible temporary differences and tax credit and operating loss carry forwards be recognized. The Balance Sheet approach is used. Deferred income tax assets and liabilities represent assets and liabilities instead of residual deferred charges and credits. Under the liability method, an enterprise recognizes a deferred tax asset or a deferred tax liability for the future income tax effects of the difference between the tax basis of the asset or liability and its reported amount in the financial statements.
Accounting for income taxes continues to be a source of controversy and difficulty for accounting standard-setters. This is corroborated by the fact that the APB and the FASB have three financial accounting standards all named the same, "Accounting for Income Taxes". Therefore, accountants have had to make multiple efforts to resolve this issue. There are three questions that help explain the difficulty to achieve consensus on this topic and what makes accounting for income taxes so difficult.
ARE INCOME TAXES AN EXPENSE?
According to SFAC No. 6, expenses are defined as (1) outflows of assets of the firm to produce revenue, (2) voluntarily, and up to the discretion of the firm as to whether the expenditures will be made, and (3) the objective of incurring expenses is to directly or indirectly produce revenue for the firm. It also list examples of expense of typical expenses such as units of product delivered or produced, employees' services used, kilowatt hours of electricity used, or taxes on current income. According to the definition, income taxes do fit the criteria of (1) because it is an outflow of assets, but it does not fit the criteria of (2) and (3). The firm does not voluntarily incur income tax expense, it is required by law, and the firm does not receive directly or indirectly any revenue from the amount of the income tax expenditure. With that said, it appears that although FASB list taxes on current income as an example of an expense, the application of the criteria does not lead you to that conclusion.
ARE NONRECIPRICAL LIABILITIES VALID?
This questions deals with accounting for income taxes under the allocation method and refers to the status of deferred tax liabilities and deferred tax assets under the FASB's approach. Deferred tax accounting arises because companies often postpone or pre-pays taxes on profits pertaining to a particular period.
Deferred Tax Liability
There are differences in the way certain items of expenses are allowed to be treated for tax purposes and how a company actually treats them. For example: pre-issue expenses expenses on R & D or expenses incurred on mergers, may be written off over a fixed number of years. The company may stretch the write-off over a longer period. Therefore, a company ends up postponing part of its tax liability on the current year's profits to future years because its profits for tax purposes in the current year would be lower than the profits computed for accounting purposes.
Deferred Tax Assets
Also tax laws may not recognize some expenses that a company has accounted for in its accounts such as bad debts, which are not fully recognized by tax authorities. In some cases a company may be pre-paying taxes pertaining to future years. The current year profit that the taxman calculates would be higher than those computed by the company. This meant a company would save on tax in the years when the expenses or provisions actually materialize. A company recognizes this excess tax paid over and above tax liability as a "deferred tax asset". Companies will recognize such deferred tax assets only if they actually anticipate that their income in future will be enough to allow the company to set off the losses or he excess tax paid.
Companies recognize deferred tax liabilities in its books in order to make sure that the tax liability for any particular year is reflected in that year's financials and does not carry over to future profits. This brings investors one step closer to understanding exactly how much of a company's profits for a period are from its operations.
People expect that if one firm reports a liability, the other party to that specific transaction will similarly report a corresponding asset. This is not the case with deferred taxes. If a firm reports a deferred tax liability, you should be able to confirm that liability by contacting the other party to the liability, which is the IRS, who should have recognized a corresponding asset. But you will not be able to confirm that. Also, if a firm reports a deferred tax asset, because of pre-paid taxes, you still cannot contact the IRS to confirm it. This means there are assets and liabilities that do not have the reciprocities that are expected for them. Therefore, this brings rise to the question, "Are nonreciprocal liabilities valid? Does the fact that deferred tax liabilities and assets cannot be confirmed by the IRS nullify the procedure or question the validity. Some people say yes and some say no.
WHAT IS THE EVENT?
This question deals with the underlying transactions or event that triggers the transaction in accounting for income taxes. According to SFAC No. 6, a liability must have a past transaction or triggering event that is the genesis of the transaction being recorded and reported. FASB explained that it views the obligating event for deferred taxes as the origin of the temporary difference. Others disagree with this. Some believe the event causing deferred taxes is not a tax event. It is an accounting event and therefore isn't appropriate. Deferred taxes is viewed as an arising accounting decision, such as using straight-line depreciation for financial reporting and double-declining depreciation for income taxes, which creates a balancing credit that is considered a deferred tax liability. Because the IRS has no involvement in this type of decision or circumstance, some people questions whether an event has occurred that created the tax liability.
All three questions raise doubt about the validity of tax allocation and there still is no consensus on how to account for income taxes, especially concerning deferred tax liability and assets.
Evans, Thomas G. (2003). Accounting Theory. Contemporary Accounting Issues.
Ohio: South-Western, a division of Thomson Learning
Bartsch, Robert A.J. (1992). Accounting for deferred taxes under FASB 109. Journal of
Accountancy. Retrieved November 13, 2007, from http://www.encycopedia.com/doc/1G1-13096835
Smith, Darlene A. (1992). Accounting for Income Taxes SFAS 109. The CPA Journal. Retrieved December 6, 2007, from http://www.luca.com/cpajournal/old/12268824.htm
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"Accounting For Income Taxes." 123HelpMe.com. 27 Apr 2015