INCOME TAXES AND FINANCIAL ACCOUNING

Indikator:
1. Understand the many possible intrepretations of income tax allocation.
2. Comprehend why discounting of deferred tx assets and liabilities is warranted.
3. Intrepret the shift from SFAS No. 96 to SFAS No. 109.

Accounting has become considerably more complex as a result of the federal

government’s attempt to influence such macroeconomic factors as corporate
investment by means of the income taxation process. In this Chapter we examine
income tax allocation a topic that has been extremely controversial for many years
but finally may be beginning to attain closure in SFAS No.109.

The income tax law of 1913 established business income as a basis for taxation.
Because “income” for tax purposes what defined differently than “income” for
accounting purposes, the law resulted in many items being recognized in different
time periods for tax and book purposes. The efforts to “synchronize” tax and book
accounting go back to the 1930s, but it was ARBs 43 and 44 (revised) (1953 and
1958, respectively) that firmly established income tax allocation as a canon of
financial accounting. After examining the basic elements of tax allocation, we
analyze extensively the principal timing difference: accelerated depreciation for
tax purposes and straight-line depreciation for published financial reporting.
Various positions on income tax allocation within the context of book-tax timing
differences arising from depreciation are explored. We also examine how
discounting of deferred taxes would work. The tax allocation portion of the
chapter concludes with an analysis of the major aspects of SFAS No.109.

Income Tax Allocation

The allocation corporate income tax is one of the most controversial issues that
has ever arisen in financial accounting theory. ARB 43 put it into practice in
words that today have an almost archaic-sounding innocence when viewed with
the hindsight of 40 years of heated debated:
income tax are an expense that should be allocated, when necessary and
practicable, to income and other acoounts, as other expenses are allocated. What
the income statement should reflect under this head ... is the expense properly
allocable to the income statement for the year.1

Tax allocation is made necessary by the timing differences between when a

revenue or expense item reaches the published financial statement as opposed to
when it appears on the tax return. In these situations, tax expense is based on the
published before-tax income figure. The problem can also be viewed from the
perspective of the balance sheet, where the tax basis and book basis of assets and
liabilities differ. Hence, the income tax expense and income tax liability numbers,
with the difference appearing on the balance sheet. We will closely scrutinize the
meaning of the income tax expense number and the balance sheet account arising
from the income tax allocation process.
APB opinion no.11 continued the thrust of ARBs 43 and 44 (revised). As long as
timing differences arise, tax allocation must take place, despite the possibility of
relevant circumstantial differences. This requirement is known as comprehensive
allocation.

After many years in process, SFAS No.96 appeared in 1987. It continued the
comprehensive allocation approach of APB opinion No.11, but it was unduly
conservative in terms of recognizing deferred tax assets on the balance sheet.
SFAS No.109 succeeded SFAS No. 96 in 1992 and restored consistency in terms
of a largely evenhanded treatment relative to the balance sheet recognition of
deferred tax assets and liabilities.

Permanent differences between published statements and tax return are not subject
to the allocation process. In the case of a nontaxable item, such as municipal bond
interest, there is no effect on either tax expense or tax liability.

Another aspect of the tax picture is called intrastatement or intraperiod tax

allocation. Where prior period adjustments, extraordinary items, changes in
accounting principle, or operations of discontinued segments of a firm have tax
effects, these items are shown net of the tax effect. The balance of the total tax
expense figure then appears below net income before income taxes and
extraordinary items. Infrastatement allocation is relatively easy to employ and
probably has relevance for users, so the benefits appear to out-weigh the costs.
Nothing else of a theoretical nature is involved in infrastatement tax allocation.

There are numerous examples of timing differences (now called temporary

differences). The tax liability would be greater than tax expense where either
revenues are recognized for tax purposes earlier than for published reporting
purposes or expenses are recognized more rapidly on the financial statements than
on the tax return. Examples include the following:

• Receipt of cash for rent or subscription prior to the period in which

services are performed.
• Warranties recognized for financial accounting purposes when good are
sold and for tax purposes when work is performed.
• Postretirement benefits other than pensions recognized prior to cash
payment.
• Bad debt expense is recognized in the period of sale for financial reporting
purposes and in the period when the actual writeoff occurs for tax
purposes.
Conversely, tax expense is greater than tax liability when either revenues are
recognized more slowly or expenses more rapidly for tax purposes than for book
purposes. These situations would include:
• Income from long term contruction contracts using the percentage of
completion approach for financial accounting and the completed contract
approach for income taxes.
• Installment sale income recognized for financial purposes at the time of
sale and when cash is collected for taxes.
• Accelerated depreciation for taxes and straight-line depreciation for
financial accounting.
• Intangible drilling and development cost deducted when incurred for taxes
and capitalized for financial accounting.

The Rationale of Income Tax Allocation

As the name explicitly states, income tax allocation is indeed an allocation.
Thomas, in fact, has characterized it in very pithy terms:
... tax allocation embodies the allocation problem in one of its most pathological
forms....... tax allocation may be perceived as an atemptt to make allocation
consistent, and its allocation problems ar the consequences of other allocations.

Although the language of ARB 43 is not explicit, it appears that income tax
allocation is grounded in the matching concept. However, matching, as it is
employed in tax allocation, differs from all other apllications of matching. In the
usual situation, expenses are matched against revenues. The result is expected at
least to roughly portray efforts (expenses) that have given rise to accomplishments
(revenues). However, the matching that occurs under income tax allocation
attempts to normalize income tax expense with pre-tax accounting income. Hence,
after tax income is also correlated with pre tax income. The macthing brought
about by tax allocation literally occurs at a lower point on the income statement
than that of any other expense. Viewed from the perspective of the 1990s,
matching provides a weak rationale for income tax allocation.
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Tax Allocation and Accelerated Depreciation

In the early years of the income tax allocation debate, the case favoring allocation
was often made by using what was, in effect, a single asset situation. For example,
assume that an asset with a five year life and a cost of $ 15.000 and no salvage is
depreciated with a 40% tax rate by the sum of years digits for tax purposes and by
straight line depreciation for financial accounting. The results are shown in exhibit
14-1. The fifth column shows an increase in deferred taxes in the first and second
years and reversal and elimination in the fourth and fifth years. If this model were
representative of real circumtances, the tax allocation situation would present few
problems. The extra tax benefit above those stemming from straight line
depreciation received in the early years of the asset’s life are paid back in the later
years.
Another situation is depicted in exhibit 14-2 where a new asset acquisition is
made each year until the firm reaches a stable point. It is assumed that beyond
year 6 the pattern of acquiring a new asset each year and the disposal of an old
one continues as before. Cost and depreciation methods are the same as in the first
example. Beyond year 5 total accelerated and straight line depreciation are equal,
so the tax benefit occuring in years 1 through 3 become permanent when viewed
in the aggregate sense. Of course, if the firm continues to expand or if costs of
new assets increase, the amount of deferred taxes will continue to increase. In
fact, the great bulk of empirical evidence appears to indicate that the deferred tax
account does indeed increase over time.

The situation of virtually permanent deferral has presented an enigma to

accounting standard setters and theoreticians in terms of interpreting the credit
and even calling into question the whole process of tax allocation where the
potential for permanent deferral exists.