Interperiod Tax Allocation Review

The Basics of Interperiod Tax Allocation

The theory behind accounting for income taxes includes the accrual basis of accounting, the matching principle, and the proper recognition of assets and liabilities. Income tax expense is usually recognized when it’s incurred, and it doesn’t matter when the payment is actually made to the IRS. The process of recognizing income tax expense is called interperiod tax allocation. One difference however, is that GAAP does not emphasize the matching concept. Instead, it adopted the asset/liability approach for measurement of income tax.

  • First, the emphasis is on the proper measurement of the income tax assets and liabilities.
  • It also says the deferred tax assets and liabilities should be measured directly along with the income tax liability.
  • And, income tax expense is now a derived amount – which is a plug figure.

So this doesn’t mean that income tax expense for a period doesn’t reflect the income tax cost of transactions in the period. Instead what it means is the greater emphasis is now placed on measuring the changes in balance sheet accounts rather than in the income statement account which is called income tax expense.

Here’s an example: If future enacted tax rates have changed, the deferred tax assets and liabilities will reflect the future tax rates since those are the tax rates that will be in effect when the deferred tax assets and liabilities are realized and paid. If this was only going by the matching approach, the current tax rate would be applied to try and measure pretax accounting income and directly measure the income tax expense. This would mean that deferred tax assets and liabilities are derived.

The Asset/Liability Approach

Income tax expense for the period reflects the amount that will actually be payable on the year’s transactions. The income tax payable account, deferred tax asset account, and the deferred tax liability account show the remaining tax receivables the company has from transactions that have already happened as of the balance sheet date.

Some Tax Allocation Definitions

  • Taxable Items: These are amounts that make a company have to pay more taxes.
  • Pretax Accounting Income: This is income before income tax for accounting purposes which results in applying GAAP accounting.
  • Deductible Items: These are amounts that let’s a company pay less taxes.
  • Taxable Income: This is income before tax for tax purposes. This is the amount you actually apply the tax rate to to see what income tax liability will be for the year.
  • Income Tax Liability: This is the amount of income tax the company must pay in taxes for the year. This is usually paid quarterly based on estimates.
  • Income Tax Expense: This is the account reported in the income statement that shows how much the cost of income tax was. Income tax expense is the income tax liability plus or minus the net change in the deferred tax accounts.
  • Current Income Tax Provision: This can also be called the current portion of income tax expense or current provision for income tax. This is the same as income tax liability.
  • Deferred Income Tax Provision: This is the portion of taxes that is not due currently.
  • Permanent Difference: This is an amount that appears in the tax return or the income statement, but never both of them. This means something that is never taxable or deductible, so it permanently creates a gap between accounting income and taxable income, hence the name.
  • Temporary Difference: This is an amount that will eventually affect taxable income and accounting income by the same amount, but ends up being recognized in different periods.
  • Net Operating Loss or NOL: This means having “negative” taxable income. An NOL can be carried back 2 years and carried forward 20 years to offset taxable income.
  • Deferred Tax Asset: This is when a tax-deductible item is deferred into the future, which means that at some point when this item is recognized, it will lower taxable income. That’s why it’s referred to as an asset.
  • Deferred Tax Liability: This is the opposite of a deferred tax asset. This causes future taxable income to increase.

This video reviews everything up to here:

Permanent Differences Explanation

Permanent differences are differences between accounting income and tax income that will never reverse. Here are some of the most common permanent differences:

  • Tax-Free Interest Income: This is usually from municipal bonds, but tax-free interest can come from other sources. Tax-free interest will obviously be reported in accounting income, but it is not reported in taxable income.
  • Life Insurance Expense: The life insurance premiums paid on a key employee when the firm is the beneficiary are NOT deductible from taxable income, but they are an expense against accounting income.
  • Proceeds on Life Insurance: If a key employee dies and the company had a life insurance policy on him or her, the proceeds are NOT taxable, but they are considered a gain in accounting income.
  • Dividends Received Deduction: The dividends received deduction occurs when a company receives dividends and a portion of the dividends are not taxable. 80% of the dividends received can be deducted from taxable income, but the full amount of the dividends are reported in accounting income.
  • Fines: Fines and penalties are usually not tax-deductible, but they are expensed or counted as a loss in financial reporting.
  • Depletion: GAAP depletion is based on the cost of the natural resource that was used up. Tax depletion is based on revenues of the resource sold. The difference in these two is a permanent difference.

Accounting for Permanent Differences and Permanent Difference Practice Problems

The general rule for accounting for permanent differences is that a permanent difference on income tax expense will have the same effect on income tax liability. Go through the practice problems in this video so that you really understand it.

 

Temporary Differences Explanation

Temporary differences do reverse, they’re pretty much just timing differences. Here are some common temporary differences:

  • Revenues or gains that are taxable after they are recognized in the books
  • Expenses or losses that are deductible after they are recognized in the books
  • Revenues or gains that are taxable before they are recognized in the books
  • Expenses or losses that are deductible before they are recognized in the books

Categories of temporary differences

  • Originating Difference: When an item first causes a temporary difference, it’s called an originating difference
  • Reversing Difference: In the years after the originating difference, the difference is then referred to as a reversing difference
  • Taxable Temporary Differences: These are differences that postpone paying taxes. In the year when it’s recognized, it makes taxable income lower than pretax accounting income. When it reverses, it makes taxable income higher than pretax accounting income. These cause deferred tax liabilities.
  • Deductible Temporary Differences: These cause taxes to be payed in advance. In the year of recognition, it makes taxable income higher than pretax accounting income. Then, when they reverse in the future, they make taxable income lower than pretax accounting income for that period. This causes deferred tax assets.

[color-box]Depreciation Example

Year Book Depreciation Tax Depreciation
1 10,000 16,000
2 10,000 9,000
3 10,000 10,000
Totals 30,000 30,000
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