Income taxes are often one of the largest, if not the largest, expenses on the P&L. For non-tax professionals, the income tax provision can be overwhelming, but it does not have to be.
Tax law, accounting standards, and disclosure requirements continue to grow more complex but, rest assured, the basic concepts of the tax provision remain the same.
What Is Tax Accounting?
Tax accounting is a structure of accounting methods focused on taxes rather than the appearance of public financial statements. Tax accounting is governed by the Internal Revenue Code, which dictates the specific rules that companies and individuals must follow when preparing their tax returns.
How to Account for Income Taxes
The essential accounting for income taxes is to recognize tax liabilities for estimated income taxes payable and determine the tax expense for the current period. Before delving further into the income taxes topic, we must clarify several concepts that are essential to understanding the related income tax accounting.
The concepts are noted below. All of these factors can result in complex calculations to arrive at the appropriate income tax information to recognize and report in the financial statements.
A company may record an asset or liability at one value for financial reporting purposes while maintaining a separate record of a different value for tax purposes. The difference is caused by the tax recognition policies of taxing authorities, who may require the deferral or acceleration of certain items for tax reporting purposes.
These differences are temporary since the assets will eventually be recovered and the liabilities settled, at which point the differences will be terminated.
A difference that results in a taxable amount in a later period is called a taxable temporary difference, while a difference that results in a deductible amount in a later period is called a deductible temporary difference. Examples of temporary differences are:
- Revenues or gains that are taxable either prior to or after they are recognized in the financial statements. For example, an allowance for doubtful accounts may not be immediately tax-deductible, but instead must be deferred until specific receivables are declared bad debts.
- Expenses or losses that are tax-deductible either prior to or after they are recognized in the financial statements. For example, some fixed assets are tax-deductible at once, but can only be recognized through long-term depreciation in the financial statements.
- Assets whose tax basis is reduced by investment tax credits.
Carrybacks and Carryforwards
A company may find that it has more tax deductions or tax credits (from an operating loss) than it can use in the current year’s tax return.
If so, it has the option of offsetting these amounts against the taxable income or tax liabilities (respectively) of the tax returns in earlier periods, or in future periods. Carrying these amounts back to the tax returns of prior periods is always more valuable since the company can apply for a tax refund at once.
Thus, these excess tax deductions or tax credits are carried back first, with any remaining amounts being reserved for use in future periods. Carryforwards eventually expire, if not used within a certain number of years.
A company should recognize a receivable for the amount of taxes paid in prior years that are refundable due to a carryback. A deferred tax asset can be realized for a carryforward, but possibly with an offsetting valuation allowance that is based on the probability that some portion of the carryforward will not be realized.
The three main objectives in accounting for income taxes are:
Optimizing After-Tax Profits
First, a company’s income tax accounting should be in line with its operating strategy. That is, to maximize profits a company must understand how it incurs tax liabilities and adjust its strategies accordingly.
Secondly, income tax accounting can enable a company to maintain financial flexibility. There are different effects of funding the company’s operations with debt and/or equity, and a company’s capital structure can influence its tax liability. Knowing these effects will allow the company to plan accordingly and transitively maintain its financial flexibility by keeping its options open.
Timing of Payments
Finally, accounting for taxes enables the company to manage cash flow and minimize cash taxes paid. It is beneficial to postpone payment of taxes into the future, as opposed to paying taxes today. A company will want to take tax deductions sooner rather than later to maximize the time value of their money.
Essential Accounting for Income Taxes
Despite the complexity inherent in income taxes, the essential accounting in this area is derived from the need to recognize two items, which are:
- Current year. The recognition of a tax liability or tax asset is based on the estimated amount of income taxes payable or refundable for the current year.
- Future years. The recognition of a deferred tax liability or tax asset is based on the estimated effects in future years of carryforwards and temporary differences.
Based on the preceding points, the general accounting for income taxes is:
|+/-||Create a tax liability for estimated taxes payable, and/or create a tax asset for tax refunds, that relate to the current or prior years|
|+/-||Create a deferred tax liability for estimated future taxes payable, and/or create a deferred tax asset for estimated future tax refunds, that can be attributed to temporary differences and carryforwards|
|=||Total income tax expense in the period|
Accounting Standard – IAS 12
IAS 12 prescribes the accounting treatment for income taxes. Income taxes include all domestic and foreign taxes that are based on taxable profits.
Current tax for current and prior periods is, to the extent that it is unpaid, recognized as a liability. Overpayment of current tax is recognized as an asset. Current tax liabilities (assets) for the current and prior periods are measured at the amount expected to be paid to (recovered from) the taxation authorities, using the tax rates (and tax laws) that have been enacted or substantively enacted by the end of the reporting period.
IAS 12 requires an entity to recognize a deferred tax liability or (subject to specified conditions) a deferred tax asset for all temporary differences, with some exceptions.
Temporary differences are differences between the tax base of an asset or liability and its carrying amount in the statement of financial position. The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
A deferred tax liability arises if an entity will pay tax if it recovers the carrying amount of another asset or liability. A deferred tax asset arises if an entity:
- Will pay less tax if it recovers the carrying amount of another asset or liability; or
- Has unused tax losses or unused tax credits.
Income Tax vs. Accounting Tax
Tax as recorded in a company’s financial statement rarely ever matches the taxes filed in their tax returns. It is because each item (company financials and tax return) has different purposes, users, and accounting treatment.
The company’s financials are intended for investors and lenders, and – as such – are made with application and dependability in mind. In contrast, the tax return is intended for the government or corresponding tax body and is made with the purpose of adhering to public tax policy.
The financial statements report a tax expense, but the true tax payable comes from the tax return. The dichotomy in reporting these two items creates differences that need to be reconciled and accounted for. These differences are either permanent differences, which never reverse, or temporary differences, which are timing differences that will reverse over time.