Accounting 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:

  • Temporary differences. 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.
  • Deferred tax liabilities and assets. When there are temporary differences, the result can be deferred tax assets and deferred tax liabilities, which represent the change in taxes payable or refundable in future periods.

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.

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, 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, 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