Tax accounting

Tax accounting refers to the rules used to generate tax assets and liabilities in the accounting records of a business or individual. Tax accounting is derived from the Internal Revenue Code (IRC), rather than one of the accounting frameworks, such as GAAP or IFRS. Tax accounting may result in the generation of a taxable income figure that varies from the income figure reported on an entity's income statement. The reason for the difference is that tax rules may accelerate or delay the recognition of certain expenses that would normally be recognized in a reporting period. 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.

The essential tax accounting 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:

  1. 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.
  2. 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.
  3. Calculate the total income tax expense in the period.