Explain the accounting for income taxes
INCOME TAXES
Income before taxes for financial reporting usually differs from taxable income reported to tax authorities. The differences arise because of (1) permanent differences (items that affect income for financial reporting but never affect taxable income, or vice versa), or (2) temporary differences (items that affect income for financial reporting in a different period than for tax reporting). U.S. GAAP and IFRS require firms to measure income tax expense based on income for financial reporting (excluding permanent differences). Income tax authorities impose taxes on taxable income. The difference between income tax expense and income tax payable represents the tax effects of temporary differences: either the firm will receive future benefits (deferred tax assets) or it must pay future taxes (deferred tax liabilities).
The preceding description suggests that deferred tax assets and deferred tax liabilities result from the computation of income tax expense and income tax payable. Thus, U.S. GAAP and IFRS require firms to compute income tax payable and changes in the amounts of deferred tax assets and deferred tax liabilities, and the result is income tax expense. Thus, deferred tax assets and deferred tax liabilities can change because of temporary differences and because of changes in income tax rates affecting future tax benefits and obligations. The net deferred tax asset reported on a firm's balance sheet will also change with changes in the valuation allowance for deferred tax assets.
Firms measure deferred tax assets and deferred tax liabilities at undiscounted amounts. One issue in accounting for income taxes is whether firms should discount these items to present values. Proponents of discounting point out that firms must measure long-term receivables and long-term liabilities at present value amounts. Consistency suggests that firms also express deferred tax assets and deferred tax liabilities at present values. Opponents argue that it is impractical to estimate the time when temporary differences will reverse and give rise to cash flow effects. Tax laws impose taxes on income before taxes, not on individual revenues and expenses. Whether a firm receives a tax benefit or pays taxes in a particular year for an individual temporary difference (such as depreciation) depends on the net effect of all other taxable revenues and expenses.
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