Discuss the accounting for income taxes and the disclosure of income taxes in the financial statements

Answer 1

ACCOUNTING FOR INCOME TAXES

Accounting for income taxes recognizes and measures the tax effects of temporary differences between book and taxable income. In measuring income tax expense, U.S. GAAP and IFRS require recognition of the tax effect when temporary differences originate. Any difference between income tax expense and income taxes payable for a given reporting period results in a deferred tax asset or deferred tax liability. The notes to the financial statements provide information on the components of book income before taxes, the current and deferred portions of income tax expense, a reconciliation between income taxes at the statutory rate and the effective rate, and the components of deferred tax assets and deferred tax liabilities.

DISCLOSURE OF INCOME TAXES IN THE FINANCIAL STATEMENTS

Notes to the financial statements provide additional information about income tax expense and deferred tax assets and deferred tax liabilities. Firms report four items of information:

1 . Components of Income Before Income Taxes

This disclosure shows the amounts of book income before income taxes from a firm's domestic operations and its international operations.

2 . Components of Income Tax Expense

This section indicates the amount of income taxes currently payable and the amount deferred because of temporary differences for both domestic operations and international operations.

The information disclosed in these first two sections permits the calculation of the effective tax rate for domestic, international, and domestic and international operations combined.

3 . Reconciliation from Statutory to Effective Tax Rate

The effective tax rate equals income tax expense divided by book income before income taxes. This section gives the reasons the effective tax rate differs from the 35% statutory federal income tax rate. The reasons generally fall into one of two categories: (1) income tax rate differences, and (2) permanent differences.

Firms recognize the fair value of acquired IPR&D as an asset and then amortize it over the expected period of benefit. However, the income tax law generally does not permit the acquiring firm to deduct this amount on its income tax return. This difference in financial reporting and tax reporting gives rise to a permanent difference between book income and taxable income. The assumption on the first line of the tax reconciliation is that all items of revenue and expense are subject to a 35% tax rate. Because IPR&D is never deductible for tax purposes, the reconciliation shows an addition to the effective tax rate.

4 . Components of Deferred Tax Assets and Liabilities

This section discloses the types of temporary differences that result in deferred tax assets and deferred tax liabilities on the balance sheet at the end of each period.

Income tax expense equals income taxes currently payable plus, or minus as appropriate, the changes in the deferred tax asset and deferred tax liability accounts. The amounts include the tax effects of temporary differences that affect book income during the current period as well as the tax effects of temporary differences that affect Other Comprehensive Income of the current period (and will affect book income of later periods).