Describe the accounting for income taxes for financial reporting purposes

Answer 1

INCOME TAXES

Income tax expense affects assessments of profitability as much as any other expense. A common ratio for analyzing the effect of income taxes on profitability is the effective tax rate, equal to income tax expense divided by financial reporting income before income taxes:

Effective Tax Rate = Income Tax Expense
Pretax Book Income

MEASUREMENT OF INCOME TAX EXPENSE

The difference between pretax book income and taxable income arises from two factors.

1 . Permanent Differences—book income includes revenues (such as tax-exempt interest revenue) or expenses (such as certain fines) that taxable income never includes.

2 . Temporary Differences—book income includes revenues and expenses (such as depreciation on long-lived assets and bad debt expense) in one period whereas taxable income includes them in a different period.

Firms compute income tax payable for a period using taxable income as the base. Taxable income excludes permanent differences and uses the accounting methods that the income tax law and regulations either require or permit firms to use for tax reporting. The number and nature of permanent differences and temporary differences are jurisdiction-specific.

The basis for both U.S. GAAP and IFRS requirements for income tax accounting for financial reporting purposes.focuses on two financial reporting objectives: recognizing the amount of taxes payable in the current year and recognizing deferred tax assets and deferred tax liabilities for the future income tax consequences of temporary differences. A temporary difference that implies a future tax deduction gives rise to a deferred tax asset, and a temporary difference that implies a future increase in income tax payable gives rise to a deferred tax liability. The accountant computes income tax expense using pretax amounts for financial reporting, not the amounts on income tax returns. Note that permanent differences never reverse, never affect cash outflows for income taxes, and therefore never affect income tax expense for any period.

ILLUSTRATION OF TEMPORARY DIFFERENCES

One purpose of the income statement is to assist a user of financial reports to understand why income behaves over time as it does. When operations remain the same year after year and tax rates do not change, the user of financial reports will expect net income to remain the same. If income tax expense equaled income taxes payable, reported earnings would vary from year to year simply because temporary differences cause book income before taxes to differ from taxable income.

U.S. GAAP and IFRS require firms to calculate income tax expense based on pretax book income.

RECORDING INCOME TAX EXPENSE

The temporary difference associated with accelerated depreciation for tax purposes and straight-line depreciation for financial reporting purposes means that a firm will pay lower income taxes in the early years of the asset's life, but this temporary difference will reverse over the entire asset life, resulting in higher taxes in later years.

A credit to the Deferred Tax Liability account represents the income taxes saved (today) because the firm claimed more depreciation for tax purposes than for book purposes. The temporary differences for depreciation reverses in later years.

Total lifetime depreciation amounts on the equipment for both financial reporting and tax reporting are the same, only the timing differs.