Describe the complexities of permanent and temporary differences on the financial reporting requirements for income taxes

Answer 1

FINANCIAL REPORTING REQUIREMENTS FOR INCOME TAXES

A firms income tax expense each period equals pretax book income multiplied by the income tax rate. Income tax expense for a firm also equals income taxes currently payable plus the change in the deferred tax liability. The deferred tax liability changed each year by the amount of the tax effect of the temporary differences between depreciation for financial reporting and depreciation for tax reporting.

U.S. GAAP and IFRS require a more complex procedure for accounting for income taxes. The principal complexities are as follows:

1 . Income tax rates change over time, so the deferred tax liability need not represent the amount of taxes that the firm must pay later.

2 . Some temporary differences create deferred tax assets. A deferred tax asset arises when a firm recognizes an expense earlier for financial reporting than for tax reporting. For example, firms provide for estimated uncollectible accounts when they recognize sales on account but delay the tax deduction until later, when firms judge that particular customers' accounts are uncollectible. As another example, firms provide for estimated warranty cost in the year they sell warranted products but delay the tax deduction until later, when firms make actual expenditures for warranty repairs.

3 . Firms recognize deferred tax assets only to the extent that they expect to generate sufficient taxable income to realize the assets in the form of tax savings in the future. U.S. GAAP requires use of a deferred tax asset valuation allowance (similar in concept to an allowance for uncollectible accounts) to reduce the balance in the Deferred Tax Asset account to the amount the firm expects to realize in tax savings in the future. IFRS requires that firms recognize the expected realizable amount of deferred tax assets, with explanatory disclosures.

Thus, the Deferred Tax Asset or Deferred Tax Liability accounts on the balance sheet can change each period because of the following factors:

1 . Temporary differences originate or reverse during the current period.

2 . Income tax rates expected to apply in future periods when temporary differences reverse or change during the current period.

3 . A firm's expectations of future taxable income, which affect whether a firm can realize the deferred tax assets through an actual reduction in cash outflows, change during the current period.

In the case of temporary differences. a firm can measure income tax expense using pretax book income amounts and add or subtract the difference between income tax expense and income tax payable to deferred tax assets or deferred tax liability accounts. Because the second and third factors often occur, U.S. GAAP and IFRS require firms to measure income tax expense following a more complex procedure.