Conceptual Aspects of Interperiod Tax Allocation

Objective

After studying this expanded discussion, you should be able to: Understand the arguments for and against interperiod tax allocation and the alternative approaches.



The desirability of using interperiod tax allocation is not unanimously agreed upon. Some believe that the appropriate tax to be reported on the income statement is the tax actually levied in that year. In short, this group, often referred to as the non-allocation (or flow-through) proponents, does not believe that the recognition of deferred income taxes provides useful information, or at least benefits in excess of cost. They note that the nature of the Deferred Tax Liability account is not clear. They contend that it is not a liability at the time the account is established because it is not payable to anyone. The payment of additional tax in the future is contingent upon the earning of future taxable income. If taxable income does not occur in the future, there is no liability. Similarly, others note that if there is no taxable income in the future, a deferred tax asset should not be recognized.

Others argue that income taxes are similar to a dividend, not an expense. As a result, allocation between accounting periods is inappropriate because taxes are considered to be an involuntary distribution of income, rather than a determinant of income.

Despite these arguments, the profession justified the recognition of deferred income taxes on the basis of asset-liability recognition concepts. Income taxes are seldom paid completely in the period to which they relate. However, the operations of a business entity are expected to continue on a going-concern basis in the absence of evidence to the contrary, and income taxes are expected to continue to be assessed in the future. Recognition of deferred taxes is needed to report the future taxes expected to be paid or recovered because the tax return treatment for various items is different from their financial statement treatment.

Although the predominant view holds that recognition of deferred taxes is appropriate, there are two concepts regarding the extent to which it should be applied: (1) comprehensive allocation and (2) partial allocation.

Comprehensive Allocation Versus Partial Allocation

Under
comprehensive allocation, recognition of deferred taxes is applied to all temporary differences.1 Supporters of this view believe that reported deferred income taxes should reflect the tax effects of all temporary differences included in pretax financial income, regardless of the period in which the related income taxes are actually paid or recovered. This view recognizes that the amount of income tax currently payable is not necessarily the income tax reported in the financial statements relating to the current period. Consequently, deferred taxes should be recognized when temporary differences originate, even if it is virtually certain that their reversal in future periods will be offset by new originating differences at that time. As a practical matter, therefore, recurring differences between taxable income and pretax financial income give rise to an indefinite postponement of tax.

An example of a recurring temporary difference is the use of accelerated depreciation for tax purposes by a company that uses straight-line depreciation for financial reporting purposes. This results in the accumulation of deferred tax liabilities that will not be paid as long as the company is acquiring depreciable assets faster than it is retiring them. Although the deferred taxes associated with specific assets do indeed reverse, the aggregate balance in deferred taxes remains stable or continues to grow because of the recurring purchases of additional assets.

Supporters of
partial allocation contend that unless deferred tax amounts are expected to be paid or recovered within a relevant period of time, they should not affect reported income. Consequently, recognition of deferred income taxes is not considered appropriate for recurring temporary differences that result in an indefinite postponement of tax. Under this view, the presumption is that reported tax expense for a period should be the same as the tax payable for the period. Accordingly, only nonrecurring, material temporary differences should give rise to the recognition of deferred taxes. Deferred taxes should be recognized only if they are reasonably expected to be paid or recovered within a relatively short period of time not exceeding, for example, three years. An example is an isolated installment sale in which the receivable and related gross profit are reported for financial reporting purposes at the date of sale and for tax purposes when collected.

The supporters of comprehensive allocation contend that partial allocation is a departure from accrual accounting because it emphasizes cash outlays, whereas comprehensive allocation results in a more thorough and consistent recognition of assets and liabilities. Present GAAP requires application of comprehensive allocation.

Conceptual Approaches to Deferred Income Taxes

The preceding viewpoints involving no allocation, partial allocation, and comprehensive allocation represent different approaches to the problem of identifying those transactions for which the recognition of deferred income taxes is appropriate. The three views differ as to whether accounting recognition should be given to the deferred tax effects of temporary differences. Because tax rates change over time, additional questions relate to what method of tax allocation should be used in accounting for tax effects and how those effects should be presented in the financial statements. Three different methods of tax allocation have been proposed: (1) the deferred method, (2) the asset-liability method, and (3) the net-of-tax method.

Deferred Method

Under the
deferred method, the amount of deferred income tax is based on tax rates in effect when temporary differences originate. The balance in deferred taxes is not adjusted to reflect subsequent changes in tax rates or the imposition of new taxes. Consequently, the balance in deferred income taxes may not be representative of the actual amount of additional taxes payable or receivable in the periods that temporary differences reverse. Under this method, deferred charges and credits relating to temporary differences "represent the cumulative recognition given to their tax effects and as such do not represent receivables or payables" in the usual economic sense.2 It is an income statement-oriented approach that emphasizes proper matching of expenses with revenue in the periods that temporary differences originate. This method is not acceptable for financial reporting purposes.

Asset-Liability Method

Under the
asset-liability method, the amount of deferred income tax is based on the tax rates expected to be in effect during the periods in which the temporary differences reverse. The most reasonable assumption about future tax rates is that the current tax rate will continue. However, if a rate change is enacted into law, the new rate will be used under the asset-liability method- one of many reasons why companies will fight a boost in tax rates. Under this method, deferred taxes are viewed as economic liabilities for taxes payable or assets for future tax deductions. This method is a balance sheet-oriented approach that emphasizes the usefulness of financial statements in evaluating financial position and predicting future cash flows. Present GAAP requires that the asset liability method be used for interperiod tax allocation.

Net-of-Tax Method

Under the
net-of-tax method, no deferred tax account is reported on the balance sheet. Further, the amount of income tax expense reported on the income statement is the same as the taxes currently payable. The tax effects of temporary differences (determined by either the deferred or asset-liability methods) are not reported separately. Instead, they are reported as adjustments to the carrying amounts of specific assets or liabilities and the related revenues or expenses. This view recognizes that future taxability and tax deductibility are important factors in the valuation of individual assets and liabilities.

For example, depreciation is said to reduce the value of an asset both because of a decline in economic usefulness and because of the loss of a portion of future tax deductibility; accelerated depreciation uses up this portion of the asset value more rapidly than does straight-line depreciation. Under this view, depreciation expense reported on the income statement would include, in addition to an amount for straight-line depreciation, an amount equal to the current tax effect of the excess of tax depreciation over accounting depreciation. On the balance sheet the related cumulative deferred tax effect would be reported as a reduction of the specific asset rather than as a credit balance in a Deferred Tax Liability account. The asset, liability, revenue, and expense accounts would be presented "net-of-tax" under this method. The net-of-tax method is not accepted currently for financial accounting purposes.


An Illustration of the Different Methods of Tax Allocation

To illustrate the differences in these three methods of interperiod tax allocation, assume that on January 1, 2001, Orange Inc. acquires for $100,000 equipment that has a 5-year useful life and no salvage value. Straight-line depreciation is used for financial reporting purposes. Depreciation for tax purposes is $25,000. The tax rate for 2001 is 40%, but the tax rate (enacted into law) for future years is 50%. Income tax payable for 2001, assuming that income before depreciation and taxes is $200,000, is computed below.


ILLUSTRATION 1:
Computation of Income Tax Payable, End of 2001

 
Income before depreciation and income taxes $200,000
Depreciation for tax purposes 25,000
Taxable income 175,000
Tax rate
        40%
Income tax payable $ 70,000
  ======

An abbreviated income statement for 2001 under the three methods is as follows:


ILLUSTRATION 2:
Income Statement Presentation of Income Tax Expense for Three Methods

 

Deferred Asset-Liability Net-of-Tax
Income before depreciation and income taxes $200,000 $200,000 $200,000
Depreciation 20,000 20,000 22,000
Income before income taxes 180,000 180,000 178,000
        Current tax expense 70,000 70,000 70,000
        Deferred tax expense 2,000 2,500     -      
Total income tax expense 72,000 72,500 70,000
Net income $108,000 $107,500 $108,000
  ======= ======= =======


Under the deferred method, the deferred portion of income taxes is computed as follows:


ILLUSTRATION 3:
Computation of Deferred Income Taxes--Deferred Method

 
Depreciation for tax purposes $25,000
Depreciation for book purposes(20% x $100,000)   20,000
        Difference 5,000
Tax rate       40%
Deferred income tax credit $2,000
  ======


Under the asset-liability method, the computation of the deferred portion of income taxes is essentially the same except that the future rate is used instead of the current rate.


ILLUSTRATION 4:
Computation of Deferred Income Tax--Asset-Liability Method

 
Depreciation for tax purposes $25,000
Depreciation for book purposes(20% x $100,000) 20,000
        Difference 5,000
Tax rate     50%
Deferred tax liability $ 2,500
 

Under the net-of-tax method the computation is more complicated. As indicated earlier, depreciation expense reported on the income statement would include, in addition to an amount for straight-line depreciation, an amount equal to the current tax effect of the excess of tax depreciation over book depreciation. This computation is as follows:3


ILLUSTRATION 5:
Computation of Deferred Income Taxes--Net-of-Tax Method

 
Depreciation for book purposes(20% x $100,000) $20,000
Tax effect for depreciation [($25,000 - $20,000) x 40%]   2,000
Depreciation expense $22,000
 

Thus, under the net-of-tax method, depreciation expense and accumulated depreciation are higher by $2,000.

Note that both the deferred method and the net-of-tax method report the same net income. The difference between these two methods relates to the classification of the expense and whether a deferred tax account is created. The asset-liability method uses a different and, in this case, higher tax rate than the deferred and net-of-tax methods; net income is therefore lower.


SUMMARY OF LEARNING OBJECTIVES


Understand the arguments for and against interperiod tax allocation and the alternative approach. Although the predominant view holds that comprehensive tax allocation is appropriate, there are those who support no allocation or partial allocation. Of those who support allocation, three different methods of tax allocation have been proposed: (1)The deferred method, (2)the asset-liability method, and (3)the net-of-tax method.

Key Terms

1Note that under the asset-liability approach (present GAAP) all temporary differences are tax affected.

2"Accounting for Income Taxes," Opinions of the Accounting Principles Board No. 11(New York: AICPA, 1967), par. 56.

3Conceptually, under the net-of-tax method we assume that a company purchases two items when it purchases an asset: one item is its service potential and the other is its tax deductibility feature. In the case above, the service potential feature is $60,000 ($100,000 X 60%), and the tax deductibility feature is $40,000 ($100,000 x 40%). In the first year, the service potential feature depreciates at a 20% rate, whereas the tax deductibility feature depreciates at a 25% rate. Total depreciation would, therefore, be computed as follows:
Depreciation of service potential feature ($60,000 x 20%) $12,000
Depreciation of tax deductibility feature ($40,000 x 25%) 10,000
Depreciation expense $22,000

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Note that the depreciation amount of $22,000 is the same as the computation reported above under net-of-tax.