As stated in an article published by the Journal of Accounting and Economics, accounting for income taxes, or AFIT, is “the process by which future cash tax payments and refunds arising from current and past transactions are recorded as deferred tax assets and liabilities and the income tax expenses are recorded in an attempt to accurately portray the financial position of the firm.” This is performed by applying the General Accepted Accounting Principles (GAAP) that guides how other economic activities of a firm should be reported.
In the US, companies follow the Accounting Standards Codification (ASC) 740 in accounting and reporting the effects of their income tax. According to the Financial Accounting Foundation, ASC 740 is a tax provision that aims to identify the payable or refundable taxes for the current year, and recognizes the the consequences for the future from the deferred tax liabilities and assets. These deferred tax liabilities and assets are recorded on the company’s balance sheet as future payable or refundable income taxes.
Scope of ASC 740
Under ASC 740-10-15-2 to 15-3, “ASC 740’s principles and requirements apply to domestic and foreign entities in preparing financial statements in accordance with U.S. GAAP, including not-for-profit entities (NFP) with activities that are subject to income taxes, including the following:
– Domestic federal (national) income taxes (U.S. federal income taxes for U.S> entities) and foreign, state, and local (Including franchise) taxes based
– An entity’s domestic and foreign operations that are consolidated, combined, or accounted for by the equity method.”
In simpler terms, income taxes that an entity pays to the government are subject to the provisions of ASC 740. However, franchise tax and withholding tax are excluded from this rule.
Different Measures of Income
There is a disparity in reporting the amount of income and expenses for income tax purposes and GAAP. In income tax purposes, the aim of the government is to boost its revenue. On the other hand, GAAP is used to report the entity’s economic activities. For each reporting system, book income and tax income are used to classify the types of income that are subject to tax.
- Book Income or Pretax Financial Income
Determined by using GAAP, book income is income tax that is computed and then used in making financial statements.
- Taxable Income
Identified by using the rules and regulations of the Internal Revenue Code, taxable income is the amount that the entity will pay for an accounting period.
Different Measures of Assets, Liabilities, and Equities
As cited from an article released by the Journal of Accounting and Economics, these differences, called Book-Tax Differences, arise from tax legislation that directly departs from GAAP accounting. There are two types of BTDs: temporary and permanent.
- Temporary Differences
According to the Economics Department of the University of California, Santa Barbara, temporary differences are the differences in the reported tax basis of an asset or liability in the financial statements that will ensue in taxable or deductible amounts.
In the income statement, if the income tax expense is larger than the income tax liability, the difference is called deferred tax liability. Otherwise, it is called deferred tax asset.
- Permanent Differences
Permanent differences are the results of items that are either recorded in the books but not on tax returns, or items that are not recorded in the books but are recorded on tax returns.
Steps in Determining Income Tax Provision
In calculating the total income tax provision, add up the current income tax expense and the deferred income tax expense.
According to an excerpt from a chapter in accounting, the following are the steps to take to identify the income tax provision.
- Conform the pretax income for permanent differences
- Determine carryforwards and temporary differences
- Know the deferred liabilities and assets
- Assess the need for valuation allowance for deferred tax assets
- Compute for the deferred income tax benefits or expenses
- Identify changes to liabilities for uncertain tax positions