Accounting for Income Taxes

According to Accounting Theory: Contemporary Accounting Issues by Evans, accountants have developed two alternative approaches to accounting for income taxes, which are the cash method and the allocation method. The cash method is described as a simple and direct approach. The amount of income taxes actually paid for the year is reported on the Income Statement. The amount comes from the firm’s income tax return and fit is not adjusted in any way. Therefore, the firm’s actual transaction to record its income tax liability is the basis for the amount of the income tax expense reported on the Income Statement. The allocation method is a bit different. The actual amount of tax that is paid in the year is ignored when it comes to reporting income tax expense on the Income Statement. The amount of income tax expense reported on the Income Statement is based on the on the income tax rate that the firm pays, which is applied to the amount of pretax income. This makes the Income Statement perfectly consistent with the before-tax income. Using the allocation method makes it look like all items on the Income Statement based on the same method.

The development of accounting pronouncements for taxation reveals the difficulty that standard-setter s had with this topic. Following are summaries of major pronouncements dealing with accounting for income taxes.

APB OPINION #11

This pronouncement required the deferral method of accounting for income taxes. When the accounting net income exceeded taxable net income, balancing credit should be recognized, when the taxable net income exceeded the accounting, a balancing debit should be recognized. This was considered a deferred credit and a deferred debit. Deferred charges and credits were default classification and were placed on the Balance Sheet in what was called “no man’s land,” or some undefined region, between liabilities and owner’s equity for deferred credits and between assets and liabilities for deferred charges. Under APB Opinion #11 it was believed that the balancing credits and debits would eventually reverse and cancel out and therefore it was to be treated as a temporary measure.

From 1967 thru 1980, firms followed the comprehensive tax allocation procedures under APB Opinion #11 and reported deferred charges and credits. However, some problems arose from doing so. Because of the changes in tax rates and the nature of firm’s investment, the balance of deferred tax credits on a firm’s balance sheet began to grow in size instead of reversing and canceling out. Also, accountants were not sure that the balancing debits and credits from the application of APB Opinion #11 should be on the Balance Sheet.

SFAC NO. 3 (now SFAC NO. 6)

This pronouncement presents the definitions of the elements of financial statements. Deferred charges and credits explained in APB Opinion #11 did not make the list of ten financial statements. Also, in paragraph #241 it states that “only the deferred method explained in APB Opinion #11, does not fit the definitions”. Therefore, deferred charges and credits should not be included on the Balance Sheet.

SFAS NO. 96

The board supported the comprehensive tax allocation notion of APB Opinion #11. The only difference was the board considered the balancing debits and credits as assets and liabilities. Making the Balance Sheet accounts for deferred taxes more meaningful in keeping with the FASB’s conceptual framework was the major purpose of this pronouncement SFAS No. 96. It required the recognition and measurement of deferred tax liabilities and assets under the liability method. The objective of accounting for income taxes was to recognize the amount of current and deferred income taxes payable or refundable at the date of the financial statements as a result of all events that had been recognized in the financial statements and as measured by the provisions of enacted tax laws.

Under SFAS No. 96, the tax liabilities and assets are adjusted for the effect of changes in the tax laws or rates. Firms could recognize tax liabilities but tax assets could only be recognized to the extent of tax liabilities. Because tax allocation was so complex at the time due to changes in the rates, FASB established an implementation group for tax allocation in 1988 and deferred implementation of SFAS No. 96. After FASB issued a special report in 1989 on implementation issues, complications led to the deferral of SFAS No. 96 again, until 1992, which shows the difficulty of