Chapter 5.4® - Future Tax Calculations using the Deferral or Liability (Accrual) Methods, Basic Illustration of Interperiod tax Allocation

• Part 5.1 - Accounting for Corporate Income Taxes & Intra-period Tax Allocations
• Part 5.2 - Income Tax Provision or Expense? Differences between Taxable & Accounting Income (Permanent & Temporary Differences)
• Part 5.3 - Conceptual Issues in Interperiod Tax Allocation - Comprehensive & Partial Tax Allocation Methods (theory only)
• Part 5.4 - Future Tax Calculations using the Deferral or Liability (Accrual) Methods, Basic Illustration of Interperiod tax Allocation
• Part 5.5 - Changes in Income Tax Rate, Recording Future Tax Liability
• Part 5.6 - Difference between Carrying Value and Tax Basis
• Part 5.7 - Reconciliation of Effective Tax Rates & Differential Reporting & Accounting Treatment of the Investment Tax Credit

Deferral Method:

The deferral method records the future tax impact by using the corporation’s effective average tax rate in the year that the temporary difference first arises, or originates. The experts of the deferral method argue that Interperiod income tax allocation is simply a method of moving expense from one period to another, and that the best measure of that expense is the effect that it had in the year that the temporary difference originated. The implication of the deferral method is that the balance sheet credit (or debit) for deferred tax is simply a deferred credit (or deferred debit) and should not be accorded the status of a liability (or asset). Deferred tax credits and debits on the balance sheet are simply a necessary component to achieving matching and improving income measurement.

Liability Method:

The liability or accrual method uses the tax rate that will be in effect in the year of reversal. Proponents of this view argue that ultimate realization of the amount of the tax deferral depends on the tax rates in effect when the temporary differences reverse, and thus the amounts to be realized bear no necessary relationship to the tax rates in effect when they originate. Conceptually, the emphasis is on measurement of the future cash flow impact, and the future amount to be paid (or the benefit to be received, in the case of temporary differences that give rise to a debit balance) is viewed as a liability.

Discounting:

The third conceptual issue is really part of the measurement issue, particularly under the liability method. If the future tax consequence of a temporary difference is a liability, then the time value of money can be taken into account. If a corporation delays paying large amount of income tax by taking advantage of completely legal provisions of the Income Tax Act. Then the balance sheet credit represents an interest free loan from the government.

If the deferred tax balances are discounted, interest is imputed on the balance each year, using the same rate as was used for discounting. The income tax expense on the income statement would therefore include:

Basic Illustration – Interperiod tax Allocation:

Lets assume that Tahir & Company has pre-tax income in each of three years of $1,000,000. Included in income first year is a gain of $600,000 that is not taxable until the third year. Taxable income therefore will be $400,000 in 2006, $1,000,000 in 2007 and $1,600,000 in 2008. Assuming an income tax rate of 40%, the taxes due for each period are $160,000 in 2006, $400,000 in 2007 and $640,000 in 2008. This information can be summarized as follows:

If the income tax assessed for each year is matched to the year in which it is assessed, each year’s full tax assessment flows through to net income:

When the $240,000 income tax impact of the $600,000 gain is recognized in the same period as the gain itself, the result will be:

If the income tax expense is recognized (in 2006) prior to its actually becoming payable to the government (in 2008), the debit to income tax expense must be offset by a credit. The credit is to future income tax liability. The entry to record the income tax expense in each year is:

The future income tax liability will be shown on the balance sheet at the end of 2006 and 2007, and then is drawn down in 2008 when the temporary difference reverses and the tax actually becomes due. Notice the distinction in terminology:

The process of reallocating the income tax assessment to accounting years on the basis of the accounting recognition of taxable revenue, gains, expenses and losses is known as Interperiod income tax allocation.