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

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:

 - the discounted present value of the future tax impact of temporary differences that originated in the current period; - plus interest on the balance at the beginning of the year; - plus or minus adjustments to the ending balance for tax rate increase or decrease; - less drawdown that occurred during the current period due to reversal of the temporary difference.

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:

 2006 2007 2008 Income before Income taxes (accounting basis) \$1,000,000 \$1,000,000 \$1,000,000 Income tax expense \$160,000 \$400,000 \$640,000 Net Income \$840,000 \$600,000 \$360,000

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:

 2006 2007 2008 Income before Income taxes \$1,000,000 \$1,000,000 \$1,000,000 Income tax expense Current \$160,000 \$400,000 \$640,000 Future \$240,000 - (\$240,000) Subtotal: \$400,000 \$400,000 \$400,000 Net Income \$600,000 \$600,000 \$600,000

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:

 December 31st, 2006 Account Name Debit Credit Dr. Income Tax Expense (IS) \$400,000 Cr. Income Tax Payable (B/S) \$160,000 Cr. Future Income Tax Liability (B/S) \$240,000 Entry to record income tax expense for 2006 & future income tax liability

 December 31st, 2007 Account Name Debit Credit Dr. Income Tax Expense (IS) \$400,000 Cr. Income Tax Payable (B/S) \$400,000 Entry to record income tax expense for 2007 & future income tax liability

 December 31st, 2008 Account Name Debit Credit Dr. Income Tax Expense (IS) \$400,000 Dr. Future Income Tax Liability (B/S) \$240,000 Income Tax Payable (B/S) \$640,000 Entry to record income tax expense for 2008 & future income tax liability

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:

 - a temporary difference reverses, while - the future income tax liability/asset that relates to the temporary differences is drawn down

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.