OCW041: Income Tax Accounting

Overview of Income Tax Accounting

There is a difference between Internal Revenue Service code and generally accepted accounting principles for reporting tax liability.

Learning Objectives

Summarize how to account for deferred taxes under the deferred method and the asset-liability method

Key Takeaways

Key Points

  • Taxable income a company reports to the IRS may not be the same as the pre-tax profit reported on its financial statements.
  • The actual amount of tax liability due to the IRS may not be the same as the income tax expense reported on the income statement.
  • Temporary difference: the book income (income shown on the company financials) may be higher one year, but lower in future years. Thus, the cumulative profit will be the same for both.
  • Permanent difference: Due to generally accepted accounting principles, treating items, such as income and expenses, differently than the IRS, the difference may never reverse.
  • If a company realizes a net loss for tax purposes, the IRS allows the company to offset this loss against the prior year’s taxable income (which could result in a refund of taxes paid in prior periods).
  • In the asset-liability method, deferred income tax amount is based on the expected tax rates for the periods in which the temporary differences reverse. It is a balance-sheet-oriented approach. This method is the only one accepted by GAAP.

Key Terms

  • deferred: Of or pertaining to a value that is not realized until a future date (e.g., annuities, charges, taxes, income, either as an asset or liability.
  • deduct: To take one thing from another; remove from; make smaller by some amount.

Income Tax Reporting

In order to properly account for income taxes, it is important to understand that the Internal Revenue Service code that governs accounting for tax liability isn’t the same as the generally accepted accounting principles (GAAP) for reporting tax liability on the financial statements.

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Income Tax: Reporting income tax is complicated by the fact that IRS code differs from generally accepted accounting principles

The result is the taxable income a company reports to the IRS may not be the same as the pre-tax profit reported on its financial statements.

Also, the actual amount of tax liability due to the IRS may not be the same as the income tax expense reported on the income statement.

The differences in what is reported on the financials and what is reported to the IRS are divided into two classifications, temporary difference and permanent difference.

Temporary difference: The book income (income shown on the company financials) may be higher one year, but lower in future years. Thus, the cumulative profit will be the same for both.

Permanent difference: Due to generally accepted accounting principles treating items such as income and expenses differently than the IRS, the difference may never reverse.

Accounting for Deferred Taxes

Deferred Method

In this method, the deferred income tax amount is based on tax rates in effect when the temporary differences originated. The deferred method is an income-statement-oriented approach. This method seeks to properly match expenses with revenues in the period the temporary difference originated. Note this method is notacceptable under GAAP.

Asset-liability Method

In the asset-liability method, deferred income tax amount is based on the expected tax rates for the periods in which the temporary differences reverse. It is a balance-sheet-oriented approach. This method is the only one accepted by GAAP.

Future Taxable Amounts, Future Deductible Amounts and Net Operating Loss

Loss Carry Backs and Loss Carry Forwards

Under U.S. Federal income tax law, a net operating loss (NOL) occurs when certain tax-deductible expenses exceed taxable revenues for a taxable year.

If a company realizes a net loss for tax purposes, the IRS allows the company to offset this loss against prior year’s taxable income (which could result in a refund of taxes paid in prior periods).

The company may carry those losses back three years. If the company doesn’t have the sufficient taxable income in the past three years to absorb the loss, then it may carry the remaining losses forward for 15 years. This allows the company to deduct the loss against future taxable income.


Source: Accounting