Every company must pay a portion of its profits as income tax to one or more governments or jurisdictions in which the firm conducts business. However, the rules for determining income under the various tax jurisdictions will differ from the rules for determining income under U.S. GAAP. Accounting for the differences between taxable income and accounting income is the primary purpose of income tax reporting.
- ACCOUNTING PROFIT AND TAXABLE INCOME
Companies keep two different sets of books, one for tax purposes and one for financial reporting purposes. Each set of books will lead to different profit figures, reflecting differences in tax and financial reporting rules. In general, tax accounting rules allow the use of fewer accruals. Thus, tax accounting is closer to “cash basis” accounting than is accounting for financial reporting purposes. Differences between taxable income and accounting income may be either temporary or permanent.
2.1. Temporary Differences
Temporary differences arise when income or expense items are recognized in different periods for tax and financial reporting purposes. These differences are considered temporary because they will eventually reverse.
A common source of temporary recognition differences is depreciation expense. For financial reporting purposes, most firms depreciate their assets using the straight-line method. For tax reporting, however, companies can recognize depreciation on an accelerated basis, thus resulting in greater tax depreciation in the early years of the asset’s useful life. Over the full useful life of the asset, the total recognized depreciation will be the same under both methods.
Another area of temporary differences is the recognition of bad debt expense and warranty expense. For financial reporting purposes, firms must recognize these expenses in the same period as their associated revenues. The firm thus records the expense with a corresponding “allowance”, against which the actual expenditures will be charged. For tax purposes, however, these expenses would not be recognized until the actual expenditures occur.
There are many other areas where revenue and/or expenses are recognized at different times under GAAP than under tax rules. The important point, however, is to recognize that these differences are temporary and expected to reverse.
2.2. Permanent Differences
Permanent differences are those differences between tax income and accounting income which will not reverse. These differences are caused by items considered as income or expense for financial reporting purposes but not for tax purposes or vice versa. For example, interest received on state and municipal bonds would be included as income for financial reporting purposes, but would not be included in taxable income (as interest on such income is not subject to federal taxation).
Permanent differences are reflected in the actual tax rate paid on reported income, known as the effective tax rate.
2.3. Deferred Income Tax Accounting
A firm must recognize income tax expense as the tax consequences of that period’s pretax income, regardless of when the tax payments will be made. However, the company’s actual income tax payable is based on taxable income in the current period. These two amounts will differ because of temporary differences, discussed above. To reconcile the difference between these two amounts, the company will recognize deferred tax assets and deferred tax liabilities.
A deferred tax liability reflects future taxes related to income which has been recognized for financial statement purposes but has not yet been recognized for tax purposes. In other words, deferred tax liabilities arise when financial reporting income exceeds tax income, reflecting an “underpayment” of tax recognition for the period.
A deferred tax asset reflects future offsets to current tax liabilities arising when income recognized for tax purposes is greater than income recognized for financial reporting purposes. Deferred tax assets arise when tax income exceeds financial reporting income and reflects an “overpayment” of tax recognition for the period.
Under U.S. GAAP, tax deferrals (assets or liabilities) may be classified as current or non-current, depending on the classification of the specific asset or liability which gave rise to the temporary difference. A deferred tax asset or liability which does not correspond to an asset or liability is classified based on the expected reversal date of the temporary difference.
2.4. Net Operating Losses
A net operating loss (NOL) occurs when a company’s deductible expenses exceed its taxable revenue (tax income is negative). Under current U.S. tax law, firms with NOLs can either carryback the losses or carryforward the losses.
When a firm carries losses back, the firm applies the NOL to past income for prior years (by filing restated tax returns for those years), and thus receives a tax refund. The firm can apply any unused loss against future income. When a firm carries a loss forward, it may apply the NOL incrementally against future taxable earnings for up to 20 years under current law.
2.5. Valuation Allowance
A firm can only realize the benefits of deferred tax assets if it has future taxable income. For this reason, GAAP requires firms to assess the likelihood that deferred tax assets may not be fully realized in future periods. Specifically, if management determines that there is a less than 50% chance that the deferred tax asset will be realized, then the firm must reduce the carrying amount of the deferred tax asset through a contra-account known as the deferred tax valuation allowance.
An increase in the valuation allowance is recorded with a corresponding increase in income tax expense. A decrease in the valuation allowance is recorded with a corresponding decrease in income tax expense. However, management must exercise considerable judgement in determining if the realization of a deferred tax asset is “more likely than not” (the 50% threshold discussed above). Because the determination of the valuation allowance is highly subjective, the valuation allowance is a potential earnings manipulation device. Specifically, management could increase the valuation allowance in highly profitable years and decrease the valuation allowance in lean years.
2.6. Changes in Tax Rates
Under current accounting rules, companies recognize deferred tax assets and liabilities based on the tax rate expected to be in effect when the temporary differences reverse. However, income tax rates may change, in which case deferred tax assets and liabilities must be adjusted to reflect the new tax rate.
When tax rates increase, deferred tax assets and liabilities also increase. Likewise, when tax rates are reduced, deferred tax assets and liabilities decrease. The company recognizes the full change in the deferred tax assets and liabilities in the year the tax rate change is enacted. The company would record the corresponding change in deferred tax assets and liabilities as an adjustment to income tax expense. Investors, thus, must understand how tax rate changes can create a transitory impact to earnings in the year that taxing authorities have adopted new rates.
- UNCERTAIN TAX PROVISION
Unfortunately, many aspects of the tax code are highly ambiguous. As such, a company may recognize tax items (particularly benefits) which may be challenged by taxing authorities. Such uncertain tax provisions pose accounting difficulties.
Under U.S. GAAP, companies record uncertain tax provisions using a two-step process. The first step is for management to determine if the chance of the firm maintaining its tax benefit is “more likely than not” (greater than 50% chance). If management decides the chance is greater than 50%, then management will move to the second step. In the second step, management recognizes the benefit as the largest amount of benefit with a greater than 50% chance of being realized. The company records the difference between the tax benefit on the tax return and the benefit as recognized under GAAP through a liability account called tax contingency reserve.
If management reassesses the probabilities of maintaining the tax benefits, or if the uncertain tax provision is settled with the tax authorities, the company would make the appropriate adjustments to the tax contingency reserve account with offsetting adjustments to the tax expense or cash.
- UNDERSTANDING THE INCOME TAX FOOTNOTE
4.1. Current and Deferred Components of Income Tax Expense
A company’s income tax expense is comprised of a current and deferred portion. As described in previous sections, the deferred portion of income tax expense arises from temporary differences between financial reporting income and taxable income. Companies are required to disclose these different components in the tax footnote. A negative deferral indicates that tax income for the period exceeded financial reporting income. A positive deferral indicates that tax income for the period was less than financial reporting income. When a company has a negative deferral, its income tax expense will be below its income tax payable. When a company has a positive deferral, its income tax expense will be above its income tax payable.
4.2. Reconciliation of Statutory and Effective Tax Rates
Companies must provide a reconciliation between the income tax expense which is based on the effective rate, and the tax amount calculated using the statutory rate. The tax amount calculated under the statutory rate is the federal corporate income tax rate times the pre-tax financial reporting income. This disclosure is arguably the most analytically useful disclosure in a company’s tax footnote.
A company’s income tax expense will differ from the statutory amount for several reasons. As noted in a previous section, permanent differences between financial reporting income and taxable income are captured in the effective rate. Permanent differences which cause financial reporting income to be higher than taxable income will decrease the effective tax rate relative to the statutory rate. Likewise, permanent differences which cause financial reporting income to be lower than taxable income will increase the effective tax rate relative to the statutory rate. Another reason the effective rate will differ from the statutory rate is the inclusion in income expense of state and local taxes. Although state and local tax payments are deductible for federal tax purposes (and thus reported net of federal tax), such payments will increase the effective tax rate relative to statutory taxes. Also, changes in the valuation allowance, which are recognized in income tax expense, will cause the effective rate to deviate from the statutory rate.
For many firms, a prominent reason for the difference in effective and statutory taxes arises from the tax treatment of foreign earnings. A company which intends to return (repatriate) the earnings of foreign subsidiaries to the U.S. will recognize the future tax payment in current income tax expense (with an offsetting deferred tax liability). However, if a firm expects foreign earnings to be invested outside the U.S. indefinitely, it may exclude those earnings from the calculation of taxable income. For many firms with extensive foreign operations, the exclusion of “permanently reinvested” foreign earnings may be the biggest reason for the discrepancy between effective tax rates and statutory rates. Specifically, effective taxes for such firms will be substantially less than statutory taxes.
4.3. Sources of Deferred Tax Assets and Liabilities
Firms must provide details of their tax deferrals within a separate schedule in the tax footnote. Under U.S. GAAP, firms may recognize the tax impact from certain items directly in shareholder’s equity. Thus, the income statement will contain only the tax expense derived from income from continuing operations. For this reason, the change in the net deferred tax asset (or liability) in the footnote schedule may not equal the change in the net deferred tax asset shown on the balance sheet.
- TAX REPORTING UNDER IFRS
IFRS is highly similar to U.S. GAAP in the treatment of income taxes. However, there are several key differences that investors should be aware of.
Under IFRS, companies must recognize deferred taxes using substantively enacted tax rates. Under U.S. GAAP, firms may only use tax rates which have been enacted.
IFRS does not allow the use of a deferred tax valuation allowance. Rather, companies must report deferred tax assets based directly on management’s assessment of realizability.
The statutory rate as described by IFRS is an aggregation of different domestic tax rates of jurisdictions in which the company operates. Under U.S. GAAP, the statutory rate is the U.S. federal corporate income tax rate.
Under IFRS, deferred tax assets and liabilities are always classified as noncurrent on the balance sheet. Under U.S. GAAP, deferred tax assets and liabilities may be classified as either current or noncurrent, depending on the classification of the underlying asset or liabilities which corresponds to the tax deferral.
Under IFRS, firms must provide a disclosure of any income taxes recognized in shareholder’s equity (other comprehensive income). No such disclosure is required under U.S. GAAP.
Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer. Financial Reporting & Analysis, 6th ed. New York: McGraw-Hill, 2015.
Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn. International Financial Statement Analysis, 3rd ed. Hoboken: Wiley, 2015.
Subramanyam, K.R. Financial Statement Analysis, 11th ed. New York: McGraw-Hill, 2014.
 Income tax reporting under U.S. GAAP is covered in ASC Topic 740
 Permanent differences are eliminated from the calculation of taxable income entirely, and thus do not create deferred tax assets or liabilities.
 Decreasing a valuation allowance reduces income tax expense, and thus increases after-tax earnings.
 Any taxes paid to foreign governments are deductible for federal taxation. Federal income tax on these net foreign earnings are paid when the earnings are repatriated to the U.S.
 IFRS treatment of income taxes is specified under IAS 12