Accounting For Income Taxes

What is Accounting For Income Taxes?

Accounting for income taxes is a vital financial practice that involves recognizing, measuring, and disclosing the expected income tax consequences of transactions and events within a specific accounting period.

Think about it as a report card that is handed in at the end of the quarter.

It ensures that a company presents an accurate and comprehensive view of its financial position and performance. This practice may adhere to accounting standards such as IFRS and GAAP.

One key principle in accounting for income taxes involves differentiating between temporary and permanent differences. Temporary differences occur when the tax base of an asset or liability differs from its carrying amount on financial statements.

These differences reverse in the future, resulting in taxable or deductible amounts. Permanent differences, however, do not reverse and have no future tax consequences.

For example, a temporary difference is seen in the variation between the tax base and the carrying amount of a company's deferred tax asset, representing a future tax benefit.

It is recognized when the company likely utilizes the tax benefit to offset future taxable income. The deferred tax asset is recorded at the expected tax rate upon realization.

On the other hand, a permanent difference arises when the tax-exempt income's tax base differs from its carrying amount. This income is not subject to income tax, it does not generate future taxable or deductible amounts.

Accounting for income taxes also involves estimating and disclosing deferred tax liabilities and assets. Tax laws and rates' impact on financial statements, including tax provisions, are considered.

In this context, the tax provision reflects the income tax expense or benefit recognized in the income statement for a specific period, calculated based on taxable income or loss multiplied by the applicable tax rate.

Types of Accounting for Income Taxes

Different approaches to accounting for income taxes are employed to effectively capture and communicate the tax implications of transactions and events. 

The choice of accounting method depends on the nature of the business and its compliance with accounting standards. 

Familiarity with these types of accounting for income taxes ensures accurate reporting of tax obligations and benefits.

Here are the main types of accounting methods:

1. Accrual basis

Under the accrual basis method, revenue and expenses are recognized when earned or incurred, irrespective of payment timing. This ensures that income tax consequences are accounted for in the period of occurrence, regardless of deferred tax payments.

2. Cash basis 

With the cash basis method, revenue and expenses are recognized when cash is received or paid, regardless of when they are earned or incurred. Consequently, income tax consequences are recognized in the accounting period when tax payments are made or received.

3. Current

Current income tax refers to the expected tax amount payable or recoverable within the present accounting period. It is based on the company's taxable income or loss and the applicable tax rate.

4. Deferred

Deferred income tax represents the discrepancy between the tax base (reported for tax purposes) and the carrying amount (reported on financial statements) of an asset or liability. 

This discrepancy is temporary, with future reversals resulting in taxable or deductible amounts. Deferred income tax is recorded as either a deferred tax asset or a deferred tax liability on the company's balance sheet.

5. Current and deferred

This type combines current and deferred income tax, recognizing them in the company's financial statements during the same accounting period.

Accounting for income taxes: Key Terms for Accurate Reporting

Key phrases play a significant role in accounting for income taxes, capturing essential concepts in this field. Proficiency in understanding and applying these terms is vital for accurately recognizing and reporting income tax implications.

Let’s take a look at some of the most used key accounting terms:

1. Temporary difference: Temporary differences in accounting for income taxes occur when the carrying amount of an asset or liability on a company's balance sheet differs from its tax base. These differences are temporary because they will reverse in the future, resulting in future taxable or deductible amounts.
2. Permanent difference: It is a difference that will never reverse and, therefore, will not result in a future taxable or deductible amount.
3. Deferred tax asset: It is a liability that represents the company's future tax obligation that will arise due to temporary differences that will reverse in the future.
4. Deferred tax liability: It is a liability that represents the company's future tax obligation that will arise due to temporary differences that will reverse in the future.
5. Tax provision: The amount of income tax expense or benefit recognized in the company's income statement for a specific accounting period. To get the provision, multiply the company's taxable income or loss by the applicable tax rate.
6. Tax base: The amount reported for tax purposes of an asset or liability.
7. Carrying amount: It is the amount reported on the company's financial statements of an asset or liability.
8. Taxable income: It is the portion of income subject to taxation after subtracting all the allowable deductions and exemptions.
9. Tax rate: It represents the percentage of a business's taxable income subject to income tax.
10. Tax benefit: A reduction in a company's tax liability that yields a lower income tax expense.
11. Tax expense: This expense is based on two factors: the taxable income of a company and its applicable tax rate. Thus, it reflects the amount the company has to pay in taxes.

Income Tax vs. Accounting Tax

These two serve different roles in the world of taxation. Let’s take a look:

"Income Tax" refers to the actual taxes people and businesses owe to the government; it is based on their earnings/profits. It's the money they have to pay, thus affecting their finances directly. 

Contrarily, "Accounting Tax," also known as "tax accounting," is the process businesses use to track their tax obligations for financial reporting. 

It's like the behind-the-scenes work of taxes. This involves recording, measuring, and reporting tax-related items on financial statements to ensure the company follows the rules and presents its tax situation accurately. 

So, while "Income Tax" directly impacts financial resources, "Accounting Tax" is more about correctly managing financial records to meet tax regulations.

Main Objectives of Accounting for Income Taxes

Accounting for income taxes is an important practice that helps companies accurately show the influence of taxes on their financial statements. 

It brings transparency and comparability, providing stakeholders with essential information for decision-making. Moreover, it assists companies in adhering to accounting standards and effectively managing tax risks.

Moving on, here are the main objectives of accounting for income taxes:

1. Presents a true and fair view: Accounting for income taxes accurately reflects tax impact on financial statements, providing a reliable view of a company's financial position and performance.
2. Enhances transparency and comparability: Proper accounting allows transparent and comparable information about income tax consequences, enabling stakeholders to understand the impact on financial performance and make informed decisions.
3. Facilitates compliance with standards: Adhering to accounting standards like IFRS and GAAP ensures consistent and uniform preparation of financial statements, enhancing reliability and credibility.
4. Supports tax planning and decision-making: Analysis of tax consequences helps identify opportunities to minimize tax liability through deductions, credits, and incentives, aiding in tax planning and informed decision-making.
5. Helps manage tax risk: Accounting for income taxes enables the identification and evaluation of tax risks, allowing the implementation of strategies to mitigate them, including assessing the impact of tax law and rate changes and disclosing uncertain tax positions.

Challenges of Deferred Tax Accounting

Accounting for income taxes has its drawbacks. It can be complex and time-consuming, increasing the risk of errors in financial statements. 

Subjective estimates and assumptions create uncertainty, while the costs can affect a company's profitability. Conflicts with tax authorities and limited comparability of financial statements are additional disadvantages.

The following are the challenges of tax accounting:

1. Complexity: Navigating deferred tax accounting involves the application of various intricate concepts and principles dictated by accounting standards. This complexity heightens the risk of errors, potentially undermining the reliability and credibility of financial statements.
2. Subjectivity: Tax accounting hinges on formulating estimates and assumptions, encompassing predictions of future taxable or deductible amounts and the expected tax rate. These elements, prone to subjectivity, can introduce uncertainty and inconsistencies within financial statements.
3. Cost: Managing income tax matters entails the engagement of proficient professionals like accountants and tax advisors, incurring additional expenditures that may affect a company's overall profitability.
4. Potential for Disputes with Tax Authorities: Situations may arise where a company's tax accounting approach diverges from the stance adopted by tax authorities. Such discrepancies can lead to conflicts and controversies, resulting in supplementary costs such as legal fees and potential harm to the company's reputation.
5. Limited comparability: The accounting for income taxes can vary across companies due to differences in their tax positions and tax rates, limiting the comparability of their financial statements.

Journal Entry of Deferred Tax Accounting

The journal entry for accounting for income taxes involves recording the expected income tax consequences of transactions and events that have occurred during a specific accounting period.

The journal entry for accounting for income taxes typically includes the following components:

1. Deferred tax assets

These are recorded as assets in the balance sheet when it is probable that the company will benefit from a future tax advantage.  The journal entry involves debiting the deferred tax asset account and crediting the income tax expense account.

The company's financial records show accumulated depreciation ($6,000), while its tax records show $4,800. 

This $1,200 difference will likely result in lower taxes in the future, creating a deferred tax asset of $1,200. 

The company records a debit of $1,200 to the Deferred Tax Asset account (an increase) and a credit of $1,200 to the Income Tax Expense account (a decrease) to reflect this.

2. Deferred tax liabilities 

These represent the future tax obligations arising from temporary differences that will reverse in the future. They are recorded as liabilities in the balance sheet.

The journal entry includes debiting the deferred tax liability account and crediting the income tax expense account.

This entry reflects the recognition of a deferred tax liability caused by temporary differences in depreciation methods. 

The company debits Income Tax Expenses by $1,000 (increasing the expense) and credits Deferred Tax Liability by $1,000 (increasing the liability) to account for the expected future tax payment.

3. Tax provision 

This is the income tax expense or benefit recognized in the income statement for a specific accounting period. It is calculated by multiplying the taxable income/loss by the corresponding tax rate. 

The journal entry involves debiting the income tax expense account and either crediting the income tax payable account (for tax expense) or crediting the income tax refundable account (for tax benefit).

The entry above records the estimated income tax expense for the fiscal year. 

$5,000 is debited to the Income Tax Expense account (increasing the expense), and $5,000 is credited to the Income Tax Refundable account (increasing the tax benefit) to account for this provision. Actual taxes may vary during year-end tax reporting.

4. Income tax expense 

This is the amount of income tax a company must pay based on its taxable income and tax rate. It is recorded as an expense in the income statement. 

The journal entry includes debiting the income tax expense account and crediting the income tax payable account.

This entry debits the Income Tax Expense account by $7,000 (increasing the expense). To correspond to the entry,  the Income Tax Payable account is credited by $7,000 (decreasing the liability) to reflect the amount paid in taxes for the year.

This entry represents the actual tax expense incurred during the year-end tax reporting.

5. Income tax payable 

It represents the income tax owed to tax authorities but not yet paid. It is recorded as a liability in the balance sheet. 

The journal entry includes debiting the income tax payable account and crediting the cash account (for cash payment) or the accounts receivable account (for credit payment).

In the previous example, $7,000 is debited to the Income Tax Payable account (increasing the liability). To match entries, $7,000 is credited to either Cash (if paid in cash) or Accounts Receivable (if paid on credit).

Conclusion

Accounting for income taxes is an essential part of financial reporting. It's all about ensuring a company properly records, measures, and communicates the tax impacts on its finances for a given period.

The main goal is to provide a clear and honest picture of the company's financial health while following specific accounting rules (like IFRS and GAAP).

This process involves figuring out the differences between how taxes work for the company's books and what it tells the tax authorities. It also includes estimating and communicating taxes the company will pay (or save) in the future and dealing with how tax laws change over time.

In addition, it calculates the amount the company expects to pay in taxes for the period and shows how taxes affect their finances. 

While it has benefits like clarifying finances, helping with following rules, and making better decisions, it can also be tricky, involve guesswork, and cost money. 

Sometimes, it can lead to disputes with tax authorities, and comparing different companies' tax accounting can be challenging.

Researched and authored by “Won S. Mejia Helfer” | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Deferred Income Tax
• Deferred Tax Asset
• Deferred Tax Liability/Asset
• Permanent/Temporary Differences in Tax Accounting
• Tax Depreciation