Interperiod tax allocation

Introduction

The liability, income taxes payable is based on taxable income. This is the amount a firm will have to pay the federal government as the result of its operations, as defined by the IRC. The question is, if the firm’s pretax accounting income is different from its taxable income because of timing differences, what should be the amount of its tax expense? That is, should it be based on the firm’s pretax accounting income or on its taxable income?

The accounting profession feels that a firm’s tax expense should not be based on its taxable income. Rather, the matching principle requires that the tax expense for the period be based on accounting income before taxes. In order to do this, current accounting practice requires the use of interperiod income tax allocation.


Definition of Interperiod Tax Allocation

The purpose of interperiod income tax allocation is to allocate the income tax expense to the periods in which revenues are earned and in which expenses are incurred.

Thus, when tax expense is based on pretax accounting income rather than on taxable income, all applicable taxes are allocated against the income for the period, regardless of when the taxes are actually paid. This concept is no different from accruing a liability for wages in the current period as they are incurred, although the wages are not paid until the next period.

Example

To demonstrate the application of interperiod income tax allocation, assume that the Price Corporation uses the same accounting principles for financial reporting purposes as it does for tax purposes, except for depreciation methods. For financial reporting purposes, the firm uses straight-line depreciation, and for tax purposes it uses ACRS. At the beginning of 2015, the firm purchased the light truck. The truck has a five-year life for accounting purposes and falls in the three-year class life for ACRS purposes.  The annual depreciation under each method is calculated as below:

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Differences between accounting and taxable income

The required calculations necessary to compute tax expenses and taxes payable are shown below.

Interperiod tax allocation

The top part of the exhibit shows how the annual tax expense is calculated. Income before taxes is based on straight-line depreciation of $2,000 per year. Given a constant tax rate of 40%, income tax expense ranges from $3,200 in 2015 to $7,200 in 2019.

The bottom part of the exhibit indicates how taxes payable are calculated each year. In this case, taxable income is based on ACRS depreciation, Because the truck falls into the three-year class life, all depreciation is taken in the first three years of the asset’s life. Income tax payable ranges from $3,000 in 2015 to $8,000 in 2019.

It is important to note that total depreciation expense, total taxes, and total net income over the five-year period are the same in both cases. This is because the total depreciation in both cases is $10,000; it is just being allocated differently among the 5 years. This is typical 0f a single-asset case in which salvage values are ignored and the asset is held for its entire life.

Journal Entries to Record Income Tax Expense

The journal entries to record the income tax expense and the related payable are:

journal entries to record interperiod income tax allocation

As these entries show, the expense in all periods is based on pretax accounting income, whereas the payable is based on taxable income, In 2015, the difference of $200 is a credit to the Deferred Income Tax account. At this point, the account is called a deferred tax credit. If the Deferred Income Tax account has a debit balance at the end of any accounting period, it is called a deferred tax charge. Similar entries are made in 2016 and 2017, both of which increase the credit balance in the Deferred Income Tax account.

Because the timing difference reverses in 2018 and 2019, the Tax Payable is greater than the Tax Expense account. The Deferred Income Tax account, therefore, is debited for $800 each year. In this case, the timing difference completely reverses by the end of 2019, so that by the end of that year the balance in the Deferred Income Tax account is zero. This point is shown in the following Deferred Income Tax T account:

Deferred Income Tax T Account

When the Deferred Income Tax account has a credit balance, it is shown on the liability section of the balance as a deferred tax credit. On the other hand, if the Deferred Income Tax account has a debit balance, it is shown on the asset side of the balance sheet as a deferred tax charge.

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A related question is whether the Deferred
Income Tax account should be shown as a current or a noncurrent asset liability. The FASB decided that the classification of the deferred charge or credit depends on the asset or liability that gave rise to it. Thus, if the timing difference is related to a current asset such as inventory, the resulting deferred income tax charge or credit should be classified as current. On the other hand, if the timing difference is related to a noncurrent asset such as equipment, the resulting deferred income tax charge or credit should be classified as noncurrent.

The Controversy Surrounding Interperiod Income Tax Allocation

There is still much controversy surrounding interperiod income tax allocation. Many research studies have shown that deferred tax credits have increased over the years and, for many firms, represent a large item in the liability section of their balance sheets. The primary reasons for this are the current use of ACRS depreciation and, before that, the use of accelerated depreciation methods for tax purposes. A company with a relatively stable or growing investment in depreciable assets that uses straight-line depreciation in determining pretax accounting income but uses ACRS in determining taxable income will be likely to have an increasing credit balance in its Deferred Income Tax account.

This is because the continued investment in higher-priced assets indefinitely postpones the total reversal of the timing difference, even though differences due to individual assets completely reverse. That is, as the effect of ACRS depreciation reverses on assets purchased in earlier years, it is offset by the effect of higher-priced assets purchased in the current year. If this is the case, then the deferred tax
credits may not meet the definition of a liability.

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Remember that a liability is defined as a probable future sacrifice of economic benefits. However, if the deferred tax credit is not reduced because the timing difference does not turn around, then the future sacrifice of cash, due to higher income taxes payable, will never take place.

Example

To illustrate, at the end of 2018 and 2019 Anheuser-Busch Companies, Inc. had $357.7 million and $455.1 million, respectively, in its deferred income tax account. These amounts represented over 21% and 19% of total liabilities, respectively, and 30% of total stockholders’ equity in both years. The deferred tax account has grown over 70% since 2017. This increase is the difference between the annual tax provisions and what Anheuser-Busch actually paid the government. In effect, between 2017 and 2020, the statutory tax rate was 46% but the effective tax rate for Anheuser-Busch (based on its actual liability) averaged only 36%. If this trend continues, then it is doubtful that the $455 million of deferred taxes shown on the liability section of the balance sheet will ever be paid.

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