1.3.1 Understanding “Events That Have Been Recognized in an Entity’s Financial Statements or Tax Returns”
The accounting for income taxes under ASC 740 can be extremely complex. This chapter summarizes the core concepts under ASC 740 and gives an overview of the objectives of the accounting for income taxes.
A basic principle of the taxation of income in many jurisdictions, including the U.S. federal jurisdiction, is that an entity is taxed only on its net earnings (i.e., it is taxed on total revenue after allowable expenses incurred to generate the revenue have been deducted to arrive at a net amount of taxable income). Generally, an entity applies a rate or series of rates to taxable income to determine a preliminary amount of income tax owed for the period. In many jurisdictions, the entity then reduces that preliminary amount by available income tax credits, if any, to determine the ultimate amount of tax owed in a particular period.
10-1 There are two primary objectives related to accounting for income taxes:
- To recognize the amount of taxes payable or refundable for the current year
- To recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns.
As it relates to the second objective, some events do not have tax consequences. Certain revenues are exempt from taxation and certain expenses are not deductible. In some tax jurisdictions, for example, interest earned on certain municipal obligations is not taxable and fines are not deductible.
10-2 Ideally, the second objective might be stated more specifically to recognize the expected future tax consequences of events that have been recognized in the financial statements or tax returns. However, that objective is realistically constrained because:
- The tax payment or refund that results from a particular tax return is a joint result of all the items included in that return.
- Taxes that will be paid or refunded in future years are the joint result of events of the current or prior years and events of future years.
- Information available about the future is limited. As a result, attribution of taxes to individual items and events is arbitrary and, except in the simplest situations, requires estimates and approximations.
10-3 Conceptually, a deferred tax liability or asset represents the increase or decrease in taxes payable or refundable in future years as a result of temporary differences and carryforwards at the end of the current year. That concept is an incremental concept. A literal application of that concept would result in measurement of the incremental tax effect as the difference between the following two measurements:
- The amount of taxes that will be payable or refundable in future years inclusive of reversing temporary differences and carryforwards
- The amount of taxes that would be payable or refundable in future years exclusive of reversing temporary differences and carryforwards.
However, in light of the constraints identified in the preceding paragraph, in computing the amount of deferred tax liabilities and assets, the objective is to measure a deferred tax liability or asset using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.