There are basically three types of accounts involved in the accounting for income taxes: 1) income tax payable or receivable, 2) deferred tax asset and liability, and 3) income tax expense or benefit. The nature and determination of income tax payable or receivable was never a point of contention since it must be determined in accordance with the provisions of the tax laws. Any question of presentation must center on the nature and determination of either income tax expense or deferred taxes. The balance-sheet (asset and liability) approach adopted by SFAS no. 109 focuses on the proper annual determination of the amount of deferred tax assets or liabilities to be presented on the balance sheet. As a result, income-tax expense for the period not only reflects the current income tax liability as determined by the tax return, but also reflects the changes occurring in the deferred tax accounts.

Temporary Differences

Temporary differences are the major cause of deferred tax assets and liabilities. In SFAS 109, temporary differences are separated into two types, namely taxable temporary differences and deductible temporary differences. Temporary differences existing at the balance sheet date that will result in net taxable amounts on future tax returns are termed "taxable temporary differences." Temporary differences that will result in net deductible amounts on future tax returns are referred to as "deductible temporary differences." Deferred tax assets are recognized for the tax effect of deductible temporary differences and deferred tax liabilities are recognized for the tax effect of taxable temporary differences.

Elements of Deferred Tax Accounts

Deferred tax assets consist of the future tax effect of the following three items--

* Current and prior operating losses carried forward to future periods;

* Current and prior tax credits carried forward to future periods; and

* Deductible temporary differences.

Deferred tax liabilities consist of the tax effect of only one item:

* Taxable temporary differences.

Some Related Issues

There are several essential issues related to the basic accounting for income taxes. These are a) the applicable tax rate, b) the valuation allowance for deferred tax asset, and c) the classification of current and non-current deferred tax assets and liabilities on the balance sheet.

The tax rates used for computation of deferred taxes are based on provisions of the enacted tax law. The effect of future changes in tax laws or rates are not anticipated. If no new rates have been enacted into law, the current rate should be used.

A valuation allowance for a deferred tax asset (a contra deferred tax asset account) is required in some cases. The balance of the allowance account represents the amount of the deferred tax asset which "more likely than not," will not be realized in the future.

Classification of current and noncurrent deferred taxes is based on the classification of related assets and liabilities. For example, any deferred tax asset or liability due to a temporary difference from depreciation shall be classified as non-current because the related depreciable asset is non-current. There are items which could be classified partially as current and partially as non-current, such as warranty obligations.

If there is no related asset or liability for financial reporting purposes, e.g. net-operating-loss (NOL) carryforwards, the classification will be based on the expected date for realization of the carryforward. The classification of the valuation allowance account will naturally follow the classification of its related deferred tax asset. Deferred taxes are presented in net current and net noncurrent amounts on the balance sheet, i.e., the net deferred tax asset or liability is presented. There could be one net current amount and one net noncurrent amount.

Accounting Procedures Schedules

Three steps are needed to derive the amount of the ending balances of

a. Income tax payable or receivable;

b. Deferred tax asset due to net operating loss (NOL) carryforwards to future years;

c. Deferred tax asset due to tax credit carryforwards to future years;

d. Deferred tax asset due to deductible temporary differences; and

e. Deferred tax liability due to taxable temporary differences.

These procedures are illustrated in the accompanying demonstration problem. The diagrams reflect the interplay of different time periods and provide a quick insight into the nature of various income tax related elements.

Financial Statement Presentation and Disclosure

Some of the more commonly required disclosures related to the income statement are as follows:

1. Current tax;

2. Deferred tax expense or benefit exclusive of other components listed below;

3. Investment tax credits;

4. The benefits of operating loss carryforward resulting in a reduction of income tax expense, i.e., the amount of tax benefit of net operating loss carry forwards from the current year only;

5. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of the enterprise; and

6. Adjustments of the beginning-of-the-year balance of a valuation allowance because of a change in circumstances that cause a change in judgment about the realization of the related deferred tax asset in future years.

The sum of items two through six should equal the deferred portion of the income tax expense recognized on the income statement.

On the balance sheet, deferred tax assets and liabilities should be classified as current and noncurrent and reported as one net current amount and one net noncurrent amount as discussed earlier. Disclosure requirements related to the balance sheet accounts are

* The total of all deferred tax liabilities,

* The total of all deferred tax assets, and

* The total of the valuation allowance recognized for deferred tax assets.

Effective Date

SFAS 109 is effective for fiscal periods beginning after December 15, 1992.

DEMONSTRATION PROBLEM

This demonstration problem is designed with enough complexity to be useful, yet simple enough for illustrative purposes. If features the following:

* Post-first year operation

* Net operating loss

* Tax credits

* Different types of temporary differences

* Different tax rates in different tax periods

* Change of tax rate during the year

* Classification of current and noncurrent deferred taxes

ABC company has been in operation since 1989. The following data are obtained in preparation for 1991's accounting for income taxes.

Prior Years' (1989, 1990) Information:

a. Taxable income used for determination of tax liability for the year 1989, $5; 1990, $10.

b. One temporary different related to depreciation originated in 1989, and no temporary differences originated in 1990.

c. There were no unused tax credits remaining from these two years.

Current Year's (1991) Incremental Information:

a. Financial loss before taxes: $(36).

b. Permanent difference: Exclusion of dividend revenue, $5.

c. One temporary difference related to warranty originated in 1991.

d. Tax credit originated in 1991, $1.

e. Beginning balances:

Deferred tax asset - $0, Deferred tax liability - $2.60

Allowance account for deferred tax asset - $0

EffectsofTemporarydifferencesontaxableincome

198919901991199219931994

Depreciation$(6)$(5)$(4)$(3)$18

With():Excessdeductionstakenfortaxpurposes.

Warranty$12$(2)$(4)$(6)

Without():Excessdeductionstakenforfinancialaccounting

purposes.

Enactedtaxratesasof1991

198919901991199219931994

40%40%30%30%30%25%

Other Information

1. Assume that ABC Company elects the carryback provision for 1991's NOL and that any remaining NOL from 1991 will be carried forward to 1992. Any remaining tax credits from 1991 will be carried forward to 1993.

2. It is "more likely than not" the $5 of the NOL carryforwards from 1991, due to the restrictive nature of the loss, will not be realized in the future.

3. Information for disclosure requirement only:

a. There was a change in the enacted tax rates during 1991. Due to the change, the tax rates for 1991 and 1992 were reduced from 40% to 30%. There was no change in tax rates scheduled for 1993 and onward.

b. Tax credits in 1991 were not investment tax credits.

Solution

Three steps are necessary for determining the ending balances for the income tax payable or receivable, deferred tax asset and liability:

I. Determination of income tax payable or receivable:

1991

Pretaxfinancialloss$(36)

Dividendincomeexclusion(5)

Depreciation(4)

Warranty12

Netoperatinglosspertaxreturn$(33)

Taxcreditsin1991$1

Taxrate40%40%30%

Year198919901991

Taxableincome$5$10

NOL(33)

(5)5

(10)10

$0$0$(18)

Assume that no portion of the 1991 tax credit, $1, could be carried back. Based on the 1991 NOL carrybacks presented in the above schedule, there is income tax receivable for the year of $6. ($10 + $5) x 40% = $6

II. Determination of parts of the "Deferred Tax Asset" ending balance due to NOL carryforwards and tax credit carryforwards:

(a) Remaining NOL carryforwards:

Taxrate30%30%30%

Year199119921993

1991NOL$(18)

Deferred Tax Asset due to NOL carryforwards is $5.40. $18 x 30% = $5.40

Current portion: $5.40 (Based on the reversal date) Non-current portion: $0

(b) Remaining tax credit carryforwards:

TaxRate30%30%30%

Year199119921993

1991TC$1

Deferred Tax Asset due to tax credit carryforwards is $1

Non-current portion: $0 Non-current portion: $1 (Based on the reversal date)

III. Determination of the ending balance of the Deferred Tax Asset" and "Deferred Tax Liability" due to temporary differences:

TaxRate30%30%25%Total

Year199219931994

Depreciation$(3)$18$15

Warranty$(2)$(4)$(6)$(12)

NOTE: A detailed schedule of temporary differences for periods beyond the next year is not necessary if the tax rate is the same for those periods.

The negative total of $(12) caused by warranty represents the deductible temporary difference. A deferred tax asset is therefore recognized for the tax effect of this temporary Difference. The amount is $3.30. ($2 + $4) x 30% $1.80 plus $6 x 25% = $1.50

Current portion: $0.60 ($2 x 30% = $0.60) Non-current portion: $2.70 ($4 x 30% = $1.20 plus $6 x 25% = $1.50)

The positive total of $15 due to depreciation represents the taxable temporary difference. Accordingly, a deferred tax liability is recognized for the tax effect of this temporary difference. The amount is $4.50.

(-$3 + $18) x 30% = $4.50

Current portion: $0 Non-current portion: $4.50

CONCLUSION: The ending balance of the deferred tax asset is $9.70, ($5.40 + $1 + $3.30).

Reminder: There are three elements of deferred tax asset. The ending balance of the deferred tax liability is $4.50.

Reminder: There is one element of deferred tax liability.

Adjustment of the Valuation Allowance Account

Due to the assumption made about the future realizability of certain NOL carryforwards in the amount of $5, an allowance in the amount of its related deferred tax asset ($5 x 30%) should be recognized on the balance sheet.

Current: $1.50 (Based on the classification of its related deferred tax asset)

IncomeStatementPresentation

Lossbeforetaxes$(36.00)

Provisionforincometax:

Currentbenefit$6.00

Deferredbenefit6.30

$12.30

Netloss$(23.70)

BalanceSheetPresentation

CurrentAssets:

Deferredtaxasset(netof

theallowance,$1.50)$4.50

Non-currentliabilities:

Deferredtaxliability$0.80

Current deferred tax asset: $6 + ($0) + ($1.50) = $4.50 Dr. Non-current deferred tax liability: $3.70 + ($4.50) = ($0.80) Cr.

Reminder: Balances of the deferred tax asset, deferred tax liability and allowance accounts are netted according to their current and noncurrent classification and deferred taxes are presented in one net current amount and one net non-current amount on the balance sheet.

Disclosure Requirements

a. Income statement related disclosures:

1. Current tax expense (benefit): ($6.00).

2. Deferred tax benefit (exclusive of the effects of other components listed below): ($3.10).

3. Investment tax credits (assuming the tax credits were not investment tax credit): None

4. The benefit of loss carryforwards: ($3.90)

Note: This refers to the $5.40 tax effect of NOL carryforwards from the current year adjusted for the valuation allowance amount of $1.50.

5. Adjustment in a deferred tax asset or liability for enacted changes in tax rates: An expense of $ 0.70.

Note: The rate change of 1991 and 1992 from 40% to 30% affects the deferred tax liability previously recognized for these two years. See temporary differences of depreciation in Step Three.

6. Adjustments of the beginning-of-year balance of a valuation allowance because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years:

Reminder: Item one reflects the current portion of the income tax benefit reported on the income statement. The sum of items two through six must equal the deferred portion of the income tax benefit reported on the income statement, ($6.30).

b. Balance-sheet-related disclosures:

1. The total of all deferred tax assets: $9.70 2. The total of all deferred tax liabilities: $4.50 3. The total valuation allowance recognized for deferred tax assets: $1.50

Anne L. Leahey, CPA, University of Texas--El Paso