Accounting: The Language of Business (Part 85)

Regulations for international accounting and funding will have to be examined to identify policies that inadvertently discourage institutional investors from putting their resources into longer-term, illiquid assets.

Jose Angel Gurria

 Income Taxes, Unusual Income Items, and Investments in Stocks (Part A)

by 

Charles Lamson

If you apply for a bank loan, you will be required to list your assets and liabilities on a loan application. In addition, you will be asked to indicate your monthly income. Assume that the day you were filling out the application, you won $4,000 in the state lottery. The $4,000 lottery winnings increase your assets by $4,000. Should you also show your lottery winnings as part of your monthly income?

The answer, of course, is no. Winning the lottery is an unusual event and, for most of us, a non-recurring event. In determining whether to grant the loan, the bank is interested in your ability to make monthly loan payments. Such payments depend upon your recurring monthly income.

Businesses also experience unusual and non-recurring events that affect their financial statements. Such events should be clearly disclosed in the financial statements so that stakeholders in the business will not misinterpret the financial effects of the events.

In the next several posts, we discuss unusual items that affect income statements and illustrate how such items should be reported. In addition, we discuss other specialized accounting and reporting topics, including accounting for income taxes, investments, and business combinations.

Corporate Income Taxes

Under the United States tax code, corporations are taxable entities that must pay federal income taxes. Depending upon where it is located, a corporation may also be required to pay state and local income taxes. Although we limit our discussion to federal income taxes, the basic concepts also apply to other income taxes.

Payment of Income Taxes

Most corporations are required to pay estimated federal income taxes in four installments throughout the year. For example, assume that a corporation with a calendar-year accounting period estimates its tax expense for the year as $84,000. The journal entry to record the first of the four estimated tax payments of $21,000 (1/4 of 84,000) is as follows:

At year-end, the actual taxable income and the related tax are determined. If additional taxes are owed the additional liability is recorded. If the total estimated tax payments are greater than the tax liability based on actual taxable income, the overpayment should be debited to a receivable account and credited to Income Tax Expense.

Income taxes are normally disclosed as a deduction at the bottom of the income statement in determining net income.

The United States imposes a tax on the profits of US resident corporations at a rate of 21 percent (reduced from 35 percent by the 2017 Tax Cuts and Jobs Act). The corporate income tax raised $230.2 billion in fiscal 2019, accounting for 6.6 percent of total federal revenue, down from 9 percent in 2017 (taxpolicycenter.org).

Allocating Income Taxes

The taxable income of a corporation is determined according to the tax laws and is reported to taxing authorities on the corporation's tax return. It is often different from the income before income taxes reported in the income statement according to generally accepted accounting principles. As a result the income tax based on taxable income usually differs from the income tax based on income before taxes. This difference may need to be allocated between various financial statement periods, depending on the nature of the items causing the differences.

Some differences between a taxable income and income before income taxes are created because items are recognized in one period for tax purposes and then another period for income statement purposes. Such differences, called temporary differences, reverse or turn around in later years. Some examples of items that create temporary differences are listed below.

1. Revenues or gains are taxed after they are reported in the income statement. Example: In some states, companies that make sales under an installment plan recognize revenue for financial reporting purposes when a sale is made but defer recognizing revenue for tax purposes until cash is collected.

2. Expenses or losses are deducted in determining taxable income after they are reported in the income statement. Example: Product warranty expense estimated and reported in the year of the sale for financial statement reporting is deducted for tax reporting when paid.

3. Revenues or gains are taxed before they are reported in the income statement. Example: Cash received in advance for magazine subscriptions is included in taxable income when received but included in the income statement only when earned in a future period.

4. Expenses or losses are deducted in determining taxable income before they are reported in the income statement. Example: MACRS depreciation (see part 60) is used for tax purposes and the straight-line method (part 58) is used for financial reporting purposes.

Since temporary differences reverse in later years, they do not change or reduce the total amount of taxable income over the life of a business. Exhibit 1 illustrates the reversing nature of temporary differences in which a business uses MACRS depreciation for tax purposes and straight-line depreciation for financial statement purposes. Exhibit 1 assumes that MACRS recognizes more depreciation in the early years and less depreciation in the later years. The total depreciation expense is the same for both methods over the life of the asset.

As Exhibit 1 illustrates, temporary differences affect only the timing of when revenues and expenses are recognized for tax purposes. As a result, the total amount of taxes paid does not change. Only the timing of the payment of taxes is affected. In most cases, managers use tax planning techniques so that temporary differences delay or defer the payment of taxes to later years. As a result, at the end of each year the amount of the current tax liability and the postponed (deferred) liability must be recorded.

To illustrate, assume that at the end of the first year of operations a corporation reports $300,000 income before income taxes on its income statement. If we assume that Trump's tax cuts were repealed and Biden raised the income tax rate to 40%, the income tax expense reported on the income statement is $120,000 ($300,000 x 40%). However, to reduce the amount owed for current taxes, the corporation uses tax planning to reduce the taxable income to $100,000. Thus, the income tax usually due for the year is only $40,000 ($100,000 * 40%). The $80,000 ($120,000 - $40,000) difference between the two tax amounts is created by timing differences in recognizing revenue. This amount is deferred to future years. The example is summarized below.

To match the current year's expenses (including income tax) against the current year's revenue on the income statement, income tax is allocated between periods, using the following journal entry:

The income tax expense reported on the income statement is the total tax, $120,000, expected to be paid on the income for the year. In future years, the $80,000 in Deferred Income Tax Payable will be transferred to Income Tax Payable as the timing differences reverse and the taxes become due. For example, if $48,000 of the deferred tax reverses and becomes due in the second year, the following journal entry would be made in the second year:

Reporting and Analyzing Taxes

The balance of deferred income tax payable at the end of the year is reported as a liability. The amount due within one year is classified as a current liability. The remainder is classified as a long-term liability or reported in a Deferred Credits section following the Long-Term Liabilities section.

Differences between taxable income and income (before taxes) reported on the income statement may also arise because certain revenues are exempt from tax and certain expenses are not deductible in determining taxable income. Such differences, which will not reverse with the passage of time, are sometimes called permanent differences. For example, interest income on municipal bonds may be exempt from taxation. Such differences create no special financial reporting problems, since the amount of income tax determined according to the tax laws is the same amount reported on the income statement. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 560-563*

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