Accounting for Income Taxes
You might ask yourself, what does accounting for income taxes mean?
Income tax is a government duty imposed on the profit which is earned by an individual or a corporation.
There are certain levels of tax liabilities involved in income taxes. These liabilities are imposed when the individual or a corporation lobbies for payable taxes on extension of deadlines, so that they would have to pay their due at a later and more convenient date to the relative jurisdiction holding agency. In this time, a certain amount of taxes is accrued which must be paid eventually. Liabilities are usually triggered by a number of transactions, such as;
I) Realization of operating income
II) Receipt of inheritance
III) Sale of assets
The basic explanation is; The Accounting for Income Taxes allows you to recognize these tax liabilities for estimated payable income taxes. It helps to determine the tax expenses for the running fiscal period.
There are several concepts which must be understood properly if you wish to gain a deeper understanding of accounting for income taxes. These concepts are prerequisites to its proper understanding. They are as follows;
1. Temporary Differences.
A business organization may record an asset or a liability at one particular value, mainly for the purposes of financial reporting, while it simultaneously maintains a separate record for the tax purposes, which is of entirely different value. This difference is mainly caused by tax recognition policies devised by the taxing authorities because they may require the deferral or the acceleration of certain class of items for tax reporting purposes. The differences are nonetheless only temporary, since they will be settled when the assets are inevitably recovered and liabilities settled. Such difference which results in taxable amount at a later date is called taxable temporary difference. While a difference which results in a deductible amount at a later date is called deductible temporary period. View following examples of temporary differences;
o) Revenues that are taxable before or after they are recognized in the financial statements. Like, an allowance for doubtful accounts may not immediately become tax
deductible, but instead may just be deferred temporarily until specific receivables are declared as bad debts.
o) Expenses or Losses that are tax deductible before or after they are recognized in the financial statements. Like, some fixed assets are readily tax deductible, but can unfortunately only be recognized through long-term depreciation.
o) Certain Assets which are reduced in tax basis by investment in the tax credits.
2. CarryBacks and CarryForwards.
A company may find itself in an unfortunate position where it has more tax deductions or tax credits than it can possibly use in the current fiscal year’s tax return. If such a situation arises, the company has the option of offsetting these amounts against the taxable income or tax liabilities of the tax returns in earlier or later periods, as it suits them. since the company can always apply for tax refunds, carrying these amounts back to the tax returns is more valuable. Therefore, these excess tax deductions or tax credits are carried back, with any remaining amount is reserved for future use. CarryForwards expire if they are not used within certain time period. A company must recognize a receivable for the amount of taxes paid in prior years that have been deemed refundable due to a CarryBack. A certain tax asset which has been deferred can be realized for a CarryForward. But it could also offset valuation allowance that is based on probability that some portion of CarryForward will not be realized.
3. Deferred Tax Liabilities & Assets.
As a result of the presence of temporary differences, the deferred tax assets and deferred tax liabilities take place. They represent the changes in taxes payable or refundable potentially in future periods.
All these above mentioned and explained factors can result in quite complex calculations to arrive at the appropriate income tax information to recognize and report in the relevant financial statements.
Essential Accounting for Income Taxes
Despite there being an inherent complexity in calculation and manipulation of income taxes, the essential accounting in this area is derived from the absolute need to recognize two particulars, which are:
I) Current year. The recognition of a tax liability or tax asset, based on the estimated amount of income taxes payable or refundable for the running fiscal year.
II) Future years. The recognition of a deferred tax liability or tax asset, based on the estimated effects of CarryForwards and temporary differences in the future years.
Based on all the preceding points, the general accounting for income taxes is in following steps;
1. Create a tax liability for estimated taxes payable, or create a tax asset for tax refunds that relate to the current or previous years.
2. Create a deferred tax liability for the future taxes payable or create a deferred tax asset for future tax refunds that can be attributed to temporary differences and CarryForwards.
3. Calculate Total income tax expense in the paid.