The proper reporting of tax liabilities is covered by statement number 109 of the Financial Account Standards Board (FASB). In it, the FASB outlines the proper reporting standards for the effects of income taxes resulting from a company’s activities. The primary objectives of these standards are to recognize not only the amount of taxes payable for the current reporting year, but also any deferred tax liabilities and assets for the future tax consequences of events that have already been reported on in the company’s financial statements or tax returns.
The standards set forth in FASB 109 are based on a few key principles:
- First, a current asset or liability account is recognized to the extent that there are current year taxes payable or refundable.
- Second, a company must recognize a deferred tax liability or asset in the amount of any estimated future taxes that can be reasonably attributed to temporary tax differences or carryforwards.
- Third, the recognition of any deferred tax assets is to be reduced by any tax assets that are not reasonably expected to be realized.
If there is a difference between the amount of recognized income or loss in a given year that is allowed by tax laws, as opposed to financial reporting standards, then these temporary differences must be recognized on the financial statements as deferred tax assets or liabilities. These accounts will be gradually drawn down over time as the deferred impact of the reporting differences are gradually recognized. For example, revenue may be recognized in the current year under generally accepted accounting principles (GAAP), but deferred under applicable tax laws, which will result in a deferment in the recognition of taxable income to later years; in this case, a tax liability will be created in the amount of the applicable tax that has been deferred. On the other hand, an increase in the deferred asset account for taxes will occur if the tax laws require a company to defer the recognition of expenses that have already been recognized under GAAP, since these can be used at a later date to reduce the amount of taxable income.
There are also differences between taxable and GAAP reporting that are permanent differences—that is, the differences between the two reporting methods will never be reconciled. An example is the interest income on municipal bonds, which is recognized in the financial records, but is permanently excluded from reportable income on the tax records.
When permanent differences are involved, no asset or liability is recorded on the financial records, since there is no prospect of the differences ever being recognized.
The first step in calculating deferred tax assets and liabilities is to itemize the nature and amount of each type of loss and tax credit carryforward, as well as the remaining time period over which each carryforward is expected to extend.
Next, we separately summarize the total deferred tax liability for all temporary differences and the total deferred asset related to all carryforwards.
The final step is to ascertain the amount (if any) of a valuation allowance needed to offset the deferred tax asset. This allowance can be necessary if there is evidence that some proportion of the deferred tax asset may not be recognized. For example, there may be an expectation that the full amount of a credit carryforward cannot be offset against a sufficient amount of income during the upcoming time period during which the tax laws allow a company to use the credit.
The estimates used to create the allowance will require a great deal of judgment, so the FASB has added some guidelines that take away some of the uncertainty. It requires one to review several sources of likely future income against which the carryforwards can be offset, which are the:
- future reversal of temporary tax differences;
- future taxable income that will arise, exclusive of the reversal of any temporary tax differences;
- tax planning strategies; and
- existing taxable income for which carrybacks are permitted.
If there is a reasonable basis for a taxable source of revenue income from any one or a combination of these four items, then there is no need for a valuation allowance.
Also, all reasonable forms of evidence regarding future expectations for taxable income should be included in the review. It is also possible to take into account during the review the presence of any tax strategies that a prudent company would consider in order to take advantage of and use any tax assets in the future. As a result of the review, a valuation allowance should be set up if it is more likely than not that there will not be sufficient taxable income in the future to offset any tax assets. However, it is not allowable to set up a valuation allowance when there is no clear need for one.
When these calculations are completed, it is necessary to separately report the deferred liability, deferred asset, and valuation allowance for the deferred asset on the balance sheet. In the first year when this entry is made, a company can include the entire adjustment in net income as of the beginning of the year of adoption of the FASB 109 rules, or it can restate the financial results of prior years to include the changes, which yields a better year-to-year comparison of financial results.
After the correct entries are booked, the accountant’s job is still not complete, for the entries may require periodic updates to reflect changes in the tax rates that apply to the company.
The tax rate at which a tax liability or asset is computed for financial statement reporting purposes is either the maximum tax rate to which the business is generally subject (assuming that its income is always so high that it exceeds any graduated rates) or else an average rate for the general range of tax rates within which its taxable income usually carries it. If there is a change in the tax laws that results in a different income tax rate structure, then the journal entries used to record the tax liabilities and assets must be altered to more appropriately reflect the new tax rates. For example, if a company has a tax asset, an increase in the tax rate will result in an increase in the recorded asset. This change to the financial records should take place as of the day when the new tax rates take effect. The entire effect of a change in tax rates on the reporting of deferred tax assets or liabilities is recorded in the period when the tax rate change occurs.