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Intermediate Accounting

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16 Income Taxes Overview Financial accounting for income taxes is far more complicated then what you have experienced thus far. Previously, you probably saw income tax expense being simply recorded as “income before taxes” multiplied by a given rate. Unfortunately, accounting for income taxes isn’t quite that easy. Otherwise, an entire chapter—this chapter— would, obviously, not be needed. Having already taken a tax course before this chapter can be useful, but it is not absolutely essential. This chapter will emphasize how financial accounting is affected by different kinds of tax adjustments, rather than your knowledge of specific tax rules and regulations. Taxable income and financial income are almost always two different numbers. Hence, merely multiplying financial “income before taxes” by a constant rate every year would distort what is actually happening. Frequently, the differences between the two (financial and taxable income) are made up of numerous, even dozens, of different adjustments. There are two different kinds of adjustments. One kind is called temporary because the adjustment will reverse itself in a different year. Temporary adjustments relate to timing differences. The tax law requires a different timetable for the recognition of some revenue and expense items. Over the life of a business, the total revenue and expenses are the same for financial and taxable income when it comes to temporary adjustments. The other kind of adjustment is called permanent. Permanent differences result when an item of revenue or expense is never recorded for taxable income but is for financial income or vice versa. When a company has higher taxable income now (due to more revenue or fewer expenses on a tax basis) relative to financial income, and it is due to temporary differences, that means the company will have lower taxable income later (again, relative to financial income). Lower taxable income and, hence, taxes later is a future economic benefit, and that sounds like our definition of an asset. Hence, a company in this situation will report a deferred tax asset.
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16-2 Chapter 16 If, on the other hand, a company has lower taxable income now, relative to financial income, it means the time to pay the piper will come later. Future obligations sound like liabilities, and indeed, that is the case here as well. Hence, a company in this situation will report a deferred tax liability. That’s not so difficult, right? Well, the prior discussion begins to scratch the surface, but there is even more to it than that. We also have to consider changing tax rates, the effect of net operating losses getting carried back and forward to offset taxable income, and several other issues. Plus, most companies don’t have just one adjusting item, so things can get messy when there are many adjustments going different ways and on differing schedules. It’s time to roll up your sleeves and get a little mess on you because this topic takes more than a bit of common sense and skimming over to master.
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