Chapter 12 - Solution Manual

Income taxes are different from other expenses

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Income taxes are different from other expenses; therefore, allocation in a manner similar to other expenses is irrelevant. Expenses are incurred to generate revenues; income taxes generate no revenues. They are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues. They are simply period costs that are incurred as obligations to the government as a result of operating the total business at a taxable profit for the tax year. In our opinion, interperiod tax allocation hides an economic difference between a company that employs tax strategies in order to reduce current tax payments (and as a result, is economically better off) and one
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273 that does not. According to SFAC No. 1 , financial statements should provide information that is useful for the reader to evaluate the performance of the company and thus to determine its value. Obscuring the economic benefits that result from effective tax strategies may mislead a potential investor and thus may result in suboptimal allocation of economic resources. SFAS No. 1 also states that financial information should help the user to predict future cash flows. Reporting a company’s income tax expense at the amount paid or currently payable is a better predictor of the company’s future cash outflows because many of the deferred taxes will never be paid, or will be paid only in the distant future. Another argument against income tax allocation is that it entails an implicit forecasting of future profits. For example, a deferred tax liability implies that there will be taxable income in the future on which income taxes will be paid. Also, a deferred tax asset implies that there will be future taxable income that can be offset or reduced by a future deductible amount, otherwise the deferred tax asset provides no future benefit. To incorporate such forecasting into the preparation of financial information is inconsistent with the long-standing principle of conservatism. It also violates the concept of representational faithfulness because a deferred tax liability may never be paid, or the deferred tax asset may never be realized. In these cases they do not meet the definitions of liabilities or assets. We believe that the most powerful argument against any income tax allocation is that there is no present obligation for the potential or future tax consequences of present or prior transactions because there is no legal liability to pay taxes until an actual future tax return is prepared. If there is no obligation to pay taxes on any future taxable amounts, how can the deferred tax liabilities meet the definition of a liability. Since no tax return has been prepared that includes the future taxable amounts and no taxes are due until a tax return is prepared, there has been no event or transaction to cause a liability to have been incurred.
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