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Chapter 12 - Solution Manual

Applying income tax allocation to all temporary

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Applying income tax allocation to all temporary differences as is done for comprehensive income tax allocation is inappropriate. Comprehensive income tax allocation distorts economic reality. The income tax regulations that cause the temporary differences will continue to exist. For instance, Congress is not likely to reduce investment incentives with respect to depreciation. Consequently, future investments are virtually certain to result in originating depreciation differences of an amount to at least offset reversing differences. Thus, consideration should be given to the impact of future, as well as historical, transactions. Instead, we believe that only those temporary differences that will reverse will result in future cash flows and thus result in deferred tax amounts that meet the definitions of assets and liabilities. In these cases, there will be probable future benefits that are eventually realizable from deferred tax assets and probably future cash outflows that will eventually be incurred from deferred tax liabilities. Thus, the resulting deferred tax assets and liabilities that are reported under partial income tax allocation will be assets and liabilities and will meet the qualitative characteristic of relevance. They will help the user to determine the financial position of the company and as well as its performance. Moreover, because they will results in eventual future cash flows, the assessment of a company’s future cash flows is enhanced by using the partial allocation approach. Since the deferred income taxes (if any) reported on a company’s balance sheet under partial allocation should actually reverse rather than continue to grow, partial allocation would better reflect future cash flows than either comprehensive tax allocation or no income tax allocation. Team 1’s arguments are flawed. Nonallocation of a company’s income tax expense hinders the determination of the company’s assets and liabilities as well as the prediction of its future cash flows. For those temporary differences that will reverse, nonalloction will distort the balance sheet and the income statement. Items that meet the definitions of liabilities and assets and are measurable will not be reported. Future cash flows that will result from the partial recognition of deferred tax assets and liabilities will not be readily determinable. The user will only see the current period obligation for income taxes that result from items reported in the income statement, not the impact on income taxes that will result from both present and future cash flows resulting from transactions and events that have already occurred. WWW Case 12-8
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275 When income tax rates increase, the new rate is used to calculate deferred tax assets and liabilities.
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