Introduction

A company’s taxable income determines its income tax liability. It is the government fee a company must pay to operate.

If timing problems cause the firm’s pretax accounting income to differ from its taxable income, what is its tax expense? Should it use the firm’s pretax accounting income or taxable income?

Accounting professionals believe a company’s tax expense shouldn’t be based on its taxable income. Instead, the matching principle demands that the period’s tax expense be based on accounting income before taxes.

Current accounting standards necessitate interperiod income tax allocation.

Interperiod Tax Allocation Definition

Interperiod income tax allocation allocates income tax expenses to revenue and expense periods.

All applicable taxes are assessed against a company’s pretax accounting income rather than taxable income for calculating tax expenses. Whatever time taxes are paid, this happens.

This is similar to accruing a liability for wages in the current period as they are incurred, even though earnings are not paid until the next period.

Example

Imagine that Price Corporation utilizes the same accounting rules for financial reporting and tax reasons, except for depreciation, to illustrate interperiod income tax allocation.

The corporation employs straight-line depreciation for financial reporting and ACRS for taxes.

In early 2015, Price Corporation bought a light truck. Accounting gives the truck a five-year life, whereas ACRS gives it a three-year class life. Calculations for annual depreciation by technique are below.

The top of the exhibit demonstrates how annual tax expense is determined. Straight-line depreciation at $2,000 per year determines income before taxes.

Income tax expense ranges from $3,200 in 2015 to $7,200 in 2019 at 40%.

The exhibit’s bottom shows how annual taxes are computed. This scenario uses ACRS depreciation for taxable income.

Since the truck has a three-year class life, full depreciation occurs in the first three years. In 2015, income tax is $3,000; in 2019, $8,000

Over the five years, both situations have the same total depreciation expense, taxes, and net income. Both scenarios include $10,000 in depreciation, but they are allocated differently over 5 years.

When salvage values are neglected and an asset is held for life, this is normal.

Journal entries for income tax expense

These entries illustrate that all expenses are based on pretax accounting income and payables on taxable income.

The $200 difference credits the Deferred Income Tax account in 2015. The account is now a deferred tax credit. Deferred tax charges occur when Deferred Income Tax has a debit balance at the end of an accounting period.

Similar entries in 2016 and 2017 boost the Deferred Income Tax account credit.

Since the timing discrepancy flips in 2018 and 2019, Tax Payable exceeds Tax Expense. Each year, Deferred Income Tax is debited $800.

Deferred Income Tax credits appear on the liabilities portion of the balance.

However, Deferred Income Tax debit balances are represented on the asset side of the balance sheet as deferred tax charges.

A similar question is whether Deferred Income Tax is a current or non-current asset liability.

The asset or liability that generated the delayed charge or credit determines its classification, according to FASB.

The deferred income tax charge or credit should be current if the timing difference is related to a current asset like inventory.

If the timing discrepancy is attributable to a noncurrent asset like equipment, the deferred income tax charge or credit should be noncurrent.

Interperiod Tax Allocation Issues

Interperiod income tax allocation remains controversial in accounting.

Academic research shows that deferred tax credits have grown in use and are a substantial problem for many corporations.

The ACRS method of depreciation and accelerated tax depreciation before it are the main reasons.

Companies with stable/rising investments in depreciable assets that use straight-line depreciation for pretax accounting income and ACRS for taxable income would likely have a growing Deferred Income Tax credit balance.

Even while asset-specific time discrepancies reverse, persistent investment in higher-priced assets permanently delays their total reversal.

As ACRS depreciation reverses on older assets, it is compensated by higher-priced assets purchased in the current year. Deferred tax credits may not be liabilities if this is true.

Liability is the likely loss of economic advantages.

If the timing discrepancy does not reverse, the deferred tax credit will never be decreased, making the future monetary sacrifice due to increased income taxes impossible.

Example

Anheuser-Busch Companies had $357.7 million and $455.1 million in deferred income tax accounts in 2018 and 2019.

Over 21% and 19% of total liabilities and 30% of stockholders’ equity in both years.

Over 70% of Anheuser-Busch’s deferred tax account has grown since 2017. This rise is the difference between the company’s annual tax provisions and its government payments.

Anheuser-Busch’s effective tax rate between 2017 and 2020 was 36%, despite the 46% statutory tax rate.

If this tendency continues, the $455 million of deferred taxes on the liability portion of the balance sheet may never be paid.