Question

• Case 12-3 Intraperiod versus Interperiod Income Tax Allocation Income tax allocation is an integral part of GAAP. The applications of intraperiod income tax allocation (within a period) and interperiod tax allocation (among periods) are both required.

Required:

a. Explain the need for intraperiod income tax allocation.

b. Accountants who favor interperiod income tax allocation argue that income taxes are an expense rather than a distribution of earnings. Explain the signifi cance of this argument. Do not explain the defi nitions of expense or distribution of earnings.

c. Discuss the nature of the deferred income tax accounts and possible classifi cations in a company’s balance sheet.

d. Indicate and explain whether each of the following independent situations should be treated as a temporary difference or a permanent difference.

i. Estimated warranty costs (covering a three-year period) are expensed for accounting purposes when incurred.

ii. Depreciation for accounting and income tax purposes differs because of different bases of carrying the related property. The different bases are a result of a business combination treated as a purchase for accounting purposes and as a tax-free exchange for income tax purposes

. iii. A company properly uses the equity method to account for its 30 percent investment in another company. The investee pays dividends that are about 10 percent of its annual earnings.

e. For each of the above independent situations, determine whether those situations that are treated as temporary differences will result in future taxable amounts or future deductible amounts and whether they will result in deferred tax assets or deferred tax liabilities. Explain

Answer 1

a.

Intraperiod tax allocation: Intraperiod tax allocation is the method of reporting extraordinary items like gain/ loss from discontinued operations, gain/ loss due to changes in accounting policies etc. net of taxes. Only items which arise out of normal operations are reported without deducting taxes from them rather income taxes are shown as a different line item.

Here the income tax expense of one year is distributed to the various sections of the financial statement.

Intraperiod tax allocation is needed in order to help the users understand the effect of income tax expense on the normal business operations. If extraordinary items are not reported net of taxes and the income tax expense for the company is reported as a whole, then the income statement would be misleading to the users to understand the impact of current income tax expense on the company’s earnings.

b.

Interperiod tax allocation: Interperiod tax allocation is the method of allocating income arising due to differences in IRS provisions and GAAP. Generally these differences are set off in future. For example: GAAP recognizes certain depreciation methods like Straight line, WDV etc whereas IRS let the company gain benefits through accelerated depreciation methods in order to help them in liquidity. This in turn results in income tax expense difference as per GAAP and as per IRS/ the actual income tax payable.

Such differences are deferred under interperiod tax allocation.

The given statement about the advocates of interperiod tax allocation is that the income tax expense on extraordinary items should also be deferred rather than reporting such items net of taxes. Also that income tax expense should be reported as a part of continuing operations.

The significance of such argument is to highlight the reason interperiod tax allocation is used where income taxes are deferred due to temporary differences in income tax expense reported and the income tax expense actually incurred.

c.

Deferred income tax asset: A deferred income tax asset is reported when the amount of income tax expense as per GAAP is lower than the actual income tax payable.

Deferred income tax liability: A deferred income tax liability is reported when the amount of income tax expense as per GAAP is higher than the actual income tax payable.

d.

Permanent difference: Permanent differences in income taxes arises where some expenses or revenues are recognized as per GAAP which are not allowed or exempt under IRS provisions.

Temporary differences: Temporary differences arises when the difference between the income tax expense as per GAAP and as per IRS is temporary in nature. For example: Depreciation allowed under IRS is greater in the starting years of the asset and lower in the ending years, if accelerated methods of depreciation is opted by the company in contrast, under GAAP it is not so. Hence a temporary difference arises.

i.

Estimated warranty costs expensed under a GAAP is generally allowed as expense by IRS as and when such expenses are actually paid off. Therefore, such difference is a temporary difference.

ii.

As discussed above under the definition of temporary differences. Depreciation is a temporary difference. But in the given case, it is clear that the exchange was a tax free exchange, making the income tax difference a permanent difference.

iii.

As the dividends received by the company is lower than the expected dividends, the difference due to such transaction is a permanent difference in nature. As the amount of income reported under the GAAP would be higher and the difference due to such reporting would increase the income tax expense reported under GAAP permanently if compared to the income tax under IRS.