Temporary Differences

Required:
a. Define the term temporary difference.
b. List the examples of temporary differences contained in SFAS No. 109. c. Defend inter-period income tax allocation.

a. Temporary Difference – Definition

An assumption inherent in an enterprise’s statement of financial position prepared in accordance with generally accepted accounting principles is that the reported amounts of assets and liabilities will be recovered and settled, respectively. Based on that assumption, a difference between the tax basis of an asset or a liability and its reported amount in the statement of financial position will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled (SFAC No. 109, par. 11).

Income tax liabilities (or assets) can arise when the amount of pretax income reported on a company’s income statement is not the same as what is reported on the company’s income tax return. These differences arise since the income tax laws measure income differently than GAAP: tax accounting is performed on a cash basis, whereas GAAP uses the accrual basis. Therefore, temporary differences will arise when a company’s tax return and income statement report revenues and expenses in different years. When these temporary differences exist, companies determine income tax expense based on the income reported on the income statement, which is often different from the amount of taxes payable to the government.

Although the temporary difference originates in one period, it reverses in subsequent periods and the tax laws permit companies to delay reporting their income as part of taxable income, therefore the company also delays paying taxes on that income. The temporary differences are due primarily to timing differences, since the timing of revenues, gains, expenses or losses in income often occurs in a different period from taxable income (Schroeder et al., 2011). It is also important to note that temporary differences affect multiple accounting periods and therefore income taxes are allocated between these accounting periods. Deferred tax assets are recognized as deductible temporary differences, whereas deferred tax liabilities are recognized as taxable temporary differences (Leahey, 1993). b. Temprary Differences – SFAS 109

Examples of temporary differences from paragraph 11 of SFAC No. 109 are listed below: a. Revenues or gains which are taxable after they are recognized in financial income. An asset (e.g. a receivable) may be recognized for revenues or gains that will result in future taxable amounts when the asset is recovered.

b.Expenses or losses which are deductible after they are recognized in financial income. A liability (e.g. a product warranty) may be recognized for expenses or losses that will result in future tax deductible amounts when the liability is settled.

c.Revenues or gains which are taxable before they are recognized in financial income. A liability (for example, subscriptions received in advance) may be recognized for an advance payment for goods or services to be provided in future years.

d. Expenses or losses that are deductible before they are recognized in financial income. The cost of an asset such as depreciable personal property may have been deducted for tax purposes faster than it was depreciated for financial reporting.

e.A reduction in the tax basis of depreciable assets because of tax credits.

f.An increase in the tax basis of assets because of indexing whenever the local currency is the functional currency.

g.An increase in the tax basis of assets because of indexing whenever the local currency is the functional currency. The tax law for a particular tax jurisdiction might require adjustment of the tax basis of a depreciable (or other) asset for the effects of inflation.

h.Business combinations accounted for by the purchase method. There may be differences between the assigned values and the tax bases of the assets and liabilities recognized in a business combination accounted for as a purchase under APB Opinion No. 16, Business Combinations. c.Inter-period Income Tax Allocation – A Defense

It is critical to understand that the transaction events which give rise to timing differences are economic in nature and therefore have economic consequences. The question then becomes how to best reflect those economic consequences in the financial statements. Inter-period income tax allocation considers the tax consequences of transaction events such as revenue, expenses, gains, and losses and associates these items with the period in which these events are recognized. In other words, inter-period tax allocation is consistent with the basic tenets of accrual accounting. Underlying this method is the understanding that there is a direct economic relationship between identifiable transactions reflected in the financial statements and related income tax effects (Arthur et al., 1984). Therefore, each transaction has a tax effect.

Information based on accrual accounting has historically and empirically provided a better indication of a company’s ability to generate cash flows than information gathered under the cash method. If there is not inter-period allocation, then the information is not as meaningful and will result in a mismatching of economic benefits and costs. One example might be a company that claims accelerated tax depreciation, where it sacrifices a future benefit to enjoy a current reduction. If there is no inter-period allocation then only one side of the exchange is reported – a reduction in taxes that is currently payable – but the cost associated with the sacrifice of the asset’s tax deductibility is ignored (Arthur et al., 1984).

Timing differences also reverse and are not permanent. When the temporary differences reverse, the tax consequences are settled in cash or new transactions that occur in the reversal period, which serve to offset the reversal by creating new timing difference which reverses in a later period (Arthur et al., 1984). It is also important to consider the conceptual framework of the asset/liability approach or balance sheet effect which argues for a perspective that extends beyond accounting for deferred taxes. As specified in SFAC 6, assets represent probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events, whereas liabilities are defined as probable future sacrifices of economic benefits as a result of past transactions or events. Therefore, inter-period tax allocation is consistent with the conceptual principle of reporting the future tax sacrifice or benefit that is attributable to temporary differences between the reported amount of an asset or liability in the financial statements and its tax basis, not to mention that research also supports the notion that deferred tax liabilities are viewed by investors as real liabilities (Spiceland et al., 2011).

Since assets and liabilities result from past or current transactions, it is not appropriate to defer accounting for the transaction just because a ‘yet to be recorded’ future transaction might nullify it i.e. accrual accounting addresses the economics of transactions that have occurred as well as the economic consequences of those transactions (Arthur et al., 1984). Therefore, the allocation of inter-period taxes recognizes that the present effect of timing differences is based on past events and that future events are subject to tax effects that will be accounted for when they occur. It is important to bear in mind that revenues are earned from utilizing assets, not purchasing them, and that under inter-period tax allocation income recognition is based upon the principles of GAAP – not the tax code (Arthur et al., 1984).

References

Arthur, R. W., Dieter, R., & John, E. S. (1984). Tax allocation revisited. The CPA Journal (Pre-1986), 54(000003), 10-10. Retrieved from: http://search.proquest.com/docview/211895970?accountid=12085 Leahey, A. L. (1993). Grasping the fundamentals of SFAS 109 – accounting for income taxes. The CPA Journal, 63(10), 54-54. Retrieved from: http://search.proquest.com/docview/212303289?accountid=12085 Schroeder, R.G., Clark, M.W., & Cathey, J.M. (2011). Financial Accounting Theory
and Analysis: Text and Cases, (10th ed.). New Jersey: John Wiley and Sons Inc. Spiceland, J.D., Sepe J.F., & Nelson, M.W. (2011). Intermediate Accounting (6th ed.). New York, NY: Mcgraw-Hill/Irwin.