Income taxes and interperiod tax allocations
Interperiod tax allocations simply means the allocation of income tax expense to the correct period through the accounting of current income taxes and deferred taxes . Income taxes are the amounts due to the tax authorities associated with the company’s income.
They can either be due in the current period (i.e., current income tax) or in a future period (i.e., deferred tax).
Tax reconciliation
To understand the concepts of income tax better, it is best to be familiar with the two types of income and how they reconcile to each other.
Note 1: Permanent differences
These are income and expenses that will never be taxable or deductible under income tax rules - for example, tax-exempt income or nondeductible expenses. Since they never affect taxable income, no deferred tax is recognized on them.
Note 2: Temporary differences
These are income and expenses that are taxable or deductible only in the future. To compute the taxable income, we need to remove these items from the accounting income because they are not yet taxable or deductible. These are called “temporary differences” because when certain conditions are finally met, they can form part of the taxable income in a future time. Finally, taxable temporary differences become the basis for the deferred tax accounting. These are discussed in more detail in succeeding sections.
Note 3: Taxable temporary differences
These are temporary differences that will increase taxable income in a future period - for example, when tax depreciation is claimed faster than book depreciation. Taxable temporary differences become the basis for a deferred tax liability.
Note 4: Deductible temporary differences
These are temporary differences that will decrease taxable income in a future period - for example, an expense accrued for book purposes but not deductible until it’s paid. Deductible temporary differences become the basis for a deferred tax asset.
Deferred income taxes - introduction and journal entries
These arise from temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their tax bases. These differences can lead to either deferred tax liabilities or deferred tax assets, depending on their nature. This concept aligns with the accrual basis of accounting, where income taxes are recognized in the period the related transaction affects the income statement, regardless of when the tax payment is due.
For instance, if a transaction is recognized in the current period’s income statement but is taxable in a future period, the associated tax effect is already accrued in the current period even though we are not expected to pay the taxes in right now. This approach ensures that the financial statements accurately reflect the company’s tax obligations corresponding to its reported earnings.
For example, say accounting income is , taxed at an enacted rate of . It includes of tax-exempt interest (a permanent difference) and of excess tax depreciation (a taxable temporary difference reversing later). Taxable income is:
Current tax expense is . Since the difference will increase taxable income later, it also creates a deferred tax liability of . The journal entry to record the deferred portion is:
| Account | Debit | Credit | Financial statement element |
| Deferred tax expense | $10,500 | Expense | |
| Deferred tax liability | $10,500 | Liability | |
| To record deferred tax liability from a $50,000 taxable temporary difference (excess tax depreciation) | |||
The deferred tax liability represents future income tax payable. The logic reverses for deductible temporary differences: say the company also accrues a warranty expense for book purposes that isn’t deductible until paid. This creates a deferred tax asset of :
| Account | Debit | Credit | Financial statement element |
| Deferred tax asset | $6,300 | Asset | |
| Deferred tax expense | $6,300 | Expense | |
| To record deferred tax asset from a $30,000 deductible temporary difference (warranty accrual) | |||
The deferred tax asset represents future deductible amounts.
In the next section on temporary differences, we’ll cover specific sources and examples of deferred tax items.
Temporary differences
Temporary differences are income or expenses that are not recognized at the same time in the accounting income and taxable income. This is the reason why these are also called timing differences.
Whenever there are timing differences, it means that the current income tax (based on the taxable income) is incomplete because we also need to accrue the tax impacts of the temporary differences.
Accounting for temporary differences can either result in:
- deferred tax liability; or
- deferred tax asset.
Determining whether a temporary difference gives rise to a deferred tax liability (DTL) or a deferred tax asset (DTA) often comes down to comparing accounting income with taxable income. In simple terms, it is a matter of identifying whether revenues, expenses, or net income are reported earlier or later in the accounting records than in the tax return.
The concept can be summarized in the following illustration:
Under ASC 740, deferred tax assets and liabilities are always classified as noncurrent, regardless of when the temporary difference reverses. Within each tax jurisdiction, they’re offset and presented as a single net noncurrent amount; amounts from different jurisdictions aren’t netted together.