Efficient Tests of Balances Series—No. 29: Auditing Income Taxes

UNDERSTANDING DIFFERENCES BETWEEN BOOK AND TAX INCOME

Basic Principles of Accounting for Income Taxes

The basic principles of accounting for income taxes are:
  • A current tax liability or refundable amount from the current year’s tax return is recorded.
  • A deferred tax liability or asset is recognized, normally at marginal tax rates, for the estimated future tax effects of temporary differences and tax carryforwards.  Permanent differences, such as non-taxable interest on state or local obligations, are considered events that do not have tax consequences and are not reflected in the accounting for deferred tax liabilities or assets.
  • Tax laws in effect at the time of measurement are used to calculate deferred tax liabilities and assets.
  • Deferred tax assets are adjusted at measurement dates with valuation allowances based on realization expectations.
Common Book/Tax Differences

ACCOUNTING TREATMENT TAX RETURN TREATMENT
1. Installment sale—Not recognized unless collectability of receivable is in doubt. 1. Installment sale—Prorata portion of gain is recognized as payments are received.
2. Bad debts—Allowance method is the only generally accepted method. 2. Bad debts—Only the direct write off method is allowed for tax purposes.
3. Overhead in inventories—Only manufacturing overhead can be allocated to work-in-process and finished goods. 3. Overhead in inventories—IRC Section 263(a) allows allocation of certain general and administrative expenses to inventories.
4. Depreciation methods and rates—Must be comparable to the useful lives of assets. 4a. Depreciation methods and rates—Accelerated methods can be elected.
4b. IRC Section 179 property—Listed property can be written off within limits.
5. Construction contracts—Only percentage of completion method may be used for long-term contracts. 5. Construction contracts—Large contracts on percentage of completion; small contracts on accrual or cash methods.
6. Rent received in advance—Deferred until it is earned. 6. Rent received in advance—Taxable in the year received under cash or accrual methods.
7. Estimated litigation expenses—Recognized when they become known and subject to estimation. 7. Estimated litigation expenses—Deductible when actual expenses are paid or accrued.


Deductible and Taxable Differences

Differences between book and tax accounting methods are either permanent or temporary differences.  Permanent differences are those events that have no tax consequences, such as interest income on state or municipal obligations, and are not considered in accounting for deferred income taxes.  Events that have deferred tax consequences cause temporary differences.

When future taxable income will be less than future book income, the difference is a future deductible difference that produces a deferred tax asset. To say it another way, a difference that results in a future tax deduction produces an asset that will be recovered as the future deductions occur.

When future taxable income will be more than future book income, the difference is a future taxable difference that produces a deferred tax liability. Again in other words, a difference that results in an increase in future taxable income creates a deferred tax liability which must be satisfied when the future taxable income is reported.

Efficient substantive procedures for income taxes and other account classifications resulting from cost-beneficial audit strategies are discussed in my live and on-demand webcasts which can be accessed by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com.



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by Larry Perry, CPA, CPA Firm Support Services, LLC - Larry has over 40 years experience as a CPA practitioner, author of accounting and auditing manuals, author and presenter of live staff training seminars and author of webcast and self-study CPE programs.  He is co-founder of CPA Firm Support Services, LLC (www.cpafirmsupport.com), an organization providing resources, training and consulting to smaller CPA firms.  Larry writes a weekly blog on AccountingWEB.com focusing on small audits, reviews and compilations.  He is currently developing documentation manuals and handbooks for small audits, reviews and compilations and related electronic practice aids.

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