Efficient Tests of Balances Series--No. 28: Accounting Standards Guiding the Audit of Income Taxes

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For most small to medium-size entities, auditing procedures will include the scheduling and calculating of deferred income tax expense, deferred tax assets and deferred tax liabilities. For this reason, we’ll first focus on obtaining a basic understanding of SFAS No. 109, Accounting for Income Taxes, and the application of its basic concepts.  The next blog will explore the basic concepts of FIN No. 48, Accounting for Uncertainty in Income Taxes.

Summary of SFAS No. 109, Accounting for Income Taxes (Excerpted from www.fasb.org/summary/stsum109.shtml&pf=true )

This Statement establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise's activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting for income taxes.

Objectives of Accounting for Income Taxes:

The objectives of accounting for income taxes are to recognize (a) the amount of taxes payable or refundable for the current year and (b) deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an enterprise's financial statements or tax returns.

Basic Principles of Accounting for Income Taxes:

The following basic principles are applied in accounting for income taxes at the date of the financial statements:

  1. A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year.
  2. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards.
  3. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated.
  4. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.

Temporary Differences:

The tax consequences of most events recognized in the financial statements for a year are included in determining income taxes currently payable. However, tax laws often differ from the recognition and measurement requirements of financial accounting standards, and differences can arise between (a) the amount of taxable income and pretax financial income for a year and (b) the tax bases of assets or liabilities and their reported amounts in financial statements.

Deferred Tax Consequences of Temporary Differences:

Temporary differences ordinarily become taxable or deductible when the related asset is recovered or the related liability is settled. A deferred tax liability or asset represents the increase or decrease in taxes payable or refundable in future years as a result of temporary differences and carryforwards at the end of the current year.

Deferred Tax Liabilities

A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years. For example, a temporary difference is created between the reported amount and the tax basis of an installment sale receivable if, for tax purposes, some or all of the gain on the installment sale will be included in the determination of taxable income in future years. Because amounts received upon recovery of that receivable will be taxable, a deferred tax liability is recognized in the current year for the related taxes payable in future years.

Deferred Tax Assets

A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards. For example, a temporary difference is created between the reported amount and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated expenses are not deductible until a future year. Settlement of that liability will result in tax deductions in future years, and a deferred tax asset is recognized in the current year for the reduction in taxes payable in future years. A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.

Measurement of a Deferred Tax Liability or Asset:

This Statement establishes procedures to (a) measure deferred tax liabilities and assets using a tax rate convention and (b) assess whether a valuation allowance should be established for deferred tax assets. Enacted tax laws and rates are considered in determining the applicable tax rate and in assessing the need for a valuation allowance.

All available evidence, both positive and negative, is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed for some portion or all of a deferred tax asset. Judgment must be used in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists (a) the more positive evidence is necessary and (b) the more difficult it is to support a conclusion that a valuation allowance is not needed.

Changes in Tax Laws or Rates:

This Statement requires that deferred tax liabilities and assets be adjusted in the period of enactment for the effect of an enacted change in tax laws or rates. The effect is included in income from continuing operations.

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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