Accounting for Income Taxes under IAS/GAAP

Art Franczek

An investor looking at the annual report of any multinational company is likely to find a large amount in an account entitled «deferred taxes». In 1999 Daimler/Chrysler showed 1.9 billion dollars, Boeing Company also showed 1.9 billion dollars Bristol Meyers showed 415 million dollars and Goodyear 376 million, similar amounts are found on every company’s Balance Sheet.

What are Deferred Taxes? How are they computed under major accounting rules such as GAAP and IAS? What is the significance of these accounting methods for the Russian Accounting Reform? Before I begin to discuss these issues I think it would be instructive to review some of the tax accounting terms that are used in both IAS and GAAP:

Accounting Income is the aggregate income or loss for a period including extraordinary items as reported in the income statement computed under IAS / GAAP accounting rules.

Taxable Income (loss) is the amount of income (loss) for a period, determined in accordance with rules established by tax legislation.

Temporary Difference, A difference between IAS / GAAP rules and tax regulations with regard to the accounting for various expense and revenue items. For example, under IAS / GAAP bad debts are expensed using the reserve method while tax regulations require that a bad debt be actually written off before it can be deducted for tax purposes. The result is that an expense is incurred on the financial statements in one year that may not become deductible for tax purposes until the next year. Another example of a temporary difference is depreciation. For financial statement purposes a company might use straight – line depreciation while for tax purposes it might elect accelerated methods. The result is that a company has different amounts of depreciation on the same asset for tax and book purposes. In both these examples the total deductions are the same but the years in which they are taken are different.

Permanent Difference, A difference between IAS / GAAP rules and tax regulations in which an item of expense / income for accounting purposes will never be allowed as a deduction / income for tax purposes. A common example of a permanent difference is meals and entertainment expenses. For accounting purposes all of these expenses will always reduce income whereas under the tax regulations of most countries there are limitations as to the amount that can be deducted. This amount will never be deducted for tax purposes.

Deferred Method, Method for computing deferred taxes whose primary objective is to match tax expense with the related revenues and expenses included in pretax financial income. In determining the amount of deferred taxes, the emphasis is on the current period tax savings or the prepayment resulting from temporary differences. Future tax rates and changes have no relevance under the deferred method because the deferred amount and reversals are based on the tax rate existing in the period when the temporary differences arose.

Asset / Liability Method, Method of calculating deferred taxes in which the tax consequences of all events that have been re cognized in the financial statements must be recognized as either 1) taxes payable or refundable or 2) deferred tax liabilities or assets. Because deferred taxes are determined by future tax rates, the tax consequences of an event that produces a deferred asset or liability as measured using enacted tax rates applicable in future years. Thus, changes in tax rates will cause changes in deferred tax asset or liability.

Other terms, Some other terms that are found in both SFAS 109 (GAAP rules) and IAS 12 are comprehensive recognition, partial recognition, and tax planning strategies, valuation allowance and net operating loss carryovers.

For the past 60 years, GAAP and IAS rule making bodies have been debating the issue of Accounting for Income Taxes. After several pronouncements on the issue the US Accounting Principles Board issued APB 11 in 1967, which adopted the deferred (income statement approach) method of accounting for Deferred Taxes. By 1987 the US FASB (Financial Accounting Standards Board) determined that APB 11 was no longer adequate because it did not take into account many of the tax law and tax rate changes. As a result, SFAS 96 and its successor SFAS 109 were issued that require use of the liability method. The IASC has gone through a similar process in developing its standard on Accounting for Income Taxes. In 1979 IAS 12 was issued that allowed either a balance sheet or the deferred method in computing Deferred Taxes. In 1998 IAS 12 was revised and essentially emulates SFAS 109 with some distinctions by requiring the use of the Liability Method.

While the accounting rules for Income Taxes under both GAAP and IAS might seem complex they do accomplish the objective of keeping tax and financial accounting separate and independent of one another. The different purposes for each accounting system must always be kept in mind. Tax Regulations in any country are designed to raise revenue, regulate business activity, encourage investment, and redistribute income between various social groups. Tax regulations are in a constant state of flux and are the result of legislative compromises, as Bismarck once said, «making tax policy is like making sausage». Thus Income Tax returns have little relevance for potential investors since they simply reflect how aggressively the taxpayer has utilized the tax laws to report as little income as possible. Accounting rules under both GAAP an IAS were developed reflect the economic reality of a firm by providing relevant Financial Statements so that users can make informed decisions about a firm. Accounting does not change as frequently as Tax Regulations. Under both GAAP and IAS financial income is the starting point from which Taxable Income is generated by applying tax regulations to the same transactions that are already reflected on the financial statements. The two accounting systems are completely separate; a change in accounting rules has no impact on taxable income while a change in tax rules will only affect the amount of tax expense reported for financial purposes.

The two systems are reconciled by a schedule of temporary differences that lists differences between tax and financial accounting and by a change in the effective tax rate as a result of permanent differences between tax and financial rules.

The concepts of Deferred Taxes and Permanent differences can be more easily understood be reviewing the following example:

As we can see from this example, taxable income is derived from financial income by applying different rules for Bad Debts expense. As a result this firm books a deferred tax asset of 450 on it’s 1997 balance sheet, this amount will reverse in 1998 because it will be taken as a deduction for tax purposes at that time. The Current Tax Liability is always the amount that is owed to the Government. The effect of the Permanent Differences is an increase in the effective tax rate from the 30% statutory rate to a 33% rate for 1997 and a 34% rate for 1998. It must be noted that in this example the Deferrred method and Liability method would result in the same answer, this is because the rate is assumed to be the same for both years.

Over the past few months a number of articles have appeared in The Accounting Report that have discussed the effect that IAS implementation would have on the tax base for computing Russian Net Profits Tax. Other authors have suggested that IAS income could not be used as a starting point for calculating Net Profits Tax. Another article suggested that the Net Profits Tax Law would have to be significantly changed if IAS were implemented. As I have tried to illustrate in this article, a principle feature of IAS / GAAP is it’s complete separation from Tax Regulations. While IAS / GAAP income is used as starting point for the calculation of Taxable Income, all applicable Tax rules are applied to arrive at Taxable Income. Different methods of depreciation, accounting for bad debts, warranties, contingencies and many other differences are reflected in Temporary Differences, while Permanent Differences include such items as meals and travel expenses that are allowed for IAS / GAAP but not allowed as a deduction for Tax purposes. Virtually all companies using IAS / GAAP have detailed schedules showing the expense and income items that are handled differently for Tax and IAS / GAAP purposes.

In my opinion, the separation of IAS/GAAP from Tax Regulations is essential for the successful implementation of IAS in Russia.

Art Franczek is Associate Dean / Professor of Accounting / Taxation, American Institute of Business and Economics in Moscow. He can be contacted by tel / fax ( 095) 373 6241 or by e-mail artf@online.ru.