Income Tax Accounting
Income Tax Accounting involves the systematic recording and reporting of a business's income tax obligations, which can significantly impact financial statements. A key aspect of this field includes understanding net operating losses (NOLs), which occur when a business’s allowable deductions exceed its taxable income during a given year. NOLs can often be carried back to offset past taxable income or carried forward to reduce future tax liabilities, thereby providing potential tax relief for businesses, especially startups experiencing initial losses.
Additionally, valuation allowances play a crucial role in assessing deferred tax assets, which represent future tax reductions that may not always be realized. According to accounting standards, organizations must evaluate whether these deferred tax assets are likely to be utilized based on factors such as historical profitability and future income projections. The distinction between Generally Accepted Accounting Principles (GAAP) and tax code is also notable, particularly for non-profit organizations, as these differences can affect how income and expenses are recognized. Overall, income tax accounting encompasses various strategies and regulations that influence how entities manage their tax liabilities and report their financial health.
Income Tax Accounting
This article focuses on how net operating losses and valuation allowances have an affect on income taxes. In addition, there is a discussion on income tax disclosures. Finally, the article compares and contrasts GAAP and tax code, especially as the two views affect non-profit organizations. A net operating loss occurs when the annual deductions are greater than the taxable income for the year. Studies show that change in the current period, income is a significant determinant of changes in valuation allowance. Changes in valuation allowance have a negative impact on changes in current income.
RESEARCH STARTERS
ACADEMIC TOPIC OVERVIEWS
Accounting > Income Tax Accounting
Overview
This article highlights some of the events that affect income taxes. Two of these events are net operating losses and valuation allowances. Each of these events is discussed in detail so that the reader has an understanding of the impact each of the two events has on income taxes.
Net Operating Losses
When does a net operating loss (NOL) occur? A net operating loss occurs when the annual deductions are greater than the taxable income for the year. Also, there is a net operating loss when the taxable income is negative. There are a number of reasons why a net operating loss is reported. For example, it could be due to deductions from a business, the cost of renting property, and casualty and theft losses. In most cases, net operating loss occurs as a result of a business operating in the red. The business may have a year where the expenses incurred exceed the revenue that has been generated. This is very common, especially for new businesses during the first couple of years.
Claiming a Net Operating Loss
The year that the NOL occurs is called the NOL year. However, the loss may be carried forward or back to another tax year and applied against the taxable income for that given year. The deduction for net operating loss can be claimed by individuals, estates and trusts. Unfortunately, partnerships and S corporations usually cannot claim a net operating loss. However, partners and shareholders of partnerships and corporations can take their individual shares of business income and deductions into account when calculating their individual net operating losses (Hagen,
Deductions not Included in Declaring Net Operation Loss
In order to claim a net operating loss on an income tax return, one must calculate the amount that can be taken as a deduction to be applied against the taxable income from another year. According to Hagen (n.d.), one must evaluate which deductions can or cannot be included in the net operating losses. Some of the deductions not included in net operating losses are:
* Personal exemptions
* Section 1202 exclusion of 50% of gains from the sale or exchange of qualified small business stock. One must add back any gain that was excluded when calculating the net operating loss.
* The excess of non-business capital losses over non-business capital gains (does not include the Section 1202 exclusion). There is a limit on the amount of business capital losses that can be included when calculating the net operating loss. The limit can be calculated as the total non-business capital gains in excess of the non-business capital losses and excess non-business deductions as well as the total business capital gains once the Section 1202 exclusions have been added back.
* Deductions that are not connected to the business or the owner's employment. Examples of this type of deduction include alimony paid, contributions to an IRA or self-employed retirement plan, and the standard deduction if the individual does not itemize. If itemization occurs, some of the deductions are taken into account in calculating a net operating loss while others are not. The net operating loss calculation includes casualty and theft losses, state income taxes on business profits, and employee business expenses.
Deductions Included in Declaring Net Operation Loss
The income tax preparer must keep in mind that there are limits for certain categories and one cannot use all tax deductions when calculating the net operating costs. Some of the deductions that are included in the net operating loss consist of:
* Moving expenses
* Employee business expenses can be claimed as an itemized deduction. These include work-related travel and entertainment expenses, education expenses, uniforms, tools, and union dues
* Casualty and theft losses, on either business or non-business property
* Deduction for one-half of the self-employment tax
* Deduction for self-employed health insurance
* State income tax on profits from the business
* Rental losses
* Loss on the sale or exchange of real or depreciable business property
* The owner's share of a loss from a partnership or S corporation
* Ordinary loss on the sale or exchange of stock in a small business corporation or a small business investment company
* The portion of an investment in a pension or annuity plan that is not recovered and is claimed on the final income tax return
Sole proprietors and independent contractors will have a net operating loss if their business expenses exceed their revenues. It should also be noted that there are some business deductions for NOL purposes that may not be connected with the business. These deductions include expenses connected with one's employment, and certain other losses, such as casualty and theft losses.
If a net operating loss has been calculated in the current year, the income tax preparer may carry this loss back to the two preceding years and apply the loss against the taxable income for those years. This action will allow the individual to receive a refund of previous income tax that has been paid. The two years mentioned above is referred to as the carry back period. If there is a situation where there are still net operating losses remaining after it has been carried back two years, the taxpayer can carry the remaining NOL forward. The taxpayer may carry forward any remaining NOL balance up to 20 years after the NOL year. This period is referred to as the carry forward period.
Valuation Allowances
The Statement of Financial Accounting Standards (SFAS) No. 109 mandates that all organizations are to establish valuation allowances if there is a possibility that their deferred tax assets will not be realized (Financial Accounting Standards Board, 1992). Some of the main points of the standard include:
* Recognition of deferred tax assets for all temporary differences that are tax deductible in the future, and the more likely than not provision in valuation of such assets (Schatzberg & Sevcik, 1994)
* Discretion to assess the possibility of deferred tax assets occurring. For example, organizations may use estimates such as future profitability and the availability of tax planning strategies
Colley (2012), however, that "deferred taxes do not represent assets and liabilities as defined by accounting standards."
Earnings Management
Organizations have the discretion to manage earning through a variety of accruals such as depreciation and allowance for questionable accounts (McNichols & Wilson, 1988). Some of the motives for earnings management include earnings smoothing, accounting numbers-based incentives in bonus plans, and debt covenants (Watts & Zimmerman, 1986). Some scholars have written on the topic of earnings management in order to provide support for motives such as asset sales and allowance for doubtful accounts (Bartov, 1993; McNichols & Wilson, 1988). The above-mentioned studies highlight how income from a specific accounting accrual is related in a systematic way to earnings management motives. Other scholars (Ali & Kuman, 1994) consider interaction effects when researching earnings management. Their studies assert that the relationship between the motives for earnings management and discretionary accruals may in turn depend on the amount of income generated by the discretionary accrual.
Sources of Income & Valuation Allowances
The guidelines provided by SFAS No. 109 need to be addressed in order to test earnings management as it relates to valuation allowance. These guidelines evaluate four sources of income in establishing the level of valuations allowances. The four sources are future taxable differences that reverse in time, history of profitability, expected future profitability, and tax planning strategies. Changes in these sources are considered in conjunction with changes in the current period. However, it does not include the change in the valuation allowance. It has been shown that changes in the current period income are a key factor to changes in valuation allowance. Studies show that change in the current period, income is a significant determinant of changes in valuation allowance. Changes in valuation allowance have a negative impact on changes in current income. For example, when current year income increases (decreases), valuation allowances decrease (increase).
Sources of Income & Deferred Tax Assets
There are four sources of taxable income outlined in SFAS No. 109 that correlate to deferred tax assets. Two of the sources are future reversals of taxable temporary differences and income in previous carry back years. Both are objective and verifiable. The other two sources (future taxable income and tax planning strategies) are subjective. The standard emphasizes the need to consider both positive and negative evidence in evaluating the value of deferred tax assets. Some examples of positive evidence are sales backlogs, existing contracts, and unrealized holding gains that will produce taxable income. Some examples of negative evidence are history of losses, anticipated losses, and any unsettled circumstances that could reduce income.
Determining Need for a Valuation Analysis
Deferred tax assets are the deferred tax consequences that can be attributed to deductible temporary differences and carry forwards. After the deferred tax asset has been measured using the appropriate tax rates and provisions of the enacted tax law, one should assess the need for a valuation allowance. A valuation allowance is needed when there is a high probability (more than 50 percent) that some or all of a deferred tax asset will not be realized. Realization of a deferred tax asset is dependent on whether there will be sufficient future taxable income of the appropriate character (e.g., ordinary income, capital gain income) in the period during which deductible temporary differences reverse or within the carry back and carry forward periods available under the tax law.
Sources of Taxable Income for Tax Benefits
When attempting to show how positive findings can reverse the impact of negative findings, a key factor could be the future taxable income that has a significant value within the carry back and carry forward periods available under the tax law. The following sources of taxable income may be available under the tax law to realize a portion or all of a tax benefit for deductible temporary differences and carry forwards:
* Future reversals of existing taxable temporary differences
* Taxable income in prior carry back year(s) if carry back is permitted under the tax law
* Tax planning strategies
* Future taxable income exclusive of reversing temporary differences and carry forwards
Application
Generally Accepted Accounting Principles (GAAP) Versus Tax Code
There are a few differences between the GAAP and tax code, especially as it relates to non profit organizations. Before those differences are discussed, some of the general issues will be mentioned. For example, there are several differences between the two views when looking at revenue recognition, the matching principle, and revenue from municipal bonds.
What are the differences in a non profit environment?
According to Miller (n.d.), a San Francisco consultant, "non-profits, being tax exempt, are creatures of the tax code. GAAP requires that professional judgment be exercised to avoid mis-leading financial statements that technically conform but distort nonetheless" (par. 2). Some of the differences in a nonprofit environment are in the areas of government awards, cost-sharing arrangements, gifts of property or service, prepaid fundraising costs, and fair market value on investments.
Viewpoint
State Corporate Tax Disclosure
Some tax professionals and policymakers reviewing the state corporate income tax believe there is a problem with it. "The share of corporate profits in the U.S. collected by state governments via the corporate income tax has fallen sharply in the past quarter century" (Wilson, 2006, p.1). Mazerov (n.d.) reported that there is data that suggests:
* The share of tax revenue supplied by this tax in the 45 states that levy it fell from more than 10 percent in the late 1970s, to less than 9 percent in the late 1980s, to less than 7 percent in 2008.
* The effective rate at which states tax corporate profits fell from 6.9 percent in the 1981-85 period, to 5.4 percent in 1991-95, to 4.8 percent in 2001-05.
* Many state-specific studies have found that most corporations filing income tax returns paid the minimum corporate tax even in years in which the economy was growing strongly. In the wake of the 2008 financial crisis, cash strapped states began to look for politically tolerable ways to raise revenues. Led by Illinois in 2010, state corporate tax rates edged up, ranking the United States second (behind Japan) among OECD countries with the highest statutory (combined federal and state) corporate tax rate at 39.2 percent (Bedell, 2011).
Benefits of Corporate Tax Disclosure
Although there is continuous debate surrounding this information, many in the business community believe that there are organizations that are taking advantage of the provisions of corporate income tax laws that have been enacted (i.e. tax incentives for businesses that make major investments in the state). However, the policymakers and advocates disagree. This group of individuals believes that corporate tax incentives are not cost-effective at stimulating economic development. Mazerov (n.d.) believes that this debate will not be able to reach closure until the states mandate public disclosure of the amount of corporate income tax that specific corporations pay to specific states. He believes that this type of change would:
* Help show policymakers and the public whether the corporate income tax is structured in a way that ensures all corporations doing business in the state are paying their fair share of tax. Because of the large number of variables that affect a corporation's tax liability, it is difficult for non-experts to understand the impact of states' tax policy choices. Examples of how these policies actually affect the tax liability of identifiable corporations could be an asset in assisting policymakers and advocates to comprehend the effectiveness and fairness of a state's corporate tax policies.
* Shed light on the effectiveness of tax policies designed to promote economic development. A number of states have enacted corporate tax incentives and/or tax cuts with the aim of creating jobs or encouraging investment in the state. Without the information provided by company-specific tax disclosure, it is difficult to analyze the effectiveness of such policies.
* Stimulate any needed reform of the state's corporate income tax system. Despite the significant drop in state corporate income taxes prior to the 2008 financial crisis, very few states have enacted meaningful reforms to address this problem. Efforts against this tax shelter have been successful in a number of states, primarily because the public has learned the names of specific well-known corporations that have exploited this shelter. Similarly, corporate tax disclosure could inspire tax reform efforts by encouraging public and policymaker interest in these issues.
In short, corporate tax disclosure would help clarify the realworld outcomes of a state's corporate tax laws and policies and facilitate reforms if needed.
Conclusion
This article highlights some of the events that affect income taxes. Two of these events are net operating losses and valuation allowances. A net operating loss occurs when the annual deductions are greater than the taxable income for the year. The year that the NOL occurs is called the NOL year. In order to claim a net operating loss on the income tax return, one must calculate the amount that can be taken as a deduction to be applied against the taxable income from another year.
The Statement of Financial Accounting Standards (SFAS) No. 109 mandates that all organizations are to establish valuation allowances if there is a possibility that their deferred tax assets will not be realized (Financial Accounting Standards Board, 1992). Some of the highlight points of the standard include recognition of deferred tax assets "for all temporary differences that are tax deductible in the future, and the more likely than not provision in valuation of such assets" (Hirst & Sevcik, 1996), and discretion to assess the possibility of deferred tax assets occurring.
The guidelines provided by SFAS No. 109 need to be addressed in order to test earnings management as it relates to valuation allowance. These guidelines evaluate four sources of income in establishing the level of valuations allowances. The four sources are future taxable differences that reverse in time, history of profitability, expected future profitability, and tax planning strategies.
There are four sources of taxable income outlined in SFAS No. 109 that correlate to deferred tax assets. Two of the sources are future reversals of taxable temporary differences and income in previous carry back years. Both are objective and verifiable. The other two sources, future taxable income and tax planning strategies, are subjective.
Some tax professionals and policymakers have been reviewing the state corporate income tax and believe there is a problem with it. "The share of corporate profits in the U.S. collected by state governments via the corporate income tax has fallen sharply in the past quarter century" (Wilson, 2006, p. 1). Although there is continuous debate surrounding this information, many in the business community believe that there are organizations that are taking advantage of the provisions of corporate income tax laws that have been enacted (i.e. tax incentives for businesses that make major investments in the state). However, the policymakers and advocates disagree. This group of individuals believes that corporate tax incentives are not cost-effective at stimulating economic development.
Terms & Concepts
Carry Back: A technique for receiving a refund of back taxes by applying a deduction or credit from a current year to a prior year.
Carry Forward: A technique for applying a loss or credit from the current year to a future year.
Generally Accepted Accounting Principles (GAAP): A set of
widely accepted accounting standards, set by the FASB, and used to standardize financial accounting of public companies.
Income Taxes: A tax levied on net personal or business income.
Independent Contractor: A person or business who performs services for another person under an express or implied agreement and who is not subject to the other's control, or right to control, the manner and means of performing the services; not as an employee.
Net Operating Losses: Occurs when a company's deductions are more than its income for the year.
Sole Proprietor: A business owned and operated by one individual.
Tax Code: Includes all federal tax laws. Originally written in 1939, and thoroughly revised in 1954.
Valuation Allowances: Actual income tax paid divided by net taxable income before taxes; expressed as a percentage.
Bibliography
Ali, A., & Kumar, K. (1994), The magnitudes of financial statement effects and accounting choice: The case of the adoption of SFAS 87. Journal of Accounting and Economics, 18, 89-114.
Bartov, E. (1993). The timing of asset sales and earnings manipulations. Accounting Review, 68, 840-855. Retrieved August 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=9403090159&site=ehost-live
Bedell, D. (2011). Cash-poor states eye corporate tax hikes. Global Finance, 25, 7. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=59543804&site=ehost-live
Colley, R., Rue, J., Valencia, A., & Volkan, A. (2012). Accounting for deferred taxes: Time for a change. Journal of Business & Economics Research, 10, 149-156. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebsco-host.com/login.aspx? direct=true&db=bth&AN=82362708&site=ehost-live
Cornia, G., Edmiston, K., Sjoquist, D., & Wallace, S. (2005). The disappearing state corporate income tax. National Tax Journal, 58, 115-138. Retrieved August 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=16478043&site=ehost-live
Cowan, M.J. (2012). A GAAP critic's guide to corporate income taxes. Tax Lawyer, 66, 209-259. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=87760103&site=ehost-live
Financial Accounting Standards Board (1992). Statement of financial accounting standards No. 109. Retrieved August 10, 2007, from http://www.fasb.org/pdf/fas112.pdf
Hagen, K. (2007). Net operating losses and U.S. income taxes. Associated Content. Retrieved August 10, 2007, from http://www.associatedcontent.com/article /18505/net%5Foperating%5Flosses%5Fand%5Fus%5Fincome.html
Mazerov, M. (n.d.) State corporate tax disclosure: The next step in corporate tax reform. Retrieved August 10, 2007, from http://www.cbpp.org/2-13-07sfp.pdf
McNichols, M., & Wilson, G. (1988). Evidence of earnings management from the provision for bad debts. Journal of Accounting Research, 26, 1-31. Retrieved August 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=6425838&site=ehost-live
Schatzberg, J., & Sevcik, G. (1994). A multiperiod model and experimental evidence of independence and "lowballing." Contemporary Accounting Research, 11, 137-174. Retrieved August 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=10987368&site=ehost-live
GAAP versus tax (2006). The Nonprofit Times. Retrieved August 10, 2007, from http://www.nptimes.com/enews/tips/accounting.html.
Watts, R., & Zimmerman, J. (1986). Positive accounting theory. New Jersey: Prentice-Hall.
Wilson, D. (2006). The mystery of falling state corporate income taxes. FRBSF Economic Letter, 2006, 1-3. Retrieved August 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=23637606&site=ehost-live
Suggested Reading
Bujaki, M., & McConomy, B. (2007). Income tax accounting policy choice: Exposure draft responses and the early adoption decision by Canadian companies. Accounting Perspectives, 6, 21-53. Retrieved July 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=24636141&site=ehost-live
Reinstein, A., & Lander, G. (2006). Accounting for income tax uncertainties: A step towards financial transparency. Real Estate Review, 35, 37-43. Retrieved July 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=23630612&site=ehost-live
Wong, N. (2005). Determinants of the accounting change for income tax. Journal of Business Finance & Accounting, 32(5/6), 1171-1196. Retrieved July 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx? direct=true&db=bth&AN=25263018&site=ehost-live