Financial Accounting: In an Economic Context

DEFERRED INCOME TAXES

We have noted that the rules for computing income and expenses for purposes of taxation, as specified by the Internal Revenue Service, are different from generally accepted accounting principles, which specify how financial accounting net income is to be measured. These differences can be divided into two categories: permanent and timing differences. Permanent differences never reverse themselves, while timing differences do. Premiums paid on life insurance policies covering key employees, for example, are not deductible for tax purposes, but they are charged against income for financial reporting purposes. Interest received on municipal bonds is not included in taxable income but is recognized as revenue on a company's income statement. The different treatments for tax and financial accounting purposes in these two examples are considered permanent, because in neither case will the effect on income of the different treatments reverse itself over the life of the asset.

One of many common temporary differences arises when a company depreciates its fixed assets using an accelerated method when computing taxable income and the straight-line method when preparing the financial statements. This strategy causes taxable income to be less than accounting income in the early periods of the asset's life, but as illustrated in Chapter 9, this difference reverses itself in the asset's later years. Many accountants believe that timing differences of this kind create a ...