THE ALLOCATION OF INCOME TAXES

by

ROBERT DON MORRIS, B.B.A.

A THESIS

IN

ACCOUNTING

Submitted to the Graduate Faculty of Texas Technological College in Partial Fulfillment of

the Requirements f6r the Degree of

mSTER OF BUSINESS ADMINISTRATION

Accepted

Dean of the Graduate School

August, 1962

f:), <-:

ACKNOWLEDGMENTS

' I am deeply indebted to Professor Reginald Rushing for his

direction of this thesis and to the other members of my committee,

Professors Fred W. Norwood and George W. Beriy, for their helpful

criticism.

11

TABLE OF CONTENTS

Page

ACKNOWLEDGMENTS ii

Chapter

I. INTRODUCTION 1

Problem Background and Development 3

Definition of Terms Used 11

Purpose and Scope of Paper 13

II. INCOME TAX ALLOCATION l5

Conditions Conducive to Income Tax Allocation. , , , 15

Types of Allocation l6

Intra-Period Allocation of Income Taxes 20

Inter-Period Allocation of Income Taxes 21

III. BAUNCE SHEET CLASSIFICATION OF DEFERRED TAX 33

Credit Balance 3k

Debit Balance 1;6

IV. TAX ALLOCATION«S EFFECTS ON INCOME STATEMENT U8

Charges Against Income U8

Credits to Income 52

V. SUMMARY AND CONCLUSION ^^

BIBLIOGRAPHY 6o

APPENDIX 65

111

CHAPTER I

INTRODUCTION

There have always been issues in accounting, for they go with

the exercise of judgment, A current problem before the profession is

the allocation of federal income taxes. Along with price level adjust­

ments, it probably occupies the foremost position among the issues cur­

rently debated in accounting circles, for it involves the largest sin­

gle item of expense in many businesses and is an issue that goes to

the heart of some fundamental accounting concepts.

This paper is not directly concerned with the computations

which determine the amount to be shown in the balance sheet as a lia­

bility for taxes currently payable under federal and state income tax

laws. Rather, it considers the question of the amount to be shown in

the income statement as an expense.

For many years showing the same amount in both the balance sheet

and in the income statement was considered to be proper accounting, but

in recent years the acceptability of this procedure has been seriously

and increasingly questioned. The problem has arisen from the fact that

net income before taxes reported in the income statement may be radi­

cally different from taxable net income with the result that the tax

-H/eldon Powell, "Accounting Principles and Income-Tax Alloca­tion," New York Certified Public Accountant, XXIX, No. 1 (January, 1959), pTTT.

liability may bear no normal relationship to the reported net income

before taxes. And, too, the high tax rates augment the distortion.

Thus, income tax allocation consists of procedures intended to

cause the tax expense shown on the income statement, but not the tax

liability shown on the balance sheet, to bear a more normal relation

to the net income before tax reported in the income statement. Basic­

ally, income tax allocation is intended to eliminate distortion when

material amounts entering into the computation of the income tax lia­

bility are omitted from the income statement or when material amounts

included in the income statement are omitted from the tax conqjutation.^

In recent years, the nature of income taxes and the related

topic of income tax allocation have received considerable attention.

Though many articles have been written, these problems have not been

completely resolved.

Accounting for income taxes is one of the subjects currently

under study in the American Institute of Certified Public Accountants*

new Division of Accounting Research. Professor Homer A. Black of

Florida State University, assisted by Robert A. Steiner, is the re­

search supervisor of the subject accounting for income taxes.

In a report from Mr. Steiner to Professor Black based on more

than four hundred published annual financial reports, an attempt was

made to show the range of problems involved in the area of income tax

allocation and the diversity of treatment in practice.-^

2H. A. Finney and Herbert E. Miller, Principles of Accounting, Intermediate (5th ed.; Englewood Cliffs, N. J.: Prentice-Hall, Inc., 195«), Po 603.

3Journal of Accountancy, Editor's Note before an Article, CXI, No. 6 (June, 1961), p. 6U.

Mr. Steiner reported that income tax allocation is treated in

a wide variety of ways in certified published financial statements.

In many cases income tax allocation is unexplained, ambiguous, or even

incorrectly handled according to the procedures outlined in Bulletin

kh (Revised). The terminology used is sometimes confusing or incorrect.

Sometimes no provision for income tax allocation is made when provision

should be made. Also, generally accepted auditing standards of report­

ing and generally accepted accounting principles are apparently ignored

at times with income tax allocation considerations seeming to take

precedence^

Problem Background and Development

Income tax allocation is a relatively young issue probably be­

cause the conditions that have given rise to it are of recent origin.

They are the important differences in the determination of income as

shown on the books and on the tax returns, accompanied by sustained

high rates of income tax.-

In the 1930's the corporate income tax became significant and

has remained at high levels continuously ever since. By the end of

the 1930*s, the Internal Revenue Code had been amended to permit the

averaging of income for tax purposes through a provision which allows

a net operating loss of one year to be carried back or carried over to

^Robert A. Steiner, "Analysis of Income Tax Allocation," Journal of Accountancy, CXI, No, 6 (June, 1961), p. 61;.

^Powell, New York Certified Public Accountant, XXIX, No, 1, p. 21.

h

another year. About the same time the decline in long-term rate of

interest brought about a wave of refundings of bond issues, thereby

creating a special problem for the public utilities in the calculation

of net income for a specific year. During the 19ii0's accelerated depre­

ciation became widely employed. These historical developments, and

other similar ones, gave rise to a substantial problem as to the proper

treatment of income taxes in financial statements.

According to Mr. Powell, the first reference to income tax allo­

cation in the Accounting Research Bulletins of the Committee on Account­

ing Procedure of the American Institute of Certified Public Accountants

is in Bulletin 18, issued in 19ii2. That bulletin was put out as a

supplement to a bulletin dealing with unamortized discount and redemp­

tion premium on bonds refunded. The accounting for bond refunding

operations was pertinent at the time because there were many sizable

ones. Disposing of the unamortized discount and redemption premium

on the refunded bonds, either by a direct charge to retained earnings

or by amortization over the remaining life of the original issue was

considered to be acceptable accounting. For income tax purposes, how­

ever, both the unamortized discount and the redemption premium were

deductible immediately and, accordingly, the tax payable for the year

in which the refunding occurred was less than it otherwise would have

7 been, in some cases by a material amount.'

"Maurice Moonitz, "Income Taxes in Financial Statements," Ac-counting Review, XXXII, No. 2 (April, 1957), p. 175.

^Powell, New York Certified Public Accountant, XXIX, p. 21.

Accounting Research Bulletin 18 dealing with this situation was

issued, and the following is a summary of the recommendation made by

the bulletin. Where unamortized discount on bonds refunded is written

off in full in the year of refunding, acceptable accounting shows such

charges as a deduction in the income statement in the year of refund­

ing in harmony with the treatment required for income tax purposes.

Where any write-off is made through retained earnings it should be

limited to the excess of the unamortized discount over the reduction

of current taxes to which the refunding gives rise, and an amount at

least equal to such reduction in current taxes should be shown as a Q

deduction in the income statement for the year of refunding.

If the alternative of spreading unamortized discount over a

future period is adopted, a charge should be made in the income state­

ment in the year of refunding equal to the reduction in current income 9

tax resulting from the refunding.

The statement that it was sound to account for unamortized dis­

count and redemption premium in harmony with the tax treatment appar­

ently bothered the committee, for it was rescinded five years later.

Of course, the income-tax law never was a good criterion of sound ac­

counting, and it is not today. In fact, the gap between tax laws and

accounting principles seems to be widening. Thus, the need for the al­

location of income taxes seems to be increasing instead of decreasing.^

^Powell, New York Certified Public Accountant, XXIX, p. 21.

^Ibid., p. 22.

lOlbid,

In 19UU, two years after Bulletin 18, a committee of the AICPA

issued Accounting Research Bulletin 23 on "Accounting for Income Taxes."

It said in effect that income taxes are like other expenses and that,

accordingly, as to material and extraordinary items, where an inter-

statement variation (income statement versus retained earnings state­

ment) or an interperiod variation (current period versus future periods)

between financial income and taxable income exists, income taxes should

be allocated, and it discussed the manner in which income tax provisions

and adjustments should be reported in financial statements.^^

The words "material and extraordinary" were used, and Bulletin

23 was silent concerning small and recurrent differences between books

and tax returns. In 1953 when it was rewritten as Chapter 10, Section

B of Accounting Research Bulletin k3i it stated that:

The section does not apply where there is a presumption that particular differences between the tax return and the income statement will recur regularly over a comparatively long period of time.- ^

Bulletin 23 did not have the unanimous approval of the committee

in that there were three dissenters. Too, after its issuance it was

warmly debated.

By 1952, however, when Bulletin U2, dealing with "Emergency

Facilities—Depreciation, Amortization, and Income Taxes," was released

llpowell, New York Certified Public Accountant, XXIX, p. 22.

- Committee on Accounting Procedure, Restatement and Revision of Accounting Research Bulletins, Accounting Research Bulletin No. U3 (New Xorks American Institute of Certified Public Accountants, 1953), p. 89.

the allocation principle had become sufficiently accepted so that the

bulletin was unanimously adopted and was generally followed. However,

the words "material and extraordinary" were again used, for the bulle­

tin was intended to deal with situations in which, without some kind

of income-tax allocation, reasonably certain material overstatement of

net income as between the present and the near future periods would

exist. The current net income would be overstated and future periods

would be charged with the income taxes which were deferred by the

adoption of the accelerated depreciation for tax purposes only. -

In 195U, the Committee, with one qualified assent and one dis­

sent, issued Bulletin kk^ entitled "Declining-Balance Depreciation,"

The bulletin was intended to answer questions that had arisen follow­

ing the recognition of certain accelerated depreciation methods in the

Internal Revenue Code of 195U. Of pertinence in this bulletin is the

part concerning situations in which an accelerated method is adopted

for income-tax purposes but other appropriate methods are followed for

financial accounting purposes. Bulletin kh said that in ordinary situ­

ations deferred income taxes need not be recognized in the accounts un­

less the reduction in taxes during the earlier years of use of the

accelerated method for tax purposes was a reasonably certain deferment

of taxes until a relatively few years later, and then only if the

amounts were clearly material."^

13committee on Accounting Procedure, Accounting Research Bulle­tin No, U3, p. 78,

l^Committee on Accounting Procedure, Accounting Research Bulle­tin No. kk (New York: American Institute of Certified Public Account­ants, October, 1951;), p. 1.

8

Mar y authors thought, however, that the language used in the

bulletin was not as clear as it might have been, for in practice, the

bulletin was interpreted by most accountants as not requiring income-

tax allocation with respect to depreciation differences related to so-

called normal property additions and replacements or to those which,

in total, appeared to be of definite or permanent duration.^

Thus, the Committee revising Accounting Research Bulletin kk in

July, 1958, partly reversed the position taken in the original issue

of the bulletin. The revision provides that in situations in which an

accelerated depreciation method is adopted for income-tax purposes,

but other appropriate methods are used for financial accounting pur­

poses, accounting recognition should be given to deferred income taxes

if the amounts thereof are material except in certain rare cases deal­

ing with public utilities which are mentioned in the bulletin.

To attempt to explain the change in its position between 195U

and 1958, the committee included the following paragraph in the re­

vised bulletin:

Since the issuance of Accounting Research Bulletin No. kk, the committee has been observing and studying cases in-volving the application of the bulletin. Studies of pub­lished reports and other source material have indicated that, where material amounts are involved, recognition of deferred income taxes in the general accounts is needed to obtain an equitable matching of costs and revenues and to avoid income distortion, even in those cases in which the

l5powell, New York Certified Public Accountant, XXIX, p. 21;.

l^Committee on Accounting Procedure, Accounting Research Bulle­tins No. kk (Revised) (New York; American Institute of Certified Pub­lic Accountants, July, 1958), pp. 1-A and 1-B.

payment of taxes is deferred for a relative long period. This conclusion is borne out by the committee^s studies which indicate that where accelerated depreciation methods are used for income-tax purposes only, most companies do give recognition to the resultant deferment of income taxes or, alternatively, recognize the loss of future de­ductibility for income tax purposes of the cost of fixed assets by an appropriate credit to an accumulated amorti­zation or depreciation account applicable to such assets,-^'

Five of the twenty-one members of the committee assented with

qualification to the revision, their qualifications in all cases con­

stituting objections to or dissents from the part of the revised bulle-

18 tin dealing with income tax allocation.

At the time that Accounting Research Bulletin 23 was issued the

accounting staff of the United States Securities and Exchange Commis­

sion did not approve of the principle of income tax allocation. The

SEC's conclusions were expressed in Accounting Series Release No. 53,

dated November l6, 19k$, and entitled "In the Matter of Charges in Lieu

of Income Taxes." In summary, one of their conclusions stated that

"the amount shown as provision for taxes should reflect only actual

taxes believed to be payable under the applicable tax laws." " With

regard to retained earnings charges the SEC rejected the first of the

two methods involving an increase in the provision for income taxes

above the amount of tax estimated to be legally due as if the item in

17comraittee on Accounting Procedure, Accounting Research Bulle­tins No, kk (Revised), p. 3-A,

iSibid,, pp, 1;-A, 5-A.

-'- United States Securities and Exchange Commission, Accounting Series Releases, Release No. 53 (Washington: U, S, Government Pnnt-ing Office, 1956), p. 12«,

10

question were not deductible. The SEC found acceptable the second

method involving a charge against income of a portion of the item

equal in amount to the tax reduction resulting therefrom.

While the SEC has neither officially rescinded nor revised

Accounting Series Release No. 53. the general understanding is now

that the SEC»s present position is that it will accept financial state­

ments involving the principle of allocation of income taxes and, in in­

stances, will suggest the use of the principle where it is concerned

with the reported "earnings per share." '-

The position taken by the 1957 revision committee of the Ameri­

can Accounting Association is definitely not in accord with the AICPA»s

position. The committee thought that the differences between financial

income and tax income should be disclosed in the financial statements,

but did not agree with the AICPA as to the method of disclosure. As

to proper disclosure they stated:

Disclosure is sometimes acconplished by recording the differences as prepayments (giving expection of future tax savings) or accruals (giving the opposing prospect). How­ever, these items do not present the usual characteristics of assets or liabilities; the possible future offsets are often subject to unusual uncertainties; and treatment on an accrual basis is in many cases unduly complicated. Con­sequently, disclosure by accrual may be more confusing than enlightening and is therefore undesirable. -

2^^1ph S. Johns, "Allocation of Income Taxes," Journal of Ac-coimtancy, CVI, No, 3 (September, 1958), p, 1;3.

^lAmerican Accounting Association, Accounting and Reporting Standards for Corporate Financial Statements and Preceding Statements and Supplements (Ohio State University, 1957), p. 7.

11

From the foregoing discussion and presentation obviously account­

ants do not agree that income tax allocation is acceptable accounting

practices. After Bulletin 1;2 it became, not generally accepted, but

widely accepted in cases dealing with "material and extra-ordinary"

accounts. However, after the issuance of Bulletin kk, accountants be­

came confused as to the AICPA*s position, for many interpreted the

bulletin as not requiring income tax allocation with respect to "so

called" normal depreciation transactions or when the difference ap­

peared to be of definite or permanent duration. In Bulletin kk (Re­

vised) the Committee on Accounting Procedure made an attenpt to

clarify its position; however, to date income tax allocation has not

attained the status of a generally accepted accounting principle, but

it does seem to be gaining support in current accounting literature.

Definition of Terms Used

Because of the technical aspects of this paper a definite need

exists for a common definition of some of the terms to be used and

also many of the arguments for and against income tax allocation are

augmented by different meanings of the same words.

The following are taken from the AICPA's Committee on Terminol­

ogy's bulletins.

The term "asset" as used in balance sheets, may be de­fined as something represented by a debit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting (provided such debit balance is not in effect a negative balance applicable to a liability) on the basis that it rep­resents either a property right or value acquired, or an ex­penditure made which has created a property right or is

12

properly applicable to the future. Thus, plant, accounts receivable, inventory, and a deferred charge are all assets in balance sheet classification.

A liability may be defined as something represented by a credit balance that is or would be properly carried for­ward upon a closing of books of account according to the rules or principles of accounting, provided such credit balance is not in effect a negative balance applicable to an asset. Thus the word is used broadly to comprise not only items which constitute liabilities in the popular sense of debts or obligations (including provision for those that are unascertained), but also credit balances to be accounted for which do not involve the debtor and creditor relation.

Accounting Principle: Initially, accounting postu­lates are derived from experience and reason; after postu­lates so derived have proved useful, they become accepted as principles of accounting. When this acceptance is suf­ficiently widespread, they become a part of the "generally accepted accounting principles" which constitute for ac­countants the canons of their art.

The term "earned surplus or retained earnings or re­tained income" means: the balance of net profits, income, gains and losses of a corporation from the date of incor­poration (or from the latest date when a deficit was elim­inated in a quasi-reorganization) after deducting distri­butions therefrom to shareholders and transfers therefrom to capital stock or capital surplus accounts.

"Depreciation accounting" is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a proc­ess of allocation, not of valuation. Depreciation for the year is the portion of the total charge under such a sys­tem that is allocated to the year. Although the allocation may properly take into account occurrences during the year, it is not intended to be a measurement of the effect of all such occurrences,

"Accelerated Depreciation" is a depreciation procedure by which larger charges are made during the early years of the life of the fixed asset than during the later years of its life.^3

22Gommittee on Terminology, Accounting Terminology Bulletins, No. I—Review and Resume (New York: American Institute of Certified Public Accountants, 1953), pp. H , 13, l6, 25.

23Finney and Miller, p. 360.

13

"Deferred Credits" are credits to be included in the determination of net income of subsequent periods covering a time span in excess of an operating cycle.^^

"Deferred Charges" are charges to be included in the determination of, net income of subsequent periods covering a time span in excess of an operating cycle.^5

Purpose and Scope of Paper

The purpose of this paper is threefold in that three areas are

involved in the income tax allocation problems considered in the paper;

(1) conditions conducive to income tax allocation, (2) the balance

sheet treatment of inter-period income tax allocation balances, and

(3) the effect of income tax allocation in the income statement.

Though an attempt will be made to separate each of these areas, th^

are not separable in that each is related to the other areas.

This paper must consider the need for income tax allocation

and through a discussion of accounting literature show how and why

this need has developed. After the need has been shown, some of the

accounting and tax provisions which give rise to the conditions that

require income tax allocation procedures will be examined.

By presenting the arguments for and against income tax alloca­

tion procedures, the paper will try to show that income tax allocation

will alleviate the accounting problems involved when accounting and

taxable concepts of income and expenses differ for a given period.

If inter-period income tax allocation procedures are followed,

then certain difficulties will arise as to the proper balance sheet

^^Finney and Mller, p. i;8.

25ibid.

lii

presentation of the balance that arises. Having discussed various

solutions, the paper will show that these difficulties can be re­

solved.

Since income tax allocation procedures were developed mainly to

avoid distorting the reported financial net income, the paper will try

to show how a truer concept of financial net income will be presented

when incone tax allocation is used.

In Chapter H the writer will discuss some of the argiiments for

and against the allocation of income taxes and will present some of

the various procedures used in the allocation of income taxes. In

Chapter III the writer will discuss the balance sheet presentation

of amounts to be carried into another accounting period and will dis­

cuss different methods of presentation. The effect of income tax al­

location on the income statement will be discussed in Chapter TV.

Chapter V will contain the summary and the conclusion.

CHAPTER II

INCOME TAX ALLOCATION

Conditions Conducive to Income Tax Allocation

Income for federal purposes is determined by the provisions of

thie Internal Revenue Code and related regulations, and such determina­

tion does not purport to rest on the foundation of generally accepted

accounting principles. To expect accounting income and taxable income

to be the same is therefore unrealistic. It follows that it is like­

wise unrealistic to expect the provision for income taxes payable to

be in direct relation to accounting income before taxes at the exist­

ing statutory rates. Also financial statements cannot at the same

time be presented in accordance with generally accepted accounting

principles and on a tax basis.-

The differences between accounting income and taxable income

fall into four classifications as follows:

1, Items included as income in the income statement which do

not constitute taxable income.

2, Items which constitute taxable income which are not in­

cluded as income in the income statement,

3, Charges made against income in the income statement which

are not deductible for tax purposes.

- Johns, Journal of Accountancy, CVI, No. 3, p. 1;3.

15

16

1;. Items deductible for tax purposes which are not shown as a

charge against income in the income statement.

Thus most authors agree that, inevitably, frequent differences

will occur between the taxable income and the accounting income for a

given accounting period. They also agree that the best solution, and

certainly not the most feasible one, is not a revision of the tax law

to conform to accounting practices. Therefore, it appears likely that

large differences in taxable and accounting income will always exist

and will demand income tax allocation if sound reporting is to be

achieved.

lypes of Allocation

Probably the simplest form of tax allocation, and therefore the

least confusing, is an allocation of the total tax estimated to be

legally due into two parts within the income statement itself. Thus,

there is no change in the reported net income, nor is the balance

sheet affected by this type of allocation. An exar jle is contained

in the published annual report of E. I. du Pont de Nemours & Gompaiiy

where in the income statement the tax provision applicable to the

General Motors Corporation and that applicable to other income are

shown separately. This allocation is desirable because at the end

of 1961 E, I. du Pont Company holdings in General Motors were repre­

sented by 63,000,000 shares or 22.1 percent interest and approximately

$126 million of dividends income was realized from these holdings.

^Johns, Journal of Accountancy, CVI, No. 3, p. U5.

17

These shares plus other family holdings brought the total interest owned

to 29 percent,^

A second type of tax allocation involves an allocation of the

tax provision between income and retained earnings (to be discussed

later in this chapter and illustrated in Appendix A), While the total

tax provision and the balance sheet are not affected by this type of

allocation, the reported net income is. To illustrate, on an assumed

extraordinary fully taxable gain of $1;00,000 the income tax is $200,000

and the income tax on net operating income is $500,000. The total tax

would then be $700,000 for the period. If the gain is to be recorded

in retained earnings, the retained earnings and the income statements

should appear as follows.

Income Statement $xxx,xxx Provision for income taxes $700,000 Less: Portion allocated to unusual gain. . 200,000 500,000

Net income $xxx,xxx

Retained Earnings Statement Retained earnings I/I/6I $xxx,xxx Add: Unusual gain $i;00,000

Less income tax thereon 200,000 200,000 Net income xxx,xxx

Retained earnings I2/3I/6I $xxx,xxx'

The problem arises when materially extraordinary items are incur­

red and are used in determining financial net income and/or taxable in­

come. By including an extraordinary item in the retained earnings

statement and by showing the tax effect thereon in the income statement,

3john Sherman Porter (ed.), Moody's Industrial Manual (New York: Moody's Investors Service, Inc., 1962), pp. 1267-1268.

19

(a) the allocation of charges and credits to operating in­come, nonoperating income, and retained earnings;

(b) the effect of differences between the time of recogni­tion of revenue and expense under accounting conventions and under tax laws and rules.°

Extraordinary gains and losses are the items frequently considered

in connection with (a) above. Apparently most accountants are in favor

of intra-period income tax allocation when nonrecurring gains and losses

that are material in amount are to be considered in the confutation of

net income for the period.

The effect of differences between the time of recognition of

revenue and expense under accounting conventions and under tax rules

very often accounts for substantial differences in the net income re­

ported on the income tax return and the net income on the certified

financial statements. The two net income amounts differ usually because

of the application to the tax return of the accelerated depreciation

provisions that are available under the tax laws and the application

of the straight-line method of depreciation to the certified statements.

It must, however, be recognized that other items also can cause a dif­

ference in the two net income figures. The charge-off of large amounts

of unamortized bond discount at the time of refunding or the collection

of a life insurance policy on a key employee are other exajrqples of situ­

ations resulting in variations between income for tax purposes and in­

come as reported for accounting purposes.

^Sidney Davidson, "Accelerated Depreciation and the Allocation of Income Taxes," Accounting Review, XXXIII, No. 2 (April, 1958), p. 176.

20

Intra-Period Allocation of Income Taxes

The proper allocation of charges and credits to operating income,

nonoperating income, and retained earnings is primarily dependent upon

whether the "all-inclusive" or the "current operating" concept of

statement presentation is being followed. The choice of one of the

above methods will determine where the gain (or loss) is to be shown

on the financial statements, A general rule adopted by many account­

ants who favor income tax allocation is that "the tax should follow the

extraordinary item,"' In other words, if the all-inclusive concept of

showing the unusual item in the income statement is followed, then the

tax effect thereon should also be shown in the income statement. Like­

wise, if the current operating concept of showing the unusual item in

the statement of retained earnings is followed, then the tax effect re­

lated to the extraordinary item should be shown in the statement of re­

tained earnings (illustrated in Appendix A ) ,

Accountants present many arguments both for and against the

intra-period allocation of income taxes. Upon examination of the

financial statements in which extraneous charges and credits have been

encountered in the determination of the net income for the period and

the related income tax expense thereon, obviously misleading inferences

are likely to be drawn from these statements if income tax allocation

procedures are not followed. The primary purpose of intra-period income

tax allocation is to achieve adequate disclosure in the financial

'Finney and Miller, p. 6o8.

21

statements. This fact is illustrated by the conparative income state­

ments in Appendix A.

Mary authors clearly state that they have no quarrel whatever

with the allocation of a provision for income taxes between the income

statement and the retained earnings statement, when a substantial and

material item in the determination of taxable income is charged or

credited directly to retained earnings. Many favor this allocation

whether it means a charge or a credit in the income statement. The

difficulties arise, however, with some of the proposals for allocation

between the income statement and the balance sheet, that is, between

periods of time.^

Inter-Period Allocation of Income Taxes

In the preceding section, the allocation problem was merely

one of statement location. However, this section deals with the

more difficult problem that arises when the year for tax recognition

differs from the year of accounting recognition. Thus, inter-period

allocation of income taxes is concerned primarily with the effect of

differences between the time of recognition of revenue and expense

under accounting conventions and under tax rules.

As pointed out earlier in this chapter, many types of trans­

actions may cause a difference between taxable net income and reported

net income. However, the difference between the depreciation rate

used for tax purposes and the rate used for financial reporting purposes

^Powell, New York Certified Public Accountant, XXIX, 1, p. 25.

22

seems to account for this discrepancy in a number of cases. This type

of situation poses some important questions that must be considered

before the problem of income tax allocation can be settled.

In deciding whether or not inter-period allocation is appro­

priate and whether a liability exists, Mr. Moonitz points out two con­

trolling questions:

(1) Are tax rates expected to remain at substantially their current levels, and

(2) Is taxable income expected to emerge each year in the foreseeable future?^

To these above questions, Davidson adds two others and states

that they should precede those listed by Moonitz:

(1) Are tax rules for depreciation methods expected to remain as generous as they now are? and

(2) Will a policy of regular investment in assets sub­ject to depreciation be maintained?!^

One can readily see that to give a positive answer to any of

the above questions with any degree of certainty is impossible. Only

the future will unveil the answer. Therefore, the best one can do

is to estimate as accurately as possible the correct answer for the

question from the available information, but the answer may not be

the same in every situation. A fundamental concept in accounting

is that each business be regarded as a separate and distinct entity.

^Moonitz, Accounting Review, XXXII, No. 2, p. 179-

l^Davidson, Accounting Review, XXXHZ, No. 2, p. 173

23

From this concept certainly follows that what might be true of one

business entity will not necessarily be true of another business en­

tity; therefore, each problem must be identified with the business

entity involved, and then a decision can be made regarding the four

questions stated earlier in the light of all known facts.

Some aspects of the four questions can be discussed, however,

in a general manner.

Provisions of the Federal Tax Law

The accelerated depreciation rates now being en^loyed by many

firms were made possible in August, 1951|-, by the adoption of the In­

ternal Revenue Code of 195U. This law made available to taxpayers

various accelerated depreciation rates such as the declining-balance

method and the sum-of-the-years-digits method. In effect this law

granted direct relief to many taxpayers who were investing substan­

tial sums of money in depreciable fixed assets.

In consideration of the favorable and the unfavorable aspects

of inter-period income tax allocation, the question of how long the

tax law will continue to permit the use of accelerated depreciation

rates is invariably raised. No one can deny that possibly the pres­

ent tax laws may be revised to eliminate the use of accelerated de­

preciation for income tax purposes. Nevertheless, accountants are

not expected to forecast future tax legislation, but they are ex­

pected only to use discretion in the presence of all known facts.

The following quote illustrates that tax laws are not likely

to change.

21;

All the history of tax legislation indicates that once special rights are granted, it is very difficult and un­usual for Congress to withdraw them, especially if the re­turn to the former rules would result in a doubling-up of tax burdens during the years of return.^^

Apparently, therefore, one can dispense with the first question

stated earlier by saying that likely the law will not be changed sub­

stantially; even if it is changed, the change will probably not be a

repeal.

Regular Investment Policy

One of the principal arguments advanced by those who oppose

the provision for deferred taxes applies to companies that are ex­

pected to be expanding or replacing facilities indefinitely. In

this situation, the higher taxes resulting from lower depreciation

in later years for older facilities would be continuously offset by

the higher depreciation allowance for new facilities or replacements.- ^

Thus, the income tax picture of an expanding company or one with a

policy of regular investment in fixed assets is unique in that a sub­

stantial amount of income taxes can be deferred indefinitely, at least,

until the corr5)any either changes its investment policy or liquidates

its assets.

The point to be enphasized is the possibility of deferring taxes

for an indefinite period, but the periodic difference will, however.

^^Davidson, Accounting Review, XXXIII, No. 2, p. 177.

^"Accounting Research Bulletin kk Revised," Journal of Account­ancy, CVI, No. 2 (August, 1958), pp. 25-26.

25

cancel out over a period of years; therefore, any tax deferment is only

teiT5)orary, and no permanent tax savings result unless tax rates change

in the future periods, but the interest-free loan does represent a

financial saving.

Since conventional accounting procedures and tax regula­tions both operate in historical cost items, the series of investments is measured in monetary, not real, terms. Dur­ing a period of rising prices fulfillment of the necessary criterion is more likely since it does not require a firm to maintain a constant rate of acquisition of productive capacity but merely of dollar investment.^3

To be emphasized, however, is that any time a firm fails to

maintain its investment in fixed assets, a subsequent increase in the

amount of income taxes currently payable will result.

Some of the writers who accept the validity of the deferral

technique in a simple situation where the tax reduction gained in early

years of the asset's life are clearly offset by higher taxes in later

years have denied the allocation's possible application to large

"pools" of assets. By pointing out that an organization which replaces

or increases its pool of fixed assets each year may never be faced with

higher taxes in later years, these authors argue that a saving which

appears to be permanent, or at least of lengthy duration, can reason­

ably be recognized in the accounts as it arises.-^

The concept of "permanent deferral" of credits (or charges) to

income tax expense (or even the payment of deferred taxes) is as

-^^avidson. Accounting Review, XXXIII, No. 2, p. 178.

-^W. Barry Coutts, "Accounting Research," Canadian Chartered Ac­countant, IXXIV, No. 1; (April, 1959), p. 3U2.

26

fallacious and illusory as the concept of permanent deferral of the

payment of pensions or even of current liabilities. In all of the

cases "permanent" means only that the net balances will not be re­

duced in the foreseeable future because of offsetting charges and

credits.

In answer to the argument against the allocation of income

taxes primarily on the grounds that a firm that is static or growing

will never have to repay the "liability," Mr. Jaedicke and Mr. Nelson

state that this approach to income measurement could result in a "cash

flow" type of income statement. On grounds that a policy of regular

investment in assets subject to depreciation is being maintained, all

expenditures for plant could be charged against current operations.

Or, conversely, only the payments made to suppliers of materials and

services could be shown as an operation deduction, on the grounds

that the increase in accounts payable is a permanent liability that

would never have to be paid. The same argument might be applied to

the current federal income tax liability or to bonds payable which

are intended to be replaced with a new issue at each maturity date.

Then possibly the bonds payable account may never be reduced.- 5

Likely such a practice would never be accepted by either busi­

nessmen or accountants. Yet, as long as the firm is operating it may

never have to repay the permanent trade credit or the bonds, and this

situation is very much like the income tax allocation problem.

Robert K. Jaedicke and Carl L. Nelson, "The Allocation of In­come Taxes—A Defense," Accounting Review, XXV, No. 2 (April, I960), pp. 279-280.

27

Changes in Future Income Tax Rates

Are future tax rates so uncertain that any effort to predict

them through a provision for deferred taxes is likely to be unrealis­

tic? One of the fundamental problems inherent in income tax allocation

is that of estimating the tax to be paid in future periods because of

the postponement of the tax payment. The AICPA recommends that "the

estimated rate should be based upon normal and surtax rates in effect

during the period covered by the income statement with such changes

therein as can be reasonably anticipated at the time that the estimate

is made."- ^

With recognition of the practical difficulties involved, this

recommendation appears to be the only reasonable solution to the prob­

lem. Generally a change in tax rates would require legislative action,

but possibly a taxpayer could shift to either a higher or a lower tax

bracket and could create the same problem. This situation, however,

is not as likely to develop in a corporation as in a partnership or a

proprietorship,

Under one concept the deferred tax is not a liability (to be

discussed more in the next chapter) but is considered to be a deferred

credit to expense. With this concept the problem of deciding how much

tax will be payable in future years or rather the problem of changes

^^Committees on Accounting Procedure, Restatement and Revision of Accounting Research Bulletins, (Bulletin 1;3), American Institute of Certified Public Accountants, 1953, p. 89.

28

in future income tax rates is eliminated because the tax "saving" is

carried forward to be offset against future tax savings.^'^

According to an editorial apparently the following argument was

most influential in causing the Committee on Accounting Procedure to

decide to revise Bulletin kk. Many proponents of a provision for de­

ferred taxes argue that despite uncertainties which are involved, fail­

ure to provide for deferred taxes distorts income more than providing

for them, even if the amount may not be exactly right.- °

Anticipation of Future Taxable Income

The effect of income tax deferment is the creation of a smaller

income tax liability in the year of deferment offset by a larger income

tax liability in later years. This relationship will generally hold

true; however, if a business entity enjoys a series of profitable years

in which the practice of income tax deferment is employed, followed by

a series of years in which it operates at a loss, the statement above

will not be correct. No income will exist against which the deferred

expense can be applied. Therefore, the liability could be erased en­

tirely by the series of loss years.

Nevertheless, accountants prepare financial statements from the

standpoint of a "going-concern," that is on the assurr Dtion that the

business entity will continue its operations indefinitely unless there

-'-' Coutts, "Accounting Research," Canadian Chartered Accountant, XXIV, No. k, pp. 3li3-3l;li.

^^"Accounting Research Bulletin kk (Revised)," Journal of Ac­countancy, CVI, No. 2, p, 25.

29

is evidence to the fact that the business»s life is limited. One

principal purpose of the balance sheet is to reflect fairly the lia­

bilities of the business entity as of a specific date. If subsequent

events eliminate the liability, in whole or in part, then the account­

ant is justified in showing the liability at its reduced amount in sub­

sequent balance sheets. Failure to record the liability in the proper

period will understate liabilities on the balance and will also under­

state the income tax expense for the period.

Accountants have said that the validity and reality of both

"deferred charges to income tax expense" and "deferred credits to in­

come tax expense" depend upon the realization of taxable income in

future periods and that such anticipation of income is unwarranted.

In a sense it is true that the realization of these deferred items

does depend upon future taxable Income, but does not the validity of

19 many assets' values depend on the presumption of future net income?

Too, many accepted accounting practices are based on the fami­

liar "continuity" assumption. Also, unless "continuity" implies con­

tinued operation at a profit, it fails to justify fully the carrying

of any assets at values that can be fully realized only by the earning

of future net income. Most asset values would shrink substantially,

and in some cases would disappear almost entirely, if continued opera­

tion at a profit were not anticipated. Does it not follow logically

that both of these deferred amounts are "legitimate" even though their

20 "realization" depends upon future taxable income?

l^Graham, Accounting Review, XXXIV, No. 1, p. l5.

20lbid.

30

An argument used by the Committee on Accounting Procedure of

the AICPA in its argument against the likelihood of changes in income

tax rates can be applied in the anticipation of future taxable income.

The argument (used earlier in this chapter) states that despite some

uncertainty, failure to provide for deferred taxes distorts income more

than providing for them, even if the amount may not be exactly right. -'•

Other Questions on the Merits of Income Tax Allocation

As one author stated, no problem of allocation exists in connec­

tion with "permanent" differences between taxable income and accounting

income, only when the differences are "temporary," that is, where dif-

22 ferences in timing are involved, that allocation is necessary.

This author also states that the refusal to adopt the alloca­

tion procedure is backed up by logical reasons. Many of these have

been presented earlier in the paper and will not be repeated, but

others have not been discussed.

In income tax allocation, no true liability for a future tax

exists and thus many people argue that no real cost can be replaced by

a charge against income. The point will be discussed in more detail

in the next chapter.

To the argument that disputes the existence of any true liabil­

ity, one can point out that the "accumulated tax reductions applicable

to future years" are not a provision for a liability. They are according

- Journal of Accountancy, Editorial, CVI, No, 2, pp. 25-26.

22coutts, Canadian Chartered Accountant, LXXIV, No. 1;, p. 3i;2.

31

to some authors' opinions, a deferred credit to expense, and under this

concept, the adjustment denies any liability.^^

Some accountants argue that even if a liability exists and even

if it will become payable at some future date, its amount is so indefin­

ite that no useful calculation of this amount can be made. Thus, they

argue that such information based on these assuuptions must be so sub­

jective that it is not valuable.

Others point out that financial statements are confusing enough

without introducing a conplication that will baffle all but the most

expert user of financial information. If the whole allocation concept

is proving difficult to explain to accountants, then it must be com­

pletely incomprehensible to laymen.^

Deferring of tax reductions to future years does not recognize

that the present value of money is changing.

Most of these arguments have a certain validity, but they all

are arguments against the allocation of income taxes in general. Ac­

cording to Mr. Coutts, apparently no arguments are based on their own

merits for the alternative, that is, "Non-allocation." In other words,

no reasoned alternative solution is offered to the basic problem, that

is, how can a significant figure of net income after taxes be obtained

unless the tax effect of each item of income and expense is reflected

in the same period as that of the item itself? However, disclosure in

published financial statements of differences between the taxable net

^Coutts, Canadian Chartered Accountant, LXXIV, p. 3^3.

32

income for the period and net income before tax stated or inplied in

the financial statements is highly desirable, and one of the more de­

sirable methods of showing this difference in taxable income and

2^ financial income is the inter-period allocation of income taxes. -

The next chapters will discuss further some of the problems

accountants incur in recording deferred income tax liabilities and de­

ferred income tax expense in the accounts.

^^Coutts, Canadian Chartered Accountant, LXXXIV, p. 3li3.

CHAPTER H I

BALANCE SHEET CLASSIFICATION OF DEFERRED TAX

In this chapter the writer will discuss the problems that develop

when inter-period income tax allocation procedures are used in the fi­

nancial statements. One problem arises when income taxes are charged

against income in the periods in which the income is recognized for ac­

counting purposes instead of being charged in the periods in which the

income is recognized as taxable income.

This problem may also arise when expenses are charged to income

for accounting purposes in one period and these same expenses are

charged to taxable income in a different period. If, for exanple, the

income tax expense charged against income for a given accounting period

is greater than the current income tax liability as shown on the bal­

ance sheet, then the accounting problem arises as to the proper balance

sheet classification of the deferred tax. The deferred tax balance is

the difference between the income tax expense charged to income and

the amount of income tax shown as a current liability on the balance

sheet.

The deferred tax may have a debit or a credit balance, but in a

majority of cases it has had a credit balance. There is much discussion

and argument as to the proper classification of this deferred tax and

in this chapter the writer presents some of the recommended balance

sheet classifications along with some discussion of each,

33

31;

Credit Balance

Many and probably most of the situations in which income tax

allocation has been advocated are those which would give rise to cre­

dits in the balance sheet. This is understandable in view of the con­

servative attitude of most businessmen and accountants. The main ap­

proach to allocation in the United States, therefore, has been by way

of recognition of deferred income taxes,-^

If an additional charge is made to the taxes assessed in order

to determine tax expense, what does a deferred tax credit balance thus

created represent? Many answers to this question have been offered.

A credit balance must be a revenue or a reduction of expense, an asset

valuation allowance, a liability, or a part of the ownership equity.

Accountants have presented arguments for almost every one of these ac-

2 count classifications.

The Committee of Accounting Procedure of the American Institute

of Certified Public Accountants has suggested that when the accumulated

difference between taxable income and financial income will continue

for a relatively long or an indefinite period the deferred tax credits

might be interpreted as additional or increased amortization or depre­

ciation applicable to such assets in recognition of the loss of future

deductibility for tax purpose.^ This suggestion is based on the premise

^Powell, New York Certified Public Accountant, XXIX, No. 1, p.

25.

^J. E. Sands, "Deferred Tax Credits Are Liabilities," Account­ing Review, XXXIV, No. k (October, 1959), p. 587.

^Accounting Research Bulletin kk (Revised), p. 2-A.

35

that the value of a depreciable asset is conprised of two factors, its

value in use and its value as a claim against taxable income.

Tax deductibility gives value to an asset, and the fair value

of an asset whose cost is not tax deductible is less than the fair

value of an otherwise identical asset whose cost is tax deductible.

Therefore, if the taking of a deduction in the tax return decreases

the future "tax deductibility" of the asset, the amount at which the

asset is carried forward should reflect this partial utilization and

recovery of the asset's cost through reduced taxes. Unless, the

assets' carrying value recognizes this reduction in value, the asset

is simply overstated.^

One simple and understandable solution is that the corporation

which deducts liberalized depreciation in its tax return but not on

its books (1) charges as depreciation in its income statement an amount

equal to the tax reduction and (2)credits accrued depreciation to re-

fleet the utilization of tax deductibility.^

While this view can be supported by the observation that a

business which has used up more of its tax allowance claims in respect

to depreciable assets is worth less to a prospective buyer, the fact

that the business as a whole is worth less does not necessarily mean

that the individual assets are worth less. There is no loss of value

in the physical sense, but only a loss of tax deductibility.

^James L. Dohr, "Tax Allocation," A letter to the Editor, Journal of Accountancy, CVII, No. 2 (February, 1959), pp. 19-20.

^Ibid.

^Sands, Accounting Review, XXXIV, No. U, p. 587.

36

Seemingly the adoption of the suggested treatment of the accu­

mulated tax adjustment as an addition to the accumulated depreciation

or amortization would draw attention to the relationship between the

tax saving and the reduction in future deductibility of fixed asset

costs and thus would help to make one of the underlying reasons for

the practice a little clearer to the reader of the balance sheet.'

So long as income taxes are treated as expense, the deferred

tax resulting from the use of different accounting methods for re­

porting and tax purposes should be "allocated" in order to show the

new source of funds arising from this practice. This allocation

should be done regardless of the fact that the liability will or will

not have to be repaid, because such a procedure will be helpful in

assessing the effects on working capital of good operations and wise

income-tax management. This method recognized the fact that the use

of accelerated depreciation methods provides a source of funds which

is interest free and that may never have to be repaid. The fact that

the "liability" is unlike other accounts should cause no difficulty

in balance sheet presentation. The amount of the deferred tax might

be included in the liabilities section under a new classification,

such as "liabilities in perpetuity" or "loans with an indefinite life."°

Still another possibility is to show the deferred tax as part of

the stockholders' equity section of the balance sheet, titled "loans

from government." An argument that might be advanced in favor of this

'^Coutts, Canadian Chartered Accountant, LXXIII, No. 5, p. iU;7.

°Jaedicke and Nelson, Accounting Review, XXXV, No. 2, pp. 279-280.

37

treatment is that comparisons between companies would be facilitated.

Suppose that two companies are being conpared which are alike in all

respects except that one corrpany uses an accelerated depreciation

method for tax purposes and the other uses straight-line depreciation

for both tax and financial purposes. The company that uses an accel­

erated method is better off than the other conpany, not because the

operating income is higher, but rather because funds have been pro­

vided through reduced taxes. Other things being equal, this addi­

tional source of funds should augment working capital and future in­

come. If the income statement and the funds statement are prepared

and used properly, the difference between the two conpanies will

show up without any distortion in the income statement.'^

After Bulletin hk was revised, some accountants accepted the

concept of income tax allocation with the deferred tax balance being

shown in the equity section of the balance sheet as a portion of re­

tained earnings. The balance was usually considered as retained earn­

ings restricted for the payment of future income taxes. Even with

the amount being acconpanied by words of limitations such as "re­

stricted" or "appropriated," this method of balance sheet presenta­

tion met with opposition from the AICPA's Committee on Accounting

Procedure. Then in February, I96O, the U. S. Securities and Exchange

Commission issued Accounting Series Release No. 85 in which it also

opposed this method of deferred tax presentation.

^Jaedicke and Nelson, Accounting Review, XXXV, No. 2, p. 281.

38

A letter in regard to balance sheet treatment of the credit

for deferred income taxes was approved by the Committee on Account­

ing Procedure and dated April 15, 1959. A copy of this letter was

to be mailed to the members of the AICPA, but mailing of the letter

was delayed because of an injunction obtained on April 15, 1959, by

the Appalachian Power Company, Ohio Power Company, and Indiana &

Michigan Electric Company. The injunction forbade the mailing of the

letter without first exposing it for comment to those to whom the ex­

posure draft of Accounting Research Bulletin No. hk (Revised) had been

submitted and required a deferring of its mailing until sixty days

after such exposure.^

On June 17, 1959, the Court of Appeals affirmed the ruling of

the lower Court that the suit should be dismissed and dissolved the in­

junction. In this case the right of the AICPA to issue opinions on ac­

counting principles was upheld by the Courts.

The letter in question reads as follows:

Question has been raised with respect to the intent of the committee on accounting procedure in using the phrase "a deferred tax account" in Accounting Research Bulletin No. kk (revised), "Declining-balance Depreciation," to in­dicate the account to be credited for the amount of the de­ferred income tax (see paragraphs 1; and 5).

The committee used the phrase in its ordinary connota­tion of an account to be shown in the balance sheet as a

1^. H. Penny, A letter from the AICPA's President to the mem­bers of the American Institute of Certified Public Accountants, "Bal­ance Sheet Treatment of Deferred Tax Credits," New York Certified Public Accountant, XXIX, No. 9 (September, 1959), pp. 6UU-6U5.

ll-Arthur Andersen & Co., The AICPA Injunction Case (Chicago: Arthur Anderson & Co., I960), p. 6.

39

liability or a deferred credit. A provision in recogni­tion of the deferral of income taxes, being required for the proper determination of net income, should not at the same time result in a credit to earned surplus or to any other account included in the stockholders' equity sec­tion of the balance sheet.

Three of the twenty-one members of the committee, Messrs. Jennings, Powell and Staub, dissented to the issu­ance at this time of any letter interpreting Accounting Re­search Bulletin No. kk (revised).^2

In passing on the form and content of financial statements to

be distributed to the public in connection with the sale of securities,

the Securities and Exchange Commission permits financial statements

to be prepared on the basis of the accounts prescribed by state regu­

latory commissions, only if the accounting principles reflected in

such statements are in accordance with generally accepted accounting

principles. And the opinions of the Committee on Accounting Procedure

are accepted by the SEC as persuasive authority in determining whether

principles of accounting are generally accepted. Because these three

public utilities carried an aggregate of more than $65 million in ac­

counts for deferred federal income taxes in the stockholders' equity

section of their balance sheets, they opposed the Committee's letter

quoted earlier. The letter in effect said that they would have to

remove this balance from the stockholders' equity section and recog­

nize it as a deferred credit. Such a recognition of the deferred tax

balance could result in these companies having to pay higher interest

rates on their debts because it would make their financial ratios less

appealing to potential investers. Also, these companies currently and

^^Accounting Research & Terminology Bulletin (Final Edition; New York: American Institute-of-Certified Public Accountants, 196l), p. 7-A,

1;0

regularly utilize short-term bank loans, and the removal of the credit

from stockholders' equity would have the effect of limiting this short-

term borrowing power under existing statutes.

If the amount in question was replaced by the issuance of com­

mon stock, the result would be a net increase in capital charges of

approximately $k*k millions each year. An increase in such capital

charges would increase the cost of these companies' products enough to

impel potential new customers to decide to locate outside these com­

panies' service area.-'-

In Accounting Series Release No. 85, issued on February 29, I960,

the SEC confirmed these companies' fears when the Commission took a

position which coincided with the view expressed by the Committee on

Accounting Procedure in the letter dated April 15, 1959. In the re­

lease, the Commission gave some of the reasons which affected their

conclusion. Many of these reasons have been mentioned earlier in this

paper and others will be discussed in Chapter IV. However, they can

be summarized now into three groups. First, the Commission stated

that unless income taxes are allocated there is a failure to match

properly costs and revenues in the financial statements. Second, they

said that in their opinion "it is improper to charge income with an

item required for the proper determination of net income and concur­

rently to credit earned surplus." Third, they stated that classifying

the item as a component of common stock equity is misleading for finan­

cial statement purposes and thus the item should not be considered as

13Arthur Andersen & Co., The AICPA Injunction Case, p, 3,

kl

part of common stock equity for analytical purposes.-^

The conclusion of the Commission with respect to the treatment

of the credit arising from income tax allocation is as follows:

For the foregoing reasons, on and after the effective date (April 30, i960) of this statement of administrative policy, any financial statement filed with this Commission which designates as earned surplus (or its equivalent) or in any manner as a part of equity capital (even though ac­conpanied by words of limitation such as "restricted" or "appropriated") the accumulated credit arising from ac­counting for reductions in income taxes resulting from de­ducting costs for income tax purposes at a more rapid rate than for financial statement purposes will be presented by the Commission to be misleading or inaccurate despite dis­closure contained in the certified report of the account­ant or in footnotes to the statements, provided the amounts involved are material,-^^

In considering the problem, however, the SEC in Release No, 85

made a very broad statement which went beyond the immediate question

considered in the release and was later interpreted by many as having

possible far-reaching consequences. The paragraph in question reads

as followsg

A number of comments indicated that, should the Com­mission take the foregoing position, it should be limited to matters connected with depreciation and amortization or, if not so limited, any additional items embraced within this principle should be clearly specified. It is the Commission's view, however, that comparable recognition of tax deferment should be made in all cases in which there is a tax reduction resulting from deducting costs for tax purposes at faster rates than for financial statement pur­poses.-^"

^ U . So Securities and Exchange Commission, Accounting Series Re­lease No. 85 (Washington£ U. S. Government Printing Office, I960).

k2

If the SEC's above statement was meant to be interpreted lit­

erally, then the release went far beyond the requirements of the gen­

erally, accepted accounting principles on income tax deferment. '

Because of the confusion caused by the release, the American

Institute of Certified Public Accountants addressed a letter to Mr.

Andrew Barr, the chief accountant of the commission, requesting Mr.

Barr to interpret the paragraph in question (the one quoted above).

The SEC also received comments from others directed toward the same 1 o

portion of the release.

Having carefully considered the various comments, the Commis­

sion clarified its position on April 12, i960, by issuing Accounting

Series Release No. 86 titled "Response to Comment on Statement of

Administrative Policy Regarding Balance Sheet Treatment of Credit

Equivalent to Reduction in Income Taxes." The release reads as fol­

lows:

The Commission has authorized me to respond to your letter in which you express concern over the wording of the last sentence in the first full paragraph on page k and the first sentence of the paragraph immediately fol­lowing it in Securities Act of 1933 Release No. 1;191 (also identified as Securities Exchange Act of 193ii Release No. 6189, Holding Company Act Release No. ll;173. Investment Company Act of 19kO Release No. 2977, and Accounting Series Release No, 85). The full paragraph to which you refer and the following sentence read as follows: [The paragraph and sentence referred to were quoted aboveJ

It was not the Commission's intention by the publica­tion of this release, stating an administrative policy

1*7Louis H. Rappaport, "Accounting and the SEC," New York Certi­fied Public Accountant, XXX, No. 6 (June, I960), pp. U19-U20,

• "Carman G, Blough, "Accounting and Auditing Problems," Journal of Accountancy, CIX, No. 6 (June, i960), pp. 65-66,

k3

regarding balance sheet treatment of the credit equivalent to the reduction in income taxes when deferred tax account­ing is employed, to make mandatory the use of deferred tax accounting beyond the requirements of generally accepted accounting principles,^^

After the AICPA and the SEC's letters and statements regarding

the classification of the deferred tax credit had been publicized it

became a well established principle that the deferred tax credit bal­

ance should not be included under the equity section caption of the

balance sheet.

A letter issued by the AICPA's Committee on Accounting Proce­

dure indicated that the deferred tax credit should be "shown in the

balance sheet as a liability or a deferred credit."^'^ Many account­

ants and businessmen argued however, that the classification as a

liability was incorrect since the account did not meet the traditional

requirements of a liability. If the government does not recognize the

liability, then to whom is the liability owed? With no creditor, how

can a liability be properly recognized, and if there is no liability,

how can one present the financial statements as if it did exist?

Even if a future liability is likely to occur, the difficulty

involved lies in the fact that the taxes ultimately payable will be

different from the taxes estimated at the time the income was recog-

nized, if profit levels change(change into a different rate) or if

tax rates change in the meantime. If the difference is significant.

-'- U. S. Securities and Exchange Commission, Accounting Series Release No. 86 (Washington: U. S. Government Printing Office, I960).

20committee on Accounting Procedure, A letter to the Members of the AICPA.

kk

the deferred balance would have to be adjusted. The necessity of es­

timating and possibly later adjusting a liability is not unusual in

accounting, however.^-^

No reasonable person will insist that the determination of the

amounts of current income tax expense payable in the future is not an

estimate. The amounts actually may be more or less than the original

estimate, depending on changes in tax rates, on the existence of tax­

able income in the future, and perhaps on other factors (some of which

have been discussed in Chapter II). But the possibility that part of

the liability may not have to be paid or, conversely, that the actual

payments may exceed the original estimate does not remove the responsi­

bility for making a charge against the current period for a reasonable

estimate of income tax expense applicable to current reported income

22 but payable in the future.

One possible solution is that the accountants' concept of lia­

bilities may change. Concern over accounting treatment of the obli­

gation assumed on a long-term lease and the past-service credits of

pensions funds and the deferred tax credits may produce a re-definition

of liabilities.^^

If the main objection to inter-period allocations is that the

credits do not present the usual characteristics of liabilities, why

21Sands, Accounting Review, XXXIV, No. 1;, p. 581;.

^^Willard J. Graham, A letter to the Editor, Journal of Account­ancy, CVII, No. 5 (May, 1959), p. 26.

23Jaedicke and Nelson, Accounting Review, XXXV, No. 2, p. 279.

U5

not broaden the definition of liabilities to include the prospective

obligation of future taxes when the probability of having to make

these tax payments is quite high?

Even the definition of a liability by the AICPA»s Committee on

Terminology (as quoted in Chapter I) includes as liabilities those

"credit balances to be accounted for which do not involve the debtor

and creditor relation."^^

The Canadian Committee on Accounting and Auditing Research of

the Canadian Institute of Chartered Accountants does not refer to the

credit account as a deferred tax liability, representing tax payments

to be made in future periods. Rather, both explicitly and iirplicitly

it expresses the concept that the credit is a deferred credit to in­

come tax expense. This concept is based on the premise that a current

reduction in income arising from deductions of a specific expense item

for tax purposes in excess of amounts recorded in the accounts should

not be reflected in current income but should be carried forward, as

deferred credits to income tax expense, to the future period or per-

iods in which the specific expense item is charged to expense.

Thus, the Canadian principle regards the adjustment as a de­

ferred credit to expense, the amount of which is determined by the

taxes actually saved in the year the adjustments are made, and no

speculations about the future are needed to arrive at the amount in­

volved.

^^Accounting Terminology Bulletins No. 1—Review and Resume, p. 11;.

25Graham, Journal of Accountancy, CVII, No. 1, p. 6U.

1;6

Debit Balances

Cases have arisen in which income-tax allocation would produce

debits in the balance sheet. These are instances in which losses or

expenses or provision therefor are recorded in the accounts before

they become deductible for income-tax purposes and those in which prof­

its or income become taxable before they can be taken up for financial

accounting purposes in conformity with generally accepted accounting

principles. If doubts occur about whether a tax credit is a liability,

then more serious doubts occur about whether a tax debit is a good

asset. It is not a receivable. If it is not a receivable, it must be

a cost that relates to a future period. This, of course, gets into

the question of the basis for matching revenues and expenses for income

statement purposes (a point discussed in the next chapter).

If differences between accounting income and taxable income

produce a debit balance of deferred taxes, the balance would fall into

the asset category of deferred charge (a deferred charge was defined

in Chapter I). One could argue on grounds of conservatism that a

debit balance should be written off immediately rather than set up as

an asset, but conservatism can be carried too far. Thus, most of the

principles which apply to deferred tax credits apply also to deferred

27 tax debits. '

From the discussion presented in this chapter apparently con­

siderable disagreement exists among accountants as to the balance

2%owell, New York Certified Public Accountant, XXIX, No. 1, p. 26.

^'^Sands, Accounting Review, XXXIV, No. k, p. 590.

1;7

sheet classifications of deferred tax balances. It seems highly likely,

however, that the usual degree of conformity obtained by recommendations

in accounting research bulletins combined with the more forceful per­

suasion practiced by the Securities and Exchange Commission will result

m a fairly general adoption of the recommended deferred income tax

procedures within a short time.

In the next chapter the effect of income tax allocation on the

income statement is presented.

CHAPTER IV

TAX ALLOCATION'S EFFECT ON INCOME STATEMENT

Charges Against Income

Income is measured in accounting by first determining what

the revenues for the period are and then by charging those revenues

with the expenses that were incurred in earning them. When the ac­

counting values involved are material, charges to income represent­

ing provisions for deferred taxes are serious because they signifi­

cantly reduce the reported net income of a company for each report­

ing period affected. Thus, the first question to be answered is

whether income taxes are an expense.

In Bulletin 1;3 the American Institute of Certified Public Ac­

countants' Committee on Accounting Procedure stated that:

Income taxes are an expense that should be allocated, when necessary and practicable, to income and other ac­counts, as other expenses are allocated. What the income statement should reflect under this head, as under any other head, is the expense properly allocable to the in­come included in the income statement for the year.^

Since income taxes are considered an expense, they must be

charged against revenues in the same way that other expenses are, that

- Arnold W. Johnson, "'More' on 'Income-Tax Allocation' Account­ing," Accounting Review, XXXVI, No. 1 (January, I96I), p. 78.

^Committee on Accounting Procedure, Accounting Research Bulle­tin No. 1;3, p. 88.

U8

k9

is, the taxes incurred in earning income must be charged against that

income in the same year that the income is recognized in the accounts,

and the period income tax expense should be measured by applying the

current tax rate to the reported financial income.

The acceptance, by its proponents, of income tax allocation

follows from the recognition of income taxes as an expense of doing

business under contemporary conditions. They argue that income tax,

being a cost incurred as part of the normal income earnings activity,

must, like other costs, be subject to the "matching principle" and

must be recorded in the accounts in the same period as that of the

related income. The fact that income tax is imposed on net profit,

and is thus affected by both revenues and expenses, may conplicate

the application of the matching principle to income tax expense, but

does not make it invalid. It merely means that an allocation or trans­

fer of income taxes is required, not only in cases where items of in­

come are transferred from one period to another, but also when items

of expense are so allocated or transferred. The process is therefore

appropriate in any case in which an item of income or expense is

recognized in the accounts in a fiscal period other than the one in

which it is taken into account for tax purposes. This does not mean

that every difference between taxable income and reported income

must inevitably be accompanied by an adjustment of tax expense. Since

the object of the procedure is to match the income tax expense with

the items of income and expense reflected in the accounts, no alloca­

tion is required on items which have no effect on taxable income or on

nfoS^ trcwNt^^b ifeAi QHaukCOl

50

items which are never included in the determination of either taxable

or financial net income.-'

The most convincing case for income tax allocation, according

to Mr. Graham, rests upon its proper matching of expense with revenue,

the allocation of income tax expense among periods in relation to the

reported net income rather than to the taxable income. While the in­

come statement does report the results of past operations, its utility

to the reader depends primarily upon its validity as a basis for ap­

praising the profitability of, or for planning the control of, future

operations. The failure to give proper recognition to the deferral of

credits to income tax expense produces a net income amount that is

likely to lead the reader to an over estimate of future earning power;

conversely, the non-recognition of deferred charges to income tax ex­

pense may lead to an underestimate of future earning power. Since the

principal function of the income statement is to facilitate the fore­

casting of future earning power, the proper matching of expense and

revenue demands the allocation of income tax expense, even in those

cases where deferment is for a relative long period.^

Many authors state that income tax allocation achieves a better

matching of expense and revenue than does non-allocation. But, accord­

ing to Mr. Ifylton, accounting income and income tax expense are not re­

lated in any measurable or definable manner. The yearly income tax ex­

pense is the amount shown on the tax return for that year, and many

3coutts, Canadian Chartered Accountant, LXXVI, No. U, pp. 393-398.

kiraham. Accounting Review, XXXIV, No. 1, pp. 15, 23.

51

factors, not only accelerated depreciation, can and do alter the re­

lationship between accounting income and income tax expense. If one

is to recognize one of these factors, surely one should recognize all

of them, and Mr. Ifylton feels that in these situations tax allocation

has not resulted in a better matching of revenues and expenses.

Much of this difficulty arises from the recognition of income

tax as an operating expense. Mr. Ifylton believes that the profession

would be well advised to recognize the difference between accounting

income and taxable income and to treat the income tax liability as a

division of profit rather than as a deduction before profit. Then

problems such as the one being debated here would be placed in their

proper perspective and would be relatively unimportant.''

Revealed in Mr. I^lton's statement is the idea that an income

tax is not an expense but it is a division of profit. This idea is

supported by others, but unless the AICPA changes its treatment of

income tax as an expense, the idea will not become widely accepted.

An argument that an asset's value is partially represented by

its tax deductibility proposes that the fair market value of an asset

whose cost is not tax deductible is less than the fair market value of

an otherwise identical asset whose cost is tax deductible. Therefore,

the using up of the deduction should be recognized in matching costs

and revenues for purposes of determining income. To be specific, using

the same depreciation method for a given asset for both book and tax-

return purposes results in an appropriate matching of income taxes and

5Delmer P. .Ifylton, "Income Tax Allocation," Letter to the Editor, Journal of Accountancy, CVII, No. 5 (May, 1959), pp. 25-26.

52

revenue. When, as a result of using different methods, book deprecia­

tion is less than tax-return depreciation, allocation is necessary to

charge against income, as a cost, that part of the tax deduction at­

taching to the asset which has expired.

An illustration of a company's reporting its net Income without

tax allocation is as follows:

Another factor contributing to the improved earnings is the change, effective January 1, I96I, in the method of ac­counting for the benefits arising from the use of accelerated depreciation for tax purposes, as described more fully in the i960 report to stockholders. The net effect of this accounting charge, which permits the tax savings to flow through to net income, and a change, made concurrently, from the sinking-fund to the straight-line method of accruing depreciation on the Company's books, was to increase net income for the first half of 1961 by about $3,512,000, equivalent to 20 cents per share of common stock.

However, the California Public Utilities Commission an­nounced, by order issued March 21, I96I, that the Company and other utilities using accelerated depreciation are required to credit the tax benefits to depreciation reserves until their rates for service are fixed on the basis of the tax benefits flowing through to earnings. The rates for the Com­pany's gas department have been so fixed. Should this order, now the subject of a rehearing, be reaffirmed and held valid and applicable to the other departments of the Company, net earnings for the twelve months ended June 30, 19§1, would be reduced from $i;.5l per share to $1;.33 per share.°

Credits to Income

A deferred charge may arise from two situations each involving

the differences between financial and taxable concepts of net income.

One situation exists when income is included in taxable income but is

not recognized as accounting income in the same given period. The

"Pacific Gas and Electric Company, "President's Quarterly Let­ter," San Francisco 6, California, June 30, I96I.

53

other situation that may arise exists when some expenses not recognized

for tax purposes until a later period are charged against income for

financial purposes. In each of these situations the accounting income

is charged with less income tax expense than is currently payable to

the government if tax allocation procedures are followed.

For example, if one assumes that a company using income tax allo­

cation procedures has taxable income of $600,000 and an accounting in­

come before taxes of $1;00,000 and that a 50 percent tax rate is applied

to the taxable income, the tax currently payable to the government is

$300,000 and the income tax expense is $200,000. The difference of

$100,000 is a deferred charge which will be shown on the balance sheet.

In each following period in which the tax expense shown in the income

statement exceeds the tax liability, the excess is credited to the de­

ferred charge account.

In such cases as described above in the exanple the accounting

income will tend to be understated unless income tax allocation proce­

dures are followed in the statements, and prospective financial state­

ment readers may be misled by the understatement of accounting income.

With income tax allocation procedures, the accounting income is

charged with income tax expense based on the accounting income. The

difference between the expense and the current liability is the amount

of the deferred charge.

Since accountants tend to be conservative and also since busi­

nesses tend to postpone the income tax liability, if possible, to an­

other accounting period, the cases resulting in the deferred tax bal­

ance being a debit seem to be less than those cases resulting in the

5ii

balance being a credit. These deferred tax credits, however, should be

recognized in the statements when they occur in material amounts.

In the next Chapter the summary and conclusions of this paper

will be presented.

CHAPTER V

SUMMARY AND CONCLUSION

" In this paper the writer has attempted to present some of the

inportant factors affecting the allocation of income taxes. From

these factors a reader can draw conclusions as to the future of in­

come tax allocation.

Income tax allocation goes into some of the very basic account­

ing principles. The problem of income tax allocation arises from the

fact that taxable income may be radically different from financial net

income before taxes as reported in the income statement. Resulting

from this difference in taxable and financial concepts of net income

is the fact that the current tax liability may bear no normal relation­

ship to the financial net income before taxes. The high tax rates

augment this distortion between accounting net income and the tax

liability. Thus, income tax allocation procedures are intended to

cause the tax expense shown on the income statement to bear a more

normal relation to financial net income before taxes as reported in

the statements.

In Chapter I some of the history and the development of proce­

dures which gave rise to the need for income tax allocation were dis­

cussed. Even though a need existed many accountants and authors thought

that income tax allocation procedures did not present a more useful

and meaningful set of financial statements than did non-allocation proce­

dures .

56

Beginning in Chapter II the writer presented some of the account­

ing conditions that created the need for income tax allocation proce­

dures. Many accountants admit that a need exists, but argue that tax

allocation has more disadvantages than advantages to offer. Thus, the

writer presented some of the leading advantages and disadvantages of

income tax allocation procedures.

From the discussion in Chapter II one can recall the three types

of income tax allocation. Most accountants favor intra-statement tax

allocation when the amounts are material and the statements are likely

to be misleading without this allocation of income tax within the in­

come statement. This allocation calls for income taxes on material

items to be shown against the item giving rise to the tax effect and

thus separated from the income taxes arising from net operating income.

Assume that a company had a material amount of income from dividends

and also a material net operating income before income taxes. If

intra-statement income tax allocation was used by the company, then

the income tax on the dividend income would be shown separately from

the income taxes applying to the net income from operations.

Most accountants also favor the intra-period income tax allo­

cation which calls for allocation between the income statement and the

retained earnings statement. Of importance in this situation is the

question of whether or not the "current operating" or the "all inclu­

sive" concept of net income is followed. Under the current operating

concept the income statement shows only the net income from current

operations with extraordinary and unusual items being carried to the

retained earnings statement. The all inclusive concept calls for the

57

unusual items to be shown on the income statement as a charge or credit

to operating net income.

If the current operating concept is followed by a company, the

tax should be shown against the unusual item giving rise to the tax.

Thus, the item and its tax effect should be shown in the retained earn­

ings statement.

Under the all-inclusive concept the unusual item would be shown

in the income statement and the tax would be shown against the item

leaving the ''net of tax effect" in the statement (illustrated in state­

ments in Appendix A ) .

The more difficult problems arise in the inter-period income

tax allocation, that is, allocation of income taxes between the income

statement and the balance sheet, or rather an allocation between ac­

counting periods. Thus, the tax expense shown on the income statement

is not the same amount that is currently payable to the government, and

the difference is the deferred tax balance which is shown on the bal­

ance sheet.

One of the main arguments against inter-period allocation is the

uncertainty involved, for one cannot be certain that future operations

will provide a need for charging or crediting the future statements

with the deferred balance. The uncertainty arises from the fact that

changes may occur in future income tax rates and that a company's future

taxable income may fluctuate greatly. Certain tax laws may be abolished

or amended so that future taxable income will be radically different

from one's estimated future taxable income.

The uncertainty involved in inter-period allocation, however,

does not mean that tax allocation should not be used. As pointed out

58

in Chapter H , although tax allocation may not be exact, it does seem

to present a truer concept of net income than if no allocation is made

on the statements.

In Chapter H I the problems involved in the balance sheet classi­

fication of the deferred tax balance were presented. Many solutions

have been offered, but the most widely accepted solution seems to be

the recognition of a deferred charge or of a deferred credit in the

balance sheet. Here it is argued that these accounts do not fit the

generally accepted definitions of balance sheet accounts. It seems

likely, however, that such classifications will continue until general

acceptance requires that the definition of these items change or until

a better solution is adopted for tax allocation reporting.

Income tax allocation and its effect on the income statement

were discussed in Chapter IV. The fact that tax allocation is neces­

sary to achieve the proper matching of revenues and expenses and to

prevent the issuance of misleading financial statements by either

over or understating net financial income was made clear.

In conclusion, the impact upon financial reporting has been and

will continue to be material both in terms of the number of conpanies

affected and the dollar amounts of income and expenses involved.

Clearly, one needs to know much more concerning the probable course

of future events in each case dealing with income tax allocation, but

seemingly the need for allocation will be increasing instead of de­

creasing, because the differences between financial and taxable concepts

of income and expenses seem to be increasing instead of decreasing.

Graham, Accounting Review. XXXTV, No. 1, p. 22.

S9

The need for income tax allocation may be increased by the cur­

rent political administration, for it is pressing for additional tax

incentives to investment which may widen the gap between net income

reported for financial purposes and taxable income for a given period.

Thus, the need for income tax allocation is likely to be ever increas­

ing.

Although the need is increasing, the allocation problem is still

a live issue in accounting circles, as evidenced by its assignment as

a subject for research by the American Institute of Certified Public

Accountants. However, the action already taken by the AICPA and the

SEC, together with an increasing general acceptance by corporations

and public accounting firms, seems to largely reduce the area of

dispute over income tax allocation procedures. If this is true, one

future question is how far will the principle be extended in financial

reporting.

While many valid arguments against it are presented, income tax

allocation is here to stay even though it may not be applied consis­

tently or universally for many years to come. The requirements and

logical dictates of accrual accounting call for a more complete ac­

counting for taxes than has been customary in the past.

BIBLIOGRAPHY

Public Documents

United States Securities and Exchange Commission, Accounting Series Releases, Release No. 53. Washington: U. S. Government Print-ing Office, 1956.

. Accounting Series Release No. 85. Washington: U. S. Govern­ment PrlJtrEIngOfTTceT^

Accounting Series Release No. 86. Washington: U. S. Govern­ment PHnHngOffic^7"T9^

Books

Arthur Andersen & Co. The AICPA Injunction Case. Chicago: Arthur Andersen & Co., I960.

. The Alton Water Company Deferred Tax Cage. Chicago: Arthur Andersen & Co,, I960.

Finney, H, A. and Miller, Herbert E. Principles of Accounting, Inter­mediate . 5th ed. New Jersey: Prentice-Hall, Inc., 195^.

Paton, W. A. and Paton, W. A., Jr. Corporate Accounts and Statements. New York: McMillan Company, 1955.

Articles and Periodicals

Blough, Carman G. (ed.), "Accounting and Auditing Problems," Journal of Accountancy, CIX, No, 6 (June, I960), pp, 65-66.

Cerf, Alan Robert, "Tax Allocation and Railroad Accounting," Journal of Accountancy, CVI, No. k (October, 1958), pp. 62-69.

Coutts, W. Barry. "Accounting Research," Canadian Chartered Account­ant, LXXII, No. 5 (November, 1958), pp, l;U3-llUa.

. (ed.). "Accounting Research," Canadian Chartered Account-- ^ , ^XIV, No. 1; (April, 1959), pp. 3U1-3U6.

__ (ed.). "Accounting Research," Canadian Chartered Account-suit, LXXVI, No. k (April, I960), pp. 393-39«.

60

61

Davidson, Sidney. "Accelerated Depreciation and the Allocation of Income Taxes," Accounting Review. XXXIII, No. 2 (April, 1958), pp. 173-180.

Dohr, James L. "Tax Allocation," A letter to the Editor, Journal of Accountancy, CVII, No. 2 (February, 1959), pp. 19-20.

Graham, Willard J. A letter to the Editor, Journal of Accountancy, CVII, No. 5 (May, 1959), p. 26, ^

, . "Allocation of Income Taxes," Journal of Accountancy, CVII, No. 1 (January, 1959), pp. 57-67.

_. "Income Tax Allocation," Accounting Review, XXXIV, No. 1 (January, 1959), pp. ll;-27.

Hartwood, Dale S., Jr. "Yet More on Tax Allocation," Accounting Re­view, XXXVI, No. h (October, 1961), pp. 619-625^

Hendriksen, Eldon S. "The Treatment of Income Taxes by the 1957 AAA Statement," Accounting Review, XXXII, No. 2 (April, 1958), pp. 216-221.

Hill, Thomas J. "Some Arguments Against the Inter-Period Allocation of Income Taxes," Accounting Review, XXXII, No. 3 (July, 1957), pp. 357-361.

Hylton, Delmer P. "Income Tax Allocation," Letter to the Editor, Journal of Accountancy, CVII, No. 5 (May, 1959), pp. 25-26.

Jaedicke, Robert K. and Nelson, Carl L. "The Allocation of Income Taxes—A Defense," Accounting Review, XXXV, No. 2 (April, i960), pp. 278-281.

Johns, Ralph S. "Allocation of Income Taxes," Journal of Accountancy, CVI, No. 3 (September, 1958), pp. l;l-50.

. "Canadian Tax Allocation," A letter to the Editor, Journal of Accountancy, CVII, No. 6 (June, 1959), p. 21;.

Johnson, Arnold W. "More on Income Tax Allocation," Accounting Review, XXXVI, No. 1 (January, I96I), pp. 75-83.

Journal of Accountancy, Editorial. "Accounting Research Bulletin 1;1; "Revised," CVI, No. 2 (August, 1958), pp. 25-26,

Journal of Accountancy, Editorial. "Institute's Right to Issue Ac­counting Opinions Upheld by Courts," CVIII, No, 2 (August, 1959), pp, 23-21;,

Journal of Accountancy, Editor's Note before an Article, CXI, No. 6 (June, 1961), p. 61;.

62

Kelly, Arthur C. "Comments on the 1957 Revision of Corporate Account­ing and Reporting Standards," Accounting Review, XXXIII, No. 21 (April, 1958), pp. 2ll;-2l5.

Li, David H. "Income Taxes and Income Tax Allocation Under the Entity Concept," Accounting Review, XXXVI, No. 2 (April, I96I), pp. li-k9.

Love, David. "Differences Between Business and Tax Accounting," Jour­nal of Accountancy, CX, No. 3 (September, I960), pp. kk'k9»

Moonitz, Maurice. "Income Taxes in Financial Statements," Accounting Review, XXXII, No. 2 (April, 1957), pp. 175-183.

"The Basic Postulates of Accounting," Accounting Research Study No. 1, New York: American Institute of Certified Public Accountants, I96I, 6I pp.

Penny, L. H. A letter from the AICPA's President to the members of the AICPA, "Balance Sheet Treatment of Deferred Tax Credits," New York Certified Public Accountant, XXIX, No. 9 (September, 195»), pp. 61;1;-61;5.

Perry, Bernard T. A letter to the Editor. Journal of Accountancy, CIX, No. 1 (January, I960), pp. 23-21;.

Powell, Weldon. "Accounting Principles and Income Tax Allocation," New York Certified Public Accountant, XXIX, No. 1 (January, 1959), pp. 21-31.

Rappaport, Louis H. "Accounting and the SEC," New York Certified Public Accountant, XXX, No. 6 (June, I960), pp. i;19-U20.

Ready, Samuel L. "Income Tax Allocation in Financial Statements— Occasions and Opinions," N.A.A. Bulletin, XLII, No. 1; (Decem­ber, i960), pp. 19-30.

Sands, J, E. "Deferred.Tax Credits Are Liabilities," Accoimting Re­view, XXXIV, No. 1; (October, 1959), pp. 581;-590.

Shield, Hans J. "Allocation of Income Taxes," Journal of Accountancy, CIII, No. k (April, 1957), pp. 53-60.

Spacek, Leonard. "Can We Define Generally Accepted Accounting Prin­ciples," Journal of Accountancy, CVI, No. I06 (December, 1958), pp. k$-k6.

Sprouse, Robert T. and Moonitz, Maurice. "A Tentative Set of Broad Accounting Principles for Business Enterprises," Accounting Re­search, Study No. 3, New York: American Institute of Certified Public Accountants, I962, pp. 2-9.

63

Steiner, Robert A. "An Analysis of Income Tax Allocation," Journal of Accountancy, CXI, No. 6 (June, 1961), pp. 61;-67.

Trumbull, Wendell P. "Tax Allocation in Managerial Analysis," Journal of Accountancy, CX, No. k (November, i960), pp. 53-57.

Walgenbach, Paul H. "Legal Views of the Corporate Income Tax Provision," Accounting Review, XXXIV, No, k (October, 1959), pp. 579-583.

_. "Periodicity and the Provisions for Federal Income Tax," as presented by James S. Schindler in his "Abstracts of Disserta­tions in Accounting," Accounting Review. XXXV, No. 2 (April, i960), pp. 312-313.

Whitney, William H. "Deferred Income Tax Liability," Accounting Re­view, XXXIII, No. 2 (April, 1958), pp. 305-309.

Other Published Sources

American Accounting Association. Accounting and Reporting Standards for Corporate Financial Statements and Preceding Statements and Supplements, Columbus, Ohio: Ohio State University, 1957.

Arthur Andersen & Co. "Deferred Income Taxes on Installment Sales," Accounting and Reporting Problems of the Accounting Profession, September, I960, pp, U9-52,

, "Deferred Income Taxes When Not Allowed for Public Utility Rate-making Purposes," Accounting and Reporting Problems of the Accounting Profession, September, I960, pp, U3-U8.

. "Income Tax Allocation," Accounting and Reporting Problems ^f the Accounting Profession, September, I960, pp, 33-36,

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. Accounting Research Bulletin No. 1;1; (Revised^. "Declining-• Falance Depreciation." New York: American Institute of Certi­

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APPENDIX

Appendix A.—Intra-Period Allocation of Income Taxes

Material Charges to Retained Earnings Material Credits to Retained Earnings Income Tax Allocation within the Income Statement

Appendix B.—Inter-Period Allocation of Income Taxes

When Income Tax Allocation Procedures are followed When Income Tax Allocation Procedures are not followed.

65

APPENDIX A: INTRA-PERIOD ALLOCATION OF INCOME TAXES^

Material Charges to Retained Earnings

Assume that XYZ Company has an unusual loss in the amount of

$60,000 that is deductible for tax purposes.^

If the income tax is not allocated, the statements will be:

XYZ COMPANY

Income Statement

For the Year Ended December, I96I

Sales $800,000 Deduct: Cost of Goods sold $500,000 Selling and administrative expenses 200,000 700,000

Net income before taxes $100,000 Income tax 20,000

Net income $ 80,000

XYZ COMPANY

Statement of Retained Earnings

For the Year Ended December, I96I

Retained earnings—beginning of year $1;80,000

Net income 80,000 Total $560,000 Deduct unusual loss 60,000 Retained earnings—end of year $500,000

^Finney and Miller, pp. 6ol;-6o8.

2Assume a 50 percent income tax rate.

66

67

If the income tax is allocated, the statements will be:

XYZ COI^ANY Income Statement

For the Year Ended December, I96I

^^]^^^ $800,000 Deduct:

Cost of goods sold ^^00 000 Selling and administrative expenses 200^000 700,000

Net income before income tax , , [ . . $100 000 Income tax expense ',',',',', 50^000

(The estimated tax liability is $20,000 by'reason of* * * a reduction of $30,000 in taxes resulting from an unusual loss. This loss has been charged to retained earnings and the related tax reduction has been treated as an offset in the retained earnings statement.) Net Income $ 50,000

XYZ C0T1PANY Statement of Retained Earnings

For the Year Ended December, I96I

Retained earnings—beginning of year $1;80,000 Add: .Net Income for the year 50,000 Total $530,000 Deduct:

Unusual loss $6o,000 Less: Offsetting tax effect 30,000 30,000

Retained Earnings—end of the year $500,000

Material Credits to Retained Earnings

Assume that XYZ Conpany has an unusual gain in the amount of

$100,000, instead of a loss of $6o,000 and that the entire $100,000

gain is fully taxable.

Illustrative income statements and statement of retained earn­

ings are thus shown under tax allocation and non-allocation assumptions

68

If the income tax is not allocated, the statements will be:

XYZ COMPANY Income Statement

For the Year Ended December, I96I

Sales $800,000 Deduct:

Cost of goods sold $500,000 Selling and administrative expenses 200,000 700,000

Net income before income tax $100,000 Income tax 100,000 Net income $ -o-

XYZ COMPANY Statement of Retained Earnings For the year Ended December, I96I

Retained Earnings—beginning of the Year $1;80,000 Unusual gain 100,000 Retained Earnings—end of year $580,000

If the income tax is allocated, the statements will be:

XYZ COlf ANY Income Statement

For the Year Ended December, I96I

Sales $800,000 Deduct:

Cost of goods sold $500,000 Selling and administrative expenses 200,000 700,000

Net income before income taxes $100,000 Income tax expense $100,000

Less portion thereof allocated to taxable gain shown in statement of retained earnings. 50,OOP 50,000

Net income $ 50,000

XYZ COMPANY Statement of Retained Earnings For the Year Ended December, I96I

Retained earnings—beginning of year $1;80,000 Add: Net income 50,000

Unusual gain $100,000 Less: Income tax on gain 50,000 50,OOP

Retained earnings—end of year $580,000

69

Income Tax Allocation within the Income Statement

If the all-inclusive concept of statement presentation is fol­

lowed, the extraneous item will be shown in the income statement as

"net-of-tax."

Extraneous Charges in the income statement:

XYZ COMPANY Income Statement

For the Year Ended December, I96I

Sales $800,000 Deduct:

Cost of goods sold $500,000 Selling and Administrative expenses 200,000 700,000

Net operating income before income tax $100,000 Income tax expense thereon 50,000 Net operating income after income tax $ 50,000 Deduct unusual loss $ 60,000

Less tax effect of loss 30,000 30,000 Net income $ 20,000

Extraneous credits in the income statement.

XYZ COI'IPANY Income Statement

For the Year Ended December, I96I

Sales $800,000 Deduct:

Cost of goods sold $500,000 Selling and administrative expenses 200,PPP 700,000

Net operating income before income tax $100,000 Income tax expense on operating income 50,000 Net operating income after income tax $ 50,000 Add: Unusual gain $100,PPP

Less income tax on gain 5P,PP0 50,000 Net income $100»OOP

APPEMDIX B-

To acquire an impression of the potential distortion involved,

compare the two sets of statements presented below:

Assume the company uses income tax allocation procedures.

ABC COMPANY Financial Statements

i960 1961 1962 1963 Income Statement: Net income before income tax. . $1;0,PPP $lpp,ppp $17P,PPP $ 9P,PPP Income Tax expense^ 2P,PPP 5P,PPP 85,PPP l;5,ppp Net income $2P,PPP $ 5P,PPP $ ^5,PPP $ I;5,PPP

Balance Sheet: Income tax payable $ 1;P,PPP $l6p,PPP Deferred income tax payable . . $2P,PPP 3P,PPP $115,PPP

$2P,PPP $ 7P,PPP $115,PPP $16P,PPP

Assume the conpany does not use income tax allocation.

1961 1961 1962 1963 Income Statement: Net income before income tax. . $1;P,PPP $1PP,PPP $17P,PPP $ 9P,PPP Income tax actually payable . , -P- 1;P,PPP -P- 16P,PPP Net income (loss^O $1;P,PPP |"6p,PPP $17P,PPP $(7P,PPP)

Balance Sheet: Income tax payable. . . . . . . -P- $ 1;P,PPP -P- $l6p,PPP

- Finney and Miller, p. 6IP.

'A 5P percent income tax rate was assumed.

7P