Income tax provisions and Schedule M-1(1) of Form 1120 (Corporation Income Tax Return) bridge the financial accounting world and the Internal Revenue Code. The benefit of understanding an income tax provision and an M-1 is that a preparer can bridge the gap between these two worlds.
This will in turn allow the preparer to talk intelligently with auditors, controllers, chief financial officers, corporate tax consultants, and tax return preparers. Because many controllers and CFOs do not have a tax background, it is important to learn at least the fundamentals of accounting for income taxes for financial accounting purposes.
This article does not discuss every situation that may arise on an income tax provision. What follows is intended to cover the purpose of a provision and the components of a provision, including deferred tax assets and liabilities as well as effective tax rate. The article concludes with an income tax provision template with the formulas footnoted.
Purpose of an Income Tax Provision
The Financial Accounting Standards Board issued "Statement 109: Accounting for Income Taxes" (FAS 109) in February 1992. The purpose of FAS 109 is to recognize (a) the amount of taxes payable or refundable for the current year and (b) the deferred tax liabilities and assets for the future tax consequences of events that have been recognized in a corporation’s financial statements or tax returns. In essence, FAS 109 requires public companies to disclose a reconciliation of the reported amount of income tax expense to the amount of income tax expense that would result from applying domestic federal statutory rates to pretax financial income.
Deferred Tax Assets/Liabilities: How Do They Work?
Technically, deferred tax assets/liabilities are timing or temporary differences multiplied by the tax rate, also known as "tax effected." Temporary differences arise where the tax treatment of an item is temporarily different from its financial accounting treatment. For example, for a specific account, GAAP may allow a $20,000 expense and the Internal Revenue Code may allow only an $8,000 tax deduction. In this case, there will be a temporary difference if the Internal Revenue Code allows for the remaining $12,000 to be deducted in subsequent years.
A deferred tax asset/liability is the sum of the temporary differences for the ending balance in that account multiplied by the tax rate. The ending balance is relevant because FAS 109 takes a balance sheet approach. "Balance sheet approach" means that in arriving at a deferred tax asset or liability, the ending balance amount is the relevant number. Therefore, in the example above, if the account had a prior-year ending balance for tax purposes of $30,000 and $65,000 for book purposes and a current-year ending balance of $38,000 for tax purposes and $85,000 for book purposes then the temporary difference would be $47,000.
To further illustrate, assume the above balances are accrued vacation. Thus, at the end of the prior year (i.e., prior-year ending balance) there was a $65,000 accrual of vacation for book purposes. This means that, as of the end of the year, there was $65,000 of vacation expense that was owed to the employees, but the employees had not taken the vacation days by year-end. For tax purposes, the balance was $30,000. The difference in the treatment results from a tax rule that allows a deduction for accrued vacation used within 2-1/2 months after yearend.(2) In the example, the employees took $30,000 of the $65,000 vacation accrual within the requisite time period. Therefore, of the $65,000 vacation for book purposes, $30,000 can be deducted-for tax purposes. As a result, at the end of the prior year, there existed a $35,000 temporary difference. This represents the amount expensed for book purposes but disallowed as a deduction for tax purposes.
At the end of the current year there exists an $85,000 balance in the vacation accrual account. This means that $85,000 worth of vacation days is owed to the company’s employees but these days have not been taken. For tax purposes, $38,000 is the deduction. The deferred tax asset would be $47,000 multiplied by the tax rate. Schedule M-1 focuses on the income statement numbers; that is to say, the flux between the prior year’s temporary difference and the current year’s balance will be the Schedule M-1 entry. This is the current-year activity.
Account 12/31/98 Current-year
Vacation Book 65,000 20,000
Accrual Tax (30,000) (8,000)
Account 12/31/99 Tax Deferred Tax
Balance Rate Asset/(Liability)
Vacation 85,000 X % 85,000 x X%
Accrual (38,000) X % (38,000) x X%
Tax Asset/ X
1. Tax Rate
The tax rate used in the previous illustration, is the federal statutory rate plus the state tax rate, net of federal benefit. The federal statutory rate is set forth in section 11(b) of Internal Revenue Code. The state tax rate net of federal benefit, however, takes several calculations. First, if the company is only subject to tax in one state, then that income tax rate is used as the starting point. Most public companies, however, are subject to state tax in many states. Therefore, an estimate must be used by looking at total state taxes paid as a percentage of taxable income. For example, if 50 percent of Company X’s income comes from New York (9 percent income tax rate) and 50 percent comes from Colorado (4.75 percent income tax rate), then the blended rate will be 6.875 percent. For more complicated provisions, rather than using a blended rate, separate components of the provision are calculated for each state based on projected apportionment factors.