Intraperiod tax allocation relates to the matching in the income statement of various categories of comprehensive income or expense (continuing operations, corrections of errors, etc.) with the tax effects of those items. The general principle is that tax effects should follow the items to which they relate. The computation of the tax effects of items I mentioned above is, however, complicated by the fact that many, if not most, jurisdictions feature progressive tax rates. For that reason, a question arises:
Should overall ‘BLENDED RATES’ be apportioned across all the disparate elements (ordinary income, corrections of errors, etc.), OR should ‘MARGINAL TAX EFFECTS’ of items other than ordinary income be reported instead?
IAS 12 does not answer the question, or even address it. It might, however, be instructive to consider the two approaches, since this will affect the presentation of the statement of comprehensive income and, in the case of errors, the statement of shareholders’ equity as well.
Blended Rate Approach
The blended rate approach would calculate the average, or effective, rate applicable to all an entity’s taxable earnings for a given year (including the deferred tax effects of items that will be deductible or taxable in later periods, but that are being reported in the current year’s financial statements). This effective rate is then used to compute income taxes on each of the individually reportable components.
For example, if an entity has an effective blended rate of 46% in a given year, after considering the various tax brackets and any available credits against the gross amount of the tax computed, this rate is used to calculate the taxes on ordinary income, extraordinary income, the results of discontinued operations, the correction of fundamental errors, and the effects of changes in accounting principles, if any.
Marginal Tax Effect and ‘With-and-Without’ Calculation Technique
The alternative to the blended rate approach is what can be called the marginal tax effect approach. Using this computational technique, a series of “with-and-without” calculations will be made to identify the marginal, or incremental, effects of items other than those arising from ordinary, continuing operations. This is essentially the approach dictated under US GAAP (FAS 109 and its predecessor standards) and is the primary approach employed under UK GAAP as well.
Prior to the promulgation of current US GAAP, the with-and-without technique was applied under prior US standards in a step-by-step fashion proceeding down the face of the statement of comprehensive income.
For example, an entity having continuing operations, discontinued operations, and extraordinary items would calculate tax expense as follows:
- Tax would be computed for the aggregate results and for continuing operations. The difference between the two amounts would be allocated to the total of discontinued operations and extraordinary items.
- Tax expense would be computed on discontinued operations. The residual amount (i.e., the difference between tax on the discontinued operations and the tax on the total of discontinued operations and extraordinary items) would then be allocated to extraordinary items.
Thus, the amount of tax expense allocated to any given classification in the statement of income (and the other financial statements, if relevant) was partially a function of the location in which the item was traditionally presented in the income and retained earnings statements.
Under current US GAAP, total income tax expense or benefit for the period is allocated among continuing operations, discontinued operations, extraordinary items, and stockholders’ equity. The standard creates a few anomalies since, as defined in current US GAAP, the tax provisions on income from continuing operations include not only taxes on the income earned from continuing operations, as expected, but also a number of other tax effects including the following:
- The impact of changes in tax laws and rates, which includes the effects of such changes on items that were previously reflected directly in stockholders’ equity.
- The impact of changes in tax status.
- Changes in estimates about whether the tax benefits of deductible temporary differences or net operating loss or credit carryforwards are probable of realization.
Note: Under current US GAAP the actual criterion is “more likely than not,” which differs from IAS’s “probable” criterion.
Under current US GAAP, stockholders’ equity is charged or credited with the initial tax effects of items that are reported directly in stockholders’ equity, including that related to corrections of the effects of accounting errors of previous periods, which under the international standards are known as fundamental errors.
The effects of tax rate or other tax law changes on items for which the tax effects were originally reported directly in stockholders’ equity are reported in continuing operations if they occur in any period after the original event. This approach was adopted by current US GAAP because of the presumed difficulty of identifying the original reporting location of items that are affected possibly years later by changing rates; the expedient solution was to require all such effects to be reported in the tax provision allocated to continuing operations.
Example Of Intraperiod Tax Allocation (Using a ‘With-And-Without’ Calculation)
Assume that there were $50,000 in deductible temporary differences at 12/31/2010; these remain unchanged during the current year, 2011:
- Income from continuing operations = $400,000
- Loss from discontinued operations = (120,000)
- Gain on involuntary conversion = 60,000
- Correction of accounting error: understatement of depreciation in 2010 = (20,000)
- Tax credits = 5,000
- Tax rates are: 15% on first $100,000 of taxable income; 20% on next $100,000; 25% on next $100,000; 30% thereafter.
- Effective (average) future tax rates were expected to be 20% at December 31, 2010, but are expected to be 28% at December 31, 2011.
- Retained earnings at December 31, 2010, totaled $650,000.
Intraperiod tax allocation proceeds as follows:
Step-1. Tax on total taxable income of $320,000 (= $400,000 – $120,000 + $60,000 – $20,000) is $61,000 (that is, $66,000 based on rate structure, less tax credit of $5,000).
Step-2. Tax on income from continuing operations, which includes the gain on the involuntary conversion (which can no longer be deemed extraordinary, since that classification has been eliminated by revised IAS-8 ) of $460,000 is $103,000, net of the tax credit.
Step-3. The difference, $42,000, is allocated pro rata to discontinued operations, and the correction of the error in prior year depreciation, which for this example is deemed not practical to account for by restating the earlier year (in practice, this would not be readily accepted). Note the effect of these intraperiod allocations are both at 30%, the marginal rate.
Step-4. Adjustment of the deferred tax asset, amounting to a $4,000 increase due to an effective tax rate estimate change [= $50,000 × (0.28 – 0.20)] is allocated to continuing operations, regardless of the actual source of the temporary difference.
A summary combined income and retained earnings statement is presented below:
Income from continuing operations,
before income taxes $460,000
Income taxes on income from –
Tax credits (5,000)
Income from continuing operations, net 361,000
Loss from discontinued operations-
net of tax benefit of $36,000 (84,000)
Net income 277,000
Retained earnings, January 1, 2011 650,000
Correction of accounting error,
net of tax effects ($6,000) (14,000)
Retained earnings, December 31, 2011 $913,000
Applicability To International Accounting Standards
Since IAS 12 is silent on the method to be used to compute the tax effects of individual captions in the statement of income and the statement of retained earnings (or changes in stockholders’ equity), in my opinion financial statement preparers have the option of using essentially a with-and-without or blended rate approach. Both can be rationalized from either practical or theoretical perspectives.
The blended rate method would clearly be easier to apply, since only one set of computations using progressive tax rates would be needed. The blended rate method also avoids the implication that items other than income from continuing operations represented the “last units of currency” earned, since the rates applicable to those items would not be the highest marginal rates.
On the other hand, the with-and-without method averts the situation where the blended rate applied to income from continuing operations is subject to wide variation due simply to the occasional existence of extraordinary and other unusual items.
On balance, and given the lack of a prescribed methodology in IAS 12, the authors slightly favor the blended rate approach. Whichever methodology is employed, however, it is vital that the notes to the financial statements clearly describe how the computation was made and disclose the tax effects of the various components presented. IAS 12 does, however, permit the tax effects of all extraordinary items to be presented in one amount, if computation of each extraordinary item is not readily accomplished.