Introduction
Sometimes temporary differences occur in accounting periods which usually affect taxable income and accounting income. Causes of temporary differences include expenses deducted from both taxable income and accounting income and expenses deducted from taxable income before being deducted for accounting purposes among other reasons. The differences lead to deferred tax that requires a special method of appropriation (Bragg, 2010). As a result, firms usually publish incomes and expenses in one period for the purposes of financial reporting and in a different period for tax reasons. In this regard, interpreted tax allocation is a method of accounting used in reporting deferred tax liability. Though this method has various advantages, there are people who have criticized it based on a variety of reasons (Bragg, 2010). The method applies different approaches namely, comprehensive allocation, partial allocation, and no allocation.
Comprehensive Allocation
It is a form of interpreted tax allocation where the net effect of taxation is based on all book income transactions within a given accounting period. The main idea under this method is that deferred tax reporting procedures are supposed to reflect tax effects of all temporary differences, regardless of the period. It should however be noted that the amount of tax that is supposed to be paid, is not necessarily income tax of a single financial period (Jarnagin, 2008). Consequently, due to the emergence of temporary differences, deferred tax should be recognized. It makes no difference whether the period being analyzed under comprehensive tax allocation falls in one financial period or not. Comprehensive tax allocation is very crucial in determining the tax effects of a period that cuts across different fiscal years.
Partial allocation
On the other hand, partial allocation does not include deferred tax in its reports unless the amount is expected to be paid in a short period of time (Jarnagin, 2008). Proponents of this method argue that deferred income taxes only serve to create indefinite postponement of tax. Therefore, this method recognizes part of the temporary differences that lead to deferred tax, but not all the differences hence the name partial allocation. Consequently, the amount of tax reported during a particular period under partial allocation is the same as the tax payable during the same period. It is important to note that partial tax allocation only takes into account deferred tax that results from material temporary differences that are non-recurring. However, critics have disregarded this method arguing that it goes against the accounting principles of accrual (Bragg, 2010).
No Allocation
Under this method, the current income tax of a specific period is considered as the income tax expense of that period. Deferred tax is considered inconsequential because at the time of reporting the expense is paid to nobody in particular (Jarnagin, 2008). Moreover, supporters of this method have argued that the deferred tax liability is not very clearly explained. Therefore, the amount of tax that is supposed to be reported should be the same as the actual tax payable in that given period. Proponents argue that the liability of deferred tax is dependent on the probability of earning a taxable income in the future. Consequently, the payment of the tax will only take place if a taxable income is earned. Furthermore, the method holds that tax is an involuntary distribution of income and its allocation between accounting periods is not fair (Bragg, 2010).
References
Bragg, S. M. (2010). Willey GAAP: Interpretation and Application of Generally Accepted Accounting Principles 2011. Hoboken: John Wiley & Sons.
Jarnagin, B.D. (2008). 2009 U.S. Masters GAAP Guide. Alphen aan den Rijn: CCH.