Income Tax Allocation: The Continuing Controversy in Historical Perspective

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Abstract: The appropriate means of accounting for income taxes on financial statements has been among the most hotly debated and frequently recycled issues of the past SO years. This retrospective account begins with the issuance of the first professional standards during the 1930s and 1940s, and illustrates how theoretical arguments, developed in professional and academic journals during the 1950s, were subsequently recycled and revised during later decades. The problems that led to reconsideration of the deferred tax issue by both the APB during the 1960s and the FASB during the 1980s and 1990s are discussed, as are the solutions offered by these standard setters.

INTRODUCTION

The appropriate means of accounting for income taxes on financial statements has been among the most hotly debated and frequently recycled issues of the past 50 years. The Committee on Accounting Procedure (CAP), the Accounting Principles Board (APB), and the Financial Accounting Standards Board (FASB) have all addressed the issue. Nevertheless, critics of FASB's most recent approach [Rosenfield, 1990; Defliese, 1991] provided evidence that agreement about the best solution to this problem is still lacking. This retrospective account of the ongoing debate is based on an examination of professional standards, research reports, and articles in leading academic and professional journals. General developments in accounting theory and the standards-setting process serve as a backdrop for examining accounting for income taxes. The paper attempts to provide readers with an understanding of how the accounting issues and authoritative literature have evolved, thereby providing a basis for understanding current requirements.

A broader perspective is taken in this paper than in other recent histories of tax accounting, which have focused solely on the development of professional standards [Rayburn, 1986; Plunkett and Turner, 1988; Johnson, 1993]. It serves to update earlier works that considered the development of both theory and practice [Black, 1966; Nurnberg, 1971; Beresford et al., 1983]. The paper focuses on the debate about the extent to which income tax allocation is appropriate and which method should be applied. Aspects of the topic that are beyond its scope include discounting of deferred taxes and the information content of tax deferrals. Based upon a review of the literature, the authors focus on those writers who introduced or distilled the prevailing theory or presented cogent discussions of the issues. The chronological organization of the paper is based on the periods during which CAP, the APB, and FASB respectively were in existence.

THE CAP ERA (1936-1959)

Income taxes became a permanent part of the federal tax system with the passage of the Corporation Tax Law in 1909 and the ratification of the Sixteenth Amendment to the Constitution in 1913. However, the main source of tax revenues prior to World War II was local property taxes. During the World War II period (1939-1945), income taxes gained in importance because of an increase in the marginal corporate income tax rate from 19% to 38% [Sommerfeld and Easton, 1987, pp. 168170]. Following World War II, there was an economic expansion and an increase in the number of shareholders. Measures such as earnings per share gained in importance, which led to pressures for more comparable income numbers [Carey, 1970, pp. 58-59]. The emphasis on the measurement of income tax expense reflected the general concern with income measurement during this era [Bailey, 1948, pp. 10-14; Shield, 1957, p. 53].

CAP had been formed in 1936 and was expanded and given the authority to issue pronouncements in 1938 [Davidson and Anderson, 1987, p. 116]. Its first pronouncements were issued in 1939, including one addressing an early tax allocation issue. This issue arose in the 1930s when a decline in long-term interest rates led many companies to refund bond issues. In computing taxable income, firms deducted the unamortized discount and redemption premium on the bonds refunded. …