What Is Comprehensive Tax Allocation?
Comprehensive tax allocation is an analysis that identifies the effect of taxation on revenue-generating transactions during a non-standard reporting period. Also known as an interperiod tax allocation, this technique allows a firm to compare the impact of taxation during an accounting period to that of a particular financial reporting period.
- Comprehensive tax allocation is an analysis that companies use to identify discrepancies between their accounting for business purposes and their accounting for tax purposes.
- Most of the discrepancies result from differences between the periods used for financial reporting and tax filing.
- The differences identified through comprehensive tax allocation are a result of accelerating or delaying deductions and/or taxable income.
Understanding Comprehensive Tax Allocation
The income and expenses a company reports in its own books versus its tax filings often differ because there are tax advantages to accelerating or delaying certain transactions on paper. For example, a company may internally write off a cost over several years but choose to claim the expense more rapidly for tax purposes based on changes in income requirements or tax laws.
Comprehensive tax allocation allows for the reconciliation of these temporary differences that arise between tax reporting and financial performance reporting timelines. As mentioned, comprehensive tax allocation is also known as interperiod tax allocation, which is a reference to the two sets of reporting periods that firms use in accounting.
Four classes of transactions can lead to a temporary discrepancy between tax and accounting periods:
- Accelerated reporting of taxable income
- Delayed reporting of taxable income
- Accelerated reporting of deductible expenses
- Delayed reporting of deductible expenses
The most common source of temporary differences is in the handling of asset depreciation, which is considered a deductible expense for tax purposes. The Internal Revenue Service (IRS) grants companies some freedom in how they elect to report these expenses, which can often lead to the type of temporary difference that may require resolution via comprehensive tax allocation.
Example of Comprehensive Tax Allocation
Companies often use straight-line depreciation and accelerated depreciation for the same piece of equipment for different purposes. A firm will typically use straight-line depreciation for accounting purposes while it applies accelerated depreciation principles for tax purposes.
Say, for example, the Acme Construction Company buys a $200,000 crane. IRS laws allow depreciation of the equipment from the time it is put into service until the company recovers its cost-basis. This allows Acme a $40,000 depreciation for five years. On the accounting side of Acme's books, however, the firm uses a 10-year straight-line accounting method, which appears as an annual expense of $20,000 for 10 years. Eventually, both methods meet in the same place: a full depreciation of the asset. The temporary difference over the financial life of the crane is resolved using a comprehensive tax allocation.
In practice, firms carry a portfolio of assets subject to a temporary allocation and their accountants must decide how aggressively to allocate the discrepancy. Some firms choose to strictly report tax expenses in the year that they make those payments. If Acme were such a company, it would stick to the $40,000 annual deduction granted by the IRS. Other firms prefer to allocate according to the book value of depreciation. The IRS has demonstrated some flexibility in this area, and it favors consistency above all.