FAR · Financial reporting · 11 practice questions
Income-tax-basis recognition rules: no deferred taxes
On the income tax basis, recognition and measurement follow the tax return for the period, and only current income taxes are recorded. Below: one scenario, four versions, one fact changed each time.
Try one first
Hint
Decide which measurement model governs recognition in these statements: tax-return measurement (income tax basis) or GAAP deferred-tax accounting.
Answer A. Financial statements prepared on the income tax (tax-return) basis use tax-return measurement for recognition rather than GAAP's deferred-tax model (ASC 740). As a result, the statements reflect current tax payable (or receivable) determined from taxable income but do not record GAAP-style deferred tax assets or liabilities for temporary differences or carryforwards in the financial statements themselves. Preparers may, if they choose, disclose or present supplemental tax-effect information, but the question is limited to amounts recognized in the financial statements.
Why not B: This option is tempting because it mirrors GAAP practice, but it incorrectly imports GAAP deferred-tax recognition into tax-basis financial statements; when statements are prepared on the income tax basis, GAAP deferred-tax balances are not recognized in the financial statements.
Why not C: This distractor sounds technically precise because it cites ASC 740 recognition and valuation language, but it is incorrect here: applying GAAP deferred-tax recognition/valuation is not appropriate for financial statements prepared on the income tax (tax-return) basis.
Why not D: This is a plausible common error because carryforwards produce future tax benefits, but it is incorrect for the same reason as the other GAAP-based choices: under the income tax basis the financial statements recognize current tax based on taxable income and do not record GAAP-style deferred tax assets in the statements themselves (discussion or schedules could show such effects).
Same scenario, one fact changes
Base case
Ridge Co. prepares Year 2 financial statements on the income‑tax (tax‑return) basis for a lender. Facts: (1) A $420,000 litigation loss related to Year 2 is probable and reasonably estimable, but it is not deductible under applicable tax rules until paid; no payment was made in Year 2. (2) A $90,000 customer advance was included in Year 2 taxable income on the return. (3) Ridge bought equipment for $40,000 in Year 2 and intends to file the return capitalizing and depreciating it under tax rules (no special election made before issuance). (4) Accelerated tax depreciation creates temporary differences that would create deferred taxes under GAAP. Statements are prepared entirely on the income‑tax basis and will not present GAAP amounts.
Answer: Do not accrue the $420,000 loss in Year 2; disclose it if material. Include the $90,000 advance in Year 2 income. Capitalize the $40,000 equipment cost for tax depreciation. Recognize only current income taxes; do not record deferred taxes.
Tax‑basis statements follow tax‑return recognition and measurement. The loss is not deductible until paid, so it is not accrued; disclose if material (FAR-72007; FAR-64009; FAR-48287; FAR-48345). The $90,000 advance was included in taxable income, so it is included in Year 2 income (FAR-34045). The equipment is capitalized because that is Ridge’s intended tax filing position at issuance (FAR-72080). Deferred tax assets or liabilities are not recorded in tax‑basis primary statements; recognize only current tax based on the return (FAR-64004; FAR-28066; FAR-24060; FAR-28293).
Before you open each one, predict the answer.
Change 1The $420,000 litigation loss was paid on December 31, Year 2.
Answer: Recognize the $420,000 loss in Year 2; other conclusions are unchanged (include the $90,000 advance; capitalize the $40,000 equipment per intended return; no deferred taxes).
Because the applicable tax rules permit a deduction when paid, payment in Year 2 triggers recognition in Year 2 on the tax-basis statements (FAR-64009). The advance and no-deferred-tax conclusions are unchanged (FAR-34045; FAR-64004, FAR-28066, FAR-24060).
Change 2On the Year 2 return, the $90,000 advance was deferred to Year 3 under a valid tax method (it was not included in Year 2 taxable income).
Answer: Defer the $90,000 to Year 3 on the tax‑basis statements; other conclusions are unchanged (do not accrue the unpaid loss; capitalize the $40,000 equipment per intended return; no deferred taxes).
Tax‑basis statements mirror the return or intended filing position. If the advance is not included in Year 2 taxable income, it is not recognized in Year 2 on the tax‑basis statements (FAR-34045). Loss recognition still follows tax deductibility (FAR-72007), and deferred taxes are not recorded (FAR-64004; FAR-28066; FAR-24060).
Change 3Before issuance on February 20, Year 3, management validly elected bonus depreciation that fully expenses the $40,000 equipment for Year 2 and intends to file the return accordingly.
Answer: Expense the $40,000 in Year 2 on the tax‑basis statements; other conclusions are unchanged (do not accrue the unpaid loss; include the $90,000 advance if included on the return; no deferred taxes).
Tax‑basis statements reflect the valid tax treatment management has elected and intends to use for the reporting period, even if the return is not yet filed (FAR-72080). The election applies to Year 2, so the expense is recognized in Year 2. Deferred taxes still are not recorded (FAR-64004; FAR-28066; FAR-24060).
Change 4Management proposes recording a deferred tax liability in the primary statements for the accelerated tax depreciation difference.
Answer: Do not record deferred taxes in the primary statements; retain tax‑basis measurements and recognize only current taxes.
Recognizing deferred taxes mixes GAAP measurement into tax‑basis primary statements and is inappropriate for a pure income‑tax basis presentation (FAR-74184). Under the income‑tax basis, no deferred taxes are recognized for temporary differences; only current taxes are recorded (FAR-64004; FAR-28066; FAR-24060; FAR-28293).
Key points
- Follow the tax return or the valid, intended filing position at issuance; do not import GAAP timing or allocation (FAR-72080).
- No deferred tax assets or liabilities are recognized for temporary differences or carryforwards in tax‑basis primary statements (FAR-64004; FAR-28066; FAR-24060; FAR-28293).
- If tax law defers recognition (for example, litigation or warranty costs deductible when paid), do not accrue the expense; disclose if material (FAR-72007; FAR-64009; FAR-48287; FAR-48345).
- Include items the return includes, such as customer advances taxed in the year received (FAR-34045).
- Special‑purpose statements still need informative notes; disclose material contingencies and related‑party matters to avoid misleading users (FAR-74184; FAR-36030; FAR-40006).
How the exam traps you
- Recording deferred tax assets or liabilities for temporary differences in tax‑basis primary statements. Do not record deferred taxes under the income tax basis; recognize only current tax based on the return (FAR-64004; FAR-28066; FAR-24060; FAR-28293).
- Accruing a probable, estimable loss in the period when tax law allows deduction only when paid. Do not accrue it on the tax basis; recognize it when deductible under tax rules and disclose if material (FAR-72007; FAR-64009; FAR-48287; FAR-48345).
- Treating a valid tax election decided before issuance as a nonrecognized subsequent event. Reflect the elected Year‑2 tax treatment in Year‑2 tax‑basis statements when management intends to file consistently (FAR-72080).
- Deferring a customer advance even though it was included in taxable income on the return. Include the advance in income in that year on tax‑basis statements to mirror the return (FAR-34045).
Now the same facts as questions
Each question changes one fact from the one before. Watch which change flips the answer.
Question 1
Answer A. Correct. Recognition follows the return: no accrual until deductible; include the advance included on the return; capitalize per intended filing; no deferred taxes (FAR-72007; FAR-64009; FAR-34045; FAR-72080; FAR-64004; FAR-28066; FAR-24060).
Why not B: Incorrect. This imports GAAP accrual and deferred tax recognition, which are not used in tax‑basis primary statements (FAR-72007; FAR-64004; FAR-24060).
Why not C: Incorrect. It defers an advance that the return included and expenses equipment the return will capitalize (FAR-34045; FAR-72080).
Why not D: Incorrect. Deferred taxes are GAAP concepts not recognized in income‑tax‑basis primary statements (FAR-64004; FAR-28066; FAR-24060).
Question 2
Answer A. Correct. Payment makes the loss deductible and therefore recognized on the tax basis; other conclusions are unchanged (FAR-64009; FAR-34045; FAR-64004; FAR-28066; FAR-24060).
Why not B: Incorrect. Once paid, the loss is deductible and recognized on the tax basis (FAR-64009).
Why not C: Incorrect. Deferred taxes are not recorded on tax‑basis primary statements (FAR-64004; FAR-28066; FAR-24060).
Why not D: Incorrect. This changes unrelated facts about the advance and equipment contrary to the return or intended filing (FAR-34045; FAR-72080).
Question 3
Answer A. Correct. The statements mirror the return’s treatment of the advance; the loss remains unaccrued because not deductible; no deferred taxes are recorded (FAR-34045; FAR-72007; FAR-64004).
Why not B: Incorrect. The advance was not included in Year 2 taxable income, so it is not recognized in Year 2 on the tax‑basis statements (FAR-34045).
Why not C: Incorrect. GAAP accrual of the loss does not apply on the tax basis when the item is not deductible (FAR-72007; FAR-64009).
Why not D: Incorrect. Deferred taxes are GAAP concepts and are not recognized in tax‑basis primary statements (FAR-64004; FAR-28066; FAR-24060).
Question 4
Answer A. Correct. Reflect the valid, intended Year‑2 election in Year‑2 tax‑basis statements; other conclusions are unchanged; no deferred taxes (FAR-72080; FAR-64004).
Why not B: Incorrect. Ignoring a valid, intended election misstates the Year‑2 tax‑basis measurement (FAR-72080).
Why not C: Incorrect. Deferred tax balances are not recognized in tax‑basis primary statements (FAR-64004; FAR-28066; FAR-24060).
Why not D: Incorrect. The loss is not deductible until paid and should not be accrued absent payment (FAR-72007; FAR-64009).
Question 5
Answer A. Correct. Deferred taxes mix GAAP into the tax basis and are not recognized in tax‑basis primary statements (FAR-74184; FAR-64004; FAR-28066; FAR-24060).
Why not B: Incorrect. This imports GAAP deferred tax accounting into a tax‑basis presentation (FAR-64004; FAR-24060).
Why not C: Incorrect. Timing of reversal does not change the no‑deferred‑tax rule on the tax basis (FAR-28066; FAR-24060).
Why not D: Incorrect. Do not swap in GAAP measurements to avoid deferred taxes; apply the income‑tax basis consistently (FAR-74184; FAR-24060).
Question 2
Hint
Decide which disclosure arises from GAAP measurement/allocation concepts rather than from presenting the chosen special purpose framework.
Answer D. Income tax-basis statements use tax accounting measurement rather than GAAP measurement and allocation. Deferred tax assets, liabilities, and valuation allowances are GAAP allocation concepts tied to differences between book and tax accounting, so a GAAP-style deferred tax note is generally not required under the income tax basis. By contrast, identification of the basis, a summary of significant accounting policies, and disclosure of material related-party transactions are core disclosures for a special purpose framework and omitting them could, by itself, render the statements not presented in accordance with the basis.
Why not A: Tempting because the basis might appear obvious from the title, but special purpose frameworks require an explicit note describing the basis and how it differs from GAAP; omitting that note could mislead users and cause the statements to be not presented in accordance with the chosen basis.
Why not B: Tempting because the transaction may be reflected in amounts already reported, but material related-party transactions and their effects are important for users' assessment of transactions and balances; failing to disclose them could be misleading and therefore problematic under the framework.
Why not C: Tempting because candidates may assume tax-basis methods are self-evident, but a summary of significant accounting policies explains measurement and presentation under the chosen basis; omitting this core disclosure could prevent users from understanding the statements and render them not in accordance with the basis.
Question 3
Hint
Focus on which framework determines measurement in the statements, and then ask whether deferred taxes belong to that framework.
Answer C. When financial statements are prepared on the income tax basis (a special-purpose framework), measurement follows tax-basis amounts rather than U.S. GAAP amounts. Deferred tax accounting is a GAAP concept that reconciles differences between GAAP and tax; it is generally not recognized in tax-basis financial statements.
Why not A: Although it keeps tax-basis measurement, adding deferred tax liabilities mixes GAAP-specific accounting into a tax-basis framework. Tax-basis statements generally do not add deferred tax accounts just to reconcile to GAAP.
Why not B: This choice reflects GAAP practice for temporary differences, but the question specifies the income tax basis for the statements. Applying GAAP depreciation and deferred tax would ignore the selected special-purpose framework.
Why not D: Preparing amounts on GAAP but labeling the statements as tax-basis would be inconsistent. If the statements are on the income tax basis, the underlying measurements should follow that basis, not GAAP with a disclosure.
Question 4
Hint
For each item, ask how it would be treated under the tax rules, not how GAAP would treat it.
Answer C. Under the income tax basis, recognition and measurement follow tax-return concepts. The warranty accrual is not deductible until paid, so it is not recognized on the tax basis. The unrealized gain is not taxable until sale (and no election applies), so it is likewise not recognized on the tax basis in Year 1.
Why not A: This imports GAAP ideas (probable liabilities and recognition of fair-value changes) that do not control under the income tax basis; if an item does not affect taxable income in the period, it generally is not recognized on tax-basis financial statements.
Why not B: This is a partial-application error. The relevant test is tax recognition, the warranty accrual is not deductible until paid, so it would not be recognized on the tax basis despite relating to Year 1 sales.
Why not D: This incorrectly assumes tax-basis statements selectively adopt GAAP fair-value treatment for investments. The stem states no tax rule or election makes the gain taxable before sale, so the unrealized gain would not be recognized under the income tax basis.
Question 5
Hint
Make two judgments: (1) which items are measurement differences under a tax basis (deferred taxes), and (2) which items are material matters that still require notes (related parties, contingencies).
Answer C. Under the income-tax (tax-basis) framework, amounts are measured using tax accounting, so GAAP deferred tax assets and liabilities arising from temporary differences are not recognized. However, using a special-purpose framework does not eliminate the need to disclose material matters that are not apparent from the face of the statements. Material related-party obligations and material contingencies generally require informative note disclosure even when measurement follows the tax basis.
Why not A: Tempting because it correctly states that tax-basis statements need not recognize GAAP deferred tax balances. It is wrong because it overgeneralizes, special-purpose statements can and often should include disclosures of material related-party transactions and contingencies, which are not eliminated simply by using the tax basis.
Why not B: Tempting if a candidate confuses deferred taxes with tax payments or assumes all tax effects must be shown. It is incorrect because deferred taxes are a GAAP construct tied to GAAP measurement, not a requirement of tax-basis statements; moreover, omitting disclosure of material related-party obligations and contingencies is inappropriate even if they do not change taxable income.
Why not D: Tempting because it reflects a mistaken belief that special-purpose frameworks force a 'minimal notes' choice. It is wrong because issuing tax-basis statements does not prohibit providing additional notes about material matters; preparers are not required to present GAAP simply to include meaningful disclosures.
Question 6
Hint
Separate measurement from disclosure: ask whether a deferred tax liability belongs to the stated income‑tax basis and whether the omitted receivable is material and apparent from the face of the statements.
Answer D. Recognizing a deferred tax liability in the primary statements applies a future‑tax‑effects measurement characteristic of GAAP and therefore mixes measurement frameworks, which is inconsistent with a pure income‑tax basis presentation. AICPA guidance on special‑purpose frameworks supports that identifying the basis of accounting does not authorize importing inconsistent GAAP measurements into the primary statements. Separately, omission of a material related‑party receivable that is not apparent from the face of the statements can render the statements misleading and generally requires disclosure to prevent misstatement under the stated framework.
Why not A: Tempting because disclosure of the basis is required, but disclosing the basis does not authorize mixing measurement frameworks or omitting material information that would mislead users.
Why not B: Plausible because special‑purpose frameworks omit many GAAP disclosures, but identification of the basis does not eliminate the obligation to disclose material related‑party information necessary to avoid misleading users.
Why not C: Attractive to those who default to GAAP practice (deferred taxes arise from temporary differences), but recognizing a deferred tax liability in the primary income‑tax‑basis statements imports a GAAP measurement into a different measurement framework and is therefore inconsistent with that basis.
Common questions
Do income‑tax‑basis financial statements record deferred taxes?
No. They generally recognize only current income taxes based on the tax return. Deferred tax assets and liabilities are GAAP concepts and are not recorded in tax‑basis primary statements (FAR-64004; FAR-28066; FAR-24060; FAR-28293).
On the tax basis, when do I recognize a probable litigation loss?
When it becomes deductible under applicable tax rules, often when paid. If not deductible in the period, do not accrue it; disclose the contingency if material (FAR-72007; FAR-64009; FAR-48287; FAR-48345).
If management elects a tax method after year‑end but before issuance, which period shows it on the tax basis?
Reflect it in the period to which the election applies if the election is valid for that period and management intends to file consistently at issuance (FAR-72080).
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