The income tax expense lists the federal and state tax liability incurred by the firm. Other types of taxes, such as property and Social Security, appear under operating expenses.
Note that companies usually maintain separate accounting books for tax reporting purposes. Taxes are paid on income, so companies try to keep profits as low as possible to minimize their tax liability when reporting to the IRS. While generally accepted accounting principles must be followed for both sets of books, differences can arise in the calculation of tax liabilities between the accounting statements prepared for the IRS and those presented to investors. For example, a firm may use an accelerated depreciation schedule when reporting income to the IRS, but a straight-line method for reporting income to investors. Since more depreciation and lower income would be recorded in the early years of the asset for tax purposes, the tax liability would be smaller for the IRS-prepared statements. The difference would be considered deferred income taxes and would show up as a liability on the balance sheet. This temporary difference would reverse itself in the later years of the asset life when the annual straight-line depreciation amounts exceed the annual accelerated depreciation expense.
Adjustments to Income
Subtracting income tax expense from income before taxes produces aftertax income. For most firms this figure will also be the net income, however there are three notable items that may be listed after taxes—extraordinary items, discontinued operations, and cumulative effect of change in accounting.
Extraordinary items are distinguished by their unusual nature and by the infrequency of their occurrence. An uninsured loss from an earthquake would qualify as an extraordinary item. The event should not be related to the firm's normal course of business.
The discontinued operations line can detail the gain or loss from disposing a segment of a firm's business or closing down a line of business.
As companies adapt new accounting policies or make corrections to past financial statements, there may be the need take a special one-time, non-cash charge. This charge would be reflected in the line item cumulative effect of change in accounting and described in the footnotes.
Investors need to be aware of management's propensity to determine these types of adjustments. Management has control over factors such as the timing of selling a business or closing down a line. Some firms have shown a tendency to bunch up adjustments to clear the slate for future profits. When earnings are expected to be weak during a particular period, there may be a push to take a "big bath." When new management takes over a company, there is also a strong temptation to write-off old projects and assets to show strong improvements during future periods.
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