Financial Accounting and Reporting-CPA Practice Exam

Which method is required by GAAP for comprehensive tax allocation?

1. Cash Basis Method

2. Asset and Liability Method/Balance Sheet Approach

3. Income Statement Approach

4. Pro-rata Allocation Method

The correct answer is: Asset and Liability Method/Balance Sheet Approach

The Asset and Liability Method, also known as the Balance Sheet Approach, is required by Generally Accepted Accounting Principles (GAAP) for comprehensive tax allocation. This method focuses on recognizing deferred tax assets and liabilities on the balance sheet based on the temporary differences between the accounting and tax bases of assets and liabilities. Under this approach, companies identify and measure deferred tax assets and liabilities that arise from differences in the timing of income and expense recognition, leading to future tax consequences. This systematic approach ensures that the tax effects of timing differences are appropriately reflected in the financial statements. Contrarily, the Cash Basis Method is not aligned with GAAP, as it does not match revenues and expenses in the period they are incurred. The Income Statement Approach primarily emphasizes current income tax expense, and does not fully address future tax impacts on the balance sheet. The Pro-rata Allocation Method lacks the comprehensive structure required for tax allocation under GAAP, which necessitates a more detailed recognition and measurement process for deferred tax items. Thus, the Asset and Liability Method is essential for a thorough understanding and accurate reporting of tax implications in financial statements.