Net Change Method
The financial accounting term net change method refers to one of two approaches used to compute the tax effects of a number of timing differences. The net change method is also known as the group-of-similar-items, net change basis. With this method, the tax effects of both originating and reversing timing differences use current rates.
Most companies have two sets of books: financial accounting and income tax. Timing differences can occur for a number of reasons, and most are temporary in nature. A timing difference will occur when the calculation of pretax net income for accounting purposes (book) is different than that determined for income tax purposes. When a timing difference is temporary in nature, companies will make both originating and reversing entries to smooth out those differences over time. These transactions typically involve journal entries to the deferred income tax account.
In practice, companies have a large number of these timing differences, making tracking the originating and reversing transactions on an individual item basis impractical. To simplify the computation of these tax effects, companies can use either the gross or net change methods.
With the net change method, both the originating journal entries to deferred income taxes, as well as the reversing entries, use the tax rate that applies in the current period. The typical steps a company goes through to compute these journal entries include:
- Separating the timing differences into similar groups such as installment sales and depreciation.
- Subdividing these groups of similar items into originating and reversing transactions.
- Calculating the difference between the aggregate originating and reversing differences for each group.
- Applying the current tax rate to the net change in the aggregate difference found in step 3, and preparing the deferred income tax journal entry for each group identified in step 1.
In the event the reversing difference decrease, deferred income taxes should continue to be amortized, but never in excess of the balance of the deferred taxes for a particular group. For example, if the company’s current tax rate is higher than its historical rate, and the timing difference for a group were decreasing over time, the net change method can result in a debit to deferred income taxes that was greater than the balance in the account for that group. The actual debit should never be higher than the balance in the deferred taxes for the group.
Gross Change versus Net Change
Preparing the journal entries under the gross change versus the net change method is similar, with one exception:
- Under the gross change method, the originating timing differences are calculated using the current tax rate, while the reversing differences use the tax rates that applied when the originating differences were calculated (historical tax rates).
- Under the net change method, both the originating and reversing differences use the current tax rate when calculating deferred income taxes.
While the determination of deferred income taxes may be different in each method, income taxes payable will be the same. In addition, if the company’s tax rate does not change over time, the journal entries for deferred income taxes under both methods will also be the same.