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Chapter 16 Accounting for Income Taxes
DEFERRED TAX ASSETS AND DEFERRED TAX LIABILITIES
Conceptual Underpinning
There are fundamental differences in the amount of income and expenses reported for
GAAP and income tax purposes. The objective for GAAP reporting is to report the
economic activities of the entity. The objective for income tax purposes is for the
government to raise revenue. There are two terms that identify the types of income
subject to tax under each reporting system.
1 Pretax financial income
Pretax financial income is the income determined using GAAP. It is the amount of
income on which income tax is computed for financial statement purposed. It is
formally presented in the income statement as income before income taxes. We
normally refer to it is pretax income.
2 Taxable income
Taxable income is the income determined using Internal Revenue Code rules and
regulations. It is the amount of income on which the entity will actually pay income
tax in the current accounting period.
There are almost always differences between the amount of income and therefore income
tax expense reported in the financial statements and the amount of income tax liability
actually paid by the entity. This difference is referred to as a deferred tax amount. If the
income tax expense in the income statement is larger than the current income tax liability
the difference is called a deferred tax liability. If the income tax expense in the income
statement is smaller than the current income tax liability the difference is called a
deferred tax asset.
Temporary Differences
Deferred taxes arise as a result of temporary difference between income tax expense
and current income tax payable. A temporary difference is the difference between the
book value of an asset or liability and the tax basis of the same asset or liability.
Deferred Tax Liabilities
A deferred tax liability is created as a result of the difference between the book value and
the tax basis of an asset or liability. The difference creates a tax liability in future
periods.
EXAMPLE: Spencer Company has pretax financial statement income for the current
year of $700,000. The company’s average income tax rate is 30% on taxable income.
Spencer Corporation calculates deprecation expense using the straight-line method for
financial reporting purposes and an ACRS (accelerated) method for tax purposes. The
result will be a deferred tax liability. There will be a smaller depreciation expense
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deduction in subsequent years because a larger portion was taken in the year of purchase.
Let’s assume that the difference is $50,000 as calculated below.
DEPRECIATION EXPENSE
IRS Form 1120
Financial statements
Difference
AMOUNT
75,000
25,000
50,000
The above is a deferred liability as a result of expenses that will be recognized for tax
purposed in subsequent periods. Now let’s look that an income item. Let’s assume that
Spencer Company sold merchandise using the installment method for tax purposes but
uses the accrual method for financial statement reporting purposes. This means that there
will be additional income in subsequent periods on the tax return with results in an
increase in the tax liability. The difference is $200,000 as calculated below.
INSTALLMENT SALE
AMOUNT
100,000
300,000
(200,000)
IRS Form 1120
Financial statements
Difference
Based on this information we are now ready to calculate the deferred tax liability for the
current year end. The liability is calculated as follows.
Deferred Tax
Temporary Difference
Depreciation
Installment sale
Future
Amounts
50,000
200,000
250,000
Tax Rate
30%
30%
Asset
Liability
15,000
60,000
75,000
If we know the financial statement pretax income we should now be able to calculate the
taxable income. The following is a computation of taxable income.
Taxable Income
Pretax financial income
Excess gross profit books
Excess depreciation per IRS Form 1120
Taxable income
Amount
700,000
(200,000)
(50,000)
450,000
Income tax payable is based on taxable income using the current average tax rate. The
following is a calculation of the income tax payable.
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Income Tax Payable
Taxable income
Tax rate
Income tax payable
Amount
450,000
30%
135,000
The deferred tax expense is the deferred portion of the income tax that is reported on the
face of the income statement. It is calculated by analyzing the deferred tax liability Taccount. In this case we are assuming that there is no beginning balance. The following
is the calculation of deferred tax expense.
Deferred Tax Expense
Deferred tax liability at end of year
Deferred tax liability at beginning of year
Deferred tax expense for year
Amount
75,000
0
75,000
Now that we know the income tax payable from the taxable income and the deferred tax
expense from the timing differences we are ready to calculate the entire income tax
expense that will be reported on the face of the income statement. The calculation of
total income tax expense is as follows.
Income Tax Expense
Deferred tax expense
Current tax expense
Income tax expense
Amount
75,000
135,000
210,000
So far all we have done is calculate the amounts required to prepare the year-end
adjusting journal entry to record income tax expenses. This journal entry sets up the
income tax expense that will be reported in the income statement, the income tax liability
that will be paid to the internal revenue service and the deferred tax liability.
ACCOUNT
DEBIT
210,000
Income tax expense
Income tax payable
Deferred tax liability
CREDIT
135,000
75,000
Summary of income tax accounting objectives
There are two objectives in accounting for income taxes.
1 To recognize the income taxes payable for the current accounting period.
2 To record future tax liabilities as a result of items recognized in the income statement
but not the tax return or recognized on the tax return but not the income statement.
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Deferred Tax Assets
So far all we have talked about it deferred tax liabilities. These were created as a result
of income reported in the income statement but deferred into future period on the tax
return, and expenses taken on the tax return in the current period which creates smaller
deductions on the tax return in future periods. Now we are going to exam the impact of
deferred tax assets on the financial statements.
A deferred tax asset is created as a result of the difference between the book value and
the tax basis of an asset or liability. The difference creates a tax asset in future periods.
The net result is a decrease in taxes in future periods. If we have and expense or loss in
the income statement that is not reported on the tax return this creates a deferred tax
asset. The expense or loss will be used on the tax return in some future period(s). Also,
if we have revenue or gain reported on the tax return that is not currently reported in the
income statement this creates a deferred tax asset. The revenue or gain will be reported
in some future period(s) but it will not be taxable.
EXERCISE: Spencer Company has pretax financial statement income for the current
year of $700,000. The company’s average income tax rate is 30% on taxable income.
Spencer Corporation has an estimated warranty liability of $125,000 which is recorded
on the income statement but is not deductible for income tax purposes. In addition, the
company has leased a piece of equipment for $100,000 per year for three years to a
customer. The lessee paid the entire three years rent in advance. At the end of the year
Spencer Company has a deferred liability (unearned rent) of $200,000 recorded in the
balance sheet. The rent is reported on a cash basis for income tax purposes. Each of
these items creates a deferred tax asset.
Using the format provided calculate the book to tax difference as a result of the estimated
warranty liability.
ESTIMATED WARRANTY
IRS Form 1120
Financial statements
Difference
AMOUNT
Solution:
ESTIMATED WARRANTY
IRS Form 1120
Financial statements
Difference
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AMOUNT
0
125,000
(125,000)
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Using the format provided calculate the book to tax difference as a result of the unearned
rent.
UNEARNED RENT
IRS Form 1120
Financial statements
Difference
AMOUNT
Solution:
UNEARNED RENT
IRS Form 1120
Financial statements
Difference
AMOUNT
300,000
100,000
200,000
Based on the information provided in the above two exercise prepare the schedule of
deferred tax assets.
Temporary Difference
Estimated warranty
Unearned rent
Future
Amount
Tax Rate
30%
30%
Asset
Liability
Solution:
Temporary Difference
Estimated warranty
Unearned rent
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Future
Amount
(125,000)
(200,000)
(325,000)
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Tax
Rate
30%
30%
Deferred Tax
Asset
Liability
(37,500)
(60,000)
(97,500)
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Chapter 16 Accounting for Income Taxes
Now that you have the future amounts involved you can calculated the taxable income.
Taxable Income
Pretax financial income
Excess warranty expense on income statement
Excess rent on IRS Form 1120
Taxable income
Amount
Solution:
Taxable Income
Pretax financial income
Excess warranty expense on income statement
Excess rent on IRS Form1120
Taxable income
Amount
700,000
125,000
200,000
1,025,000
Now that you have taxable income you can calculate income tax payable.
Income Tax Payable
Taxable income
Tax rate
Income tax payable
Amount
Solution:
Income Tax Payable
Taxable income
Tax rate
Income tax payable
Amount
1,025,000
30%
307,500
Instead of a deferred tax expense we will have a deferred tax benefit as a result of the
deferred tax assets.
Deferred Tax Benefit
Deferred tax benefit at end of year
Deferred tax benefit at beginning of year
Deferred tax benefit for year
Amount
Solution:
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Deferred Tax Benefit
Deferred tax benefit at end of year
Deferred tax benefit at beginning of year
Deferred tax benefit for year
Amount
(97,500)
0
(97,500)
The deferred tax benefit reduces current period income tax expense. Using the format
calculate income tax expense.
Income Tax Expense
Deferred tax benefit
Current tax expense
Income tax expense
Amount
Solution:
Income Tax Expense
Deferred tax benefit
Current tax expense
Income tax expense
Amount
(97,500)
307,500
210,000
Base on your experience with the deferred tax liability see if you can prepare the yearend adjusting journal entry to record income tax expense, income tax payable, and the
deferred tax asset.
ACCOUNT
DEBIT
CREDIT
ACCOUNT
DEBIT
210,000
97,500
CREDIT
Income tax expense
Deferred tax asset
Income tax payable
Solution:
Income tax expense
Deferred tax asset
Income tax payable
307,500
Valuation Allowance
In accounting we are always careful that assets are not overstated. If the balance in the
deferred asset account is greater than the expected benefit to be realized we must
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establish a valuation allowance account to that will reduce the amount reported in the
balance sheet to the expected realized value. This is a contra asset account off setting the
deferred tax benefit. When recording the valuation allowance we charge the reduction to
current period income tax expense.
EXAMPLE: At December 31, 2002, Spencer Company has a deferred tax asset of
$200,000. After a careful review of all available evidence, it is determined that it is more
likely than not the $80,000 of this deferred tax asset will not be realized. Prepare the
necessary journal entry.
ACCOUNT
Income tax expense
Allowance to reduce deferred tax asset to expected
realizable value
DEBIT
CREDIT
DEBIT
80,000
CREDIT
Solution:
ACCOUNT
Income tax expense
Allowance to reduce deferred tax asset to expected
realizable value
80,000
The above examples and exercises had you working with either a deferred tax liability or
a deferred tax benefit but not both in the same problem. Now we need to integrate what
you have learned into a more complete situation.
EXAMPLE: The following facts relate to Spencer Company:
(1) Deferred tax liability, January 1, 2003, $40,000
(2) Deferred tax asset, January 1, 2003, $0
(3) Taxable income for 2003, $95,000
(4) Pretax financial income for 2003, $200,000
(5) Cumulative temporary difference at December 31, 2003, giving rise to future
taxable amounts, $240,000
(6) Cumulated temporary difference at December 31, 2002, giving rise to future
deductible amounts, $35,000
(7) Tax rate for all years, 40%
(8) The company is expected to operate profitability in the future.
A. Compute income taxes payable for 2003.
Taxable income
Enacted tax rate
Income tax payable
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Solution:
Taxable income
Enacted tax rate
Income tax payable
95,000
40%
38,000
B. Prepare the journal entry to record income tax expense, deferred income taxes,
and income taxes payable for 2003
ACCOUNT
Income tax expense
Deferred tax asset
Income tax payable
Deferred tax liability
DEBIT
CREDIT
Analysis of income tax expense:
Income before income taxes
Enacted tax rate
Income tax expense
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Analysis of deferred tax asset and liability:
Deferred Tax
Future
Amounts
Temporary difference
Future taxable amounts
Future deductable amounts
Totals
Tax Rate
Asset
Liability
Analysis of deferred tax liability:
Deferred tax liability at end of 2002
Deferred tax liability at beginning of 2002
Deferred tax expense for 2002
Analysis of deferred tax asset:
Deferred tax asset at end of 2002
Deferred tax asset at end of 2002
Deferred tax benefit for 2002
Analysis of income tax expense:
Deferred tax expense for 2002
Deferred tax benefit for 2002
Net deferred tax expense for 2002
Current tax expense for 2002
Income tax expense for 2002
Solution:
ACCOUNT
DEBIT
80,000
14,000
Income tax expense
Deferred tax asset
Income tax payable
Deferred tax liability
38,000
56,000
Analysis of income tax expense:
Income before income taxes
Enacted tax rate
Income tax expense
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CREDIT
200,000
40%
80,000
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Analysis of deferred tax asset and liability:
Future
Amounts
240,000
(35,000)
205,000
Temporary difference
Future taxable amounts
Future deductable amounts
Totals
Analysis of deferred tax liability:
Deferred tax liability at end of 2002
Deferred tax liability at beginning of 2002
Deferred tax expense for 2002
96,000
40,000
56,000
Analysis of deferred tax asset:
Deferred tax asset at end of 2002
Deferred tax asset at end of 2002
Deferred tax benefit for 2002
14,000
0
14,000
Analysis of income tax expense:
Deferred tax expense for 2002
Deferred tax benefit for 2002
Net deferred tax expense for 2002
Current tax expense for 2002
Income tax expense for 2002
56,000
14,000
42,000
38,000
80,000
Tax
Rate
40%
40%
Deferred Tax
Asset
Liability
96,000
(14,000)
(14,000)
96,000
C. Prepare the income tax expense section of the income statement for 2003,
beginning with the line “Income before Income Taxes.”
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Income before income taxes
Income tax expense
Current
Deferred
Net income
$
$
$
RECONCILATION WITH TAX RETURN
Financial statement income
Temporary differences:
Deduct: future taxable amounts
Current period
Prior period
Beginning deferred tax liability
Enacted tax rate
Prior period future taxable amount
$
$
$
$
$
%
$
$
$
$
$
Add: future deductions
Taxable income per tax return
Solution:
Income before income taxes
Income tax expense
Current
Deferred
Net income
200,000
38,000
42,000
RECONCILATION WITH TAX RETURN
Financial statement income
Temporary differences
Deduct: future taxable amounts
Current period
Prior period
Beginning deferred tax liability
Enacted tax rate
Prior period future taxable amount
80,000
120,000
200,000
240,000
40,000
40%
100,000
140,000
60,000
35,000
95,000
Add: future deductions
Taxable income per tax return
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Chapter 16 Accounting for Income Taxes
Income Statement Presentation
On the face of the income statement we break out the current income tax expense and the
net change in deferred tax benefit or expense. These two amounts are then added
together to give us income tax expense as reported on the income statement. The
following is an example of a typical presentation.
Spencer Company
Income Statement
For the Year Ending December 31, 2000
Revenue
Expenses
Income before income taxes
Income tax expense
Current
Deferred
Net income
$900,000
400,000
500,000
$150,000
75,000
225,000
$275,000
Specific Differences
There are actually two kinds of book to tax differences. So far we have only talked about
temporary differences that will reverse in future accounting periods. There are also
differences that don’t reverse and we call these permanent differences.
Temporary Differences
As we have discussed above there are taxable temporary differences and deductible
temporary differences.
1
Taxable temporary differences
a) Revenues and gains are recognized in the current income statement but
taxable in some future accounting period(s) on the tax return.
b) Expenses and losses are deducted on the current tax return but recognized on
the income statement in some future accounting period(s).
2
Deductible temporary differences
a) Revenue and gains are recognized on the current tax return but recognized in
the income statement in some future accounting period(s).
b) Expenses and losses are deducted on the current income statement but
expensed in some future accounting period(s) on the tax return.
Permanent differences
Permanent differences occur as a result of differences between GAAP and income tax
law. Income or expenses reported on the income statement are never reported on the tax
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return; or income or expenses reported on the tax return are never reported on the income
statement. There are no deferred taxes involved here.
The book to tax differences are reconciled on the IRS Form 1120 which you will deal
with in your corporate tax class.
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