Insight into Deferred Taxes
How Do Deferred Taxes Arise?
ƒ Differences exist between the accounting
books and the tax books because of
temporary differences
» Depreciation
» Inventory
» Restructuring charges
» Allowance for bad debts
ƒ Ignore permanent differences
– Examples: Goodwill, tax-free income, ...
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Components of Deferred Taxes
ƒ Deferred taxes separated into
– Short-term and long-term components
– Assets and liabilities
ƒ Deferred tax liabilities
– Debt or equity?
» When is reversal expected?
» Continual growth: Maybe no reversal.
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Financial Statement Presentation
ƒ On the balance sheet, an enterprise should
separate deferred tax liabilities and assets
into a current amount and a non-current
amount.
ƒ Deferred tax liabilities and assets should be
classified as current or non-current based
on the classification of the related asset or
liability for financial reporting.
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Changing Tax Rates
ƒ What is the effect of changing tax rates?
ƒ Rule:
– Establish deferred taxes at the rate expected to exist
when the timing difference reverses
ƒ Tax increase:
» Debit: Tax expense
» Credit: Deferred tax liability
ƒ Tax decrease:
» Debit: Deferred tax liability
» Credit: Tax expense.
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The Thought Process
ƒ Deferred tax liability
– Accounting books show more income than tax
books
ƒ Deferred tax asset
– Tax books show more income than accounting
books
– May have a partially/entire offsetting valuation
allowance.
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Thought Process:
Deferred Tax Liability
ƒ Increase in deferred tax liability
– Expense more (or revenue less) on the tax
books than on the accounting books
ƒ Reverse the logic for a decrease in the
deferred tax liability
ƒ Example:
– $100 depreciation on accounting books; $150
depreciation on tax books
» Deferred tax liability increases $50 * tax rate.
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Thought Process:
Deferred Tax Asset
ƒ Increase in deferred tax asset
– Expense less (or revenue more) on the tax books than
on the accounting books
ƒ Reverse the logic for a decrease in the deferred tax
asset
ƒ Example:
– $100 restructuring charge on accounting books; $0
restructuring on tax books until money spent
» Deferred tax asset increases $100 * tax rate
» Like a prepayment of taxes.
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Temporary Differences Effect
Revenue/
Expense
When recorded in
books relatively to the
taxable income
Deferred
tax effect
Revenue
Earlier
Liability
Revenue
Later
Asset
Expense
Earlier
Asset
Expense
Later
Liability
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Basic Journal Entry to Record Deferred
Taxes
Tax Liability
Income Tax Expense
xxx
Def.Tax Liability
Taxes Payable
xxx
xxx
Tax Asset
Income Tax Expense
Def. Tax Asset
Taxes Payable
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xxx
xxx
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Valuation Allowance
ƒ Deferred tax asset balance may be reduced
by a valuation allowance
ƒ Allowance represents management’s
concern about not being able to generate
enough future accounting income to utilize
deferred tax assets
ƒ Reduction in deferred tax asset means
» Debit: Tax expense
» Credit: Deferred tax asset.
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Analyze Deferred Taxes
Currently payable
Federal
State
Total
Deferred
Total
‘03
‘02
‘01
17.3
3.7
21.0
30.0
51.0
1.0
3.7
4.7
33.0
37.7
6.6
2.2
8.8
29.0
37.8
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Breakdown of Deferred Taxes
‘03 ‘02
Customer leases
27.6 33.8
Spare parts
59.0
Depreciation
8.3 9.3
Other
9.5 4.9
Tax loss & carryfwds -74.4 -15.0
Total
30.0 33.0
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‘01
15.5
2.2
7.9
-5.4
29.0
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Example: Deferred Tax Liability -
Depreciation
ƒ Bryant Corporation purchased a new
machine for $100,000 on January 1, 2001
ƒ The machine has a four-year estimated
service life and no salvage value
ƒ Bryant’s pretax income for each year
2001 - 2004 is 200,000 before depreciation
and taxes.
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Example …
ƒ Bryant Corp. uses straight-line depreciation
on its books and MACRS for tax reporting
ƒ For tax purposes the machine is also
depreciated over 4 years using MACRS (an
accelerated depreciation method)
ƒ The depreciation percentages for each of the
years are 33%, 44%, 15% and 8%
ƒ Assume a 40% tax rate.
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Example …
A. Compute financial (book) income after
depreciation but before taxes. What is
income tax expense?
B. Compute taxable income. What is income
tax payable?
C. Give the journal entries to record taxes.
D. Give the balance of the deferred tax
liability at the end of each of the years.
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Solution
A.
Financial (book) income
2001
Income before Depreciation
Depreciation Expense
($100,000/4)
Income after depreciation
but before taxes
Income Tax Expense (40%)
2002
2003
$200,000 $200,000 $200,000
(25,000)
(25,000)
2004
$200,000
(25,000)
(25,000)
$175,000 $175,000 $175,000
$70,000 $70,000 $70,000
$175,000
$70,000
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Solution …
B.
2001
2002
2003
2004
Pre-Tax Income before Depreciation
$200,000
$200,000
$200,000
$200,000
Depreciation Deduction:
(33,000)
(44,000)
(15,000)
(8,000)
Taxable Income
$167,000
$156,000
$185,000
$192,000
Income Taxable Payable (40%)
$66,800
$62,400
$74,000
$76,800
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Solution …
C. Journal entries:
2001
Income Tax Expense
Tax Payable
Deferred Tax Liability
70,000
66,800
3,200
2002
Income Tax Expense
Tax Payable
Deferred Tax Liability
70,000
62,400
7,600
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Solution …
2003
Income Tax Expense
70,000
Deferred Tax Liability
Tax Payable
4,000
74,000
2004
Income Tax Expense
70,000
Deferred Tax Liability
Tax Payable
6,800
76,800
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Solution …
D. The deferred tax liability account
Dr.
Cr.
3,200
2001 entry
3,200
12/31/2001
7,600
2002 entry
10,800
12/31/2002
4,000
2003 entry
6,800
6,800
12/31/2003
2004 entry
0
12/31/2004
The liability has reversed itself
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Example: Deferred Tax Liability –
Advances from Customers
ƒ Miller Co. received $30,000 of subscriptions
in advance at the end of 2001
ƒ Subscription revenue will be equally
recognized in 2002, 2003, and 2004, for
financial accounting purposes
– All of the $30,000 will be recognized in 2001 for
tax purposes
ƒ Pretax income for each year 2001-2004 is
$100,000 -- assume a 40% tax rate.
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Questions
A. Compute Financial (book) income including
subscription revenue but excluding taxes.
What is income tax expense?
B. Compute taxable income. What is income tax
payable?
C. Give the journal entries to record taxes.
D. Give the balance of the deferred tax asset at
the end of each of the years.
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Questions …
E. For this requirement only, assume that as a
result of examining available evidence in
2004, it is more likely than not that
$10,000 of the deferred tax asset will not
be realized
•
Give the journal entry to record this
reduction.
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Solution
A.
2001
2002
2003
2004
100,000
100,000
100,000
100,000
0
10,000
10,000
10,000
100,000
110,000
110,000
110,000
40,000
44,000
44,000
44,000
Financial (book) income
Income before subscription
Subscription revenue received
in 2004
Income before taxes
Income tax expense (40%)
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Solution …
Pretax income
Subscription received in 2001
Taxable Income
Taxes Payable (40%)
2001
2002
2003
2004
100,000
100,000
100,000
100,000
30,000
-
-
-
130,000
100,000
100,000
100,000
52,000
40,000
40,000
40,000
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Solution …
C. Journal entries
2001
Income tax expense
Deferred tax asset
Tax payable
40,000
12,000
52,000
2002 - 2004
Income tax expense
Deferred tax asset
Tax payable
44,000
4,000
40,000
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Solution …
D. The deferred tax asset account
Dr.
Cr.
12,000
2001 entry
12,000
12/31/2001
4,000
8,000
2002 entry
12/31/2002
4,000
4,000
2003 entry
12/31/2003
4,000
2004 entry
0
12/31/2004
The asset has reversed itself.
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Solution …
E.
Income Tax Expense
Allowance to Reduce Deferred Tax Asset
To Expected Realizable Value
10,000
10,000
To record the reduction in the deferred tax asset
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Example: Permanent Differences
Calculation
ƒ Hunter Corporation reports the following information for
2004:
Financial (Book) Income before Income Taxes
Income Taxes Payable (for 2004)
Income Tax Expense
$548,000
157,500
210,000
• Hunter Corp. has both temporary and permanent
differences between book income and taxable income
• Temporary difference results from depreciation
• Permanent difference results from a fine that the
company has to pay (but can not be deducted on its tax
return).
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Question
ƒ What is the amount of the permanent difference
for the year?
ƒ The tax rate is 35%.
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Solution
Step 1: Find the change in the deferred tax liability
Income Tax Expense (Book)
$210,000
Income Taxes Payable
157,500
∆ Deferred Tax Liability
52,500
Step 2: Find the temporary difference
∆ Deferred Tax Liability/0.35
$52,500/0.35=
150,000
Step 3: Find taxable income
Income Taxes Payable (from current year)/0.35 $157,500/0.35=
450,000
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Solution …
Step 4: Find the permanent difference
Taxable Income (IRS)
$450,000
Temporary Differences
150,000
Financial (Book) Income before Taxes Excluding
Permanent Differences
600,000
Permanent Differences (P.N)
52,000
Financial (Book) Income before Taxes
548,000
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The End
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