Chapter 20
Chapter 20 - Accounting for Income Taxes
I.
II.
Accounting for Differences
A.
Pre-tax Financial Income [on the Income Statement] is determined in accordance
with GAAP.
B.
Taxable Income [on the Tax Return] is determined in accordance with the rules
and regulations of the IRS.
C.
The basic objectives of measuring income are different for the IRS and GAAP.
Accordingly, income reported on the Income Statement is often different from
Income reported on the Tax Return.
Two Types of Differences
A.
Permanent Differences Items that:
1.
enter into the determination of financial income but will never enter into the
determination of taxable income, or
2.
enter into the determination of taxable income but will never enter into the
determination of financial income.
#1 is more common
Examples:
1.
2.
3.
Proceeds [and premiums] from Life insurance policies
Interest on Municipal bonds
Fines and Penalties
Since Permanent differences affect only the current period, there are
NO DEFERRED TAX CONSEQUENCES!!
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B.
Temporary [Timing] Differences
Textbook definition -
Temporary differences arise when the Tax Basis of an asset
or liability differs from the reported amounts in the financial
statements.
My definition -
When an income or expense item is recognized in one year
on the income statement and another year on the tax return.
Examples:
1.
2.
3.
4.
5.
6.
Accelerated vs. straight-line depreciation
Unearned Rent or Subscription Income
Warranty Costs
Installment Sales
Use of the Equity method in accounting for investments
Prepaid Insurance and other contracts
Since these items ORIGINATE in one period and REVERSE in another, the tax
consequences are DEFERRED, and result in deferred income taxes.
C.
Types of Deferrals
1.
When the differences result in FUTURE TAXABLE AMOUNTS:
When Current Taxable Income < Current Financial Income
A.
B.
Higher Income Amounts [on the tax return] in future periods, or
Lower Expense Amounts [on the tax return] in future periods
This results in a DEFERRED TAX LIABILITY
Sample journal entry:
Income Tax Expense
[based on Income Statement]
Deferred Tax Liability
[Deferred income x Tax rate]
Income Tax Payable
[based on the Tax Return]
2.
When the differences result in FUTURE DEDUCTIBLE AMOUNTS:
When Current Taxable Income > Current Financial Income
A.
B.
Lower Income Amounts [on the tax return] in future periods, or
Higher Expense Amounts [on the tax return] in future periods
This results in a DEFERRED TAX ASSET
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Sample journal entry:
Income Tax Expense
[based on Income Statement]
Deferred Tax Asset
[Deferred income x Tax rate]
Income Tax Payable
[based on the Tax Return]
III.
Tax Rates
A.
Deferred income tax assets and liabilities are recorded at RECOVERABLE
amounts. This means that they are recorded using the tax rates that will be in
effect when the temporary difference reverses.
B.
Tax rates other than the current tax rate should be used if the future tax rates
have been enacted into law. If the future tax rate has not yet been enacted, the
current tax rate should be used.
C.
When a tax rate change is enacted, and deferred tax assets and liabilities exist,
the effect of the change in tax rate is recorded immediately in the deferred account
and the income tax expense account.
SEE EXAMPLE ON PAGES 1040 - 1041
D.
V.
The appropriate enacted tax rate is the AVERAGE tax rate when graduated tax
rates exist.
Net Operating Loss Carryback and Carryforward
A.
Tax laws permit a corporation that experiences alternate periods of income and
losses to equalize their tax burdens by matching loss periods against income
periods.
1.
NOL Carryback
If a loss is suffered in the current period, the corporation is permitted to offset the loss
against the previous three years' income. This would necessitate filing amended tax
returns for the three previous years and claiming a tax refund.
For book purposes, the income tax effect is recognized in the year of the loss, since the
loss gives rise to a refund that is both measurable and currently realizable.
2.
NOL Carryforward
If the NOL is not fully absorbed through the Carryback, OR the corporation decides not to
carry the loss back, the NOL can be carried forward for 15 years. Because carryforwards
are used to offset future taxable income, the tax effect of a loss carryforward is a
Deferred Tax Asset.
SEE EXAMPLES ON PAGES 1042-1043
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