CHAPTER 19: ACCOUNTING FOR INCOME TAXES
Objectives:
1. Be able to explain differences between financial and taxable income. Conceptual overview.
2. Be able to identify and account for a deferred tax liability (taxable amounts).
3. Be able to identify and account for a deferred tax asset (deductible amounts) including use of a valuation allowance with deferred tax assets.
4. Distinguish between temporary and permanent differences.
5. Calculate the effect of changing tax rates.
6. Apply loss carrybacks and loss carryforwards.
7. Describe disclosure requirements.
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Objective 1: Difference between taxable and pretax financial income
Taxable Income:
Computed in accordance with prescribed tax regulations and rules
Pretax financial income:
Book income. Computed in accordance with generally accepted accounting principles.
Difference between the two is attributable to either temporary differences or permanent differences

Temporary: difference between the tax basis of an asset or liability and its book value that will increase or decrease taxable income in the future.

Permanent: items that enter into book income but never into tax income or items that enter into tax income but never into book income.
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CONCEPTUAL OVERVIEW:
Most recent SFAS’s take the asset-liability approach to reporting income taxes in the financial statements.
We consider only temporary differences between book and tax and create a deferred tax liability or asset
(originating temporary difference). In the future the originating temporary difference will be eliminated and the tax effect removed from the deferred tax account
(reversing temporary difference).
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Objective 2: When we recognize a deferred tax liability
A deferred tax liability is created when taxable amounts will arise in the future (i.e., there will be an increase in taxes payable in future years) as the result of temporary differences existing at the end of the current year.
Example: Accelerated depreciation used for tax, straight-line for books. Tax rate = 40%. The amount owed the IRS (income tax payable) in 2003 is $16,000, in
2004 $20,000 and in 2005 $18,000.
(originating) (reversing) (reversing)
2003 2004 2005
TI<BI TI>BI TI>BI
$10,000 ($5,000) ($5,000) x 40% x 40% x 40%
_______ _______ _______
$ 4,000 ($ 2,000) ($ 2,000)
2003 JE:
Income tax expense 20,000
(current & future)
Income tax payable 16,000
Deferred tax liability 4,000
What are the JE's for 2004 and 2005?
What happens to income tax expense in each year?
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Objective 3: When we recognize a deferred tax asset
A deferred tax asset is created when deductible amounts will arise in the future (i.e., there will be an decrease in taxes payable in future years) as the result of temporary differences existing at the end of the current year.
Example: For book we recognize an estimated warranty expense associated with each product sale. For tax we can only recognize the expense when we pay it. Tax rate =
40%. The amount owed the IRS (income tax payable) in
2003 is $16,000, in 2004 $20,000 and in 2005 $18,000.
(originating) (reversing) (reversing)
2003 2004 2005
BI<TI BI>TI BI>TI
($10,000) $5,000 $5,000 x 40% x 40% x 40%
______ _______ _______
($ 4,000) $ 2,000 $ 2,000
2003 JE:
Income tax expense 12,000(current & future)
Deferred tax asset 4,000
Income tax payable 16,000
What are the JE's for 2004 and 2005?
What happens to income tax expense each year.
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Use of a valuation allowance:
If it is anticipated that a favorable tax benefit is not expected to be realized for a portion of the deductible temporary difference, a valuation allowance is established.
Income tax expense 1,000
Allowance to reduce DTA 1,000
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Objective 4: Temporary versus permanent differences
See list in text. Major ones:
Temporary: installment sales (accrual for book, cash for tax)
% of completion for book, completed contract for tax
Investments under equity for book, under cost for tax
Product warranties (accrued estimate for book, cash for tax)
Litigation (accrued estimate for book, cash for tax)
Advance payments (accrued liability for book, cash for tax)
Straight-line depreciation for book, accelerated for tax
Permanent: (actually all listed in text are important)
Municipal interest (in book but not tax)
Life insurance premiums (deducted in book but not tax)
Goodwill amortization (deducted in book but not tax)
Dividend deduction on U.S. Corp. (deducted in tax but not book)
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Objective 5: Changing tax rates
If the future tax rates have been enacted into law, then the deferred income taxes should be based on the future average rates.
If the new rates are not yet enacted, the current rate should be used. When rates are revised, we revise our deferred tax asset or liability.
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Objective 6: Accounting for NOL's
Federal tax law allows taxpayers to use the losses of one year to offset the profits of other years.
Loss Carryback/Carryforward:
The NOL may be carried back two years and if any loss is remaining, the company may carry forward
20years. On the carryback, the company will receive refunds for income taxes paid in those years.
Income tax receivable XX
Benefit due to NOL XX
(credit to operating loss on fin. stmt)
On the carryforward, a deferred tax asset is established for the tax effect. The FASB essentially treats an NOL carryfoward the same as a deductible temporary difference.
Deferred tax asset XX
Benefit due to NOL XX
Carryforward
Note: This asset can also have a valuation allowance.
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Objective 7: Disclosure
The issue is classification. The deferred tax asset or liability is classified as current or noncurrent based on the classification of the related asset or liability.
If it is not related to an asset or liability (as is the case with NOL carryforwards), then it is classified according to the expected reversal dates.
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