Chapter 16 Accounting for Income Taxes

Chapter 16 Accounting for Income Taxes

DEFERRED TAX ASSETS AND DEFERRED TAX LIABILITIES

Fundamental Concepts

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.

Temporary Differences

Deferred taxes arise as a result of temporary difference between income tax expense and 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. 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 .

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 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.

F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 1


Depreciation Expense

Financial statements

IRS Form 1120

Difference

Amount

$25,000

75,000

($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


IRS Form 1120

Difference

$300,000

100,000

$200,000

Step #1: The first step in calculating and reporting deferred income taxes is the analysis of the book to tax differences. The following is a computation of taxable income starting with pretax accounting income.

Taxable Income

Pretax accounting income

Amount

$700,000

Temporary differences:

Accelerated depreciation

Installment sales

Taxable income

(50,000)

(200,000)

$450,000

Step #2: Income tax payable is based on taxable income using the current average tax rate. The following is a calculation of the income tax payable.

Income Tax Payable Amount

Taxable income

Tax rate

Income tax payable

$450,000

30%

$135,000

Step #3: 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 Tax Rate

$50,000

200,000

$250,000

30%

30%

Asset Liability

$15,000

60,000

$75,000

Step #4: 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 T-account analysis is as follows:

T-Account: Deferred Tax Liability

Description

Beginning balance

Adjusting journal entry

Ending balance

Debit Credit

$0

75,000

$75,000

In this case the deferred tax expense is the change (adjusting journal entry) in the deferred tax liability account. If there is a change in both the deferred tax asset account (deferred tax benefit) and the deferred tax liability account (deferred tax expense) the amounts net to be netted together to derive a single amount of deferred tax expense or deferred tax benefit.

Step #5: 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 total 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 Amount

Current tax expense

Deferred tax expense

Income tax expense

$135,000

75,000

$210,000

Step #6: 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

Income tax expense

Debit

$210,000

Credit

Income tax payable $135,000

Deferred tax liability 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.

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 Amount


IRS Form 1120

Difference

$

$

$



Solution:

Estimated Warranty


IRS Form 1120

Difference

Amount

$125,000

0

$125,000

Using the format provided calculate the book to tax difference as a result of the unearned rent.

Unearned Rent Amount


IRS Form 1120

Difference

$

$

$

Solution:

Unearned Rent


IRS Form 1120

Difference

Amount

$100,000

300,000

($200,000)

Based on the information above compute taxable income by starting with pretax accounting income.

Taxable Income

Pretax financial income


$

Estimated warranty expense

Unearned rent income

Taxable income

$

$

$

Solution:

Taxable Income

Pretax financial income

Temporary differences

Estimated warranty expense

Unearned rent income

Taxable income

$700,000

125,000

200,000

$1,025,000



Now that you have taxable income you can calculate income tax payable.

Income Tax Payable Amount

$ Taxable income

Tax rate

Income tax payable $

%

Solution:

Income Tax Payable

Taxable income

Tax rate

Income tax payable

Amount

$1,025,000

30%

$307,500

Based on the information provided in the above exercises prepare the schedule of deferred tax assets.

Future

Amount

Tax

Rate

Deferred Tax

Asset Liability Temporary Difference

Estimated warranty

Unearned rent

$

$

$

% $

% $

$

Solution:

Temporary Difference

Estimated warranty

Unearned rent

Future

Amount

$125,000

200,000

$325,000

Tax

Rate

Deferred Tax

Asset

30% $37,500

Liability

30% 60,000

$97,500

Instead of a deferred tax expense we will have a deferred tax benefit as a result of the deferred tax assets.



T-Account: Deferred Tax Asset

Decsription

Beginning balance


Ending balance

Debit Credit

Solution:


Decsription

Beginning balance


Ending balance

Debit

$0

97,500

$97,500

Credit

The deferred tax benefit, which is the change in the deferred asset account, reduces current period income tax expense. Using the format calculate income tax expense.

Income Tax Expense Amount

Deferred tax benefit

Current tax expense

Income tax expense

Solution:

Income Tax Expense

Current tax expense


Income tax expense

Amount

$307,500

(97,500)

$210,000

Base on your experience with the deferred tax liability see if you can prepare the year-end adjusting journal entry to record income tax expense, income tax payable, and the deferred tax asset.

Account Debit Credit

Income tax expense

Deferred tax asset

Income tax payable

$

$

$



Solution:

Account

Income tax expense

Debit

$210,000

Credit

Deferred tax asset

Income tax expense

Allowance to reduce deferred tax asset to

97,500

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 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 that the $80,000 of this deferred tax asset will not be realized. Prepare the necessary journal entry.


$ expected realizable value

Solution:

Account

Income tax expense

Debit

$80,000

$

Credit

Allowance to reduce deferred tax asset to expected realizable value $80,000

COMPREHENSIVE REVIEW

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, 2003, 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.

1.

Based on the information provided compute taxable income by starting with pretax accounting income.

Taxable Income

$ Financial statement income


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:

Financial statement income


Deduct: future taxable amounts

Current period

Taxable Income

Prior period

Beginning deferred tax liability

Enacted tax rate

Prior period future taxable amount

$40,000

40%

$240,000

100,000

$200,000

Add: future deductions

Taxable income per tax return

140,000

60,000

35,000

$95,000

2.

Calculate income tax payable based on the taxable income.



Taxable income

Enacted tax rate

Income tax payable


$

$

$

SOLUTION:

Taxable income

Enacted tax rate

Income tax payable


$95,000

40%

$38,000

3.

Based on the above information prepare a schedule of deferred tax assets and deferred tax liabilities.

Deferred Tax

Future

Future taxable amounts

Future deductable amounts

Totals

Temporary difference

$

$

$


%

% $

$

Asset

$

$

Liability

SOLUTION:

Temporary difference

Future taxable amounts

Future deductable amounts

Totals

Deferred Tax

Future


$240,000

(35,000)

$205,000

40%

40%

Asset

($14,000)

($14,000)

Liability

$96,000

$96,000

4.

Prepare a t-account analysis of the deferred tax asset account.


Debit Credit Description

Beginning balance


Ending Balance

$

$

$



SOLUTION:


Description Debit

Beginning balance


Ending Balance

$0

14,000

$14,000

Credit

5.

Prepare a t-account analysis of the deferred tax liability account.


Debit Credit Description

Beginning balance


Ending Balance

$

$

$

SOLUTION:


Description

Beginning balance

Debit


Ending Balance

Credit

$40,000

56,000

$96,000

6.

Prepare a schedule of net deferred tax expense (benefit).

Net Deferred Tax Expense (Benefit)



Net deferred tax expense

$

$

$

Amount

SOLUTION:

Net Deferred Tax Expense (Benefit)




Amount

$56,000

(14,000)

$42,000

7.

Prepare a schedule of income tax expense.



Amount Income Tax Expense

Current tax expense


Income tax expense

$

$

$

SOLUTION:

Income Tax Expense

Current tax expense


Income tax expense

Amount

$38,000

42,000

$80,000

8.

Prepare the journal entry to record income tax expense, income tax payable, the change in deferred tax assets and deferred tax liabilities for the year.


Income tax expense

Deferred tax asset

$

$

Deferred tax liability

Income tax payable

SOLUTION:

Account

Income tax expense

Current

Deferred

Net income

Debit

$80,000

$

$

$

$

Credit

Deferred tax asset

Deferred tax liability

Income before income taxes

Income tax expense

14,000

$56,000

Income tax payable 38,000

9.

Prepare a partial income statement starting with income before income tax.

Partial Income Statement

$

$

$



SOLUTION:

Partial Income Statement

Income before income taxes

Income tax expense:

Current

Deferred

Net income

$38,000

42,000

$200,000

80,000

$120,000

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 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.


Chapter 16 Accounting for Income Taxes

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