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CHAPTER 5: SUPPLEMENT FOR DEFERRED INCOME TAXES
Introduction
This chapter discusses the recognition of income taxes for financial accounting purposes and for
income tax purposes. There are differing objectives between the rules of GAAP and the income tax laws,
leading to differing recognition of some revenue and expense items. The result is that GAAP will lead to
a different calculation of net income than the tax laws. We will differentiate the two in this chapter by
calling net income on the GAAP basis “financial income,” and net income under tax rules “taxable
income.”
We will be preparing the following basic journal entry to recognize the components of income tax:
Income tax expense
xx
Deferred Income Tax
xx / xx
Income Tax Payable
xx
Deferred income tax (DIT) represents the timing difference of the payment of taxes due to tax laws
that recognize revenues and expenses in different periods than GAAP. If it is a credit balance, it is
classified as a liability. Historically, the greatest contributor to this liability was depreciation. We saw in
Chapter 6 how the depreciation for one asset could lead to significantly higher depreciation expense in
early years using MACRS rather than straight line. If you multiply this times many assets, and many new
asset purchases over many years, the difference continues to grow, rather than reverse out.
For many years prior to the current standard (SFAS No. 109), companies were calculating income tax
expense based on the net income in the financial statement, and calculating income tax payable based on
the tax laws. This meant that Deferred Income Taxes (DIT), the difference, was a “plug”:
Income tax expense
xx
net income x percentage
Deferred Income Tax
xx / xx
plug
Income Tax Payable
xx
taxable income x percentage
However, after many years of growing differences (because of things like depreciation), this liability
account became larger than any other liability on the balance sheet, and sometimes dominated equity as
well. Part of the problem with the method of recognition was that accountants were creating this huge
liability on the balance sheet, but couldn’t explain specifically what was in the account, because it was just
a plug. (There is a bigger problem that we will address later in this chapter: Is it really a liability?)
When SFAS No. 109 was developed, it called for a detailed schedule to calculate deferred income
taxes, to show what items were causing the difference. The same schedule shows the calculation of
taxable income and income tax payable. Now the journal entry is prepared as follows:
Income tax expense
xx
plug
Deferred Income Tax
xx / xx
schedule
Income Tax Payable
xx
schedule
We will be preparing several schedules to calculate DIT, but first you need to understand what items need
to go into the schedule.
Temporary Differences and Deferred Income Taxes
Some transactions affect accounting income and taxable income differently. Some differences may
be permanent. For example, income from municipal bonds is not taxable (not today, not later). This
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permanent difference is removed from the schedule of calculations before DIT is calculated. DIT should
relate only to those items which are temporary, and which will reverse out in future periods. These
temporary (or timing) differences result from the different rules of recognition for GAAP and for tax. The
differences “originate” in one period and reverse out over one or more future periods.
These differences fall into 2 categories:
1. Differences leading to financial income in excess of taxable income at time of origination (future
taxable - taxable in the future):
a.
Revenues or gains that are taxable after they are recognized in financial income (such as income
from an equity investment in excess of dividends received).
b. Expenses or losses that are deductible for income tax purposes before they are recognized in
financial accounting (such as MACRS depreciation for tax with straight-line for financial
accounting).
2. Differences leading to taxable income in excess of financial income at time of origination (future
deductible – deductible in the future but taxable now).
a.
Revenues or gains which are taxable before they are recognized in financial income (such as
cash received in advance for future service).
b. Expenses and losses which are deductible for income tax purposes after they are recognized in
financial income (this includes most estimates, such as warranty expense, bad debt expense,
loss contingencies).
We will focus in this chapter on the specific items mentioned above, and use them in different
illustrations: accelerated depreciation (MACRS versus straight line), accelerated revenue (cash received
in advance versus unearned revenue), estimated losses/expenses (like warranties and loss contingencies)
and deferred revenue (equity method versus cash received for dividends).
Scheduling Deferred Income Taxes
The schedule to calculate deferred income taxes accomplishes several things (See page 15 of this
handout for an illustration). The schedule will yield the amount of income tax payable in the current year,
and the amount of the deferred tax asset or liability that will be recognized in a future year.
The scheduling of a DIT component is different in the year of origination than it is in subsequent years.
The year of origination is the first year that the difference enters into the schedule. In subsequent years,
the difference will proceed to reverse out, sometimes over many years (like depreciation).
In the First Year of a Difference
In the first year a DIT component is scheduled, it is entered into the first and second numerical
columns, and will have opposite signs, and a net -0- effect.
Look at the first column. The first numerical column starts with the current year's financial income
and converts it to taxable income by adjusting the differences between the GAAP method and the tax
method for various income statement techniques. The resulting taxable income is then used to calculate
income tax payable for the journal entry.
The second numerical column holds the amounts that
represent the total reversals of the effects scheduled.
We will be looking at several common DIT items, both in this chapter and in your company analysis.
Several of these items are explained (and illustrated) in the next section.
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Depreciation: In Chapter 6, we found that MACRS depreciation gave more depreciation expense
in the early years, and less in the later years. More expense means less income. Therefore, to convert
financial income (FI) to taxable income (TI) for the current year, we need to subtract the excess expense to
convert FI to TI. Whatever we subtract now, we will be adding back later, so we schedule the addition
into the DIT column.
Estimated expenses: In Chapters 6 and 8 we have looked at several estimated expenses; these
include bad debt expense, warranty expense and contingent losses. In all of these cases, we recorded
estimated expense before it had been realized. The IRS takes the position that we should record these
expenses only when realized: bad debt expense when the accounts receivable is written off; warranty
expense when the warranty service is delivered; contingent loss when the loss is finally settled. For these
situations we must back the estimated expense out of FI in the current year to convert to TI; to back out
the expense we must add to FI. We will get to deduct the expense in the future, when incurred, so the
reversal is carried as a deduction in the DIT column until it reverses out.
Pension expense: Note that pension expense (for the defined benefit pension plan) is an estimated
expense, and fits into this category. However, the general rule in tax is that the expense can be deducted
as paid. When we compare funding to expense, we find the difference between financial income and
taxable income. Sometimes pension expense is more than cash paid, and we need to adjust the excess
expense out of FI to get to TI. Sometimes pension expense is less than cash paid, and we get to include
the extra amount paid for tax purposes. Therefore, this adjustment can go either way (it can cause a
deferred tax asset or a deferred tax liability). Watch for this item in your company project. If it is a
deferred tax asset, pension expense was higher than the cash paid that period. The reverse is true for a
deferred tax liability.
Customer advances: when companies receive advance payments from customers for goods or
services yet to be delivered, the amount is taxable when received, even though FI does not yet reflect the
income. To convert from FI to TI, we must add the amount to FI.
Illustration of Schedule - First Year
In the year of origination, the effects would be scheduled with the following signs:
Current year
Future years
I.T. Payable
Deferred I.T.
Pretax financial income
xx
Future deductible examples:
Revenue: Customer advances
+
Expense: Estimated expenses
+
Future taxable examples:
Revenue: Excess equity income
+
Expense: Excess MACRS depr.
+
Taxable income
xx
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Illustration of Schedule - Subsequent Years
In subsequent years, the effects that were indicated for "future years" would enter into the "current
year" column. The sign of the effect does not change when it rolls into the current year. Note that some
amounts might fully reverse in one year (like some warranties), some amounts might partially reverse each
year for a number of years (like depreciation), and some items might remain deferred for many years (like
equity income). Each item should be scheduled according to the "new" information regarding that item.
For example if an estimated warranty of $10,000 was recorded in pretax financial income in 2005, and is
expected to be paid in 2006, the $10,000 would be scheduled in the year of origination (2005) as follows:
2005
DIT
Pretax financial income
xx
Future deductible:
Warranty expense
+ 10,000
- 10,000
Taxable income
xx
This backs the expense out of 2005 income and indicates that it will be deducted for tax purposes when
paid. Note that the net effect in the row of the scheduled amount (in the first year schedule) is zero.
If we go forward to 2006, and $9,000 of the warranty has been paid out, but the other $1,000 is not
expected to be paid until 2007, the information would be scheduled as follows:
Prior
2006
DIT
Pretax financial income
xx
Future deductible:
Warranty expense
+10,000
- 9,000
- 1,000
Taxable income
xx
Note that the amounts in subsequent years do not total to zero. The only way to see that the total
equals zero is to continue to carry the "originating" column as well.
Additional Issues in Preparing the DIT Schedule
The first column of the schedule will calculate Income Tax Payable by using the current tax rate
and multiplying it times Taxable Income. The second column of the schedule will calculate the "desired
ending balance" in Deferred Income Taxes (either a deferred tax asset (DTA) or deferred tax liability
(DTL) depending on a negative or positive balance). We will use the enacted tax rate for the future years,
and multiply that rate times the net amount for the future taxable or future deductible.
One other caution in the schedule: I stated earlier that the second column of the schedule indicates
the desired ending balance in DTA or DTL, so the account must be analyzed similar to the Allowance for
Doubtful Accounts. If there is a beginning balance in the account, the adjusting journal entry to record
DIT would include only that amount necessary to bring the DTA or DTL up or down to the desired
balance.
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Illustration 1: Depreciation and Deferred Income Taxes
The following problem illustrates the effect of MACRS depreciation on deferred income
taxes, when straight-line depreciation is used for financial reporting. Company D
purchases equipment on January 2, 2005 for $10,000. For its financial reports, Company D
uses the straight-line method to depreciate this asset, assuming an 8 year life and no salvage
value. For income tax purposes, the MACRS schedule requires that Company D use a 5
year life (with a half year in the first and last year). Assume that Company D has pretax
financial income each year of $20,000, and a tax rate of 30% each year. No other
temporary or permanent differences exist.
The following differences in depreciation expense will result in the years 2005-2012:
2005
2006
2007
2008
2009
2010
2011
2012
Straight
Line
1,250
1,250
1,250
1,250
1,250
1,250
1,250
1,250
MACRS
2,000
3,200
1,920
1,152
1,152
576
-0-0-
Diff .
- 750
- 1,950
- 670
98
98
674
1,250
1,250
Summary for 2005 Schedule
2005 ITP
DIT
(750)
╗
║
║
╠════════════►
║
║
╝
750
The schedule for 2006 timing differences (assuming no other activity) would be:
Straight
Summary for 2006 Schedule
Line
MACRS
Diff.
2006 ITP
DIT
2005
1,250
2,000
- 750
2006
2007
2008
2009
2010
2011
2012
1,250
1,250
1,250
1,250
1,250
1,250
1,250
3,200
1,920
1,152
1,152
576
-0-0-
- 1,950
- 670
98
98
674
1,250
1,250
(1,950)
╗
║
╠═════════════►
║
║
╝
2,700
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The schedule for 2007 timing differences (assuming no other activity) would be:
2005
2006
Straight
Line
1,250
1,250
MACRS
2,000
3,200
Diff.
- 750
- 1,950
2007
2008
2009
2010
2011
2012
1,250
1,250
1,250
1,250
1,250
1,250
1,920
1,152
1,152
576
-0-0-
- 670
98
98
674
1,250
1,250
Summary for 2007 Schedule
2007 ITP
DIT
(670)
╗
║
╠══════════►
║
╝
3,370
The schedule for 2008 timing differences (assuming no other activity) would be as follows:
Straight
Summary for 2008 Schedule
Line
MACRS
Diff.
2008 ITP
DIT
2005
1,250
2,000
- 750
2006
1,250
3,200
- 1,950
2007
1,250
1,920
- 670
2008
2009
2010
2011
2012
1,250
1,250
1,250
1,250
1,250
1,152
1,152
576
-0-0-
98
98
674
1,250
1,250
98
╗
╠══════════►
║
╝
3,272
Required:
Prepare schedules (see attached pages) to calculate deferred income taxes for
2005 - 2008, and prepare journal entries for 2005 - 2008 to record income taxes.
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ILLUSTRATION 1 - DEPRECIATION
Schedule - 2005
Pretax financial income
Future Deductible:
I.T. Payable
20,000
DIT
Future Taxable:
Taxable (deductible) amount
Tax rate
30%
30%
Income tax payable
DIT - liab (asset)
DIT
|
|
===
|
Journal entry - 2005:
Income tax expense
Income tax payable
2005
2006
2007
2008
2009
2010
2011
2012
Straight
Line
1,250
1,250
1,250
1,250
1,250
1,250
1,250
1,250
MACRS
2,000
3,200
1,920
1,152
1,152
576
-0-0-
Diff .
- 750
- 1,950
- 670
98
98
674
1,250
1,250
Summary for 2005 Schedule
2005 ITP DIT
(750)
╗
║
║
╠════════════►
║
║
╝
750
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Schedule - 2006
Pretax financial income
Future Deductible:
I.T. Payable
20,000
DIT
Future Taxable:
Taxable (deductible) amount
Tax rate
30%
30%
Income tax payable
DIT - liab (asset)
DIT
|
|
===
|
Journal entry - 2006:
Income tax expense
Income tax payable
Straight
Line
MACRS
2005
1,250
2,000
- 750
2006
2007
2008
2009
2010
2011
2012
1,250
1,250
1,250
1,250
1,250
1,250
1,250
3,200
1,920
1,152
1,152
576
-0-0-
- 1,950
- 670
98
98
674
1,250
1,250
Diff.
Summary for 2006 Schedule
2006 ITP
DIT
(1,950)
╗
║
╠═════════════►
║
║
╝
2,700
Page 9
Schedule - 2007
Pretax financial income
Future Deductible:
I.T. Payable
20,000
Future Taxable:
Depreciation
Taxable (deductible) amount
Tax rate
DIT
-670
19,330
30%
Income tax payable
DIT - liab (asset)
3,370
3,370
30%
5,799
1,011
DIT
| 810
| 201
===
|1,011
Journal entry - 2007:
Income tax expense
DIT
Income tax payable
6,000
201
5,799
2005
2006
Straight
Line
1,250
1,250
MACRS
2,000
3,200
Diff.
- 750
- 1,950
2007
2008
2009
2010
2011
2012
1,250
1,250
1,250
1,250
1,250
1,250
1,920
1,152
1,152
576
-0-0-
- 670
98
98
674
1,250
1,250
Summary for 2007 Schedule
2007 ITP
DIT
(670)
╗
║
╠══════════►
║
╝
3,370
Page 10
Schedule - 2008
Pretax financial income (loss)
Future Deductible:
Future Taxable:
Depreciation
Taxable (deductible) amount
Tax rate
Income tax payable
DIT - liab (asset)
I.T. Payable
20,000
98
20,098
30%
DIT
3,272
3,272
30%
6,029
982
DIT
|1011
29 |
===
| 982
Journal entry - 2008:
Income tax expense
DIT
Income tax payable
2005
2006
2007
Straight
Line
1,250
1,250
1,250
2008
2009
2010
2011
2012
1,250
1,250
1,250
1,250
1,250
MACRS
2,000
3,200
1,920
1,152
1,152
576
-0-0-
Diff.
- 750
- 1,950
- 670
98
98
674
1,250
1,250
6,000
29
6,029
Summary for 2008 Schedule
2008 ITP
DIT
98
╗
╠══════════►
║
╝
3,272
Page 11
Illustration 2: Deferred Income Taxes Comprehensive Example
2005 Only:
Given the following 2005 (originating) differences between financial accounting income and taxable income
(Company D's first year of operation):
1. Estimated warranty costs in 2005 (expected to be paid out in 2007) were $4,000.
2. Depreciation difference for computers purchased in 2005 at a total cost of $40,000 (3 year life for MACRS, 5
year life for straight-line; see Chapter 9 for 3 year MACRS percentages):
SL
MACRS
Difference
2005
8,000
13,332
-5,332
2006
8,000
17,780
-9,780
2007
8,000
5,924
2,076
2008
8,000
2,964
5,036
2009
8,000
-08,000
3. Company D collected $3,000 from customers in advance of delivering subscriptions. The subscriptions are
expected to be delivered in 2006.
4. Pretax financial income for 2005 was $200,000, and the enacted tax rate for current and future periods is 30%.
Requirements for Part A:
1.
Prepare a schedule to calculate income tax payable and deferred income taxes for 2005.
2.
Prepare the journal entry for 2005 to record income taxes.
ILLUSTRATION 2 - COMPREHENSIVE PROBLEM
A.1. Schedule
2005
Pretax financial income
200,000
Future Deductible:
DIT
Future Taxable:
Taxable (deductible) amount
Tax rate
30%
30%
Income tax payable
DIT - liab (asset)
DIT
|
|
===
|
A.2. Journal entry:
Income tax expense
Inc. tax payable
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Information for Company Project
1. You will be examining the footnote disclosure for deferred income taxes as well as the financial
statement presentation. Exhibit 5.6 indicates the schedule of DTA and DTL for Pfizer. The second
column illustrates the disclosure for the DTA and DTL (this is the disclosure you want to find for your
company). This disclosure indicates the different items that are contributing to the DTA or DTL, and the
amount of DTA or DTL that was recognized each year for that item.
Some companies list the revenue or expense item that is causing the deferral. Other companies list
the related asset (like PP&E) or liability (like pensions) to indicate the category.
2. In your project evaluation, you will see some items listed in the DIT disclosure that we have not
discussed (you may omit these from your discussion for the company project). They are more complex
than the subjects we have already examined. For your information (not for the exam or project), a short
explanation is offered here:
Equity Investments: when a company owns greater than 20% of another company, this is an equity
investment. The investing company recognizes income as a percentage of the investees income; the
company does not recognize dividend income (based on cash flows as the investor receives the dividend).
The IRS taxes only dividends received; the difference each year leads to a deferred tax liability until the
investment is sold.
Loss carryforwards: when a company or its subsidiaries has a loss, the company may file for a tax
refund for prior years it has paid in (2 years prior, to the amount of the tax benefit on the loss). The
company may also carry any unused loss forward (up to 20 years), and apply it against future earnings.
The "carryforward" results in a deferred tax asset until it is used up (or expires). Problem: the company
must generate income to get benefit from the deferred tax asset. If there is a probability that the asset will
not get used, the company needs to estimate a valuation allowance (see below).
Valuation Allowance: Deferred tax assets require that a company have future income before the
DTA can be applied against that income. When a company has DTA, especially those caused by things
that can expire (like the loss carryforward), the company must evaluate the asset to see if some of the asset
might not be used. The allowance account writes down the DTA to the amount that is expected to be
used.
3. In your company project, you will be asked to find the amounts reported in the balance sheet relating
to DIT. SFAS No. 109 requires companies to distinguish between "current deferred" income taxes and
"noncurrent deferred" income taxes. The difference is that the "current deferred" items are expected to
reverse in 1 year, where the "noncurrent deferred" will reverse beyond one year. In this chapter, we did
not distinguish between the current deferred and the noncurrent deferred (i.e., we calculated and recorded
only one item of deferred income taxes). However, when reviewing financial statements for your project,
please note that your company will usually have an amount in current deferred taxes (either asset or
liability) and in noncurrent deferred taxes (either asset or liability). Some companies even report current
DTA, noncurrent DTA, current DTL, and noncurrent DTL.
Also, you will be asked to see if the disclosure reconciles to the display in the balance sheet. This
will not be the case for many companies. Some companies aggregate current DTA and DTL with other
current assets and liabilities, and you will not be able to reconcile the amounts.
Page 13
Conceptual Issues with Deferred Income Taxes
For this part of the discussion, let us focus only on the effect of different depreciation
methods on deferred income taxes. We can extrapolate to other types of assets and
liabilities once the concept has been established.
Question 1: Is the DTL from depreciation difference really a liability?
First: refer to the definition of a liability (see Chapter 8 notes), particularly the part that
says "probable future sacrifices of economic benefits . . ." For deferred income taxes, the
implied benefit that we are going to sacrifice is cash.
Now: refer to the spreadsheet for Illustration 1 (year 2005 – attached again for discussion).
What happens to deferred tax liability if a company chooses to use MACRS for both
financial and tax reporting?
Did the company pay any cash to make the deferred tax liability disappear?
If the company can make a "liability" disappear with an accounting choice, and not a cash
payment, is it really a liability?
This finding can be applied to many deferred tax items, but is particularly obvious with DIT
relating to depreciation.
Question 2: How do analysts perceive DIT?
The research findings are mixed, but many analysts completely ignore DIT when
evaluating a company's financial position. They often reclassify the DIT effect to equity.
Other analysts have found that the current portion of DIT has value when predicting cash
flows for a company. Financial statement users are cautioned to view DIT differently than
other assets and liabilities.
Page 14
ILLUSTRATION 1 - DEPRECIATION
REVISED FOR MACRS FOR BOTH
Schedule - 2005
Pretax financial income
Future Deductible:
I.T. Payable
DIT
Future Taxable:
Taxable (deductible) amount
Tax rate
30%
30%
Income tax payable
DIT - liab (asset)
DIT
|
|
===
|
Journal entry - 2005:
Income tax expense
Income tax payable
2005
2006
2007
2008
2009
2010
2011
2012
Straight
Line
1,250
1,250
1,250
1,250
1,250
1,250
1,250
1,250
MACRS
2,000
3,200
1,920
1,152
1,152
576
-0-0-
Diff .
- 750
- 1,950
- 670
98
98
674
1,250
1,250
Summary for 2005 Schedule
2005 ITP DIT
(750)
╗
║
║
╠════════════►
║
║
╝
750