Chapter 16
Accounting for Income
Taxes
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-2
Deferred Tax Assets/Liabilities
GAAP is the set of
rules for preparing
financial
statements.
Results in . . .
Financial statement
income tax expense.
The Internal
Revenue Code is
the set of rules for
preparing tax
returns.
Usually. . .
Results in . . .
IRS income taxes
payable.
The difference between tax expense and tax
payable is referred to as deferred taxes.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-3
Deferred Tax Assets/Liabilities
Example
Examine the December 31, 2003, information
for X-Off Inc.
Revenues
Depreciation Expense:
Straight-line
Accelerated
Other Expenses
$ 1,000,000
200,000
320,000
650,000
X-Off uses straight-line depreciation for
financial reporting and accelerated depreciation
for income tax reporting.
X-Off’s tax rate is 30%.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-4
Deferred Tax Assets/Liabilities
Example
Compute X-Off’s income tax expense
and income tax payable.
Income
Statement
Tax
Return
Difference
Revenues
Less:
Depreciation
Other expenses
Income before taxes
?
?
?
?
?
?
?
?
?
?
?
?
× Tax rate
Income taxes
?
?
?
?
?
?
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-5
Deferred Tax Assets/Liabilities
Example
Compute X-Off’s income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
× Tax rate
Income taxes
McGraw-Hill/Irwin
$
30%
45,000
Tax
Return
Difference
The income tax
amount computed
based on financial
statement income
is income tax
expense for the
period.
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-6
Deferred Tax Assets/Liabilities
Example
Compute X-Off’s income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
× Tax rate
Income taxes
McGraw-Hill/Irwin
$
30%
45,000
Tax
Return
Difference
Next,
compute
income
taxes for
the tax
return.
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-7
Deferred Tax Assets/Liabilities
Example
Compute X-Off’s income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
× Tax rate
Income taxes
McGraw-Hill/Irwin
$
Tax
Return
$ 1,000,000
$
30%
45,000 $
320,000
650,000
30,000
30%
9,000
Difference
Income taxes
based on tax
return
income are
the taxes
payable for
the period.
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-8
Deferred Tax Assets/Liabilities
Example
Compute X-Off’s income tax expense
and income tax payable.
Income
Statement
Tax
Return
Revenues
$ 1,000,000 $ 1,000,000
The deferred tax
for the period
Less:
of $36,000 is the 200,000
difference 320,000
Depreciation
between
income tax650,000
expense 650,000
of
Other
expenses
Income before
taxes
150,000tax$
30,000
$45,000
and$income
payable of $9,000.
× Tax rate
Income taxes
McGraw-Hill/Irwin
$
30%
45,000 $
Difference
$
-
$
(120,000)
120,000
30%
9,000 $
30%
36,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-9
Deferred Tax Assets/Liabilities
Example
The entry to record the deferred taxes
would appear as follows:
GENERAL JOURNAL
Date
Description
Page 77
Post.
Ref.
Debit
Credit
2003
Dec. 31 Income Tax Expense
McGraw-Hill/Irwin
45,000
Deferred Tax Liability
36,000
Income Taxes Payable
9,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-10
Temporary Differences
Often, the difference between pretax
accounting income and taxable income
results from items entering the income
computations at different times.
These are called
temporary
differences.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-11
Temporary Differences
Temporary differences will reverse out in
one or more future periods.
Financial Income > Taxable Income
Financial Income < Taxable Income
Future Taxable Amounts
Future Deductible Amounts
Deferred Tax Liability
Deferred Tax Asset
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-12
Revenues (or gains)
Installment sales of
property (installment
method for taxes)
Items
reported on
the tax return
AFTER the
 Unrealized gain from
income
recording investments at
statement
fair value (taxable when
asset is sold)
Items
reported on
the tax return
BEFORE the
income
statement
 Rent or subscriptions
collected in advance
 Other revenue
collected in advance
Expenses (or losses)
 Estimated expenses and
losses (tax deductible
when paid)
 Unrealized loss from
recording investments at
fair value or inventory at
LCM (tax deductible when
asset is sold)
 Accelerated
depreciation on tax return
(straight-line on income
statement)
 Prepaid expenses (tax
deductible when paid)
The temporary differences in the yellow boxes
create deferred tax assets because they result in
deductible amounts in the future.
© 2004 The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Slide
16-13
Revenues (or gains)
Installment sales of
property (installment
method for taxes)
Items
reported on
the tax return
AFTER the
 Unrealized gain from
income
recording investments at
statement
fair value (taxable when
asset is sold)
Items
reported on
the tax return
BEFORE the
income
statement
 Rent or subscriptions
collected in advance
 Other revenue
collected in advance
Expenses (or losses)
 Estimated expenses and
losses (tax deductible
when paid)
 Unrealized loss from
recording investments at
fair value or inventory at
LCM (tax deductible when
asset is sold)
 Accelerated
depreciation on tax return
(straight-line on income
statement)
 Prepaid expenses (tax
deductible when paid)
The temporary differences in the gray boxes
create deferred tax liabilities because they result
in taxable amounts in the future.
© 2004 The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Slide
16-14
Deferred Tax Liabilities
In 2001, Baxter records $100,000 on its books resulting
from revenue earned. The revenue will be taxed as the
cash is collected in 2002 and 2003. Baxter expects to
collect $70,000 in 2002 and the remaining $30,000 in 2003.
Financial Income $
Installment Sale
Taxable Income
$
2001
2002
2003
300,000 $ 200,000 $ 200,000
(100,000)
70,000
30,000
200,000 $ 270,000 $ 230,000
The company is subject to a 32% tax rate.
There are no other temporary differences.
Let’s look at Baxter’s 2001 tax entry.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-15
Deferred Tax Liabilities
Financial Income $
Installment Sale
Taxable Income
$
2001
2002
2003
300,000 $ 200,000 $ 200,000
(100,000)
70,000
30,000
200,000 $ 270,000 $ 230,000
Income tax expense = $300,000 × 32% = $96,000
Income tax payable = $200,000 × 32% = $64,000
General Journal
Description
Debit
Income tax expense
96,000
Income tax payable
Deferred tax liability
McGraw-Hill/Irwin
Credit
64,000
32,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-16
Deferred Tax Liabilities
The Deferred Tax
Liability
represents the
future taxes Baxter
will pay in 2002
and 2003.
General Journal
Description
Debit
Income tax expense
96,000
Income tax payable
Deferred tax liability
Future taxable amounts
Enacted tax rate
Deferred tax liability
McGraw-Hill/Irwin
Credit
64,000
32,000
Deferred Tax Liability
32,000 2001
2002
2003
Total
$ 70,000
$ 30,000
$ 100,000
32%
$ 22,400
32%
$ 9,600
$ 32,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-17
Deferred Tax Liabilities
Recall this
Financial Income
information for Installment Sale
Baxter for 2002. Taxable Income
$
$
2001
2002
2003
300,000 $ 200,000 $ 200,000
(100,000)
70,000
30,000
200,000 $ 270,000 $ 230,000
Income tax expense = $200,000 × 32% = $64,000
Income tax payable = $270,000 × 32% = $86,400
General Journal
Description
Debit
Income tax expense
64,000
Deferred tax liability
22,400
Income tax payable
McGraw-Hill/Irwin
Credit
86,400
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-18
Deferred Tax Liabilities
General Journal
Description
Debit
Income tax expense
64,000
Deferred tax liability
22,400
Income tax payable
Credit
86,400
Deferred Tax Liability
2002
22,400
32,000 2001
9,600 Balance
Reversing difference
McGraw-Hill/Irwin
Originating difference
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-19
Deferred Tax Liabilities
Future
Taxable
Amount
Schedule
Future taxable amounts
Enacted tax rate
Deferred tax liability
2003
Total
$ 30,000
$ 30,000
32%
$ 9,600
$ 9,600
Deferred Tax Liability
2002
22,400
32,000 2001
9,600 Balance
The Deferred Tax Liability represents the future taxes
Baxter will pay in 2003.© 2004 The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Slide
16-20
Deferred Tax Liabilities
Recall the information for Baxter, Inc. for 2003:
Financial Income $
Installment Sale
Taxable Income
$
2001
2002
2003
300,000 $ 200,000 $ 200,000
(100,000)
70,000
30,000
200,000 $ 270,000 $ 230,000
Income tax expense = $200,000 × 32% = $64,000
Income tax payable = $230,000 × 32% = $73,600
General Journal
Description
Debit
Income tax expense
64,000
Deferred tax liability
9,600
Income tax payable
McGraw-Hill/Irwin
Credit
73,600
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-21
Deferred Tax Liabilities
General Journal
Description
Debit
Income tax expense
64,000
Deferred tax liability
9,600
Income tax payable
Credit
73,600
Deferred Tax Liability
2002
22,400
32,000 2001
9,600 Balance
2003
9,600
0 Balance
© 2004 The McGraw-Hill Companies, Inc.
Reversing difference
McGraw-Hill/Irwin
Slide
16-22
Deferred Tax Assets
Health Magazine received $150,000 of subscriptions in
advance during 2001.
Subscription revenue will be earned equally in 2002,
2003 and 2004 for financial accounting purposes.
The entire $150,000 will be taxed in 2001.
There is additional income of $500,000 in each year.
The company is subject to a 30% tax rate in each year.
Financial Income $
Subscription Rev.
Taxable Income $
McGraw-Hill/Irwin
2001
2002
2003
2004
500,000 $ 550,000 $ 550,000 $ 550,000
150,000
(50,000)
(50,000)
(50,000)
650,000 $ 500,000 $ 500,000 $ 500,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-23
Deferred Tax Assets
Financial Income $
Subscription Rev.
Taxable Income $
2001
2002
2003
2004
500,000 $ 550,000 $ 550,000 $ 550,000
150,000
(50,000)
(50,000)
(50,000)
650,000 $ 500,000 $ 500,000 $ 500,000
This is the computation for the Deferred Tax Asset.
Calculation of Deferred Tax
Asset
Future deductible amount
Tax rate
Deferred tax asset at year-end
2001
$ 150,000
30%
$ 45,000
2002
$ 100,000
30%
$ 30,000
2003
$ 50,000
30%
$ 15,000
2004
$
30%
$
-
Now, let’s record the income tax
entry for 2001.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-24
Deferred Tax Assets
Financial Income $
Subscription Rev.
Taxable Income $
Calculation of Deferred Tax
2001
2002
2003
2004
Asset
500,000 $ 550,000 $ 550,000 $ 550,000
Future deductible amount
150,000
(50,000)
(50,000)
(50,000)
Tax rate
650,000 $ 500,000
500,000
500,000
Deferred$ tax
asset at$year-end
2001
$ 150,000
30%
$ 45,000
$
$
Income tax expense = $500,000 × 30% = $150,000
Income tax payable = $650,000 × 30% = $195,000
Description
Income tax expense
Deferred tax asset
Income tax payable
McGraw-Hill/Irwin
Debit
150,000
45,000
Credit
195,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-25
Deferred Tax Assets
Description
Income tax expense
Deferred tax asset
Income tax payable
Debit
150,000
45,000
Credit
195,000
Aftertax
posting
this entry,165,000
the Deferred Tax
Income
expense
Asset
account
will have a balance of $45,000.
Deferred
tax asset
15,000
Income tax payable
150,000
Deferred Tax Asset
2001
Balance
McGraw-Hill/Irwin
45,000
45,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-26
Deferred Tax Assets
In 2002, Health Magazine
earns $50,000 for
financial reporting
purposes.
Financial Income $
Subscription Rev.
Taxable Income $
2001
500,000 $
150,000
650,000 $
2002
550,000 $
(50,000)
500,000 $
2003
550,
(50,
500,
Income tax expense = $550,000 × 30% = $165,000
Income tax payable = $500,000 × 30% = $150,000
In 2002, the
balance in the
Deferred Tax
Asset should
decrease to
$30,000.
McGraw-Hill/Irwin
Calculation of Deferred Tax
Asset
Future deductible amount
Tax rate
Deferred tax asset at year-end
2001
$ 150,000
30%
$ 45,000
2002
$ 100,000
30%
$ 30,000
2
$
$
Let’s see the income©tax
entry for 2002.
2004 The McGraw-Hill Companies, Inc.
Slide
16-27
Deferred Tax Assets
Income tax expense = $550,000 × 30% = $165,000
Income tax payable = $500,000 × 30% = $150,000
Description
Income tax expense
Deferred tax asset
Income tax payable
Debit
165,000
Credit
15,000
150,000
Deferred Tax Asset
Income tax expense
165,000
2001
45,000
15,000 2002
Deferred tax asset
15,000
Balance
30,000
Income tax payable
150,000
Originating difference
McGraw-Hill/Irwin
Reversing
difference
© 2004 The McGraw-Hill
Companies, Inc.
Slide
16-28
Deferred Tax Assets
Financial Income $
Subscription Rev.
Taxable Income $
2001
2002
2003
2004
500,000 $ 550,000 $ 550,000 $ 550,000
150,000
(50,000)
(50,000)
(50,000)
650,000 $ 500,000 $ 500,000 $ 500,000
This is the computation for the Deferred Tax Asset.
Calculation of Deferred Tax
Asset
Future deductible amount
Tax rate
Deferred tax asset at year-end
2001
$ 150,000
30%
$ 45,000
2002
$ 100,000
30%
$ 30,000
2003
$ 50,000
30%
$ 15,000
2004
$
30%
$
-
Can you finish Health Magazine’s income tax
entries for 2003 and 2004?
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-29
Deferred Tax Assets
This would be the entry for 2003 and 2004.
Description
Income tax expense
Deferred tax asset
Income tax payable
Debit
165,000
Credit
15,000
150,000
tax expense
165,000
At the Income
end
of
2004,
the
balance
in the15,000
Deferred
Deferred tax asset
Taxtax
Asset
would be zero. 150,000
Income
payable
Deferred Tax Asset
2001
45,000
15,000 2002
15,000 2003
15,000 2004
Balance
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-30
Sharpen Your Pencil . . . There Is
Still More!!
McGraw-Hill/Irwin
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Slide
16-31
Valuation Allowance
 A valuation allowance account
is required when it is more
likely than not that some
portion of the deferred tax
asset will not be realized.
 The deferred tax asset is then
reported at its net realizable
value.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-32
Non-Temporary Differences
Created when an income item is
included in taxable income or
accounting income but will never be
included in the computation of the
other.
Example: Interest on tax-free
municipal bonds is included in
accounting income but is excluded from
taxable income
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-33
Non-Temporary Differences
Also called
permanent
differences.
Disregarded when
determining both taxes
payable and the
deferred tax asset or
liability.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-34
Tax Rate Considerations
 Deferred tax assets and liabilities
should be determined using the
future tax rates, if known.
 The deferred tax asset or liability
must be adjusted if a change in a
tax law or rate occurs.
McGraw-Hill/Irwin
IRC
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-35
Net Operating Losses (NOL)
Tax laws often allow a company to use tax
NOLs to offset taxable income in earlier or
subsequent periods.
When used to offset
earlier taxable income:
 Called: operating loss
carryback.
 Result in a tax refund.
McGraw-Hill/Irwin
When used to offset
future taxable income:
 Called: operating loss
carryforward.
 Result in reduced tax
payable.
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-36
Carryback and Carryforward
Carryback
Period
-2
-1
Carryforward
Period
+1 +2 +3 +4 +5
Current
Year
. . . +20
The NOL may first be applied against taxable
income from two previous years.
Unused NOL may be carried forward for 20
years.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-37
Net Operating Losses (NOL)
In 2003 Garson, Inc. incurred an $85,000 net
operating loss. The company is subject to a
30% tax rate. In 2001, Garson reported
taxable income of $20,000, and in 2002,
taxable income was $10,000. The company
elects to carryback the NOL.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-38
Net Operating Losses (NOL)
Tax
year
Taxable
Income
2001
$ 20,000
2002
10,000
Tax
rate
Taxes
Paid
30% $ 6,000
30%
3,000
In 2003, no taxes are paid and Garson claims a tax
refund of $9,000 for taxes paid in 2001 and 2002.
General Journal
Description
Debit
Income tax refund receivable
9,000
Benefits of NOL carryback
McGraw-Hill/Irwin
Credit
9,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-39
Net Operating Losses (NOL)
Garson’s Income Statement for 2003 looks like this . . .
Garson, Inc.
Partial Income Statement
For the Year Ended December 31, 2003
Operating loss before income taxes $ (85,000)
Benefit of NOL carryback
9,000
Net loss
$ (76,000)
Now let’s look at the treatment of the remaining
NOL of $55,000 ($85,000 - $20,000 - $10,000).
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-40
Net Operating Losses (NOL)
Garson prepares this estimate
of taxable income based upon
the best available evidence at
12/31/03.
Year
2004
2005
2006
Estimated
Taxable
Income
$
25,000
25,000
30,000
Enacted
Taxes to
Tax Rate
be Paid
30% $
7,500
30%
7,500
40%
12,000
The NOL carryforward will provide a tax benefit of $17,000.
Year
2004
2005
2006
McGraw-Hill/Irwin
Estimated
Taxable
NOL
Future Tax
Income
Carryforward
Savings
$
25,000 $
(25,000) $
7,500
25,000
(25,000)
7,500
30,000
(5,000)
2,000
$
(55,000) $
©
2004 The McGraw-Hill Companies, Inc.
17,000
Slide
16-41
Net Operating Losses (NOL)
It is likely that Garson will receive the benefits
of the NOL in future periods. As a result, the
following journal entry is made . . .
General Journal
Description
Debit
Deferred tax asset
17,000
Benefits of NOL carryforward
Credit
17,000
Garson’s income statement for 2003 will
look like this . . .
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-42
Net Operating Losses (NOL)
Garson, Inc.
Partial Income Statement
For the Year Ended December 31, 2003
Operating loss before income taxes
$ (85,000)
Benefit of NOL carryback
9,000
Benefit of NOL carryforward
17,000
Net loss
$ (59,000)
The deferred tax asset account created by the
benefit of the carryforward will be used to lower
income taxes payable in future years.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-43
Balance Sheet Classification
Deferred tax
assets/liabilities
are classified as
current or
noncurrent based
on the
classification of
the related asset
or liability.
McGraw-Hill/Irwin
Disclose the following:
 Total of all deferred tax liabilities
and assets.
 Total valuation allowance
recognized.
 Net change in valuation account.
 Approximate tax effect of each
type of temporary difference
(and carryforward).
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-44
Additional Disclosures
 Current portion of tax expense (benefit)
 Deferred portion of tax expense (benefit),
with separate disclosure for

Portion that does not include the effect of the
following separately disclosed amounts.
 Operating
loss carryforwards.
 Adjustments due to changes in tax laws or
rates.
 Adjustments to the beginning-of-the-year
valuation allowance due to revised estimates.
 Investment tax credits.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-45
Intraperiod Tax Allocation
 SFAS No. 109 requires
intraperiod tax allocation for:
Income from continuing
operations.
 Discontinued operations.
 Extraordinary items.
 Changes in accounting principle.
 Prior period adjustments (to the
beginning retained earnings).

McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
16-46
End of Chapter 16
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.