Module 5, Part 2:
Deferred Income Taxes
1
IT Expense and Deferred Income Taxes

Financial versus tax accounting
– Financial income based on GAAP.
– Taxable income based on tax laws.
– The difference between financial income and
taxable income is generally leads to something
called “deferred income taxes.
 Historical treatment of income taxes
– Recognize income tax expense based on
financial income.
– Recognize income tax payable based on taxable
income.
– The difference is a “plug,” and represents the
timing difference between taxable and financial
income.
2
Problems with Historical Treatment

Journal entry for historical treatment:
I. T. Expense
xx
net income x %
DIT (debit or credit) xx / xx
plug
I. T. Payable
xx
tax income x %

Problems:
– after many years, the difference, primarily due to
things like depreciation, had become one of the
larger liabilities on the balance sheet.
– in some cases, the liability was greater than
anything else in the balance sheet.
Solution (in SFAS 109): prepare a detailed
schedule to calculate the amount for IT Payable
and DIT, and let IT Expense be the plug.

3

SFAS 109
Journal entry for SFAS 109:
I. T. Expense
xx
plug
DIT
xx / xx
schedule
I. T. Payable
xx
schedule
 Before developing the schedule, we first need to
discuss what items need to go into the schedule.
– Permanent differences (like income on municipal
bonds) are excluded from the DIT schedule.
– Only temporary differences are included in the
schedule.
 Temporary differences fall into two categories:
– those differences that lead to lower taxable income
at the time of origination (future taxable).
– those differences that lead to higher taxable
income at the time of origination (future
deductible).
4
SFAS 109 - Future Taxable Items

Future taxable (FT) items are amounts that
are taxable in the future, because they are
not taxable now. They represent the
difference between financial and taxable
income in the year of origination. They
include:
– Revenues or gains that are recognized in
taxable income after they are recognized in
financial income (such as income from equity
investments in excess of dividends received).
– Expenses or losses that are recognized in
taxable income before they are recognized in
financial income (such as MACRS depreciation
used for taxable income, while straight-line
depreciation used for financial income.)
5
SFAS 109 - Future Deductible Items

Future deductible (FD) items are amounts that
lead to more tax now, but less tax in the future
They represent the difference between
financial and taxable income in the year of
origination. They include:
– Revenues or gains that are recognized in taxable
income before they are recognized in financial
income (such as cash received in advance for
future services: unearned revenues).
– Expenses or losses that are recognized in taxable
income after they are recognized in financial
income (this includes most estimates, such as
bad debt expense, warranty expense loss
contingencies, and pension expense in excess of
cash paid).
6
SFAS 109 - Future Deductible Items



Future deductible (FD) items also include the
net operating loss carryforward. The NOL
carryforward occurs when a company
generates a loss, rather than income, in a
particular period.
The loss may be carried back and applied to
recent previous income, and the company may
receive a tax refund.
The loss may also be carried forward to future
periods, and be offset against future income,
to reduce future taxes.
7
Illustration of Schedule in First Year
Current year
I. T. Payable
$ xx
Pretax financial income
Future deductible:
Rev: customer advances
+
Exp: estimated expenses
+
Future taxable:
Rev: excess equity income
Exp: excess MACRS depr.
Taxable income
$ xx
Future years
Deferred I.T.
-
+
+
Note: if you schedule -1,000 for excess MACRS for the IT
Payable column, then you would schedule +1,000 in the
DIT column. Any originating amounts must reverse out
in future periods in order to be considered for DIT.
Effect in schedule is shown on the next slide.
8
Illustration of Schedule in First Year
Assume a 30% tax rate for current and future years.
Current year Future years
I. T. Payable Deferred I.T.
Pretax financial income
$100,000
Future taxable:
Exp: excess MACRS depr.
(1,000)
1,000
Taxable income
$ 99,000
Deferred amount
1,000
Tax rate
.30
.30
Income tax payable
$29,700
$300
Deferred tax liability
Journal entry (income tax expense is the plug):
Income tax expense
30,000
Income tax payable
29,700
Deferred tax liability
300
9
Disclosure of Deferred Income Taxes
The
footnote disclosure indicates the
components of deferred income taxes, both
Deferred Tax Assets and Deferred Tax
Liabilities.
For future deductible items, such as the NOL
carryforward, the company must estimate the
likelihood of the deferred tax asset being used,
and establish a valuation allowance
(reduction) for the portion that might not be
used.
10