Income Tax Reporting
Revsine/Collins/Johnson: Chapter 13
Learning objectives
1. The different objectives underlying income determination for
financial reporting (book) purposes versus tax purposes.
2. The distinction between temporary (timing) and permanent
differences, the items that cause these differences, and how each
affects book income versus taxable income.
3. The distortions created when the deferred tax effects of
temporary differences are ignored.
4. How tax expense is determined with interperiod tax allocation.
5. How changes in tax rates are measured and recorded.
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Learning objectives:
Concluded
6. The reporting rules for net operating loss carrybacks and carryforwards.
7. How to read and interpret tax footnote disclosures and how these
footnotes can be used to enhance comparisons across firms.
8. How tax footnotes can be used to evaluate the degree of
conservatism in firms’ book (GAAP) accounting choices.
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Book income and taxable income
Book Income:
Income computed for
financial reporting purposes
≠
Taxable Income:
Income computed for
tax compliance purposes
 Intended to reflect increases in
the firm’s “well-offness”.
 Governed by the “constructive
receipt/ability to pay” doctrine.
 Includes all earned inflows of
net assets, even when the
inflow is not immediately
convertible into cash.
 The timing of taxation usually
(but not always) follows the
inflow of cash or equivalents.
 Deductions generally are
allowed only when the
expenditures are made or
when a loss occurs.
 Reflects expenses as they
accrue, not just when they are
paid.
Divergence complicates the way income
taxes are reflected in financial reports
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Understanding income tax reporting:
Timing differences
Book Income
Timing
differences:
≠
• Depreciation expense
• Bad debt expense
• Installment sales
• Revenues received in advance
Permanent
differences
Taxable Income

A timing difference results when a revenue (gain) or expense (loss) enters book
income in one period but affects taxable income in a different (earlier or later)
period.

Timing differences give rise to deferred tax assets and deferred tax liabilities
because they are temporary (they eventually reverse):
Book
income
Current period
Later period
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Taxable
income
$100
$0
$0
$100
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Type
Originating
Reversing
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Understanding income tax reporting:
Permanent differences
Book Income
Timing
differences:
≠
Taxable Income
Permanent
differences
• Interest on state and municipal bonds.
• Goodwill write-offs
• Statutory depletion in excess of
cost-based depletion
• Dividend received deduction
 Permanent differences are caused by income items that:


Enter into book income but never affect taxable income.
Enter into taxable income but never affect book income.
 Because permanent differences do not reverse, they do not give
rise to deferred tax assets or liabilities.
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Understanding income tax reporting:
Problems caused by temporary differences
Mitchell Corporation buys new equipment for $10,000 on January 1, 2005. The
asset has a five-year life and no salvage value. It will be depreciated using the
straight-line method for book purpose, but for tax purposes the sum-of-theyears’-digits method will be used. (Technically, firms are required to use
MACRS depreciation for tax purposes.)
Straight-line
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SYD method
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Understanding income tax reporting:
Mitchell’s income tax payable
 Assume for Mitchell Corporation that depreciation is the only book
versus tax difference.
 If income before depreciation is expected to be $20,000 each year
over the next five years, and the statutory tax rate is 35%, then:
Taxes due
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Understanding income tax reporting:
Mitchell’s temporary differences
Depreciation Expense
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Income
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Understanding income tax reporting:
The mismatch problem
 If book income tax expense is set equal to actual taxes payable
each year, then:
Expense
increases with
taxes due
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Book income
declines
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Understanding income tax reporting:
A financial reporting distortion
 When book income tax expense is set equal to the actual taxes
payable each year, there is a mismatch:
Tax Expense Without
Interperiod Tax Allocation
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Understanding income tax reporting:
The FASB’s solution
 Interperiod tax allocation overcomes
the mismatch problem.
$3,333
Tax
depreciation
$1,333 of “extra”
depreciation
in year 1
 The “extra” tax depreciation thus
generates a liability for future taxes.
$2,000
Book
depreciation
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 The “extra” tax depreciation in early
years will be offset by lower tax
depreciation in later years.
Future tax liability
is $1,333 X 35%
or $467
 Recording this deferred tax liability
as it accrues eliminates the
mismatch.
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Deferred income tax accounting:
Interperiod tax allocation
 SFAS No. 109 requires that the journal entry for income taxes
reflect both:


Taxes currently due
Any liability for future taxes arising from current period book-versustax differences that will reverse in later periods.
Originating
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Reversing
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Deferred income tax accounting:
Interperiod tax allocation journal entry
Originating
 The accounting entry for 2005 income taxes is:
DR Income tax expense
CR Income tax payable
CR Deferred income taxes payable
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$7,000
$6,533
467
Current and
future tax
payments are
matched with
book income
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Deferred income tax accounting:
Calculating tax expense
Relation between tax expense, taxes payable, and changes in deferred tax liabilities
$7,000
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=
$6,533
+
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$467
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Deferred income tax accounting:
Journal entry when timing differences reverse
Reversing
 The accounting entry for 2008 income taxes is:
DR Income tax expense
DR Deferred income taxes payable
CR Income tax payable
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$7,000
233
$7,233
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Deferred income tax accounting:
How the accounts change over time
$7,600
$7,400
$700
Reversing
$600
Originating
$7,200
$500
$7,000
$400
$6,800
$300
$6,600
$200
$6,400
$100
$6,200
$6,000
2005
2006
2007
Tax expense
2008
$-
2009
Taxes payable
Book Tax Expense and
Current Period Taxes Payable
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2005
2006 2007 2008 2009
Deferred tax liability
Future Period Taxes Payable
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Deferred income tax accounting:
The mismatch is eliminated
Tax Expense With
Interperiod Tax
Allocation
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Deferred income tax assets:
An example
In December 2005, Paul corporation leases its office building to another
company for $100,000. The covers all of 2006 and specifies that the tenant
pays the $100,000 to Paul Corporation immediately.
Revenue “earned”
in 2006
Cash Received
in 2005
 Paul Corporation makes the following entry in 2005 on receiving
the cash:
DR Cash
CR Rent received in advance
$100,000
$100,000
A book liability (deferred
revenue) that will be brought
into income as earned in 2006
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Deferred income tax assets:
Computing tax expense
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Deferred income tax assets:
Journal entries
 The 2005 entry for income taxes:
DR Income tax expense
DR Deferred income tax asset
CR Income tax payable
$525,000
35,000
$560,000
 The 2006 entry is:
DR Income tax expense
CR Deferred income tax asset
CR Income tax payable
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$525,000
$35,000
490,000
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Deferred income tax assets:
Computing SFAS No. 109 income tax expense
Relation between tax
expense, taxes payable,
and changes in deferred
tax assts and liabilities
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Deferred income tax assets:
Valuation allowances
 The FASB requires firms with deferred tax assets to assess the
likelihood that those assets may not be fully realized in future
periods.
 Realization depends on whether or not the firm has future taxable
income.
“More likely than not ”
0%
• DTA carrying value is
reduced until the new
amount falls within this
range
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50%
Probability that
DTA will NOT
100% be realized
• Deferred tax asset (DTA)
valuation allowance is then
required
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Deferred income tax assets:
Valuation allowance example
 Norman Corporation records a deferred tax asset in 2005 related to
accrued warranty expenses:
DR Income tax expense ($600,000 x .35)
DR Deferred income tax asset ($900,000 x .35)
CR Income tax payable ($1,500,000 x .35)
$210,000
315,000
$525,000
 In early 2006, Norman determines that it is unlikely to earn enough
taxable income in future years to realize more than $200,000 of the
deferred tax asset. The entry made in 2006 is:
DR Income tax expense ($315,000 - $200,000)
CR Allowance to reduce deferred tax asset
to expected realizable value
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$115,000
$115,000
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Deferred income tax assets:
Valuation allowance disclosures
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Deferred income tax accounting:
When tax rates change
 When tax rates change, the tax effects of “reversals” change as well.
Year 1
Year 2
$1,000
$1,000
Tax effect at 35%
350
350
at new 30%
300
300
Reversal
$700
Deferred tax liability
 SFAS No. 109 adopts the “liability approach” to measure deferred income
taxes in this situation. In any year current or future tax rates are
changed:


The income tax expense number absorbs the full effect of the change,
The relationship between that year’s tax expense and book income is
destroyed.
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Deferred income tax accounting:
Mitchell Company example
$700
= ($1,333 +
$667) x .35
$760
Deferred tax liability before
the tax rate change
= ($1,333 +
$667) x .38
Deferred tax liability after
the tax rate change
 Under the SFAS No. 109 “liability approach”, income tax expense
for 2007 would be:
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Deferred income tax accounting:
Mitchell Company journal entries
 The accounting entry for 2007, the year that tax rates for 2008
and 2009 were increased:
DR Income tax expense
CR Income tax payable
CR Deferred Income taxes payable
$7,060
$7,000
60
 Here’s the revised income tax computation schedule:
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Deferred income tax accounting:
Analytical insights
 Tax rate changes can inject one-shot (transitory) adjustments to earnings.
The earnings impact depends on:



Whether the tax rates are increased or decreased.
Whether the firm has net deferred tax assets or net deferred tax liabilities.
The magnitude of the deferred tax balance.
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Net operating losses:
Carrybacks and carryforwards
 The U.S. Income Tax code allows firms reporting operating losses
to offset those losses against either past or future tax payments.
Carry back
2004
2005
Carry forward
Loss
incurred
2006
2007
2008
Years
 Firms can elect one of two options:


Both carryback and carryforward incurred losses.
Only carryforward incurred losses.
Option 1
Carry back
Loss
Option 2
2004
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Loss
2005
2006
Carry forward
Carry forward only
2007
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2008
Years
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Net operating losses:
Carrybacks and carryforwards example
 Unfortunato Corporation experienced a $1 million pre-tax operating
loss in 2006. Under U.S. Income Tax Code, the company can either:
 Or:
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Net operating losses:
Carryback and carryforward entries
 Suppose Unfortunato had the following operating profit history:
 The following entry would be made to reflect the carryback:
DR Income tax refund receivable
$262,500
CR Income tax expense (carryback benefit)
$262,500
 If future pre-tax operating profits are expected to exceed $250,000,
then the carryforward entry would be :
DR Deferred income tax asset
$87,500
CR Income tax expense (carryforward benefit)
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$87,500
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Understanding the tax footnote:
Tax expense components
Taxes due
GAAP tax
expense
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Understanding the tax footnote:
Effective tax rate
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Understanding the tax footnote:
Deferred tax assets and liabilities
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Understanding the tax footnote:
Intraperiod tax allocation
GAAP expense
per Exhibit 13.12
$311.5 increase?
• Other comprehensive income
$1,172.6
$861.1
2002
($58.9)
• Acquisitions & distribution
(74.4)
• Current period deferral
444.8
$311.5
2001
Net deferred tax liability
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Understanding the tax footnote:
Analytical insights
Elsewhere ChipPAC said it increased the estimated useful lives of certain
equipment from 5 to 8 years. This change decreased depreciation expense for
the year by $29 million.
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Understanding the tax footnote:
Assessing earnings quality
 Large increases in deferred income tax liabilities are a potential
sign of deteriorating earnings quality.
 Consider ChipPAC. The depreciation-induced increase in the
company’s deferred tax liability could be due to:


Growth in capital expenditures
Change in estimated useful lives of existing equipment
 Sudden decreases in deferred income tax assets are also a
potential sign of deteriorating earnings quality.
On January 1, 2005 Carson Company begins offering a one-year warranty on all sales. Its
2005 sales were $20 million, and Carson estimates that warranty expenses will be 1% of
sales or $200,000. Warranty expense of $200,000 is deducted on Carson’s books in 2005.
Tax deductions for warranties in 2005 are zero.
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Understanding the tax footnote:
Assessing earnings quality
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Understanding the tax footnote:
Improving interfirm comparability
 Lubrizol’s 10-K states:
 Cambrex’s 10-K states:
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Understanding the tax footnote:
Improving interfirm comparability
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Understanding the tax footnote:
Improving interfirm comparability
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Understanding the tax footnote:
Assessing conservatism in accounting choices
 Conservative choices (like accelerated depreciation) decrease
earnings and asset values relative to more liberal techniques (like
straight-line depreciation).
 Other things being equal, the more conservative the set of
accounting choices, the higher the quality of earnings.
 One way to assess accounting conservatism is by using the earnings
conservatism ratio:
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Understanding the tax footnote:
Computing the EC ratio
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Understanding the tax footnote:
Limitations to the EC ratio
1. EC ratio comparisons over time can be misleading if the tax law
has changed over the period of comparison.
2. Comparisons across companies in different industries should be
made cautiously since tax burdens can vary with business
models (e.g., capital intensity) and because of industry-specific
tax rules (e.g., the oil depletion allowances).
3. The EC ratio overlooks one category of deteriorating earnings
conservatism: one-shot earnings boost from a LIFO liquidation.
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Summary
 The rules for computing income for financial reporting purposes—
book income—differ from those for computing income for tax
purposes.
 The differences between book income and taxable income are
caused by both permanent and temporary (timing) differences in
the revenue and expense items reported on a company’s books
versus its tax return.
 Temporary differences give rise to both deferred tax assets and
deferred tax liabilities.
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Summary concluded
 Deferred tax accounting (SFAS No. 109) allows firms to report tax
costs (or benefits) on the income statement in the same period as
the related revenue or expense items are reported (matching
principle).
 The income tax footnote provides useful information for
understanding how much tax is paid and how much is deferred
each year.
 Tax footnotes also help explain why effective tax rates may differ
from statutory rates.
 Tax footnotes provide a wealth of information that can be
exploited to improve interfirm comparability and evaluate firms’
earnings quality.
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