Accounting for Income Taxes
Overview
In this chapter we explore the financial accounting and reporting standards for the effects of
income taxes. The discussion defines and illustrates “temporary differences,” which are the basis for
recognizing deferred tax assets and deferred tax liabilities, as well as “permanent differences,” which
have no deferred tax consequences. You also will learn how to adjust deferred tax assets and
deferred tax liabilities when tax laws or rates change. We also discuss accounting for operating loss
carrybacks and carryforwards and intraperiod tax allocation.
Learning Objectives
After studying this chapter, you should be able to:
LO16-1 Describe the types of temporary differences that cause deferred tax liabilities and determine
the amounts needed to record periodic income taxes.
LO16-2 Identify and describe the types of temporary differences that cause deferred tax assets.
LO16-3 Describe when and how a valuation allowance is recorded for deferred tax assets.
LO16-4 Explain why non-temporary differences have no deferred tax consequences.
LO16-5 Explain how a change in tax rates affects the measurement of deferred tax amounts.
LO16-6 Determine income tax amounts when multiple temporary differences exist.
LO16-7 Describe when and how an operating loss carryforward and an operating loss carryback are
recognized in the financial statements.
LO16-8 Explain how deferred tax assets and deferred tax liabilities are classified and reported in a
classified balance sheet and describe related disclosures.
LO16-9 Demonstrate how to account for uncertainty in income tax decisions.
LO16-10 Explain intraperiod tax allocation.
LO16-11 Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting
for income taxes.
Describe the types of temporary differences that cause deferred tax liabilities and determine the
amounts needed to record periodic income taxes.
2. Identify and describe the types of temporary differences that cause deferred tax assets.
3. Describe when and how a valuation allowance is recorded for deferred tax assets.
4. Explain why permanent differences have no deferred tax consequences.
5. Explain how a change in tax rates affects the measurement of deferred tax amounts.
6. Determine income tax amounts when multiple temporary differences exist.
7. Describe when and how an operating loss carryforward and an operating loss carryback are
recognized in the financial statements.
8. Explain how deferred tax assets and deferred tax liabilities are classified and reported in a
classified balance sheet and describe related disclosures.
9. Demonstrate how to account for uncertainty in income tax decisions.
10. Explain intraperiod tax allocation.
11. Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting
for income taxes.
Lecture Outline
Part A: Deferred Tax Assets and Deferred Tax Liabilities
I.
Temporary Differences
A. Revenues and expenses included on a company’s income tax return usually are the same
as those reported on the company’s income statement for the same period.
B. If GAAP and tax rules differ, tax payments might occur in years different from when the
revenues and expenses that cause the taxes are generated. This would produce a
difference between pretax accounting income and taxable income and, consequently,
between the reported amount of an asset or liability in the financial statements and its tax
basis.
C. The difference is a temporary difference if it originates in one period and reverses, or
"turns around," in one or more later periods. (T16-1)
D. Income tax expense includes both the current and deferred tax consequences of the
activities of the reporting period.
II.
Deferred Tax Liabilities
A. A temporary difference causes a future taxable amount if the taxable income will be
increased relative to accounting income in the year(s) when the difference reverses.
B. Such differences create deferred tax liabilities for the taxes to be paid on the future
taxable amounts.
1. Revenues or gains reported on the tax return after the income statement. (T16-2
through T16-4)
2. Expenses or losses reported on the tax return before the income statement. (T16-5
through T16-11).
III. Deferred Tax Assets
A. A temporary difference causes a future deductible amount if the taxable income will be
decreased relative to accounting income in the year(s) when the difference reverses.
B. Such differences create deferred tax assets for the taxes to be paid on the future taxable
amounts.
1. Expenses or losses reported on the tax return after the income statement. (T16-12
through T16-14)
2. Revenue or gains reported on the tax return before the income statement.
IV.
Valuation Allowance
A. Deferred tax assets are recognized for all deductible temporary differences.
B. A deferred tax asset is then reduced by a valuation allowance if it is “more likely than
not” that some portion or all of the deferred tax asset will not be realized. (T16-15)
V.
Permanent Differences
A. Permanent differences, are those caused by transactions and events that under existing tax
law will never affect taxable income or taxes payable. (T16-16)
B. Permanent differences are disregarded when determining both the tax payable currently
and the deferred tax effect. (T16-17)
Part B: Other Tax Accounting Issues
I.
Change in Tax Rates
A. A deferred tax liability or asset is calculated using currently enacted tax rates and laws
rather than anticipated tax rates. If a phased-in change in rates is scheduled to occur, the
specific tax rates of each future year are multiplied by the amounts reversing in each of
those years. The total tax effect is the deferred tax liability or asset. (T16-18)
B. When a change in a tax law or rate occurs, we adjust the deferred tax liability or asset to
reflect the change in the amount to be paid or recovered. The effect of the adjustment is
reported in operating income in the year of the tax law or rate changes. (T16-19)
C. Although differences in the specific IFRS and U.S. GAAP guidance in several areas
account for many of the disparities, the principal reason is that a great many of the nontax differences between IFRS and U.S. GAAP affect deferred taxes. (T16-20)
II.
Multiple Temporary Differences
A. A company usually has several temporary differences, both originating and reversing, in
any particular year.
B. This doesn’t change our approach. We multiply the total of the future taxable amounts
by the future tax rate to determine the appropriate balance for the deferred tax liability,
and the total of the future deductible amounts by the future tax rate to determine the
appropriate balance for the deferred tax asset. (T16-21 through T16-23)
III.
Net Operating Losses
A. An operating loss can be used to reduce taxable income in other, profitable years by
either: (T16-24)
1.
A carryback of the loss to the previous two years (T16-25), or
2.
A carryforward of the loss to later years (up to 20). (T16-26)
B. The income tax benefit of both an operating loss carryback and an operating loss
carryforward are recognized for accounting purposes in the year the operating loss
occurs.
IV.
Financial Statement Presentation
A. In the balance sheet, deferred tax assets and deferred tax liabilities are classified as either
current or noncurrent depending on how the related assets or liabilities are classified for
financial reporting. A net current amount and a net noncurrent amount are reported as
either an asset or a liability. (T16-27)
B. Additional relevant information needed for full disclosure pertaining to deferred tax
amounts is reported in disclosure notes, including the components of income tax expense
and available operating loss carryforwards.
V.
Dealing with Uncertainty
A. The means of dealing with uncertainty in tax decisions is prescribed by FASB ASC 740–:
Income Taxes–Overall (previously “Accounting for Uncertainty in Income Taxes, an
Interpretation of FASB Statement No. 109,” FASB Interpretation No. 48 (Norwalk,
Conn.: FASB, June 2008)), commonly called FIN 48). This guidance allows companies
to recognize in the financial statements the tax benefit of a position it takes only if it is
“more likely than not” (greater than 50% chance) to be sustained if challenged. Guidance
also prescribes how to measure the amount to be recognized. The decision, then, is a
“two-step” process.
B.
VI.
Step 1. A tax benefit may be reflected in the financial statements only if it is "more
likely than not" that the company will be able to sustain the tax return position,
based on its technical merits.
Step 2. A tax benefit should be measured as the largest amount of benefit that is
cumulatively greater than 50-percent likely to be realized. (T16-28) (T16-29)
Intraperiod Tax Allocation
A. Intraperiod tax allocation means the total income tax expense for a reporting period is
allocated among the financial statement items that gave rise to it.
B. Each of the following income statement items is reported net of its respective income tax
effects. (T16-30)
1. Income (or loss) from continuing operations
2. Discontinued operations
3. Extraordinary items
C. Extraordinary items are not reported separately under IFRS. IAS No. 1, “Presentation of
Financial Statements” states that neither the income statement nor any notes may contain
any items called “extraordinary.” As a result, the only income statement item reported
separately net of tax using IFRS is discontinued operations.
Decision-Makers’ Perspective
A. One of the most important aspects of most business decisions is the tax effect.
B. Income tax is one of the largest expenditures many firms incur.
C. Investors, creditors, and managers should be alert to choices that minimize or delay taxes
and to disclosures that indicate potential tax expenditures.
1. Investments in buildings and equipment can signify deferred tax liabilities from
temporary differences in depreciation.
2. New investments that cause the level of depreciable assets to at least remain
constant over time can effectively delay that deferred tax liability indefinitely.
3. Impending plant closings suggest declining levels of depreciable assets and
therefore might cause material paydowns of that deferred tax liability.
D. Deferred tax assets represent future tax savings.
1. An operating loss carryforward is a deferred tax asset that often reflects sizable
future tax deductions.
2. Operating loss carryforwards indicate potential future tax benefits because they
allow large amounts of future income to be earned tax-free.
E. Because deferred tax liabilities increase debt, deferred tax liabilities increase risk as
measured by the debt to equity ratio.
PowerPoint Slides
A PowerPoint presentation of the chapter is available at the textbook website.
An alternate version of the PowerPoint presentation also is available.
Teaching Transparency Masters
The following can be reproduced on transparency film as they appear here, or
you can use the disk version of this manual and first modify them to suit your
particular needs or preferences.
TEMPORARY DIFFERENCES
Kent Land Management reported pretax accounting income in
2013, 2014, and 2015 of $100 million, plus additional 2013
income of $40 million from installment sales of property.
However, the installment sales income is reported on the tax
return when collected, in 2014 ($10 million) and 2015 ($30
million). The enacted tax rate is 40% each year.
($ in millions)
PRETAX ACCOUNTING INCOME
Installment sale income on
the income statement
Installment sale income on
the tax return
TAXABLE INCOME
Temporary Difference:
originates
reverses



2013
2014
2015
$140
(40)
0
$100
$100
$100
Total
$340
0
0
(40)
10
$110
30
$130
40
$340
Accounting income and taxable income are the same over the
three-year period, but different in each individual year.
T16-1
DEFERRED TAX LIABILITY
Because tax laws permit the company to delay reporting this
profit as part of taxable income, the company is able to defer
paying the tax on that profit. The tax is not avoided – just
deferred. In the meantime, the company has a liability for the
income tax deferred.
Deferred Tax Liability
16
2014 ($10 million x 40%)
2015 ($30 million x 40%)
2013 ($40 million x 40%)
4
12
0
balance after 3 years
T16-2
RECORDING INCOME TAXES

Each year, income tax expense comprises both the current
and the deferred tax consequences of events and transactions
already recognized. This means we:
 Calculate the income tax that is payable currently.
 Separately calculate the change in the deferred tax liability
(or asset).
 Combine the two to get the income tax expense.
($ in millions)
Current
Year
2013
Pretax accounting income
Temporary difference:
Installment income
140
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
100
40%
40
(40)
Future
Taxable
Amounts
2014
2015
10
30
Future
Taxable
Amounts
[total]
40
40%
16

Deferred tax liability:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2013
Income tax expense (to balance)
Income tax payable (determined above)
Deferred tax liability (determined above)
$16
0
$16
56
40
16
T16-3
TEMPORARY BOOK–TAX DIFFERENCE

The deferred tax liability each year is the tax rate times the
temporary difference between the financial statement
carrying amount of the receivable and its tax basis.
($ in millions)
2013
Receivable from
installment sales of property:
Accounting basis
Tax basis
TEMPORARY DIFFERENCE
Tax rate
DEFERRED TAX LIABILITY
40
0
40
$40
0
$40
December 31
2014
(10) $30
(0)
0
(10) $30
x 40%
$16

originating
difference
2015
(30)
(0)
(30)
x 40%
$12

$0
0
$0
x 40%
$0

reversing
differences
T16-4
TYPES OF TEMPORARY DIFFERENCES
Revenues (or gains)
Reported
in the Income
Statement Now,
but on the Tax
Return Later
Reported
on the Tax
Return Now,
but in
the Income
Statement
Later





Installment sales of
property (installment
method for taxes)
Unrealized gain from
recording investments at
fair value (taxable when
asset is sold)
Rent collected in advance
Expenses (or losses)



Subscriptions collected in
advance
Other revenue collected in
advance

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 the tax return in excess
of straight-line depreciation
in the income statement
Prepaid expenses (taxdeductible when paid)
 The temporary differences in the diagonal unshaded areas create deferred tax
liabilities because they result in taxable amounts in some future year(s) when
the related assets are recovered or the related liabilities are settled (when the
temporary differences reverse).
 The
temporary differences in the opposite diagonal (shaded) areas create
deferred tax assets because they result in deductible amounts in some future
year(s) when the related assets are recovered or the related liabilities are settled
(when the temporary differences reverse).
T16-5
EXPENSE REPORTED ON THE TAX RETURN
BEFORE THE INCOME STATEMENT

To determine taxable income, we add back to accounting
income the actual depreciation taken in the income statement
and then subtract the depreciation deduction allowed on the
tax return.
Woods Temporary Services reported pretax income in 2013, 2014, 2015, and
2016 of $100 million. In 2013, an asset was acquired for $100 million. The asset is
depreciated for financial reporting purposes over four years on a straight-line basis
(no residual value). For tax purposes the asset’s cost is deducted (by MACRS) over
2013-2016 as follows: $33 million, $44 million, $15 million, and $8 million. No
other depreciable assets were acquired. The enacted tax rate is 40% each year.
($ in millions)
Temporary Difference:
originates
reverses

2013
ACCOUNTING INCOME
Depreciation on the
income statement
Depreciation on the
tax return
TAXABLE INCOME

2014

2015

2016
$100
$100
$100
$100
Total
$400
25
25
25
25
100
(33)
$ 92
(44)
$ 81
(15)
$110
(8)
$117
(100)
$400
T16-6
DETERMINING AND RECORDING INCOME TAXES - 2013

Taxable income is $8 million less than accounting income
because that much more depreciation is deducted on the 2013
tax return ($33 million) than is reported on the income
statement ($25 million).
($ in millions)
Pretax accounting income
Temporary difference:
Depreciation
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
Current
Year
2013
Future
Taxable
Amounts
2014 2015 2016
Future
Taxable
Amounts
[total]
100
(8)
92
40%
36.8
(19)
10
17
8
40%
3.2

Deferred tax liability:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2013
Income tax expense (to balance)
Income tax payable (determined above)
Deferred tax liability (determined above)

$3.2
0.0
$3.2
40
36.8
3.2
Income tax expense is comprised of two components: the
amount payable now and the amount deferred until later.
T16-7

2014 INCOME TAXES
The cumulative temporary difference between the book basis
($50 million) and tax basis ($23 million) is both (a) the sum
of the amounts originating in 2013 ($8 million) and in 2014
($19 million) and (b) the sum of the amounts reversing in
2015 ($10 million) and in 2016 ($17 million).
($ in millions)
Future
Taxable
Amounts
Current
Year
2013
Pretax accounting income
Temporary difference:
Depreciation
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
2014
2015
Future
Taxable
Amounts
2016
[total]
100
(8)
(19)
81
40%
32.4
10
17
27
40%
10.8

Deferred tax liability:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2014
Income tax expense (to balance)
Income tax payable (determined above)
Deferred tax liability (determined above)

$10.8
(3.2)
$ 7.6
40
32.4
7.6
Since a balance of $3.2 million already exists, $7.6 million
must be added.
T16-8
2015 INCOME TAXES

A portion of the tax deferred from 2013 and 2014 is now
being paid in 2015.
($ in millions)
2013
Pretax accounting income
Temporary difference:
Depreciation
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
2014
Current
Year
2015
Future
Taxable
Amount
2016
Future
Taxable
Amount
[total]
17
17
100
(8)
(19)
10
110
40%
44
40%
6.8

Deferred tax liability:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2015
Income tax expense (to balance)
Deferred tax liability (determined above)
Income tax payable (determined above)
$ 6.8
(10.8)
$( 4.0)
40
4
44
T16-9
2016 INCOME TAXES

Because the entire temporary difference has now reversed,
there is a zero cumulative temporary difference, and the
balance in the deferred tax liability should be zero.
($ in millions)
2013
Pretax accounting income
Temporary difference:
Depreciation
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
2014
2015
Current
Year
2016
Future
Taxable
Amount
[total]
100
(8)
(19)
Deferred tax liability:
Ending balance (balance currently needed)
Less: beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2016
Income tax expense (to balance)
Deferred tax liability (determined above)
Income tax payable (determined above)
10
17
117
40%
46.8
0
40%
0.0

$ 0.0
(6.8)
$(6.8)
40.0
6.8
46.8
T16-10
DEFERRED TAX LIABILITY

The deferred tax liability increases the first two years and is
paid over the next two years.
Deferred Tax Liability ($ in millions)
3.2
7.6
2015 ($10 x 40%)
2016 ($17 x 40%)
2013 ($8 x 40%)
2014 ($19 x 40%)
4.0
6.8
0
balance after 4 years
T16-11
DEFERRED TAX ASSETS

Deferred tax assets are recognized for the future tax benefits
of temporary differences that create future deductible
amounts.
Lane Electronics reported pretax income in 2013, 2014, and
2015 of $70 million, $100 million, and $100 million,
respectively. The 2013 income statement includes a $30 million
warranty expense that is deducted for tax purposes when paid in
2014 ($15 million) and 2015 ($15 million). The income tax rate
is 40% each year.
($ in millions)
Temporary Difference:
originates
reverses

2013
ACCOUNTING INCOME
Warranty expense on
the income statement
Warranty expense on
the tax return
TAXABLE INCOME
$70

2014
$100

2015
$100
30
$100
Total
$270
30
(15)
$ 85
(15)
$ 85
(30)
$270
T16-12
RECORDING INCOME TAXES

Because the warranty expense was subtracted on the 2013
income statement, but isn’t deductible on the 2013 tax return,
it is added back to accounting income to find taxable income.
($ in millions)
Pretax accounting income
Temporary difference:
Warranty expense
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax asset
Current
Year
2013
Future
Deductible
Amounts
2014
2015
Future
Deductible
Amounts
[total]
70
30
100
(15)
(15)
(30)
(30)
40%
40%
40
(12)

Deferred tax asset:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2013
Income tax expense (to balance)
Deferred tax asset (determined above)
Income tax payable (determined above)

$12
0
$12
28
12
40
The amounts deductible in 2014 and 2015 will produce tax
benefits that are recognized now as a deferred tax asset.
T16-13
DEFERRED TAX ASSET

At the end of 2013 and 2014, the company reports a deferred
tax asset for future income tax benefits.
Deferred Tax Asset
2013 ($30 million x 40%)
12
6
6
balance after 3 years

2014 ($15 million x 40%)
2015 ($15 million x 40%)
0
If we continue the assumption of $85 million taxable income
in each of 2014 and 2015, income tax those years would be
recorded this way:
2014
Income tax expense (plug) ......................................
Deferred tax asset ($15 million x 40%) ....................
Income tax payable ($85 million x 40%) ..................
2015
Income tax expense (plug) ......................................
Deferred tax asset ($15 million x 40%) ....................
Income tax payable ($85 million x 40%) ..................
40
6
34
40
6
34
T16-14
VALUATION ALLOWANCE

Deferred tax assets are recognized for all deductible
temporary differences. However, a deferred tax asset is then
reduced by a valuation allowance if it is “more likely than
not” that some portion or all of the deferred tax asset will not
be realized.
Assume management determines that it’s more likely than not
that $3 million of an $8 million deferred tax asset will not
ultimately be realized.
Income tax expense ................................................
Valuation allowance – deferred tax asset ............
3
3
The deferred tax asset is reported at its estimated net realizable
value:
Deferred tax asset
Less: Valuation allowance – deferred tax asset
$8
(3)
$5
T16-15
PERMANENT DIFFERENCES

Provisions of the tax laws, in some instances, dictate that the
amount of a revenue that is taxable or expense that is
deductible permanent ly differs from the amount reported on
the income statement.
 Interest received from investments in bonds issued by state
and municipal governments (not taxable)
 Investment expenses incurred to obtain tax-exempt income
(not tax deductible)
 Life insurance proceeds upon the death of an insured
executive (not taxable)
 Premiums paid for life insurance policies when the payer is
the beneficiary (not tax deductible)
 Compensation expense pertaining to some employee stock
option plans (not tax deductible)
 Expenses due to violations of the law (not tax deductible)
 Portion of dividends received from U.S. corporations that is
not taxable due to the “dividends received deduction”
 Tax deduction for depletion of natural resources (percentage
depletion) that permanent ly exceeds the income statement
depletion expense (cost depletion)
T16-16
TEMPORARY AND PERMANENT
DIFFERENCES
Kent Land Management reported pretax income in 2013, 2014, and 2015 of $100
million except for an additional income of $40 million from installment sales and
$5 million interest from investments in municipal bonds in 2013. The
installment sales income is reported for tax purposes in 2014 ($10 million) and
2015 ($30 million). The enacted tax rate is 40% each year.
($ in millions)
Current
Year
2013
Accounting income
Permanent difference:
Municipal bond interest
Temporary difference:
Installment income
145
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
100
40%
40
Future
Taxable
Amounts
2014
2015
Future
Taxable
Amounts
[total]
(5)
(40)
10
30
40
40%
16

Deferred tax liability:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2013
Income tax expense (to balance)
Income tax payable (determined above)
Deferred tax liability (determined above)
$16
0
$16
56
40
16
T16-17
WHEN ENACTED TAX RATES DIFFER

When a phased-in change in rates is scheduled to occur, the
specific tax rates of each future year are multiplied by the
amounts reversing in each of those years. The total is the
deferred tax liability or asset. Suppose the enacted tax rates
are 40% for 2013 and 2014, and 35% for 2015.
($ in millions)
Current
Year
2013
Future
Taxable
Amounts
2014
2015
Accounting income
Permanent difference:
Municipal bond interest
Temporary difference:
Installment income
145
(40)
10
30
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
100
40%
40
40%
35%
4
10.5
Future
Taxable
Amounts
[total]
(5)
40
14.5

Deferred tax liability:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2013
Income tax expense (to balance)
Income tax payable (determined above)
Deferred tax liability (determined above)
$14.5
0.0
$14.5
54.5
40.0
14.5
T16-18
CHANGES IN TAX LAWS OR RATES

Tax laws sometimes change. If a change in a tax law or rate
occurs, the deferred tax liability or asset must be adjusted.
The effect is reflected in operating income in the year of the
enactment of the change in the tax law or rate. Assume
Congress passed a new tax law in 2014 that will cause the
2015 tax rate to be 30%, instead of the previously scheduled
35% rate.
($ in millions)
Current
Year
2014
Accounting income
Temporary difference:
Installment income
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
*2015 rate enacted into law in 2014
Future
Taxable
Amount
2015
100
10
110
40%
44
30
30%*
9
9.0

Deferred tax liability:
Ending balance (balance currently needed)
$ 9.0
Less: beginning balance
(14.5)
Change needed to achieve desired balance
$ (5.5)
Journal entry at the end of 2014
Income tax expense (to balance)
38.5
Deferred tax liability (determined above)
5.5
Income tax payable (determined above)
44.0
T16-19
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Non-Tax Differences Affect Taxes. Despite the similar
approaches for accounting for taxation under IAS 12,
“Income Tax,” and U.S. GAAP, differences in reported
amounts for deferred taxes are among the most frequent
between the two reporting approaches. The reason is that a
great many of the nontax differences between IFRS and
U.S. GAAP affect deferred taxes as well.
For example, we noted in Chapter 13 that we accrue a loss
contingency under U.S. GAAP if it’s both probable and can
be reasonably estimated and that IFRS guidelines are
similar, but the threshold is “more likely than not.” This is a
lower threshold than “probable.” In this chapter, we noted
that accruing a loss contingency (like warranty expense) in
the income statement leads to a deferred tax asset if it can’t
be deducted on the tax return until a later period. As a
result, under the lower threshold of IFRS, we might record a
loss contingency and thus a deferred tax asset, but under
U.S. GAAP we might record neither. So, even though
accounting for deferred taxes is the same, accounting for
loss contingencies is different, causing a difference in the
reported amounts of deferred taxes under IRFS and U.S.
GAAP.
T16-20
MULTIPLE TEMPORARY DIFFERENCES
2013
During 2013, its first year of operations, Eli-Wallace Distributors reported pretax
accounting income of $200 million which included the following amounts:
1. Income from installment sales of warehouses in 2013 of $9 million to be
reported for tax purposes in 2014 ($5 million) and 2015 ($4 million).
2. Depreciation is reported by the straight-line method on an asset with a four-year
useful life. On the tax return, deductions for depreciation will be more than
straight-line depreciation the first two years but less than straight-line
depreciation the next two years ($ in millions):
2013
2014
2015
2016
Income Statement
$50
50
50
50
$200
Tax Return
$66
88
30
16
$200
Difference
$(16)
(38)
20
34
0
3. Estimated warranty expense that will be deductible on the tax return when
actually paid during the next two years. Estimated deductions are as follows ($
in millions):
2013
2014
2015
Income Statement
$7
$7
Tax Return
$4
3
$7
Difference
$7
(4)
(3)
0
2014
During 2014, pretax accounting income of $200 million included an estimated loss
of $1 million from having accrued a loss contingency. The loss is expected to be
paid in 2016 at which time it will be tax deductible.
The enacted tax rate is 40% each year.
T16-21
MULTIPLE TEMPORARY DIFFERENCES-2013
($ in millions)
Current
Year
2013
Accounting income
Temporary differences:
Installment sales
Depreciation
Warranty expense
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
Deferred tax asset
Future
Taxable
(Deductible)
Amounts
2014
2015
2016
Future
Taxable
Amounts
[total]
Future
Deductible
Amounts
[total]
200
(9)
(16)
7
182
5
(38)
(4)
4
20
(3)
40%
72.8
34
9
16
(7)
25
40%
(7)
40%
10
(2.8)


Deferred tax
liability
Ending balances (balances currently needed):
Less: Beginning balances:
Changes needed to achieve desired balances
Journal entry at the end of 2013
Income tax expense (to balance)
Deferred tax asset (determined above)
Deferred tax liability (determined above)
Income tax payable (determined above)
$10
0
$10
Deferred tax
asset
$2.8
(0.0)
$2.8
80.0
2.8
10.0
72.8
T16-22
MULTIPLE TEMPORARY DIFFERENCES-2014
($ in millions)
Current
Year
2013
Accounting income
Temporary differences:
Installment sales
Depreciation
Warranty expense
Estimated loss
Taxable income
Enacted tax rate
Tax payable currently
Deferred tax liability
Deferred tax asset
2014
Future
Taxable
(Deductible)
Amounts
2015
2016
Future
Taxable
Amounts
Future
Deductible
Amounts
[total]‡
[total]‡
200
(9)
(16)
7
5
(38)
(4)
1
164
4
20
(3)
34
4
54
(3)
(1)
(1)
58
40%
40%
65.6
23.2
(1.6)

Ending balances (balances currently needed):
Less: Beginning balances:
Changes needed to achieve desired balances
Journal entry at the end of 2014
Income tax expense (to balance)
Deferred tax asset (determined above)
Deferred tax liability (determined above)
Income tax payable (determined above)
(4)
40%

Deferred tax
liability
Deferred
tax asset
$23.2
(10.0)
$13.2
$1.6
(2.8)
$(1.2)
80.0
1.2
13.2
65.6
‡ Total future taxable and deductible amounts also are equal to the cumulative temporary
differences in the related assets and liabilities.
T16-23
OPERATING LOSSES

An operating loss can be carried back two years and forward
20 years:
Carryforward 
up to 20 years
2011 2012 LOSS 2014 2015 2016  2032 2033
2 years  Carryback

Tax laws permit a choice. A company can elect to carry an
operating loss back if taxable income was reported in either of
the two previous years. By reducing taxable income of a
previous year, the company can receive a refund of taxes paid
that year.
T16-24
OPERATING LOSS CARRYFORWARD
During 2013, its first year of operations, American
Laminating Corporation reported an operating loss of $125
million for financial reporting and tax purposes. The enacted
tax rate is 40%.
($ in millions)
Operating loss
Loss carryforward
Enacted tax rate
Tax payable
Deferred tax asset
Current
Year
2013
(125)
125
0
40%
0
Future
Deductible
Amounts
[total]
(125)
40%
(50)

Deferred tax asset:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2013
Deferred tax asset (determined above)
Income tax benefit–operating loss (to balance)
$50
0
$50
50
50
($ in millions)
Operating loss before income taxes
Less: Income tax benefit – operating loss
Net operating loss
$125
50
$ 75
T16-25
OPERATING LOSS CARRYBACK
During 2013, American Laminating Corporation reported an
operating loss of $125 million. The enacted tax rate is 40% for
2013.
Taxable
Income
2011
2012
$20 million
55 million
Income
Taxes Paid
Tax Rates
35%
40%
($ in millions)
Prior Years
2011
2012
$7 million
22 million
Current
Year
2013
Future
Deductible
Amounts
[total]
Operating loss
Loss carryback
Loss carryforward
Enacted tax rate
Tax payable (refundable)
Deferred tax asset
(125)
(20) (55)
75
50
0
35% 40%
40%
(7) (22)
0
(50)
40%
(20)

Deferred tax asset:
Ending balance (balance currently needed)
Less: Beginning balance
Change needed to achieve desired balance
Journal entry at the end of 2013
Receivable – income tax refund ($7 + 22)
Deferred tax asset (determined above)
Income tax benefit – operating loss (to balance)
$20
0
$20
29
20
49
T16-26
BALANCE SHEET CLASSIFICATION
 Classified as either current or noncurrent according to how the
related assets or liabilities are classified for financial reporting.
 Net current amount and the net noncurrent amount.
Warren Properties, Inc. had future taxable amounts and future deductible amounts
relating to temporary differences between the tax bases of the assets and liabilities
indicated below and their financial reporting amounts:
($ in millions)
Related Balance
Sheet Account
Classification
current-C
noncurrent-N
Receivable – installment sales
Receivable – installment sales
Depreciable assets
Allowance – uncollectible accounts
Liability – subscriptions received
Estimated warranty liability
C
N
N
C
C
C
Future
Taxable
(Deductible)
Amounts
10
5
105
(15)
(20)
(30)
Net current liability (asset)
Net noncurrent liability (asset)
BALANCE SHEET PRESENTATION:
Current Assets:
Deferred tax asset
Long-Term Liabilities:
Deferred tax liability
Tax
Rate
x 40%
Deferred
Tax (Asset)
Liability
C
N
4
2
42
x 40%
x 40%
x 40%
x 40%
x 40%
(6)
(8)
(12)
(22)
44
$22
$44
Note: Before offsetting assets and liabilities within the current and noncurrent
categories, the total deferred tax assets is $26 ($6+8+12) and the total deferred tax
liabilities is $48 ($4+2+42).
T16-27
Dealing with Uncertainty
GAAP allows companies to recognize in the financial statements the tax
benefit of a position it takes only if it is “more likely than not” (greater than
50% chance) to be sustained if challenged. Guidance also prescribes how
to measure the amount to be recognized. The decision, then, is a “twostep” process.
Step 1.
A tax benefit may be reflected in the financial
statements only if it is "more likely than not" that the
company will be able to sustain the tax return position,
based on its technical merits.
Step 2.
A tax benefit should be measured as the largest amount
of benefit that is cumulatively greater than 50-percent
likely to be realized.
For the step-one decision as to whether the position can be sustained we
assume that the position is reviewed by the IRS or other taxing authority
(state and local governments) and litigated to the “highest court possible”
and that the IRS has knowledge of all relevant facts.
T16-28
Dealing with Uncertainty
Illustration
Derrick Company claims a deduction on its tax return that will save the
company $8 million in 2013 income taxes. Derrick knows that,
historically, the IRS has challenged many deductions of this type. Since
tax returns usually aren't examined for one, two, or more years, uncertainty
exists. Management believes the more-likely-than-not criterion is met. .
Suppose the following table represents management’s estimates of the
likelihood of various amounts of tax benefit that would be upheld:
Likelihood Table:
Amount of the tax benefit that
management expects to be
sustained
$8
$7
$6
$5
$4
Percentage likelihood that the tax
position will be sustained at this
10% 20% 25% 25%
level
Cumulative probability that the tax
position will be sustained
10% 30% 55% 80%
20%
100%
The amount of tax benefit that Derrick can recognize in the financial
statements (reduce tax expense) is $6 million because it represents the
largest amount of benefit that is more than 50-percent likely to be the end
result. So, Derrick would record tax expense as if there is a $6 million
benefit, income tax payable that reflects the entire $8 million benefit of the
deduction, and a liability that represents the potential obligation to pay the
additional taxes if the deduction is not ultimately upheld:
($ in millions)
Income tax expense (with $6 tax benefit)
Income tax payable (with $8 tax benefit)
Liability – projected additional tax ($8 – 6)
26
24
2
T16-29
INTRAPERIOD TAX ALLOCATION
The total income tax expense for a reporting period should be
allocated among the income statement items that gave rise to
it. Each of the following items should be reported net of its
respective income tax effects:
Income (or loss) from continuing operations
Discontinued operations
Extraordinary items
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Extraordinary Items. Recall from Chapter 4 that
extraordinary items are not reported separately under IFRS.
IAS No. 1, “Presentation of Financial Statements” states that
neither the income statement nor any notes may contain any
items called “extraordinary.” As a result, the only income
statement item reported separately net of tax using IFRS is
discontinued operations.
T16-30
Suggestions for Class Activities
1.
Dell Analysis
Have students, individually or in groups, go to the most recent Dell annual report at Dell’s web site
at: www.dell.com/. Ask them to:
1. Determine the temporary difference that for Dell creates the largest deferred taxes. Given what
you know about Dell, why do you suppose this is the largest contributor? Is the deferred tax
effect getting higher or lower? Why?
2. Determine how deferred taxes are reported in the balance sheet.
3. Compare deferred taxes reported with those in the 2011 report that accompanied the text. Are
there any discernible trends? How might they be interpreted?
Points to note:
In 2011, the temporary difference that for Dell creates the largest deferred taxes was deferred
revenue. Dell reports revenue from extended warranty and service contracts, for which it is
obligated to perform, as deferred revenue and subsequently recognized over the term of
the contract or when the service is completed.
In 2011 and earlier years, Dell reported a net current asset and a net noncurrent asset in the
balance sheet under “other” assets. A disclosure note details specific deferred tax assets and
liabilities.
2.
Professional Skills Development Activities
The following are suggested assignments from the end-of-chapter material that will help your
students develop their communication, research, analysis, and judgment skills.
Communication Skills. In addition to Communication Case 16-5, Question 16-15 can be adapted
to ask students to choose one of the two views and write a short paper defending that choice.
Judgment Cases 16-4 and 16-12, Real World Case 16-6, Integrating Case 16-2 and Problem
16-7 do well as group assignments. Judgment Cases 16-4 and 16-12, and Integrating Case 163 are suitable for student presentation(s). Integrating Case 16-3, Research Case 16-7, and
Question 16-7 create good class discussions.
Research Skills. The “Broaden Your Perspective” section includes Research Cases that direct
students to locate and extract relevant information from available resource material to
determine the correct accounting practice, perhaps identifying the appropriate authoritative
literature to support a decision. Research Case 16-7 provides an excellent opportunity to help
students develop this skill. In addition, Analysis Case 16-9 requires students to research the
way Kroger reports deferred taxes.
Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct
students to gather, assemble, organize, process, or interpret date to provide options for making
business and investment decisions. In addition to Analysis Cases 16-1, 16-8, and 16-9,
Exercise 16-14, Problems 16-3 and 16-11, Real World Case 16-6, and Integrating Cases 16-2
and 16-3 also provide opportunities to develop analysis skills.
Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require
students to critically analyze issues to apply concepts learned to business situations in order to
evaluate options for decision-making and provide an appropriate conclusion. In addition to
Judgment Cases 16-10 and 16-12, Trueblood Case 11 and Integrating Case 16-4 also require
students to exercise professional judgment.
3.
Real World Scenario
In AT&T’s 2000 annual report, the company reported long-term deferred tax assets of
$4,523,000,000 and current deferred tax assets of $1,791,000,000. Disclosure note 15 reported, in
part:
“At December 31, 2000, we had net operating loss carryforwards (tax-effected), excluding
Excite@Home, for federal and state income tax purposes of $79 and $164, respectively,
expiring through 2017. In addition, we had federal tax credit carryforwards of $145, of
which $64 have no expiration date and $81 expire through 2010. We also had state tax
credit carryforwards (tax-effected) of $32 expiring through 2008. In connection with the TCI
merger, we acquired certain federal and state net operating loss carryforwards subject to a
valuation allowance of $59.”
Suggestion:
Ask students to consider the following questions:
1. As a potential investor, what significance would you place on the existence of operating
loss carryforwards?
2. What might contribute to AT&T’s need to record a valuation allowance?
Points to note:
Deferred tax assets represent future tax savings. Operating loss carryforwards create deferred tax
assets that can reflect sizable potential tax deductions. AT&T has large operating loss
carryforwards, signifying that a large amount of future income can be earned tax-free. This is a tax
shelter that should not be overlooked by a potential investor.
Deferred tax assets are recognized for every deductible temporary difference. At each reporting
date, a deferred tax asset is then reduced by a valuation allowance if it is “more likely than not” that
some portion or all of the deferred tax asset will not be realized. A future deductible amount reduces
taxable income and saves taxes only if there is taxable income to be reduced when the future
deduction is available. So, a valuation allowance is needed if taxable income is anticipated to be
insufficient to realize the tax benefit. AT&T probably feels it will have sufficient future taxable
income - as a whole - to reap the benefits of the deferred tax assets its reports. The need to report a
valuation allowance presumably is due to the timing of deductions becoming available and the mix
of foreign and domestic taxable income projections.