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Income
Taxes
Learning Objectives
 Understand the concept of deferred
taxes and the distinction between
permanent and temporary differences.
 Compute the amount of deferred tax
liabilities and assets.
 Explain the provisions of tax loss
carrybacks and carryforwards, and be
able to account for these provisions.
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Learning Objectives
 Schedule future tax rates, and determine
the effect on tax assets and liabilities.
 Determine appropriate financial
statement presentation and disclosure
associated with deferred tax assets and
liabilities.
 Comply with income tax disclosure
requirements associated with the
statement of cash flows.
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Learning Objectives
 Describe how, with respect to deferred
income taxes, international accounting
standards have converged toward the
U.S. treatment.
EXPANDED MATERIALS
 Perform intraperiod tax allocation.
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Deferred Tax Liabilities
Defined: Income taxes expected
to be paid on future taxable
amounts resulting from
temporary differences between
financial and taxable income.
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Deferred Tax Liabilities
• Examples
– Revenues (or gains) taxable after they are
recognized for financial reporting, such as
receivables from installment sales.
– Expenses (or losses) deductible for tax
purposes before they are recognized for
financial reporting purposes, such as
accelerated tax depreciation.
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Deferred Tax Assets
Defined: An expected benefit in
the form of tax savings on
future deductible amounts
resulting from deductible
temporary differences between
financial and taxable income.
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Deferred Tax Assets
• Examples
– Expenses (or losses) that are deductible for
tax purposes after they are recognized for
financial reporting purposes, such as
warranty expenses.
– Revenues (or gains) that are taxable before
they are recognized for financial reporting
purposes, such as subscriptions received in
advance.
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Permanent and Temporary
Differences
• Permanent Differences: Nondeductible
expenses or nontaxable revenues that are
recognized for financial reporting purposes
but are never part of taxable income.
• Temporary Differences: Differences
between pretax financial income and
taxable income arising from business
events that are recognized for both
financial and tax purposes, but in different
time periods.
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Illustration of Permanent and
Temporary Differences
For the year ended December 31, 2002,
Monroe Corporation reported net income
before taxes of $420,000. This amount
includes $20,000 of nontaxable revenues
and $5,000 of nondeductible expenses. The
depreciation method used for tax purposes
allowed a deduction that exceeded the book
approach by $30,000.
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Illustration of Permanent and
Temporary Differences
Pretax income from income statement
Add (deduct) permanent differences:
Nontaxable revenues
$(20,000)
Nondeductible expenses
5,000
Financial income subject to tax
Add (deduct) temporary differences:
Excess of tax depreciation over
book depreciation
Taxable income
Tax on taxable income (income
taxes payable): $375,000 x .35
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$420,000
(15,000)
$405,000
(30,000)
$375,000
$131,250
Advantages of the Asset and
Liability Method

Because the assets and liabilities
recorded under this method are in
agreement with the FASB definitions
of financial statement elements, the
method is conceptually consistent with
other standards.
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Advantages of the Asset and
Liability Method

The asset and liability method is a
flexible method that recognizes
changes in circumstances and adjusts
the reported amounts accordingly.
This flexibility may improve the
predictive value of the financial
statements.
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Annual Computation of Deferred
Tax Liabilities and Assets
Identify type and amounts of existing
temporary differences.
Measure the deferred tax
liability for taxable
temporary differences
(use enacted rates).
Measure the deferred tax
asset for deductible
temporary differences
(use enacted rates).
Establish valuation allowance account if
more likely than not some portion or all of the
deferred tax asset will not be realized.
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Example: Computation of Deferred
Tax Liabilities and Assets
• Rodney’s Burger Barn had GAAP income
of $4,200. Rodney identified the following
possible differences between GAAP and
Taxable income:
– Interest from municipal bonds
– Premium for Life Insurance on Joe
– Straight-Line Depreciation
– MACRS Depreciation
– Franchising Fees Earned
– Cash Franchising Fees Received
• Rodney’s enacted tax rate is 40%.
$
$
$
$
$
$
100
50
100
200
500
800
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Annual Computation of Deferred
Tax Liabilities and Assets
Identify type and amounts of existing
temporary differences.
Measure the deferred tax
liability for taxable
temporary differences
(use enacted rates).
Measure the deferred tax
asset for deductible
temporary differences
(use enacted rates).
Establish valuation allowance account if
more likely than not some portion or all of the
deferred tax asset will not be realized.
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Example: Identifying Type(s)
of Differences for Rodney’s
Difference
Temporary/
Permanent
Interest on bonds Permanent
Life Insurance
Net
Depreciation
Net Franchising
Fees
Permanent
Temporary
Temporary
Type
Reduction in
Taxable Income
Increase in
Taxable Income
Deferred Tax
Liability
Deferred Tax
Asset
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Example: Identifying Amount
of Differences for Rodney’s
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Pretax income
$4,200
Add (deduct) permanent differences:
Interest on municipal bonds
$(100)
Life insurance
50
(50)
Income subject to tax
$4,150
Add (deduct) temporary differences:
Net depreciation ($100 - $200) $(100)
Net fran. revenue ($800 - $500) 300
200
Taxable income
$4,350
Annual Computation of Deferred
Tax Liabilities and Assets
Identify type and amounts of existing
temporary differences.
Measure the deferred tax
liability for taxable
temporary differences
(use enacted rates).
Measure the deferred tax
asset for deductible
temporary differences
(use enacted rates).
Establish valuation allowance account if
more likely than not some portion or all of the
deferred tax asset will not be realized.
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Example: Measure Deferred
Tax Liabilities for Rodney’s
Depreciation for financial income
Depreciation for taxable income
Net deferred amount
Tax rate
Deferred tax liability
$100
200
$100
x 40%
$ 40
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Annual Computation of Deferred
Tax Liabilities and Assets
Identify type and amounts of existing
temporary differences.
Measure the deferred tax
liability for taxable
temporary differences
(use enacted rates).
Measure the deferred tax
asset for deductible
temporary differences
(use enacted rates).
Establish valuation allowance account if
more likely than not some portion or all of the
deferred tax asset will not be realized.
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Example: Measure Deferred
Tax Assets for Rodney’s
Franchising revenue for
financial revenue
Franchising revenue for taxable
revenue
Net deferred amount
Tax rate
Deferred tax asset
$(500)
800
$ 300
x 40%
$ 120
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Deferred Tax Asset
Some possible sources of taxable income to
be considered in evaluating the realistic value
of a deferred tax asset are:
 Future reversals of existing taxable
temporary differences.
 Future taxable income exclusive of
reversing temporary differences.
 Taxable income in prior (carryback) years.
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Deferred Tax Asset
A typical journal entry to record the deferred
portion of income tax expense is:
Deferred Tax Asset--Current
xxx
Deferred Tax Asset--Noncurrent
xxx
Allowance to Reduce Deferred
Tax Asset to Realizable Value-Current
Allowance to Reduce Deferred
Tax Asset to Realizable Value-Noncurrent
Deferred Tax Liability--Noncurrent
xxx
xxx
xxx
Taxable Income
Commonly Confused
Relationships:
Pretax financial income
Income
Statement
+/-
Permanent differences
=
Financial income subject to tax
+/-
Temporary differences
=
Taxable income
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Net Operating Losses (NOL)-Alternative Elections
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Carryback Election
Year
-2
Year
+20
Loss
Year
Carryforward Election
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Accounting for NOL Carryback
Year
Income
(Loss)
Tax Rate
Income
Tax
2001
2002
2003
$10,000
14,000
(19,000)
35%
30%
30%
$3,500
4,200
0
Journal Entry in 2003:
Income Tax Refund Receivable
6,200
Income Tax Benefit From NOL Carryback
[$3,500 + (30% x $9,000)]
6,200
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Accounting for NOL Carryforward
Year
Income
(Loss)
Tax Rate
2003
2004
$(19,000)
(35,000)
30%
30%
Income
Tax
$0
0
The only loss remaining against which
operating income can be applied is $5,000
from 2002. This leaves $30,000 to be
carried forward from 2004 as a future tax
benefit of $9,000 ($30,000 x .30).
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Accounting for NOL Carryforward
The journal entry recorded at the end of 2004
indicates that is more likely than not that the
carryforward benefit will be realized in full.
Journal Entry:
Deferred Tax Asset--NOL Carryforward
Income Tax Benefit From NOL
Carryforward
9,000
9,000
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Accounting for NOL Carryforward
The firm reports a taxable income of $50,000
in 2005. The tax carryforward allows
management to deduct the carryforward from
the $15,000 tax ($50,000 x .30) that would be
due without the carryforward.
Journal Entry:
Income Tax Expense
Income Taxes Payable
Deferred Tax Asset--NOL
Carryforward
15,000
6,000
9,000
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Accounting for NOL Carryforward
What if, due to a declining
market, management believes
that losses will continue in the
future and the tax benefit will
not be realized?
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Accounting for NOL Carryforward
Journal Entry:
Deferred Tax Asset--NOL Carryforward
Allowance to Reduce Deferred Tax
Assets to Realizable Value--NOL
Carryforward
9,000
9,000
As a result of this entry, the deferred tax
asset is zero--the expected realizable
value.
Presentation in
Financial Statements
Balance Sheet
Classify deferred
taxes as current or
noncurrent based on
asset or liability to
which they relate.
Report a net current
and a net noncurrent
amount.
Income Statement
Report current tax
expense (benefit)
and deferred tax
expense (benefit) and
total income tax
expense (benefit).
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Financial Statement
Presentation and Disclosure
The following items must appear in the
income statement or an accompanying note:
•
•
•
•
Current tax expense or benefit
Deferred tax expense or benefit
Investment tax credits
Government grants recognized as tax
reductions
Continued
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Financial Statement
Presentation and Disclosure
The following items must appear in the
income statement or an accompanying note:
• Benefits of NOL carryforwards
• Adjustments of a deferred tax liability or asset
(for enacted laws or rate changes)
• Adjustments in beginning-of-the-year valuation
allowance (for a change in circumstances)
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Approaches to Deferred Tax
Accounting
• No-Deferral Approach: Ignore the differences
and report income tax expense equal to the
amount of tax payable for the year.
• Comprehensive Recognition Approach:
Deferred taxes are included in the computation
of income tax expense and reported on the
balance sheet.
• Partial Recognition Approach: A deferred tax
liability is recorded only to the extent that the
deferred taxes are actually expected to be paid
in the future.
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Intraperiod Tax Allocation
Using interperiod tax allocation, the
income tax effect of each special item is
reported with the individual item rather
than being included with income tax
expense related to current operations.
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The End