Chapter 16 Accounting for Income Taxes

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1 DEFERRED TAX ASSETS AND DEFERRED TAX LIABILITIES Fundamental Concepts There are fundamental differences in the amount of income and expenses reported for GAAP and income tax purposes. The objective for GAAP reporting is to report the economic activities of the entity. The objective for income tax purposes is for the government to raise revenue. There are two terms that identify the types of income subject to tax under each reporting system. 1 Pretax financial income Pretax financial income is the income determined using GAAP. It is the amount of income on which income tax is computed for financial statement purposed. It is formally presented in the income statement as income before income taxes. We normally refer to it is pretax income. 2 Taxable income Taxable income is the income determined using Internal Revenue Code rules and regulations. It is the amount of income on which the entity will actually pay income tax in the current accounting period. Temporary Differences Deferred taxes arise as a result of temporary difference between income tax expense and income tax payable. A temporary difference is the difference between the book value of an asset or liability and the tax basis of the same asset or liability. If the income tax expense in the income statement is larger than the current income tax liability the difference is called a deferred tax liability. If the income tax expense in the income statement is smaller than the current income tax liability the difference is called a deferred tax asset. Deferred Tax Liabilities A deferred tax liability is created as a result of the difference between the book value and the tax basis of an asset or liability. The difference creates a tax liability in future periods. EXAMPLE: Spencer Company has pretax financial statement income for the current year of $700,000. The company s average income tax rate is 30% on taxable income. Spencer Corporation calculates deprecation expense using the straight-line method for financial reporting purposes and an ACRS (accelerated) method for tax purposes. The result will be a deferred tax liability. There will be a smaller depreciation expense deduction in subsequent years because a larger portion was taken in the year of purchase. Let s assume that the difference is $50,000 as calculated below. F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 1

2 Depreciation Expense Amount Financial statements $25,000 IRS Form ,000 Difference ($50,000) The above is a deferred liability as a result of expenses that will be recognized for tax purposed in subsequent periods. Now let s look that an income item. Let s assume that Spencer Company sold merchandise using the installment method for tax purposes but uses the accrual method for financial statement reporting purposes. This means that there will be additional income in subsequent periods on the tax return with results in an increase in the tax liability. The difference is $200,000 as calculated below. Installment Sale Amount Financial statements $300,000 IRS Form ,000 Difference $200,000 Step #1: The first step in calculating and reporting deferred income taxes is the analysis of the book to tax differences. The following is a computation of taxable income starting with pretax accounting income. Taxable Income Amount Pretax accounting income $700,000 Temporary differences: Accelerated depreciation (50,000) Installment sales (200,000) Taxable income $450,000 Step #2: Income tax payable is based on taxable income using the current average tax rate. The following is a calculation of the income tax payable. Income Tax Payable Amount Taxable income $450,000 Tax rate 30% Income tax payable $135,000 Step #3: Based on this information we are now ready to calculate the deferred tax liability for the current year end. The liability is calculated as follows. F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 2

3 Deferred Tax Temporary Difference Future Amounts Tax Rate Asset Liability Depreciation $50,000 30% $15,000 Installment sale 200,000 30% 60,000 $250,000 $75,000 Step #4: The deferred tax expense is the deferred portion of the income tax that is reported on the face of the income statement. It is calculated by analyzing the deferred tax liability T- account. In this case we are assuming that there is no beginning balance. The T-account analysis is as follows: T-Account: Deferred Tax Liability Description Debit Credit Beginning balance $0 Adjusting journal entry 75,000 Ending balance $75,000 In this case the deferred tax expense is the change (adjusting journal entry) in the deferred tax liability account. If there is a change in both the deferred tax asset account (deferred tax benefit) and the deferred tax liability account (deferred tax expense) the amounts net to be netted together to derive a single amount of deferred tax expense or deferred tax benefit. Step #5: Now that we know the income tax payable from the taxable income and the deferred tax expense from the timing differences we are ready to calculate the total income tax expense that will be reported on the face of the income statement. The calculation of total income tax expense is as follows. Income Tax Expense Amount Current tax expense $135,000 Deferred tax expense 75,000 Income tax expense $210,000 Step #6: So far all we have done is calculate the amounts required to prepare the year-end adjusting journal entry to record income tax expenses. This journal entry sets up the income tax expense that will be reported in the income statement, the income tax liability that will be paid to the internal revenue service and the deferred tax liability. F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 3

4 Income tax expense $210,000 Income tax payable $135,000 Deferred tax liability 75,000 Summary of income tax accounting objectives There are two objectives in accounting for income taxes. 1 To recognize the income taxes payable for the current accounting period. 2 To record future tax liabilities as a result of items recognized in the income statement but not the tax return or recognized on the tax return but not the income statement. Deferred Tax Assets So far all we have talked about it deferred tax liabilities. These were created as a result of income reported in the income statement but deferred into future period on the tax return, and expenses taken on the tax return in the current period which creates smaller deductions on the tax return in future periods. Now we are going to exam the impact of deferred tax assets on the financial statements. A deferred tax asset is created as a result of the difference between the book value and the tax basis of an asset or liability. The difference creates a tax asset in future periods. The net result is a decrease in taxes in future periods. If we have and expense or loss in the income statement that is not reported on the tax return this creates a deferred tax asset. The expense or loss will be used on the tax return in some future period(s). Also, if we have revenue or gain reported on the tax return that is not currently reported in the income statement this creates a deferred tax asset. The revenue or gain will be reported in some future period(s) but it will not be taxable. EXERCISE: Spencer Company has pretax financial statement income for the current year of $700,000. The company s average income tax rate is 30% on taxable income. Spencer Corporation has an estimated warranty liability of $125,000 which is recorded on the income statement but is not deductible for income tax purposes. In addition, the company has leased a piece of equipment for $100,000 per year for three years to a customer. The lessee paid the entire three years rent in advance. At the end of the year Spencer Company has a deferred liability (unearned rent) of $200,000 recorded in the balance sheet. The rent is reported on a cash basis for income tax purposes. Each of these items creates a deferred tax asset. Using the format provided calculate the book to tax difference as a result of the estimated warranty liability. Estimated Warranty Amount Financial statements $ IRS Form 1120 $ Difference $ F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 4

5 Estimated Warranty Amount Financial statements $125,000 IRS Form Difference $125,000 Using the format provided calculate the book to tax difference as a result of the unearned rent. Unearned Rent Amount Financial statements $ IRS Form 1120 $ Difference $ Unearned Rent Amount Financial statements $100,000 IRS Form ,000 Difference ($200,000) Based on the information above compute taxable income by starting with pretax accounting income. Taxable Income Pretax financial income $ Temporary differences: Estimated warranty expense $ Unearned rent income $ Taxable income $ Taxable Income Pretax financial income $700,000 Temporary differences Estimated warranty expense 125,000 Unearned rent income 200,000 Taxable income $1,025,000 F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 5

6 Now that you have taxable income you can calculate income tax payable. Income Tax Payable Amount Taxable income $ Tax rate % Income tax payable $ Income Tax Payable Amount Taxable income $1,025,000 Tax rate 30% Income tax payable $307,500 Based on the information provided in the above exercises prepare the schedule of deferred tax assets. Future Tax Deferred Tax Temporary Difference Amount Rate Asset Liability Estimated warranty $ % $ Unearned rent $ % $ $ $ Future Tax Deferred Tax Temporary Difference Amount Rate Asset Liability Estimated warranty $125,000 30% $37,500 Unearned rent 200,000 30% 60,000 $325,000 $97,500 Instead of a deferred tax expense we will have a deferred tax benefit as a result of the deferred tax assets. F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 6

7 T-Account: Deferred Tax Asset Decsription Debit Credit Beginning balance Adjusting journal entry Ending balance T-Account: Deferred Tax Asset Decsription Debit Credit Beginning balance $0 Adjusting journal entry 97,500 Ending balance $97,500 The deferred tax benefit, which is the change in the deferred asset account, reduces current period income tax expense. Using the format calculate income tax expense. Income Tax Expense Deferred tax benefit Current tax expense Income tax expense Amount Income Tax Expense Amount Current tax expense $307,500 Deferred tax benefit (97,500) Income tax expense $210,000 Base on your experience with the deferred tax liability see if you can prepare the year-end adjusting journal entry to record income tax expense, income tax payable, and the deferred tax asset. Income tax expense $ Deferred tax asset $ Income tax payable $ F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 7

8 Income tax expense $210,000 Deferred tax asset 97,500 Income tax payable $307,500 Valuation Allowance In accounting we are always careful that assets are not overstated. If the balance in the deferred asset account is greater than the expected benefit to be realized we must establish a valuation allowance account to that will reduce the amount reported in the balance sheet to the expected realized value. This is a contra asset account off setting the deferred tax benefit. When recording the valuation allowance we charge the reduction to current period income tax expense. EXAMPLE: At December 31, 2002, Spencer Company has a deferred tax asset of $200,000. After a careful review of all available evidence, it is determined that it is more likely than not that the $80,000 of this deferred tax asset will not be realized. Prepare the necessary journal entry. Income tax expense $ Allowance to reduce deferred tax asset to expected realizable value $ Income tax expense $80,000 Allowance to reduce deferred tax asset to expected realizable value $80,000 COMPREHENSIVE REVIEW The above examples and exercises had you working with either a deferred tax liability or a deferred tax benefit but not both in the same problem. Now we need to integrate what you have learned into a more complete situation. EXAMPLE: The following facts relate to Spencer Company: (1) Deferred tax liability, January 1, 2003, $40,000 (2) Deferred tax asset, January 1, 2003, $0 (3) Taxable income for 2003, $95,000 (4) Pretax financial income for 2003, $200,000 (5) Cumulative temporary difference at December 31, 2003, giving rise to future taxable amounts, $240,000 F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 8

9 (6) Cumulated temporary difference at December 31, 2003, giving rise to future deductible amounts, $35,000 (7) Tax rate for all years, 40% (8) The company is expected to operate profitability in the future. 1. Based on the information provided compute taxable income by starting with pretax accounting income. Taxable Income Financial statement income $ Temporary differences: Deduct: future taxable amounts Current period $ Prior period Beginning deferred tax liability $ Enacted tax rate % Prior period future taxable amount $ $ $ Add: future deductions $ Taxable income per tax return $ Taxable Income Financial statement income $200,000 Temporary differences: Deduct: future taxable amounts Current period $240,000 Prior period Beginning deferred tax liability $40,000 Enacted tax rate 40% Prior period future taxable amount 100, ,000 60,000 Add: future deductions 35,000 Taxable income per tax return $95, Calculate income tax payable based on the taxable income. F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/2006 9

10 Income Tax Payable Taxable income $ Enacted tax rate $ Income tax payable $ Income Tax Payable Taxable income $95,000 Enacted tax rate 40% Income tax payable $38, Based on the above information prepare a schedule of deferred tax assets and deferred tax liabilities. Deferred Tax Temporary difference Future Amounts Tax Rate Asset Liability Future taxable amounts $ % $ Future deductable amounts $ % $ Totals $ $ $ Deferred Tax Temporary difference Future Amounts Tax Rate Asset Liability Future taxable amounts $240,000 40% $96,000 Future deductable amounts (35,000) 40% ($14,000) Totals $205,000 ($14,000) $96, Prepare a t-account analysis of the deferred tax asset account. T-Account: Deferred Tax Asset Description Debit Credit Beginning balance $ Adjusting journal entry $ Ending Balance $ F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/

11 T-Account: Deferred Tax Asset Description Debit Credit Beginning balance $0 Adjusting journal entry 14,000 Ending Balance $14, Prepare a t-account analysis of the deferred tax liability account. T-Account: Deferred Tax Liability Description Debit Credit Beginning balance $ Adjusting journal entry $ Ending Balance $ T-Account: Deferred Tax Liability Description Debit Credit Beginning balance $40,000 Adjusting journal entry 56,000 Ending Balance $96, Prepare a schedule of net deferred tax expense (benefit). Net Deferred Tax Expense (Benefit) Deferred tax expense $ Deferred tax benefit $ Net deferred tax expense $ Amount Net Deferred Tax Expense (Benefit) Amount Deferred tax expense $56,000 Deferred tax benefit (14,000) Net deferred tax expense $42, Prepare a schedule of income tax expense. F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/

12 Income Tax Expense Amount Current tax expense $ Net deferred tax expense $ Income tax expense $ Income Tax Expense Amount Current tax expense $38,000 Net deferred tax expense 42,000 Income tax expense $80, Prepare the journal entry to record income tax expense, income tax payable, the change in deferred tax assets and deferred tax liabilities for the year. Income tax expense $ Deferred tax asset $ Deferred tax liability $ Income tax payable $ Income tax expense $80,000 Deferred tax asset 14,000 Deferred tax liability $56,000 Income tax payable 38, Prepare a partial income statement starting with income before income tax. Partial Income Statement Income before income taxes $ Income tax expense Current $ Deferred $ $ Net income $ F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/

13 Partial Income Statement Income before income taxes $200,000 Income tax expense: Current $38,000 Deferred 42,000 80,000 Net income $120,000 Specific Differences There are actually two kinds of book to tax differences. So far we have only talked about temporary differences that will reverse in future accounting periods. There are also differences that don t reverse and we call these permanent differences. Temporary Differences As we have discussed above there are taxable temporary differences and deductible temporary differences. 1 Taxable temporary differences a) Revenues and gains are recognized in the current income statement but taxable in some future accounting period(s) on the tax return. b) Expenses and losses are deducted on the current tax return but recognized on the income statement in some future accounting period(s). 2 Deductible temporary differences a) Revenue and gains are recognized on the current tax return but recognized in the income statement in some future accounting period(s). b) Expenses and losses are deducted on the current income statement but expensed in some future accounting period(s) on the tax return. Permanent differences Permanent differences occur as a result of differences between GAAP and income tax law. Income or expenses reported on the income statement are never reported on the tax return; or income or expenses reported on the tax return are never reported on the income statement. There are no deferred taxes involved here. The book to tax differences are reconciled on the IRS Form 1120 which you will deal with in your corporate tax class. F:\course\ACCT3322\200720\module2\c16\tnotes\c16a.doc 11/10/

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