Extension_Chapter 9

Deferred taxes

GAAP and IRC

Separate rules govern the preparation of financial
statements (GAAP) and tax returns (Internal Revenue
Code-IRC)
The Internal Revenue Code governs the accounting for
tax liability.
The IRS is the US government agency responsible for
tax collection.

GAAP and IRC

As a result:

taxable income reported to

the IRS may not be the
same as pre-tax income
that is reported to
shareholders.

The amount of income tax

liability due to the IRS may
not be the same as income
tax expense that is reported
on the income statement.

Deferred Taxes: basics

To reflect this difference, companies establish a separate
account called Deferred Taxes.
Deferred taxes arise when income tax expense differs
from income tax liability.
Distinction between Deferred Tax Assets and Deferred Tax
Liabilities

Some of these differences are temporary and reverse

over time (in future accounting periods).
Others are permanent and do not reverse.

Deferred Taxes: basics

book income or pre-tax income (income reported to
shareholders) versus taxable income (income reported to
the IRS).
Temporary differences: ex. The book income may be higher
than taxable income this year, but will be lower in a future year so that
cumulative income will be the same for both.

Permanent differences: this is due to GAAP treating some

items as income or expenses that the IRS does not (ex. municipal
bond income that is treated as revenue under GAAP, but is not taxed
by the IRS).

Deferred Taxes: example

Consider a company that depreciates its assets using the straight-line method
for financial reporting purposes and an accelerated method for tax purposes.
Assume that income before depreciation is $15,000. Pre-tax (financial reporting)
and taxable (IRS) income might be reported as follows:

Pre-tax income
Income before depr.

Taxable income

15,000

15,000

Depr. expense

2,000

3,000

Pre-tax/taxable income

13,000

12,000

Deferred Taxes: example

Accelerated depreciation matches higher depreciation
expense with higher revenues in the early years of an
assets useful life when the asset is more efficient.

Taxable income is lower than pre-tax income, so this year the

company pays less taxes.
We know, however, that over the life of the asset the same
amount of depreciation expense will be reported under both
methods.
As a result, taxable income will be higher in future years and
tax liability as well.

Deferred Tax Liability

Since we know that a future tax liability exists, we need to report
it in the companys balance sheet. This is the essence of
deferred taxes.

A deferred tax liability must be accrued for the future tax

liability.
This liability will remain on the companys balance sheet
until taxable income is, in fact, higher and the tax liability is
paid.

Deferred Tax Liabilities

In
In 2009,
2009, Baxter
Baxter reports
reports $300,000
$300,000 of
of pretax
pretax income.
income. Included
Included in
in this
this
amount
amount is
is $100,000
$100,000 resulting
resulting from
from revenue
revenue earned
earned from
from an
an
installment
installment sale
sale for
for which
which no
no cash
cash was
was collected.
collected. The
The revenue
revenue will
will be
be
taxed
taxed as
as the
the cash
cash is
is collected
collected in
in 2010
2010 and
and 2011.
2011. Baxter
Baxter expects
expects to
to
collect
collect $70,000
$70,000 in
in 2010
2010 and
and the
the remaining
remaining $30,000
$30,000 in
in 2011.
2011. In
In 2010
2010 and
and
2011,
2011, Baxter
Baxter reports
reports $200,000
$200,000 of
of pretax
pretax income.
income. The
The company
company is
is
subject
subject to
to aa 32%
32% tax
tax rate.
rate.
There
There are
are no
no other
other temporary
temporary differences.
differences.

Deferred Tax Liabilities

2009 Income tax payable = $200,000 32% = $64,000

2009 Deferred tax liability change = ($100,000 32%) - $0
General Journal= $32,000
Description
Income tax expense
Income tax payable
Deferred tax liability

Debit
96,000

Credit
64,000
32,000

Deferred Tax Liabilities

The Deferred Tax

Liability
represents the
future taxes Baxter
will pay in 2010
and 2011.

General Journal
Description
Debit
Income tax expense
96,000
Income tax payable
Deferred tax liability

Credit
64,000
32,000

Deferred Tax Liabilities

Recall this
information for
Baxter.

2010 Income tax payable = $270,000 32% = $86,400

2010 Deferred tax liability change = ($30,000 32%) - $32,000
= $22,400
General Journal
General Journal
Description
Debit
Description
Debit
Income
64,000
Income tax
tax expense
expense
64,000
Deferred
22,400
Deferred tax
tax liability
liability
22,400
Income
Income tax
tax payable
payable

Credit
Credit

86,400
86,400

Deferred Tax Liabilities

The Deferred Tax Liability represents the future taxes
Baxter will pay in 2011.
Future
Taxable
Amount
Schedule

Deferred Tax Liabilities

Recall this
information for
Baxter.

2011 Income tax payable = $230,000 32% = $73,600

2011 Deferred tax liability change = ($0 32%) - $9,600
= $9,600
General Journal
General Journal
Description
Debit
Description
Debit
Income
64,000
Income tax
tax expense
expense
64,000
Deferred
9,600
Deferred tax
tax liability
liability
9,600
Income
Income tax
tax payable
payable

Credit
Credit

73,600
73,600

Deferred Tax Liabilities

The Deferred Tax Liability represents the future taxes
Baxter will pay.
Future
Taxable
Amount
Schedule

Deferred Tax Liability

Deferred Tax Liabilities are created as a result of:
-income reported in the income statement but deferred into future
periods on the tax return
-expenses taken on the tax return in the current period which
creates smaller deductions on the tax return in future periods
(depreciation example)

Deferred Tax Assets

Health Magazine received $150,000 of subscriptions in
advance during 2009.
Subscription revenue will be earned equally in 2010,
2011 and 2012 for financial accounting purposes.
The entire $150,000 will be taxed in 2009.
There is additional income of $500,000 in each year.
The company is subject to a 30% tax rate in each year.

Deferred Tax Assets

This is the computation for the Deferred Tax Asset.

Now, lets record the income tax entry for 2009.

Deferred Tax Assets

2009 Income tax payable = $650,000 30% = $195,000

2009 Deferred tax asset change = [($150,000 30%] - $0
= $45,000
General Journal
General Journal
Description
Debit
Description
Debit
Income
150,000
Income tax
tax expense
expense
150,000
Deferred
45,000
Deferred tax
tax asset
asset
45,000
Income
Income tax
tax payable
payable

Credit
Credit

195,000
195,000

Deferred Tax Assets

After posting the entry, the Deferred Tax Asset account
will have the desired ending balance of $45,000.

General
General Journal
Journal
Description
Debit
Description
Debit
Income
150,000
Income tax
tax expense
expense
150,000
Deferred
45,000
Deferred tax
tax asset
asset
45,000
Income
Income tax
tax payable
payable

Credit
Credit

195,000
195,000

Deferred Tax Assets

2010 Income tax payable = $500,000 30% = $150,000

2010 Deferred tax asset change = [($100,000) 30%] -$45,000
=Journal
($15,000)
General
General Journal
Description
Debit
Credit
Description
Debit
Credit
Income
165,000
Income tax
tax expense
expense
165,000
Deferred
15,000
Deferred tax
tax asset
asset
15,000
Income
150,000
Income tax
tax payable
payable
150,000

Deferred Tax Assets

In 2010, the balance in the Deferred Tax Asset should
decrease to $30,000.

Can you prepare the entries for 2011 and 2012?

Deferred Tax Assets

This would be the entry for 2011 and 2012.

General
General Journal
Journal
Description
Debit
Description
Debit
Income
165,000
Income tax
tax expense
expense
165,000
Deferred
Deferred tax
tax asset
asset
Income
Income tax
tax payable
payable

Credit
Credit
15,000
15,000
150,000
150,000

At the end of 2012, the balance in the Deferred

Tax Asset would be zero.

Deferred Tax Asset

Deferred Tax Assets are created as a result of:
-expense or loss in the income statement that is not reported on
the tax return (ex. expenses that will not be deductible for tax
purposes until paid)
-revenue or gain reported on the tax return that is not currently
reported on the income statement
In this case, pre-tax income is less than taxable income and the firm
will realize a future deductible amount.

Temporary Differences
Temporary
Temporary differences
differences will
will reverse
reverse out
out in
in
one
one or
or more
more future
future periods.
periods.
Accounting Income>Taxable Income

Accounting Income<Taxable Income

Future Taxable Amounts

Future Deductible Amounts

Deferred Tax Liability

Deferred Tax Asset

Deferred Tax Liability/Asset

Revenues and gains, recognized in financial income, are
later taxed for income tax purposes.
Expenses and losses, recognized in financial income, are
later deducted for income tax purposes.

Transaction

When recorded
in books

When recorded
on tax return

Deferred
tax effect

Rev or Gain

Earlier

Later

Liability

Exp or Loss

Earlier

Later

Asset

Deferred Tax Liability/Asset

Revenues and gains are taxed for income tax purposes
before they are recognized in financial income.
Expenses and losses are deducted for income tax purposes
before they are recognized in financial income.

Transaction

When recorded
in books

When recorded
on tax return

Deferred
tax effect

Rev or Gain

Later

Earlier

Asset

Exp or Loss

Later

Earlier

Liability

Summary of temporary
differences
Transaction

When recorded
in books

When recorded
on tax return

Deferred
tax effect

Rev or Gain

Earlier

Later

Liability

Exp or Loss

Earlier

Later

Asset

Rev or Gain

Later

Earlier

Asset

Exp or Loss

Later

Earlier

Liability

Multiple Temporary Differences

It would be unusual for any but a very small
company to have only a single temporary
difference in any given year.
Categorize all temporary
differences according to
whether they create

Future taxable
amounts

Future deductible
amounts