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Chapter 1: Accounting for Income Taxes

Learning Objectives
1. Identify differences between pretax financial income and taxable
income.
2. Describe a temporary difference that results in future taxable
amounts.
3. Describe a temporary difference that results in future deductible
amounts.
4. Explain the purpose of a deferred tax asset valuation allowance.
5. Describe the presentation of income tax expense in the income
statement.
6. Describe various temporary and permanent differences.
7. Explain the effect of various tax rates and tax rate changes on
deferred income taxes.
8. Apply accounting procedures for a loss carryback and a loss
carryforward.
9. Describe the presentation of deferred income taxes in financial
statements.
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 ACCOUNTING FOR INCOME TAXES

Corporations must file income tax returns following the

guidelines developed by the Internal Revenue Service (IRS).

Because GAAP and tax regulations differ in a number of ways,

the amounts reported for the following will differ:

 income tax expense (GAAP).

 income tax payable (Internal Revenue Code).

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 ACCOUNTING FOR INCOME TAXES

Illustration: Chelsea, Inc. reported revenues of $130,000 and

expenses of $60,000 in each of its first three years of
operations. For tax purposes, Chelsea reported the same
expenses to the IRS in each of the years. Chelsea reported
taxable revenues of $100,000 in 2017, $150,000 in 2018, and
$140,000 in 2019. What is the effect on the accounts of
reporting different amounts of revenue for GAAP versus tax?

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 Book vs. Tax Differences
ILLUSTRATION 1-2
GAAP Reporting 2017 2018 2019 Total

Revenues $130,000 $130,000 $130,000 $390,000

Expenses 60,000 60,000 60,000 180,000
Pretax financial income $70,000 $70,000 $70,000 $210,000

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

ILLUSTRATION 19-3
Tax Reporting 2017 2018 2019 Total

Revenues $100,000 $150,000 $140,000 $390,000

Expenses 60,000 60,000 60,000 180,000
Taxable income $40,000 $90,000 $80,000 $210,000

Income tax payable (40%) $16,000 $36,000 $32,000 $84,000

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 Book vs. Tax Differences
ILLUSTRATION 1-4
Comparison 2017 2018 2019 Total

Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

Are the differences accounted for in the financial statements? Yes

Year Reporting Requirement

2017 Deferred tax liability account increased to $12,000
2018 Deferred tax liability account reduced by $8,000
2019 Deferred tax liability account reduced by $4,000

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Future Taxable and Deductible Amounts
is the difference between the tax basis of an
asset or liability and its reported (carrying or book) amount in the financial
statements that will result in taxable amounts or deductible amounts in
future years.

Future Taxable Amounts Future Deductible Amounts

represents the
increase in taxes payable in future
years as a result of taxable temporary
differences existing at the end of the
current year.
represents the
increase in taxes refundable (or saved)
in future years as a result of deductible
temporary differences existing at the
end of the current year.

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 Future Taxable Amounts

Illustration: In Chelsea’s situation, the only difference between

the book basis and tax basis of the assets and liabilities relates to
accounts receivable that arise from revenue recognized for book
purposes. Chelsea reports accounts receivable at $30,000 in the
December 31, 2017, GAAP-basis balance sheet. However, the
receivables have a zero tax basis.

Illustration 1-5
Temporary Difference, Sales Revenue

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 Future Taxable Amounts

Deferred Tax Liability

A deferred tax liability represents the increase in taxes payable
in future years as a result of taxable temporary differences
existing at the end of the current year.

ILLUSTRATION 1-4

2017 2018 2019 Total

Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

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 Deferred Tax Liability
Illustration: Because it is the first year of operations for Chelsea, there
is no deferred tax liability at the beginning of the year. Chelsea
computes the income tax expense for 2017 as follows:

ILLUSTRATION 1-9
Computation of Income Tax Expense, 2017

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 Deferred Tax Liability
ILLUSTRATION 1-4

2017 2018 2019 Total

Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Chelsea makes the following entry at the end of 2017 to record

income taxes.

Income Tax Expense 28,000

Income Taxes Payable 16,000
Deferred Tax Liability 12,000

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 Deferred Tax Liability
ILLUSTRATION 1-4

2017 2018 2019 Total

Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Chelsea makes the following entry at the end of 2018 to record

income taxes.

Income Tax Expense 28,000

Deferred Tax Liability 8,000
Income Taxes Payable 36,000

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 Deferred Tax Liability
ILLUSTRATION 1-4

2017 2018 2019 Total

Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Chelsea makes the following entry at the end of 2019 to record

income taxes.

Income Tax Expense 28,000

Deferred Tax Liability 4,000
Income Taxes Payable 32,000

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 Deferred Tax Liability

The entry to record income taxes at the end of 2019 reduces the
Deferred Tax Liability by $4,000. The Deferred Tax Liability account
appears as follows at the end of 2019.

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 Financial Statement Effects
ILLUSTRATION 1-13
Balance Sheet Presentation,
Deferred Tax Liabilities

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 Future Deductible Amounts

Deferred Tax Asset

A deferred tax asset represents the increase in taxes
refundable (or saved) in future years as a result of deductible
temporary differences existing at the end of the current year.

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 Future Deductible Amounts

During 2017 Inc. estimated its warranty costs

related to the sale of microwave to be $500,000, paid evenly over
the next two years. For book purposes, in 2017 reported
warranty expense and a related estimated liability for warranties of
$500,000 in its financial statements. For tax purposes, the warranty
tax deduction is not allowed until paid.

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 Future Deductible Amounts

Illustration: Reversal of Temporary Difference.

pays the warranty liability,

 in the December 31, 2017,

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 At December 31, 2017,Agarfa
Corporation had an estimated warranty liability of
$105,000 for accounting purposes and $0 for tax
purposes.
(The warranty costs are not deductible until paid.)
The effective tax rate is 40%.

Compute the amount Agarfa should report as a

deferred tax asset at December 31, 2017.

19-19
 Income Statement Presentation

Given the previous information related to Chelsea Inc.,

Chelsea reports its income statement as follows.

ILLUSTRATION 19-28
19-20 Income Statement Presentation of Income Tax Expense LO 2
 ACCOUNTING FOR INCOME TAXES

Specific Differences
Temporary Differences
 Taxable temporary differences - Deferred tax liability
 Deductible temporary differences - Deferred tax
Asset

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 Temporary Differences

Revenues or gains are taxable after they are recognized in financial income.

An asset (e.g., accounts receivable or investment) may be recognized for revenues or

gains that will result in taxable amounts in future years when the asset is recovered.
Examples:
1. Sales accounted for on the accrual basis for financial reporting purposes and on the
installment (cash) basis for tax purposes.
2. Contracts accounted for under the percentage-of-completion method for financial
reporting purposes and a portion of related gross profit deferred for tax purposes.
3. Investments accounted for under the equity method for financial reporting purposes
and under the cost method for tax purposes.
4. Gain on involuntary conversion of nonmonetary asset which is recognized for
financial reporting purposes but deferred for tax purposes.
5. Unrealized holding gains for financial reporting purposes (including use of the fair
value option), but deferred for tax purposes.

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 Temporary Differences

Expenses or losses are deductible after they are recognized in financial income.

A liability (or contra asset) may be recognized for expenses or losses that will result in
deductible amounts in future years when the liability is settled. Examples:
1. Product warranty liabilities.
2. Estimated liabilities related to discontinued operations or restructurings.
3. Litigation accruals.
4. Bad debt expense recognized using the allowance method for financial reporting
purposes; direct write-off method used for tax purposes.
5. Stock-based compensation expense.
6. Unrealized holding losses for financial reporting purposes (including use of the fair
value option), but deferred for tax purposes.

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 Temporary Differences

Revenues or gains are taxable before they are recognized in financial income.

A liability may be recognized for an advance payment for goods or services to

be provided in future years. For tax purposes, the advance payment is
included in taxable income upon the receipt of cash. Future sacrifices to
provide goods or services (or future refunds to those who cancel their orders)
that settle the liability will result in deductible amounts in future years.
Examples:
1. Subscriptions received in advance.
2. Advance rental receipts.
3. Sales and leasebacks for financial reporting purposes (income deferral)
but reported as sales for tax purposes.
4. Prepaid contracts and royalties received in advance.

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 Temporary Differences

Expenses or losses are deductible before they are recognized in financial income.

The cost of an asset may have been deducted for tax purposes faster than it was
expensed for financial reporting purposes. Amounts received upon future recovery of
the amount of the asset for financial reporting (through use or sale) will exceed the
remaining tax basis of the asset and thereby result in taxable amounts in future
years. Examples:
1. Depreciable property, depletable resources, and intangibles.
2. Deductible pension funding exceeding expense.
3. Prepaid expenses that are deducted on the tax return in the period paid.

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 Originating and Reversing Aspects of Temporary Differences.

 Originating temporary difference is the

initial difference between the book basis and the tax basis
of an asset or liability.

 Reversing difference occurs when eliminating

a temporary difference that originated in prior periods and
then removing the related tax effect from the deferred tax
account.

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 Permanent differences result from items that (1) enter into
pretax financial income but never into taxable income or (2)
enter into taxable income but never into pretax financial income.

Permanent differences affect only the period in which they occur.

They do not give rise to future taxable or deductible amounts.
There are no deferred tax consequences to be recognized.

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 Permanent Differences

Items are recognized for financial reporting purposes but not for tax purposes.

Examples:
1. Interest received on state and municipal obligations.
2. Expenses incurred in obtaining tax-exempt income.
3. Proceeds from life insurance carried by the company on key officers or employees.
4. Premiums paid for life insurance carried by the company on key officers or
employees (company is beneficiary).
5. Fines and expenses resulting from a violation of law.

Items are recognized for tax purposes but not for financial reporting purposes.

Examples:
1. “Percentage depletion” of natural resources in excess of their cost.
2. The deduction for dividends received from U.S. corporations, generally 70% or 80%.

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 Yeroket Company began operations in 2014 and has provided
the following information.
1. Pretax financial income for 2014 is Birr 100,000.
2. The tax rate enacted for 2014 and future years is 40%.
3. Differences between the 2014 income statement and tax return are listed
below.
a) Warranty expense accrued for financial reporting purposes amounts to
Birr 5,000. Warranty deductions per the tax return amount to Birr 2,000.
b) Gross profit on construction contracts using the percentage-of-
completion method for books amounts to Birr 92,000. Gross profit on
construction contracts for tax purposes amounts to Birr 62,000.
c) Depreciation of property, plant, and equipment for financial reporting
purposes amounts to Birr 60,000. Depreciation of these assets amounts
to Birr 80,000 for the tax return.
d) A Birr 3,500 fine paid for violation of pollution laws was deducted in
computing pretax financial income.
e) Interest revenue earned on an investment in tax-exempt municipal
bonds amounts to Birr 1,400.
4. Taxable income is expected for the next few years.
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 Instructions
1) Compute taxable income for 2014.

2) Compute the deferred taxes at December 31, 2014, that relate to the
temporary differences described above.

3) Prepare the journal entry to record income tax expense, deferred

taxes, and income taxes payable for 2014.

4) Draft the income tax expense section of the income statement,

beginning with “Income before income taxes.”

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19-31
19-32
19-33
 Havaci Company reports pretax financial income of
$80,000 for 2017. The following items cause taxable income to be
different than pretax financial income.
1. Depreciation on the tax return is greater than depreciation on
the income statement by $16,000.
2. Rent collected on the tax return is greater than rent earned on
the income statement by $27,000.
3. Fines for pollution appear as an expense of $11,000 on the
income statement.
Havaci’s tax rate is 30% for all years, and the company expects to
report taxable income in all future years. There are no deferred
taxes at the beginning of 2017.

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 Specific Differences
Illustration: Current Yr. Deferred Deferred
INCOME: 2014 Asset Liability
Financial income (GAAP) $ 80,000
Excess tax depreciation (16,000) $ 16,000
Excess rent collected 27,000 $ (27,000)
Fines (permanent) 11,000
Taxable income (IRS) 102,000 (27,000) 16,000 -
Tax rate 30% 30% 30%
Income tax $ 30,600 $ (8,100) $ 4,800 -

Income Tax Expense 27,300

Deferred Tax Asset 8,100
Deferred Tax Liability 4,800
Income Taxes Payable 30,600
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 Tax Rate Considerations
Future Tax Rates
A company must consider presently enacted changes in the tax
rate that become effective for a particular future year(s) when
determining the tax rate to apply to existing temporary
differences.

In determining the appropriate enacted tax rate for a given year,

companies must use the average tax rate.

19-36 LO 2
 Tax Rate Considerations
Revision of Future Tax Rates
When a change in the tax rate is enacted, companies should
record its effect on the existing deferred income tax accounts
immediately.

A company reports the effect as an adjustment to income tax

expense in the period of the change.

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 NET OPERATING LOSSES

Net operating loss (NOL) = tax-deductible expenses exceed

taxable revenues.

The federal tax laws permit taxpayers to use the losses of one
year to offset the profits of other years (loss carryback and
loss carryforward).

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 NET OPERATING LOSSES

Loss Carryback
 Back 2 years and forward 20 years

 Losses must be applied to earliest year first

ILLUSTRATION 19-36
Loss Carryback Procedure

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 NET OPERATING LOSSES

Loss Carryforward
 May elect to forgo loss carryback and

 Carryforward losses 20 years

ILLUSTRATION 19-37
Loss Carryforward Procedure

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 NET OPERATING LOSSES

Illustration: Conlin Corporation had the following tax information.

Taxable Tax Taxes

Year Income Rate Paid
2015 $ 300,000 35% $ 105,000
2016 325,000 30% 97,500
2017 400,000 30% 120,000

In 2018 Conlin suffered a net operating loss of $480,000, which it

elected to carry back. The 2018 enacted tax rate is 29%.
Prepare Conlin’s entry to record the effect of the loss carryback.

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 NET OPERATING LOSSES
Illustration: 2015 2016 2017 2018
Financial income $ 300,000 $ 325,000 $ 400,000
Difference
Taxable income (loss) 300,000 325,000 400,000 (480,000)
Rate 35% 30% 30% 29%
Income tax $ 105,000 $ 97,500 $ 120,000

NOL Schedule
Taxable income $ 300,000 $ 325,000 $ 400,000 (480,000)
Carryback (325,000) (155,000) 480,000
Taxable income 300,000 - 245,000 -
Rate 35% 30% 30% 29%
Income tax (revised) $ 105,000 $ - $ 73,500 -

Refund $ 97,500 $ 46,500 $144,000

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 NET OPERATING LOSSES
Illustration: 2015 2016 2017 2018
NOL Schedule
Taxable income $ 300,000 $ 325,000 $ 400,000 (480,000)
Carryback (325,000) (155,000) 480,000
Taxable income 300,000 - 245,000 -
Rate 35% 30% 30% 29%
Income tax (revised) $ 105,000 $ - $ 73,500 -

Refund $ 97,500 $ 46,500

Journal Entry for 2018

Income Tax Refund Receivable 144,000

Benefit Due to Loss Carryback 144,000

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 NET OPERATING LOSSES

Illustration: Rode Inc. incurred a net operating loss of $500,000

in 2017. Combined income for 2015 and 2016 was $350,000. The
tax rate for all years is 40%. Rode elects the carryback option.
Assume that it is more likely than not that the entire net operating
loss carryforward will not be realized in future years. Prepare all
the journal entries necessary at the end of 2017.

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 NET OPERATING LOSSES

Journal Entries for 2017

Income Tax Refund Receivable 140,000

Benefit Due to Loss Carryback 140,000

Deferred Tax Asset 60,000

Benefit Due to Loss Carryforward 60,000

Benefit Due to Loss Carryforward 60,000

Allowance for Deferred Tax Asset 60,000

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 FINANCIAL STATEMENT PRESENTATION

Balance Sheet
Income taxes payable and income tax refund receivable are
reported as a current liability and current asset, respectively, on
the balance sheet.
Companies should classify deferred tax accounts as a net
noncurrent amount on the balance sheet.

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 Balance Sheet

To illustrate, assume that Scott Company has four deferred tax

items at December 31, 2017, as shown in the following table.

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 FINANCIAL STATEMENT PRESENTATION

Income Statement
Companies are required to report income before income taxes
and income tax expense on the income statement. PepsiCo
reported the following amounts related to tax expense.

Illustration 19-47
Tax Expense Disclosures

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 CHAPTER TWO
SHARE BASED
COMPENSATION

19-49