Intermediate Financial Accounting II

Chapter 19

Accounting for Income Taxes

Overview of Deferred Tax Theory

• Pretax financial income and taxable income are usually different amounts

• due to differences in measurement of income and valuation of assets and liabilities between GAAP and tax rules - see later discussion of permanent and temporarytax differences

• result is that Income tax expense and income tax payable are usually different amounts also

• Income tax payable = taxes actually owed (income tax rate * taxable income)

• Income tax expense = income tax payable +/- change in the current period of amounts payable for future taxes or future tax benefits receivable

• Deferred tax liability or asset = difference between income tax payable and income tax expense

• deferred tax asset - represents amount of taxes that an entity has prepaid

• deferred tax liability - represents amount of taxes that an entity will pay in the future

Permanent Differences

• occurs when a revenue or expense is included only in pretax financial income or taxable income, but never in both

• does not result in deferred taxes because no future tax consequences are created

• only affects current reconciliation of book income to taxable income

• examples of permanent differences

• state and municipal bond interest income

• life insurance premium expense or premiums when corporation is the beneficiary

• payments of penalties or fines

• dividend received deduction

Temporary Differences

• occurs when there is a difference between the book and tax basis of an asset or liability that will result in taxable or deductible amounts in future years

• working definition - occurs when a revenue or expense item is

• included in both financial and taxable income and

• is recognized in one period for financial accounting and another for income tax purposes

• When the temporary difference originates, it will be recorded as either a deferred tax liability or deferred tax asset. as the difference reverses the deferred tax amount is removed from the balance sheet.

• Examples of Temporary Differences

• estimated warranty liability - expense is recognized for fs when liability is incurred. deduction for tax is recognized when the work is performed

• unearned rent revenue - liability is recognized when amounts are received for fs, revenue when earned. Tax revenue is recognized when cash is received

• depreciation - tax depreciation is usually accelerated over fs depreciation

Deferred Tax Assets

• Deferred Tax Assets - represents taxes that will be saved in the future when taxable income is lower than book income. Usually occurs because taxable deductions will be more than book expenses in the future.

• ex: warranty liability - accrued liability is deducted from fs income currently, but is not deductible from taxable income until paid

• Deferred Tax Assets - created when

• book basis of assets < Tax basis of assets

• ex: Bad debt expense - for fs purposes, the amount of uncollectible accounts is estimated each year, reducing accounts receivable. For tax purposes, uncollectible accounts are expensed as they become uncollectible.

• book basis of liabilities > Tax basis of liabilities

• ex: warranty liability - in current year, liability is accrued for fs purposes, but no liability is recognized for tax purposes until paid, thus, book basis of liability > tax basis of liability

• Deferred Tax Benefit

• not an account name

• this is a component of Income tax expense that represents any increases in the deferred tax asset account during the year

• Deferred Tax Liability - represents taxes that will be paid in the future when taxable income is higher because either

• taxable deductions will be less than book expenses in the future

• ex: MACRS depreciation is used for tax, and straight-line is used for financial income

• taxable revenue will be more than book revenue in the future

• ex: installment sales recognized as revenue for book purposes, but for taxes, revenue is recognized as payments are received.

• Deferred Tax Liability - created when

• Book basis of assets > Tax basis of assets

• ex: net asset value (asset - acc dep) on the books is higher when MACRS is used for tax and straight-line is used for financial income

• Book basis of liabilities < Tax basis of liabilities

• Deferred Tax Expense

• not an account name

• this is a component of income tax expense - which represents the increase in the deferred tax liability during the current year

Other Items

• Deferred Tax Asset - Valuation Account - used to recognize a reduction in the carrying amount of a deferred tax asset when it is unlikely that a portion of the asset will not be realized

• Future Tax rates - only enacted (not estimated) future tax rates can be used to calculate future tax consequences associated with timing differences - if there are no enacted future rates, use current tax rate

• Net Operating Losses - may be carried back 2 years and carried forward 20. NOLs are offset against earnings during the carryback and carryforward period to received refunds or reduce taxes

Financial Statement Presentation

• Income Statement - continuing operations - for each year presented, the following should be disclosed on the face of the income statement

• current tax expense or benefit

• deferred tax expense or benefit

• benefits of NOL carryforwards

• Income Statement - other components - if net income includes items such as discontinued operations, extraordinary items and accounting changes, the amount of income tax expense associated with these items must be disclosed (usually in parentheses next to the item)

• Balance Sheet

• all deferred tax liabilities and assets are classified as either current of noncurrent based on the classification of the related asset or liability.

• if the deferred tax liability or asset are not related to an asset or liability account, the classification is based on the timing of its expected reversal

• once classified, net all current amounts and noncurrent amounts to get one current amount and one noncurrent amount

• valuation accounts for deferred tax assets are deducted from the deferred tax asset account

Back to Intermediate 2 Daily Schedule