1. Accounting Clinic VI

2. Prepared by: Nir Yehuda Stephen H. Penman – Columbia University
Accounting Clinic VI
Accounting for
Income Taxes
Prepared by: Nir Yehuda
With contributions by
Stephen H. Penman – Columbia University

3. Deferred Taxes: Basics
Deferred taxes arise when income tax expense differs from income tax liability
The income tax liability is based on income determined under provisions of the United States Internal Revenue Code and foreign, state, and other taxes (including franchise taxes) based on income.
The tax expense is the amount of income taxes (whether or not currently payable or refundable) allocable to a period in the determination of net income.
Some of these differences are temporary and some are permanent

4. Why do we need Deferred Taxes?
Main issue: the need to match tax expense to related accounting income so appropriate after-tax income is reported, independent of when taxes on that income is assessed by tax authorities.
Advantages of deferred taxes:
Smoothing of earnings
Better relationship between earnings and income tax expense
effective tax rate reflects statutory rate

5. Temporary and Permanent Differences
Temporary difference.
Differences between the taxable amount of a revenue or expense and its reported amount in the financial statements that result in taxable or deductible amounts in future years when the revenue or expense enters the tax return.
Permanent differences.
Permanent differences arise from statutory provisions under which specified revenues are exempt from taxation and specified expenses are not allowable as deductions in determining taxable income.
Other permanent differences arise from items entering into the determination of taxable income which are not components of pretax accounting income in any period.

6. Examples of Permanent Differences
Interest received on municipal obligations
premiums paid on officers' life insurance.
Fines and other expenses that result from a violation of law.
Deduction for dividend received from U.S. corporations.
Percentage depletion of natural resources in excess of their cost.

7. Examples of Temporary differences
Revenues or gains that are taxable after they are recognized in financial income. An asset (for example, a receivable from an installment sale) may be recognized for revenues or gains that will result in future taxable amounts when the asset is recovered.
Expenses or losses that are deductible after they are recognized in financial income. A liability (for example, a product warranty liability) may be recognized for expenses or losses that will result in future tax deductible amounts when the liability is settled.

8. Examples of Temporary differences
Revenues or gains that are taxable before they are recognized in financial income. A liability (for example, subscriptions received in advance) 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) will result in future tax deductible amounts when the liability is settled.

9. Examples of Temporary differences
Expenses or losses that are deductible before they are recognized in financial income. The cost of an asset (for example, depreciable personal property) may have been deducted for tax purposes faster than it was depreciated for financial reporting. Amounts received upon future recovery of the amount of the asset for financial reporting will exceed the remaining tax basis of the asset, and the excess will be taxable when the asset is recovered.
A reduction in the tax basis of depreciable assets because of tax credits. Amounts received upon future recovery of the amount of the asset for financial reporting will exceed the remaining tax basis of the asset, and the excess will be taxable when the asset is recovered.

10. Deferred Tax Liability
A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years.
For example, a temporary difference is created between the reported amount and the tax basis of an installment sale receivable if, for tax purposes, some or all of the gain on the installment sale will be included in the determination of taxable income in future years. Because amounts received upon recovery of that receivable will be taxable, a deferred tax liability is recognized in the current year for the related taxes payable in future years.

11. Deferred Tax Asset
A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards.
For example, a temporary difference is created between the reported amount and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated expenses are not deductible until a future year. Settlement of that liability will result in tax deductions in future years, and a deferred tax asset is recognized in the current year for the reduction in taxes payable in future years.

12. Temporary Differences Effect

13. Basic Journal Entry to Record Deferred Taxes
Tax Liability
Income Tax Expense xxx Def.Tax Liability xxx Taxes Payable xxx
Tax Asset
Income Tax Expense xxx Def. Tax Asset xxx Taxes Payable xxx

14. Recording a Valuation Allowance for Doubtful Deferred Tax Assets
A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.
The net deferred tax asset should equal that portion of the deferred tax asset which, based on the current available evidence, will not be realized.
Journal entry: Income Tax Expense xxx Allowance to Reduce Deferred Tax Asset to Expected Realizable Value xxx

15. Example – Deferred Tax Liability - Depreciation
Bryant Corporation purchased a new machine for $100,000 on January 1, 2004.
The machine has a four-year estimated service life and no salvage value.
Bryant’s pretax income for each year is 200,000 before depreciation and taxes.

16. Bryant Corp. uses straight-line depreciation on its books and MACRS for tax reporting.
For tax purposes the machine is also depreciated over 4 years using MACRS (an accelerated depreciation method).
The depreciation percentages for each of the years are 33%, 44%, 15% and 8%.
Assume a 40% tax rate.

17. Compute financial (book) income after depreciation but before taxes
Compute financial (book) income after depreciation but before taxes. What is income tax expense?
Compute taxable income. What is income tax payable?
Give the journal entries to record taxes.
Give the balance of the deferred tax liability at the end of each of the years.

18. Solution A. Financial (book) income 2004 2005 2006 2007
Income before Depreciation
Depreciation Expense
($100,000/4)
Income after depreciation but before taxes
Income Tax Expense (40%)
$200,000
(25,000)
$175,000
$70,000

19. B. 2004 2005 2006 2007 Pre-Tax Income before Depreciation $200,000
Depreciation Deduction:
(33,000)
(44,000)
(15,000)
(8,000)
Taxable Income
$167,000
$156,000
$185,000
$192,000
Income Taxable Payable (40%)
$66,800
$62,400
$74,000
$76,800

20. C. Journal entries:
2004
Income Tax Expense
Tax Payable
Deferred Tax Liability
70,000
66,800
3,200
2005
62,400
7,600

21. 2006
Income Tax Expense
70,000
Deferred Tax Liability
Tax Payable
4,000
74,000
2007
6,800
76,800

22. D. The deferred tax liability account
Dr.
Cr.
3,200
2004 entry
12/31/2004
7,600
2005 entry
10,800
12/31/2005
4,000
2006 entry
6,800
12/31/2006
2007 entry
12/31/2007
The liability has reversed itself

23. Example - Deferred Tax Liability – Advances from Customers
Miller Co. received $30,000 of subscriptions in advance at the end of 2004.
Subscription revenue will be equally recognized in 2005, 2006, and 2007, for financial accounting purposes but all of the $30,000 will be recognized in 2004 for tax purposes.
Miller’s pretax income for each year is $100,000 before taxes.
Assume a 40% tax rate.

24. Compute Financial (book) income including subscription revenue but excluding taxes. What is income tax expense?
Compute taxable income. What is income tax payable?
Give the journal entries to record taxes.
Give the balance of the deferred tax asset at the end of each of the years.

25. For this requirement only, assume that as a result of examining available evidence in 2004, it is more likely than not that $10,000 of the deferred tax asset will not be realized. Give the journal entry to record this reduction.

26. Solution A. 2004 2005 2006 2007 Financial (book) income
Income before subscription
100,000
Subscription revenue received
in 2004
10,000
Income before taxes
110,000
Income tax expense (40%)
40,000
44,000

27. 2004
2005
2006
2007
Pretax income
100,000
Subscription received in 2004
30,000 -
Taxable Income
130,000
Taxes Payable (40%)
52,000
40,000

28. C. Journal entries
2004
Income tax expense 40,000
Deferred tax asset 12,000
Tax payable 52,000
Income tax expense 44,000
Deferred tax asset 4,000
Tax payable 40,000

29. D. The deferred tax asset account
Db.
Cr.
12,000
2004 entry
12/31/2004
4,000
2005 entry
8,000
12/31/2005
2006 entry
12/31/2006
2007 entry
12/31/2007
The asset has reversed itself.

30. To record the reduction in the deferred tax asset
Income Tax Expense 10,000
Allowance to Reduce Deferred Tax Asset
To Expected Realizable Value 10,000
To record the reduction in the deferred tax asset

31. Example - Permanent Differences Calculation
Hunter Corporation reports the following information for 2004:
Financial (Book) Income before Income Taxes $548,000
Income Taxes Payable (for 2004) ,500
Income Tax Expense ,000
Hunter Corp. has both temporary and permanent differences between book income and taxable income.
The temporary difference results from depreciation.
The permanent difference results from a fine that the company has to pay (but can not be deducted on its tax return).

32. What is the amount of the permanent difference for the year?
The tax rate is 35%

33. Solution Step 1: Find the change in the deferred tax liability
Income Tax Expense (Book) $210,000
Income Taxes Payable ,500
∆ Deferred Tax Liability ,500
Step 2: Find the temporary difference
∆ Deferred Tax Liability/ $52,500/0.35=
150,000
Step 3: Find taxable income
Income Taxes Payable (from current year)/0.35 $157,500/0.35=
450,000

34. Solution (Cont.) Step 4: Find the permanent difference
Taxable Income (IRS) $450,000
Temporary Differences ,000
Financial (Book) Income before Taxes Excluding
Permanent Differences ,000
Permanent Differences (P.N) ,000
Financial (Book) Income before Taxes ,000

35. Financial Statement Presentation
On the balance sheet, an enterprise should separate deferred tax liabilities and assets into a current amount and a noncurrent amount.
Deferred tax liabilities and assets should be classified as current or noncurrent based on the classification of the related asset or liability for financial reporting.

36. Financial Statement Presentation
A deferred tax liability or asset that is not related to an asset or liability for financial reporting, including deferred tax assets related to carryforwards, should be classified according to the expected reversal date of the temporary difference.
The valuation allowance for a particular tax jurisdiction should be allocated between current and noncurrent deferred tax assets for that tax jurisdiction on a pro rata basis.