1. Accounting for Income Taxes
Chapter 16
Accounting for Income Taxes

2. Deferred Tax Assets/Liabilities
The Internal Revenue Code is the set of rules for preparing tax returns.
GAAP is the set of rules for preparing financial statements.
Results in . . .
Results in . . .
Usually. . .
Financial statement income tax expense.
IRS income taxes payable.
The difference between tax expense and tax payable is referred to as deferred taxes.

3. Deferred Tax Assets/Liabilities Example
Examine the December 31, 2003, information for X-Off Inc.
X-Off uses straight-line depreciation for financial reporting and accelerated depreciation for income tax reporting.
X-Off’s tax rate is 30%.

4. Deferred Tax Assets/Liabilities Example
Compute X-Off’s income tax expense and income tax payable.

5. Deferred Tax Assets/Liabilities Example
Compute X-Off’s income tax expense and income tax payable.
The income tax amount computed based on financial statement income is income tax expense for the period.

6. Deferred Tax Assets/Liabilities Example
Compute X-Off’s income tax expense and income tax payable.
Next, compute income taxes for the tax return.

7. Deferred Tax Assets/Liabilities Example
Compute X-Off’s income tax expense and income tax payable.
Income taxes based on tax return income are the taxes payable for the period.

8. Deferred Tax Assets/Liabilities Example
Compute X-Off’s income tax expense and income tax payable.
The deferred tax for the period of $36,000 is the difference between income tax expense of $45,000 and income tax payable of $9,000.

9. Deferred Tax Assets/Liabilities Example
The entry to record the deferred taxes would appear as follows:

10. Temporary Differences
Often, the difference between pretax accounting income and taxable income results from items entering the income computations at different times.
These are called temporary differences. 8 8 8

11. Temporary Differences
Temporary differences will reverse out in one or more future periods.
Financial Income > Taxable Income
Future Taxable Amounts
Deferred Tax Liability
Financial Income < Taxable Income
Future Deductible Amounts
Deferred Tax Asset 8 8 8

12. The temporary differences in the yellow boxes create deferred tax assets because they result in deductible amounts in the future. 16 16 16

13. The temporary differences in the gray boxes create deferred tax liabilities because they result in taxable amounts in the future. 16 16 16

14. Deferred Tax Liabilities
In 2001, Baxter records $100,000 on its books resulting from revenue earned. The revenue will be taxed as the cash is collected in 2002 and Baxter expects to collect $70,000 in 2002 and the remaining $30,000 in 2003.
The company is subject to a 32% tax rate.
There are no other temporary differences.
Let’s look at Baxter’s 2001 tax entry.

15. Deferred Tax Liabilities
Income tax expense = $300,000 × 32% = $96,000
Income tax payable = $200,000 × 32% = $64,000

16. Deferred Tax Liabilities
The Deferred Tax Liability represents the future taxes Baxter will pay in 2002 and 2003.

17. Deferred Tax Liabilities
Recall this information for Baxter for 2002.
Income tax expense = $200,000 × 32% = $64,000
Income tax payable = $270,000 × 32% = $86,400

18. Deferred Tax Liabilities
Originating difference
Reversing difference

19. Deferred Tax Liabilities
Future Taxable Amount Schedule
The Deferred Tax Liability represents the future taxes Baxter will pay in 2003.

20. Deferred Tax Liabilities
Recall the information for Baxter, Inc. for 2003:
Income tax expense = $200,000 × 32% = $64,000
Income tax payable = $230,000 × 32% = $73,600

21. Deferred Tax Liabilities
Reversing difference

22. The entire $150,000 will be taxed in 2001.
Deferred Tax Assets
Health Magazine received $150,000 of subscriptions in advance during 2001.
Subscription revenue will be earned equally in 2002, 2003 and 2004 for financial accounting purposes.
The entire $150,000 will be taxed in 2001.
There is additional income of $500,000 in each year. The company is subject to a 30% tax rate in each year.

23. Deferred Tax Assets Now, let’s record the income tax entry for 2001.
This is the computation for the Deferred Tax Asset.
Now, let’s record the income tax entry for 2001.

24. Deferred Tax Assets Income tax expense = $500,000 × 30% = $150,000
Income tax payable = $650,000 × 30% = $195,000

25. Deferred Tax Assets
After posting this entry, the Deferred Tax Asset account will have a balance of $45,000.

26. Deferred Tax Assets
In 2002, Health Magazine earns $50,000 for financial reporting purposes.
Income tax expense = $550,000 × 30% = $165,000
Income tax payable = $500,000 × 30% = $150,000
In 2002, the balance in the Deferred Tax Asset should decrease to $30,000.
Let’s see the income tax entry for 2002.

27. Originating difference
Deferred Tax Assets
Income tax expense = $550,000 × 30% = $165,000
Income tax payable = $500,000 × 30% = $150,000
Originating difference
Reversing difference

28. Deferred Tax Assets
This is the computation for the Deferred Tax Asset.
Can you finish Health Magazine’s income tax entries for 2003 and 2004?

29. This would be the entry for 2003 and 2004.
Deferred Tax Assets
This would be the entry for 2003 and 2004.
At the end of 2004, the balance in the Deferred Tax Asset would be zero.

30. Sharpen Your Pencil . . . There Is Still More!!44 43 43

31. Valuation Allowance
A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized.
The deferred tax asset is then reported at its net realizable value. 55 54 54

32. Non-Temporary Differences
Created when an income item is included in taxable income or accounting income but will never be included in the computation of the other.
Example: Interest on tax-free municipal bonds is included in accounting income but is excluded from taxable income 6 6 6

33. Non-Temporary Differences
Also called permanent differences.
Disregarded when determining both taxes payable and the deferred tax asset or liability. 6 6 6

34. Tax Rate Considerations
Deferred tax assets and liabilities should be determined using the future tax rates, if known.
The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs.
IRC 45 44 44

35. Net Operating Losses (NOL)
Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or subsequent periods.
When used to offset earlier taxable income:
Called: operating loss carryback.
Result in a tax refund.
When used to offset future taxable income:
Called: operating loss carryforward.
Result in reduced tax payable. 45 44 44

36. Carryback and Carryforward
Carryback Period +3 +2 +1
. . .
+20 +4 +5
Carryforward Period -1 -2
Current Year
The NOL may first be applied against taxable income from two previous years.
Unused NOL may be carried forward for 20 years. 48 47 47

37. Net Operating Losses (NOL)
In 2003 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a 30% tax rate. In 2001, Garson reported taxable income of $20,000, and in 2002, taxable income was $10,000. The company elects to carryback the NOL. 50 49 49

38. Net Operating Losses (NOL)
In 2003, no taxes are paid and Garson claims a tax refund of $9,000 for taxes paid in 2001 and 2002.

39. Net Operating Losses (NOL)
Garson’s Income Statement for 2003 looks like this . . .
Now let’s look at the treatment of the remaining NOL of $55,000 ($85,000 - $20,000 - $10,000).

40. Net Operating Losses (NOL)
Garson prepares this estimate of taxable income based upon the best available evidence at 12/31/03.
The NOL carryforward will provide a tax benefit of $17,000.

41. Net Operating Losses (NOL)
It is likely that Garson will receive the benefits of the NOL in future periods. As a result, the following journal entry is made . . .
Garson’s income statement for 2003 will look like this . . .

42. Net Operating Losses (NOL)
The deferred tax asset account created by the benefit of the carryforward will be used to lower income taxes payable in future years. 51 50 50

43. Balance Sheet Classification
Disclose the following:
Total of all deferred tax liabilities and assets.
Total valuation allowance recognized.
Net change in valuation account.
Approximate tax effect of each type of temporary difference (and carryforward).
Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability. 55 54 54

44. Additional Disclosures
Current portion of tax expense (benefit)
Deferred portion of tax expense (benefit), with separate disclosure for
Portion that does not include the effect of the following separately disclosed amounts.
Operating loss carryforwards.
Adjustments due to changes in tax laws or rates.
Adjustments to the beginning-of-the-year valuation allowance due to revised estimates.
Investment tax credits. 55 54 54

45. Intraperiod Tax Allocation
SFAS No. 109 requires intraperiod tax allocation for:
Income from continuing operations.
Discontinued operations.
Extraordinary items.
Changes in accounting principle.
Prior period adjustments (to the beginning retained earnings). 59 58 58

46. End of Chapter 16