1. Corporations: Paid-in Capital and the Balance Sheet
Chapter 12
Chapter 12 explains corporations, paid-in capital and the balance sheet. 1 1 1 1 1

2. Advantages and Disadvantages of Corporations
Corporations can raise more money
Corporations have continuous life
Ownership transfer is easy
No mutual agency
Stockholders have limited liability
DISADVANTAGES
Ownership and management separated.
Double taxation
Government regulation is expensive
Start-up costs are higher
Several advantages exist in the corporate form of business. A corporation has the ability to raise more money than partnerships or sole proprietors. In addition, a corporation has a continuous life, and there is ease in transferring ownership. No mutual agency exists among the shareholders, and they have limited liability.
A disadvantage of a corporation is the separation of ownership and management. Also, a corporation is taxed twice–once at the corporate level on it earnings and again at the shareholder level on any dividends paid. Further, corporations are subject to government regulation and start-up cost are higher.

3. Corporate Organization
Authorization–State’s permission to operate
Authorized stock–How many shares of a class of stock a corporation may issue
Capital stock–Represents ownership of the corporation's capital
Stock certificate–Paper evidencing ownership in a corporation
Company name
Stockholder name
Number of shares owned
Outstanding stock–Stock held by stockholders
The state authorizes, in the bylaws of a corporation, how many shares of a stock class the corporation may issue. This is called authorization of stock. A corporation issues stock certificates to the stockholders when they buy the stock. The stock certificate represents the individual’s ownership of the corporation’s capital, so it is called capital stock. The basic unit of stock is a share. A corporation may issue a stock certificate for any number of shares. Stock that is held by the stockholders is said to be outstanding. The outstanding stock of a corporation represents 100% of its ownership.

4. Stock
A corporation may issue a physical stock certificate for any number of shares. Today, many corporations issue the stocks electronically, rather than “printing” a paper certificate. The certificate shows the company name, stockholder name and the number of shares owned by the stockholder.

5. Stockholders’ Equity Basics
Paid-in capital (Contributed capital)
Retained earnings
Amounts received from stockholders
Common stock is main source
Externally generated
Resulting from transactions with outsiders
Earned by profitable operations
Internally generated
Results from internal corporate decisions to retain net income for use in the company
The two basic sources are as follows:
● Paid-in capital (also called contributed capital), which represents amounts received from the stockholders. Common stock is the main source of paid-in capital. Paid-in capital is externally generated capital and results from transactions with outsiders.
● Retained earnings, which is capital earned by profitable operations. Retained earnings is internally generated capital because it results from corporate decisions to retain net income to use in future operations or for expansion.
The stockholders’ equity section of the balance sheet includes information on Paid-in capital and Retained earnings. Paid-in capital lists the various stocks authorized, the amount outstanding and the total capital raised by selling the stock. It also list the earnings that have been retained by the company and not paid out to shareholders in the form of dividends.

6. Classes of Stock Common stock Preferred stock Four basic rights
Vote—voting on corporate matters
Dividends—receive a proportionate part of dividend declared
Liquidation—receive a proportionate part of assets remaining
Preemption—maintain their proportionate ownership
Certain advantages over common stock
Receive dividends before common
Fixed dividend amount
Upon liquidation, receive assets before common
Also have basic rights of common stockholders unless withheld
Corporations can issue different classes of stock. The stock of a corporation may be either:
• common or preferred
• par or no-par
Every corporation issues common stock, which represents the basic ownership of the corporation. The real “owners” of the corporation are the common stockholders. Some companies issue Class A common stock, which carries the right to vote. They may also issue Class B common stock, which may be non-voting. There must be at least one voting “class” of stock. However, there is no limit as to the number or types of classes of stock that a corporation may issue. Each class of stock has a separate account.
Preferred stock gives its owners certain advantages over common. Most notably, preferred stockholders receive dividends before the common stockholders. They also receive assets before common stockholders if the corporation liquidates. Corporations pay a fixed dividend on preferred stock, which is printed on the face of the preferred stock certificate. Investors usually buy preferred stock to earn those fixed dividends. With these advantages, preferred stockholders take less investment risk than common stockholders. Owners of preferred stock also have the four basic stockholder rights, unless a right is withheld. The right to vote, however, is usually withheld from preferred stock. Companies may issue different series of preferred stock (Series A and Series B, for example). Each series is recorded in a separate account.

7. Par, Stated and No-par Par value No-par
Arbitrary amount assigned to a share of stock
Set when the corporate charter is filed
Usually set low as to avoid legal difficulties
No arbitrary amount assigned
Could have a stated value
Stated value treated as par
Stock may carry a par value or it may be no-par stock. Par value is an arbitrary amount assigned by a company to a share of its stock. Most companies set par value low to avoid issuing their stock below par. Par value of preferred stock may be higher per share than common stock par values. Par value is arbitrary and is assigned when the organizers file the corporate charter with the state. There is no real “reason” for why par values vary. It is a choice made by the organizers of the corporation.
Companies maintain some minimum amount of stockholders’ equity for the protection of creditors (often through retaining earnings), and this minimum represents the corporation’s legal capital. However, the concepts of par and legal capital have been virtually eliminated entirely by the Model Business Corporation Act. Accountants still use the outdated concepts of par and legal capital because many corporations’ stocks were issued prior to the adoption of the provisions of the Model Business Corporation Act, which is why we are still guided by these terms in our recording of stock issuances.
No-par stock does not have par value. But some no-par stock has a stated value, an arbitrary amount similar to par-value. Usually the state the company incorporates in will determine whether a stock may be par or stated value stock. As far as accounting for it goes, par is treated the same as stated value.

8. Accounting for the Issuance of Stock
Sell directly to stockholders
Use an underwriter/brokerage firm
Buys unsold stock
Issue price–price received for issuing stock
Usually exceeds par value
Stock exchange– here public company stock is traded
NYSE–New York Stock Exchange
NASDQ
A company can sell its stock directly to stockholders or it can use the services of an underwriter, such as the brokerage firms Merrill Lynch and Morgan Stanley. An underwriter usually agrees to buy all the stock it cannot sell to its clients. The price that the corporation receives from issuing stock is called the issue price. Usually, the issue price exceeds par value because par value is normally set quite low.
Stocks of public companies are bought and sold on a stock exchange, such as the New York Stock Exchange (NYSE). The Wall Street Journal is the most popular medium for advertising initial public offerings of stock. These ads are called tombstones due to their heavy black borders and heavy black print.

9. Accounting for the Issuance of Stock
Issuing 1,000,000 common stock ($1 par) at par
Suppose Smart Touch’s common stock carried a par value of $1 per share. The stock issuance entry of one million shares at par value on January 1 would include a debit to Cash for the $1,000,000 received and a credit to Common stock for the par value of the stock issued.
Most corporations set par value low and issue common stock for a price above par. The amount above par is called a premium. A premium on the sale of stock is not a gain, income, or profit for the corporation because the company is dealing with its own stock. A company can have no income statement reported profit or loss when buying or selling its own stocks. So, the premium is another type of paid-in capital account called Paid-in capital in excess of par. It is also called Additional paid-in capital.
With a par value of $1, Smart Touch creates an entry to record the issuance of its stock at $20 per share on January 2.

10. Accounting for the Issuance of Stock
Issuing common stock($1 par) above par
Amount received above par is called a premium
Not a gain; called additional paid-in capital
Another account is created for the premium amount

11. Stockholders’ Equity Presentation
Total Paid-in capital is the sum of Common stock plus Paid-in capital in excess of par
A company would report stockholders’ equity on its balance sheet after the January 1 and January 2 stock issuance. Paid-in capital in excess of par is the total amount received from issuing the common stock minus its par value.
The balance of the Common stock account is calculated

12. Accounting for Stock Issuances
No-par stock
No Paid-in capital in excess of par account needed
Full amount received is credited to Common stock
Balance sheet shows only the Common stock account
When a company issues no-par stock, it debits the asset received and credits the stock account. For no-par stock, there can be no paid-in capital in excess of par, because there isn’t any par to be in excess of. Regardless of the stock’s price, Cash is debited and Common stock is credited for the cash received.

13. Accounting for Stock Issuances
Stated value stock
Similar to accounting for par value stock
Amount above stated value is credited to Paid-in capital in excess of stated value
Accounting for no-par stock with a stated value is almost identical to accounting for par-value stock. The only difference is that no-par stock with a stated value uses an account titled Paid-in capital in excess of stated value to record amounts received above the stated value.
A corporation may issue stock for assets other than cash. It records the assets received at their current market value and credits the stock accounts accordingly. The prior book value of asset received is irrelevant.
Stated value
Stated value

14. Accounting for Stock Issuances
Issuing stock for assets other than cash
Asset is debited for its fair value
Building is debited instead of cash

15. Accounting for Stock Issuances
Issuing preferred stock
Similar to issuing common stock, except Preferred stock is credited at par value
Accounting for preferred stock follows the pattern illustrated for issuing common stock. Most preferred stock is issued at par value. Therefore, Paid-in capital in excess of par for preferred stock is rare.

16. Accounting for Stock Issuances
Preferred stock usually is not issued above par

17. Stockholders’ Equity on the Balance Sheet
Equity accounts are listed in the following order on the balance sheet: Preferred stock , Common stock, Retained earnings
Observe the order of the equity accounts:
• Preferred stock
• Paid-in capital in excess of par—preferred (contributed by the preferred stockholders)
• Common stock at par value
• Paid-in capital in excess of par—common (contributed by the common stockholders)
• Retained earnings (after the Paid-in capital accounts)

18. S12-5: Issuing stock and interpreting stockholders’ equity
Scifilink.com issued stock beginning in 2012 and reported the following on its balance sheet at December 31, 2012:
Common stock, $ 2.00 par value
Authorized: 6,000 shares
Issued: 4,000 shares $ 8,000
Paid-in capital in excess of par ,000
Retained earnings ,500
Requirement:
Journalize the company’s issuance of the stock for cash.
Short Exercise demonstrates the accounting of stock issuances.

19. S12-5: Issuing stock and interpreting stockholders’ equity
Common stock, $ 2.00 par value
Authorized: 6,000 shares Issued: 4,000 shares $ 8,000 Paid-in capital in excess of par ,000
Retained earnings ,500
Journal Entry
DATE
ACCOUNTS
DEBIT
CREDIT
Dec 31
Cash
12,000
Common stock
8,000
Paid in capital in excess of par
4,000
Total Paid-in capital is the sum of the Common stock, Preferred stock, and the Paid-in capital in excess of par accounts.

20. 1. Journalize the transactions. Explanations are not required.
E12-15: Issuing stock
Susie Systems completed the following stock issuance transactions:
May 19 Issued 2,000 shares of $1 par common stock for cash of $9.50 per share.
June 3 Sold 300 shares of $3, no-par preferred stock for $15,000 cash.
June 11 Received equipment with market value of $78,000. Issued 3,000 shares of the $1 par common stock in exchange.
Requirements:
1. Journalize the transactions. Explanations are not required.
2. How much paid-in capital did these transactions generate for Susie Systems?
Exercise focuses on issuing stock.

21. Susie Systems completed the following stock issuance transactions:
E12-15: Issuing stock
Susie Systems completed the following stock issuance transactions:
May 19 Issued 2,000 shares of $1 par common stock for cash of $9.50 per share.
Journal Entry
DATE
ACCOUNTS
DEBIT
CREDIT
May 19
Cash
19,000
Common stock
2,000
Paid in capital in excess of par
17,000
The exercise continues on this slide.

22. Susie Systems completed the following stock issuance transactions:
E12-15: Issuing stock
Susie Systems completed the following stock issuance transactions:
June 3 Sold 300 shares of $3, no-par preferred stock for $15,000 cash.
Journal Entry
DATE
ACCOUNTS
DEBIT
CREDIT
Jun 3
Cash
15,000
Preferred stock
The exercise continues on this slide.

23. Susie Systems completed the following stock issuance transactions:
E12-15 : Issuing stock
Susie Systems completed the following stock issuance transactions:
June 11 Received equipment with market value of $78,000. Issued 3,000 shares of the $1 par common stock in exchange.
Journal Entry
DATE
ACCOUNTS
DEBIT
CREDIT
Jun 11
Equipment
78,000
Common stock
3,000
Paid in capital in excess of par
75,000
The exercise continues.

24. E12-15: Issuing stock
2. How much paid-in capital did these transactions generate for Susie Systems?
19,000 issue of CS for Cash +
15,000 issue of PS for Cash +
78,000 stock issued for equipment with market value of 78,000
$112,000
The exercise concludes on this slide.

25. Retained Earnings Closing entries Step 1 – Close Revenues
Step 2 – Close Expenses
Recall that corporations close their revenues and expenses into the Income summary account. Then, they close net income from the Income summary account to the Retained earnings account. Now, the Income summary holds revenues, expenses, and net income.

26. Retained Earnings Closing entries Step 3 – Close Income summary
Finally, the Income summary’s balance is closed to Retained earnings.

27. Deficit Balance A loss causes Retained earnings to decrease
A debit balance in Retained earnings is a deficit
A loss may cause a debit balance in Retained earnings. This condition—called a Retained earnings deficit—is reported as a negative amount in stockholders’ equity. To close this $60,000 loss, the final closing entry credits Income summary and debits Retained earnings.

28. Deficit Balance on Balance Sheet
A deficit is reported as a negative amount
A loss may cause a debit balance in Retained earnings. This condition—called a Retained earnings deficit—is reported as a negative amount in stockholders’ equity.

29. Accounting for Cash Dividends
Sometimes a state prohibits using Paid-in capital for dividends
Legal capital is the portion of equity unavailable for dividends
Dividends are declared before paying
Three dates:
Declaration date–Board declares a dividend and creates a liability
Date of record–determines which stockholders receives dividends
Payment date–pay dividends and remove liability
Cash dividends cause a decrease in both assets and equity (Retained earnings). Most states prohibit using paid-in capital for dividends. Accountants, therefore, use the term legal capital to refer to the portion of stockholders’ equity that cannot be used for dividends. A corporation declares a dividend before paying it. Three dividend dates are relevant:
1. On the declaration date, the board of directors announces the intention to pay the dividend. The declaration of a cash dividend creates an obligation (liability) for the corporation.
2. Those stockholders holding the stock at the end of business on the date of record—a week or two after declaration-- will receive the dividend check.
3. Payment of the dividend usually follows the record date by a week or two.

30. Declaring and Paying Dividends
Preferred dividends expressed as either:
A percent of par value
Or a flat dollar amount per share
Common dividends are expressed as a dollar amount per share
2,000 shares of $100 par 8% preferred = $16,000 dividend
2,000 shares of no-par $3 preferred = $6,000 dividend
The cash dividend rate on preferred stock is often expressed as a percentage of the preferred-stock par value, such as 6%. But sometimes cash dividends on preferred stock are expressed as a flat dollar amount per share, such as $2 per share. Therefore, preferred dividends are computed two ways, depending on how the preferred stock cash dividend rate is expressed. Cash dividends on common stock are computed the second way, because those cash dividends are not expressed as a percentage.
To account for the declaration of a cash dividend, we debit Retained earnings and credit Dividends payable on the date of declaration. To pay the dividend on the payment date, debit Dividends payable and credit Cash.

31. Declaring and Paying Dividends
Declaration date
Date of Record (no entry)
Payment date
To account for the declaration of a cash dividend, we debit Retained earnings and credit Dividends payable on the date of declaration. To pay the dividend on the payment date, debit Dividends payable and credit Cash. There is no journal entry on the date of record as the date of record is the cutoff point to determine who owned the stock and, therefore, whose name is on the dividend check. To pay the dividend on the payment date, we debit Dividends payable and credit Cash.

32. Dividing Dividends Between Preferred and Common
Note: Preferred dividend per share ($50 x 6%) = $3
Annual preferred dividend is (2,000 shares x $3) = $6,000

33. Dividing Dividends Between Preferred and Common
Preferred stockholders receive dividends before common
Common stockholders receive dividends if total declared is large enough to cover preferred
When a company has issued both preferred and common stock, the preferred stockholders get their dividends first. The common stockholders receive dividends only if the total dividend is large enough to satisfy the preferred requirement.
A company has 2,000 shares of $50, 6% preferred stock outstanding and 2,000,000 shares of $1 par common stock outstanding. Annual preferred dividend is $6,000; 2,000 shares of no-par $3 preferred = $6,000 dividend. So, total declared dividends must exceed $6,000 for the common stockholders to get anything.
If the year’s dividend is equal to or less than the annual preferred amount (Case A), the preferred stockholders will receive the entire dividend, and the common stockholders get nothing that year. But, if the dividend is large enough to cover the preferred dividend (Case B), the preferred stockholders get their regular dividend of $6,000, and the common stockholders get the remainder of $44,000.

34. Cumulative and Noncumulative Preferred Stock
Accumulates dividends each year until the dividends are paid
Dividends in arrears—dividends passed or not paid
Noncumulative preferred stock
Dividends not paid do not accumulated from one year to the next
Dividend in arrears are paid first, then current dividends paid
Preferred stock can be either cumulative or noncumulative. Most preferred stock is cumulative. As a result, preferred is assumed to be cumulative unless it’s specifically designated as noncumulative. A corporation may fail to pay the preferred dividend if, for example, it does not have cash to fund the dividend. This is called passing the dividend, and the dividends are said to be in arrears. Cumulative preferred-stock shareholders must receive all dividends in arrears before the common stockholders get any dividend. .

35. Cumulative and Noncumulative Preferred Stock
A company declares $50,000 for dividends
In arrears, 1 year at $6,000
Preferred gets $6,000 in arrears + $6,000 current
Common receives the remainder
Distribution if Preferred is Noncumulative
Preferred $6,000
Common $44,000
Suppose a company passed the 2013 preferred dividend of $6,000. Before paying any common dividend in 2014, the company must first pay preferred dividends of $6,000 for 2013 and $6,000 for 2014, a total of $12,000. Assume that in 2014, the company declares a $50,000 total dividend.

36. Different Values of Stock
Market value
Price at which a person can buy or sell a share
Most important to shareholders
Liquidation value
Amount guaranteed to preferred if company liquidates
Book value
Amount of equity per share of stock
If preferred stock exists, subtract preferred equity from total equity to compute book value of common shares
There are several different stock values in addition to par value. Market value, book value, and liquidation value are all used for decision making.
Market value, or market price, is the price for which a person can buy or sell a share of stock. The corporation’s net income and general economic conditions affect market value. The Internet and most newspapers report stock prices. Log on to any company’s Web site to track its stock price, which usually changes daily. In almost all cases, stockholders are more concerned about the market value of a stock than about any other value.
Liquidation value is the amount that is guaranteed to the preferred shareholders in the event a company liquidates. If a liquidation value exists, it will be printed on the face of the preferred stock certificate. Note that this value only has meaning if the corporation liquidates.
Book value per share of stock is the amount of stockholders’ equity on the company’s books for each share of its stock. If the company has both preferred and common stock outstanding, owners of preferred stock have first claim to the equity—just like they have first claim to the dividends. Therefore, we subtract preferred equity from total equity to compute book value per share of common stock.

37. Book Value of Preferred Stock
Book value attributed to preferred stock + any preferred dividends that are in arrears
Book value attributed to preferred stock is either
the number of outstanding preferred shares times liquidation value per share, OR
the book value of preferred equity (the Preferred stock account balance)
Plus any dividends that are in arrears, if the preferred stock is cumulative.
The preferred equity is as follows: Book value attributed to preferred stock + any preferred dividends that are in arrears, if cumulative.
Book value attributed to preferred stock is either the number of outstanding preferred shares times liquidation value per share, or the book value of preferred equity (the Preferred stock account balance). Then, we add any dividends that are in arrears, if the preferred stock is cumulative. The common stockholders, once again, get whatever is left over in stockholders’ equity.

38. Book Value per Share Book value of preferred stock:
Liquidation price or Preferred stock account A
Dividends in arrears on any outstanding preferred shares B
Total book value attributed to preferred stock
A+B
Number of outstanding preferred shares C
Book value per share of preferred stock
(A+B)/C
Book value of common stock:
Total stockholders’ equity D
Less: book value attributed to preferred
A+B
Total book value attributed to common stock
D-(A+B)
Number of outstanding common shares E
Book value per share of common stock
D-(A+B)/E
If the company has both preferred and common outstanding, owners of preferred stock have first claim to the equity—just like they have first claim to the dividends. Therefore, we subtract preferred equity from total equity to compute book value per share of common. The preferred equity is either the liquidation price x outstanding shares or par value of the preferred shares issued. Also, any dividends in arrears are included in book value attributed to preferred shares. The book value attributed to preferred stock is divided by the number of outstanding preferred shares to get the book value of preferred stock.
To determine the book value of common, preferred book value is subtracted from total stockholders’ equity. This is called common equity. This amount is divided by the number of common shares outstanding.

39. S12-10 : Book value per share of common stock
Bronze Tint Trust has the following stockholders’ equity: Bronze Tint has not declared preferred dividends for five years (including the current year).
Paid-in capital:
Preferred stock, 5%, $10 par, 6,000 shares authorized, 4,500 shares issued
$ 45,000
Common stock, $0.20 par, 1,200,000 shares authorized and issued
240,000
Paid-in capital in excess of par—common
400,000
Total paid-in capital
$685,000
Retained earnings
255,000
Total stockholders’ equity
$ 940,000
Short Exercise reviews book value per share of common stock.

40. S12-10: Book value per share of common stock
Compute the book value per share of Bronze Tint’s preferred and common stock.
Preferred stock
Par value of Preferred stock
$45,000
Cumulative dividends
11,250
Total book value attributed to preferred stock
56,250
Number of outstanding preferred shares
4,500
Book value per share of preferred stock
$12.50
The exercise continues on this slide.

41. S12-10: Book value per share of common stock
Compute the book value per share of Bronze Tint’s preferred and common stock.
(*$ rounded)
Common stock
Total stockholders’ Equity
$940,000
Less: Preferred equity
(56,250)
Common equity
$883,750
Number of outstanding Common shares
1,200,000
Book value per share of common stock *
$0.74
The exercise continues.

42. Rate of Return on Total Assets
Measures a company’s success in using assets
Net income + Interest expense
Average total assets
Investors are constantly comparing companies’ profits. To compare companies, we need some standard profitability measures. Two important ratios to use for comparison are return on assets and return on common stockholders’ equity.
The rate of return on total assets, or simply return on assets, measures a company’s success in using assets to earn income. Two groups invest money to finance a corporation:
• Stockholders
• Creditors
Net income and interest expense are the returns to these two groups. The stockholders earn the corporation’s net income, and the creditors get its interest expense.
The sum of net income plus interest expense is the numerator of the return-on assets ratio. The corporation incurs interest because it borrowed money. Interest expense is added back to determine the real return on the assets employed regardless of the corporation’s financing choices (debt or equity). The denominator is average total assets. Net income and interest expense are taken from the income statement. Average total assets comes from the beginning and ending balance sheets.
What is a good rate of return on total assets? There is no single answer because rates of return vary widely by industry. In most industries, a 10% return on assets is considered good.

43. Rate of Return on Common Stockholders’ Equity
Relationship between net income available and their average common equity invested
Net income – Preferred dividends
Average common stockholders’ equity
Rate of return on common stockholders’ equity, often shortened to return on equity, shows the relationship between net income available to the common stockholders and their average common equity invested in the company. The numerator is net income minus preferred dividends. Preferred dividends are subtracted because the preferred stockholders have first claim to any dividends. The denominator is average common stockholders’ equity—total equity minus preferred equity.
Most companies strive for return on equity of 15% or higher.

44. S12-11: Computing return on assets and return on equity
Godhi’s 2012 financial statements reported the following items—with 2011 figures given for comparison:
Short Exercise addresses the computation of return on assets (ROA) and return on equity (ROE).

45. S12-11: Computing return on assets and return on equity
Compute Godhi’s rate of return on total assets and rate of return on common stockholders’ equity for Do these rates of return look high or low?
Rate of return
on total assets =
Net income + Interest expense
Average total assets
$3, / $31,550 = 13% ( )
Rate of return on common
stockholders’ equity =
Net income – Preferred dividends
Average common stockholders’ equity
The exercise continues on this slide.
$3, / $15,519 = 25.1% ( )
High

46. Income Taxes
Federal tax rate of 35% when combined with State taxes can increase total taxes to 40%
Corporations measure two income tax amounts
Income tax expense–income statement based
Income tax payable–IRS taxable income based
Income tax expense
Income before tax on the income statement x Income tax rate
Income tax payable
Taxable income from the IRS filed tax return x Income tax rate
Major difference–depreciation methods differ
Corporations pay income tax just as individuals do, but not at the same rates. At this writing, the federal tax rate on most corporate income is 35%. Most states also levy a corporate income tax, so most corporations pay a combined federal and state income tax rate of approximately 40%.
These calculations are simplified as:
Income tax expense = income before taxes from the income statement x the income tax rate.
Income tax payable = taxable income from the tax return x the income tax rate.
The income statement and the income tax return are entirely separate documents. For most companies, income tax expense and income tax payable differ. The most important difference occurs when a corporation uses straight-line depreciation for the income statement and accelerated depreciation for the tax return (to save tax dollars).

47. Differences Between Income Statement and the Tax Return
Example
Income before income tax of $33,000,000
$33,000,000 X 40% = $13,200,000 taxes
Taxable income of $20,000,000
$20,000,000 X 40% = $8,000,000 IRS taxes
Difference is $5,200,000
$13,200,000 - $8,000,000
Deferred until taxable income catches up
Assume
Income before income tax of $33,000,000. (This comes from the income statement, which is not presented here.)
Taxable income of $20,000,000 .(This comes from the tax return, which is not presented here.)
A company will record income tax for 2014 as follows (assume an income tax rate of 40%):
Debit - Income tax expense ($33,000, ) (E+) 13,200,000
Credit - Income tax payable ($20,000, ) (L+) 8,000,000
Credit - Deferred tax liability (L+) 5,200,000
The company will pay the $8,000,000 of Income tax payable to the IRS and the applicable states within a few months. The difference between Income tax expense and Income tax payable is the Deferred tax liability of $5,200,000. It is a liability because Income tax expense (the amount of expense incurred in 2014) is greater than Income tax payable (the amount it has to pay to the IRS when it files its 2014 tax return). It is deferred because the company will have to pay the 5,200,000 difference in future years on its tax return. The Deferred tax liability account is long-term because it is related to a long-term depreciable asset.