1. Accounting for Income Taxes
ACCTG 5120
David Plumlee

2. Accounting for Income Taxes
Why do accountants record Deferred Taxes?
Income is measured in two different ways, taxable income and GAAP income. Deferred taxes result from timing differences between these two.

3. Accounting Income = Taxable Income
Why are GAAP and tax income computed differently?
Tax income is intended to
raise sufficient tax revenues
stimulate or depress certain sectors of the economy
GAAP is intended to provide relevant, reliable and representationally faithful
GAAP is full accrual, while tax is accrual with some cash basis adjustments.

4. Inter-period Tax Allocation
From an income statement perspective what is the justification for inter-period tax allocation?
It improves matching of tax expense to related accounting income.
From a balance sheet perspective what is the justification for inter-period tax allocation?
to summarize:
I can offer to arguments to justify interperiod tax allocation
first: from an income statement perspective - accountants do interperiod tax allocation because they want to do a better job of matching tax expense to accounting income than would be possible without it
second: from an income statement perspective - accountants want to disclose the fact that from an accounting perspective taxes may be prepaid giving rise to a deferred tax asset that should be recorded on the balance sheet or taxes may be underpaid giving rise to a deferred tax liability that needs to be recorded
really these are two sides of the same coin
think back to our last example
since we paid $2,700 in taxes in the first year but only expensed $1,350 the extra $1,350 represents a prepayment of tax -- a deferred tax asset to the company that will get consumed in 1995
so the income statement impact of the allocation is that we get better matching and the balance sheet impact is that we get to record an asset representing the taxes paid but not incurred by the end of 1994
questions on this?
these are not easy concepts so be patient...
It allows recognition of deferred tax assets and liabilities associated with future deductible and future taxable amounts.

5. A Simple Example
Assume that $9,000 is received on day 1, year 1 in payment of year 1 and year 2 rent ($4,500/year). What is the taxable and accounting income for each of these years?

6. “Cash” Basis No matching of Tax Expense to related accounting income.
Assume a tax rate of 30%, then the $2,700 of income tax would be paid in 2003.
What is wrong with this approach?
No matching of Tax Expense to related accounting income.

7. “Accrual” Basis Using Interperiod Tax Allocation:
Total tax expense is still $2,750, but:
net income better reflects “effort”
effective tax rate reflects statutory rate
less volatility in earnings

8. Is a deferred tax really a liability?
Some say yes
eventually the timing difference will be reversed and the tax recorded in the deferred tax liability account will become payable
future cash outflow in the amount of the deferred tax liability (asset) will occur
Some say no
many reversing temporary differences continually replaced with new originating temporary differences
in reality deferred income tax liabilities continually grow
net temporary differences do not require future cash outflows
not a legal obligation of the firm until tax return filed

9. Permanent Differences
A difference arising from an item that enters into accounting income but never taxable income (interest on state issued bonds)
or enters into taxable income but never accounting income (excess depletion on wasting assets)
lets start with permanent differences and illustrate why permanent differences do not give rise to deferred tax balances
a permanent difference arises when an item gets included in accounting income that will never get included in taxable income or gets included in taxable income that will never get included in accounting income
it is very important that we be able to distinguish between permanent differences and temporary differences because we never want to record deferred taxes or tax expense on permanent differences, while we do record deferred taxes arising from permanent differences
to see why lets consider interest income on a state bonds

10. Examples of Permanent Differences
Interest on state/municipal bonds
Proceeds from executive life insurance
Premiums paid on executive life insurance
Fines due to violations of the law
Dividend received deduction - 70% - 80% of dividends received from U. S. corporations
Excess depletion on wasting assets
here’s a list
we just finished looking at interest on government bonds - this is interest income that is included in accounting income but will never be subject to income tax
proceeds from a life insurance policy we had on one of our executives - considered accounting income but never taxable
etc.
dividend received deduction - when one us company gets dividends from another us company they don’t have to pay tax on a large portion of the dividends (usually, depending on percentage ownership 70-80% is sheltered from tax)
100% of the dividends are considered income for accounting purposes under FAS 115 but only 20% is ever taxed the other 80% gives rise to a permanent difference
questions
well if that’s a permanent difference what’s a temporary difference?

11. Example: Interest Income on State Bonds
A company receives $1,000 in interest income on state bonds and tax rate is 45%. The company NEVER pays tax on this income. What if we did this?
tax expense
deferred tax liability 450
lets say company A receives 1,000 in interest income on state bonds
assume that this is the only income the company had and it has no expenses
interest income on government bonds is not taxable
but what if we ignored that and went ahead and did an entry to record tax expense on the interest income anyway
so we debit tax expense 450 and since we aren’t paying the tax this year we credit a deferred tax liability 450
what’s wrong with this picture?
when is the $450 in tax ever become do and payable? - never
so when is the deferred tax liability ever going to get paid off? - never
so the deferred tax liability would just sit on the balance sheet forever
also, does it make sense to record tax expense when in fact there never will be any taxes paid on the interest income? - no
so what should the company do? they should make no entry to record tax expense on items that are identified as permanent differences
so if this were a real company that we were dealing with they would say well we have accounting income of $450 and tax expense of $0
what are some other kinds of items that cause permanent differences between accounting income and taxable income?
Deferred tax would stay on the books forever!

12. Temporary Differences
A difference between an asset or liability’s tax basis and its amount for accounting purposes that will result in taxable or deductible amounts in future years
Or, a difference between in the financial and tax amounts for income (or expense) in a given year (or years)
a temporary difference is an item that enters into both the computation of accounting income and taxable income but at different points in time
in other words because of differences in timing these are items that cause accounting income and taxable income to be different but only temporarily
for example, earlier we talked about depreciable property where the tax department allows the company to write the cost off over two years but for accounting purposes the cost is written off over ten years
over the entire ten year period the same total cost will be written off for both accounting and tax purposes but the timing of the write off will be different so that from year 1 through 10 there will be differences between accounting income and taxable income even though over the entire ten year period total accounting income and total taxable income would be equal
because we are depreciating the asset at different rates for tax and accounting purposes the NBV of the asset from a tax point of view (refer to this as the tax basis of the asset) and the NBV of the asset from an accounting point of view (refer to this as the accounting basis of the asset) will be different
it is this difference that is referred to in the definition of a temporary difference
specifically, a temporary difference is defined as the difference between the tax basis of an asset or liability and its reported amount for accounting purposes that will result in taxable or deductible amounts in future years
since this may still not be perfectly clear lets look at a simple example

13. How do we get taxable income?
Start with GAAP/financial ‘books’
Make tax-related adjustments
permanent items that are in accounting income but not taxable or vice versa
temporary/timing items that are included in financial income at a different time than taxable income
Complete tax return and pay required taxes (taxes payable)

14. Temporary Difference - Example
A company purchases an asset for $100,000.
Depreciation expense:
accounting - straight-line over 4 years
tax - straight-line over 2 years

15. Reconciliation - Year 1

16. AJE to Record Tax Expense
What is adjusting entry at the end of year 1?
tax expense $80,000
tax payable $70,000
deferred tax liability $10,000

17. Reconciliation - Year 2

18. AJE to Record Tax Expense
What is the balance in Deferred Tax Liability at the end of year 2?
($25,000+25,000) x 40% = $20,000
What is adjusting entry at the end of year 2?
tax expense $40,000
tax payable $30,000
deferred tax liability $10,000

19. Reconciliation - Year 3

20. AJE to Record Tax Expense
What is the balance in Deferred Tax Liability at the end of year 3?
($25,000+25,000-25,000) x 40% = $10,000
What is the entry to record tax expense for year 3?
so the journal entry to record tax expense in year 3 would look like this
notice that as the temporary differences reverse, the balance in the deferred tax account is drawn down
by the end of year three - the cumulative temporary difference is sitting at $25,000 (the difference between the accounting basis and the tax basis of the asset)
and the deferred tax liability associated with that cumulative difference (computed at a rate of 40%) has dropped to 10,000 - the opening balance in the deferred tax liability account of $20,000 minus this years reduction in liability of $10,000
if we were to look at the entry for year four what would we see happening to the deferred tax liability - it would be reduced by another $10,000 to zero
and the cumulative temporary differences at that point in time would be zero also
the example we just looked at was just one kind of temporary difference - the difference arising because we typically depreciate assets faster for tax purposes than we depreciate then for accounting purposes
however, there are many items which eventually impact both accounting income and taxable income by the same amount but only the timing of the inclusion is different
the handout entitled “temporary differences” lists the more common ones
go through handout
questions so far?
Tax Expense $72,000
Deferred Tax Liability $10,000
Tax Payable $82,000

21. Changes in tax rates across time?

22. AJE to Record Tax Expense
What is the balance in Deferred Tax Liability at the end of year 4?
Should be $0, but ($25, ) x 40% +(-25,000)x 30% = 2500
What is the entry to record tax expense for year 4?
so the journal entry to record tax expense in year 3 would look like this
notice that as the temporary differences reverse, the balance in the deferred tax account is drawn down
by the end of year three - the cumulative temporary difference is sitting at $25,000 (the difference between the accounting basis and the tax basis of the asset)
and the deferred tax liability associated with that cumulative difference (computed at a rate of 40%) has dropped to 10,000 - the opening balance in the deferred tax liability account of $20,000 minus this years reduction in liability of $10,000
if we were to look at the entry for year four what would we see happening to the deferred tax liability - it would be reduced by another $10,000 to zero
and the cumulative temporary differences at that point in time would be zero also
the example we just looked at was just one kind of temporary difference - the difference arising because we typically depreciate assets faster for tax purposes than we depreciate then for accounting purposes
however, there are many items which eventually impact both accounting income and taxable income by the same amount but only the timing of the inclusion is different
the handout entitled “temporary differences” lists the more common ones
go through handout
questions so far?
Tax Expense $21,000
Deferred Tax Liability $ 7,500
Tax Payable $28,500

23. Computing Tax Expense
*differences that will reverse in the future. If differences are permanent, ignore!
Find cumulative temp. basis differences = book - tax *
Compute ending deferred tax balance. Prepare a schedule of anticipated reversals and applying appropriate enacted tax rates
Compute
taxes payable
and so this is why we compute tax expense not by looking directly at accounting income but by computing the changes to deferred taxes and taxes payable and then plugging tax expense to balance the entry
this is summarized by this flow chart which shows the procedures that are followed under FAS 109 to compute tax expense
we went through these steps last class when we looked at a simple example so hopefully they are somewhat familiar
first we compute the cumulative temporary differences by taking the difference between the book basis and the tax basis for items giving rise to temporary differences
so for depreciable property for example the cumulative temporary difference is the difference between the book value of the asset for accounting purposes and the book value of the asset for tax purposes
this is the sum of all of the temporary differences arising to date on the item under consideration
then we prepare a schedule of when we expect the temporary differences to reverse and multiply those amounts by the enacted tax rates that are expected to be in effect at the time
adding all of the amounts together gives the balance in the deferred tax asset or liability that we want to show on our balance sheet
we then compute the change in deferred taxes by comparing the closing balance just computed to the balance currently sitting in the account
this gives us the amount that we need to debit or credit to deferred taxes
then we compute taxable income just like we did before, starting with accounting income and making all the necessary adjustments to come down to taxable income
and then multiplying taxable income by current tax rate to figure out how much tax we actually owe
we then plug tax expense for the sum of these two amounts or the difference between them depending on the direction of the deferred tax entry
Compute change in Deferred Tax balance
Tax Expense = tax payable +/- change in Deferred Tax balance

24. Example Year 2000 pretax accounting income = $500,000
Current tax rate = 40%
Deferred Tax liability (Jan 1, 2000) = $320,000
Year 2000 depreciation
accounting = $200,000
tax = $400,000
Municipal Bond Interest $10,000
lets say pretax accounting income is, what the current tax rate is and what the opening balance in the deferred tax liability account is
and how much was taken for depreciation for accounting purposes this year and how much is allowed for tax purposes this year
given that there is still some amount being taken for tax purposes while the year end tax value is zero implies that this was the last year for which any tax depreciation was avail.
after this year the asset is fully depreciated for tax purposes and the temporary differences will begin to reverse

25. Example (continued) As at the end of year 2000:
Book basis of depreciable assets $1,000,000
Tax basis of depreciable assets
Cumulative temporary difference $1,000,000
Additional information:
enacted tax rates as shown in schedule
temporary differences expected to reverse as shown in schedule
piece of cake right!
well just in case it’s not perfectly clear lets illustrate with an example
say that depreciable assets is the only item the company has that gives rise to a temporary difference
say that at the end of the current year the book basis of the depreciable assets is $1million
and the tax basis is $0 giving rise to cumulative temporary differences of $1,000,000
will this difference have given rise to a deferred tax asset or a deferred tax liability
since the book basis is greater than the tax basis this implies that in the past we have taken less depreciation for accounting purposes than for tax purposes
which implies that accounting income was higher than taxable income
which implies that tax expense > taxes payable
which implies that debits exceeded credits giving rise to the need for a deferred tax liability
or go to the chart we looked at last day - this is an example of an item which was deductible for tax purposes before it was deductible for accounting purposes
as a result compared to accounting we actually paid to little tax in the past so need to set a liability for the tax that will become payable when tax depreciation runs out before accounting deprecation does
in any event the $1,000,000 represents an amount that will give rise to future taxes payable or a deferred tax liability

26. Change in Deferred Tax Balance
in class all this information is given to us in reality the first thing the accountant would have to do is prepare a schedule showing when he/she thinks the $1,000,000 cumulative temporary difference will reverse
then multiply these amounts by the tax rates expected to be in effect at the time that the reversal is expected to occur
in this case the ending deferred tax liability is computed to be $350,000
the opening deferred tax liability was $320,000
so we have an increase in the liability of $30,000
i.e. we are going to have to credit deferred tax liabilities for $30,000
Closing deferred tax liability $350,000
Opening deferred tax liability ,000
Net increase in deferred tax liability $ 30,000

27. Compute Taxes Payable Pre-tax accounting income $500,000
add accounting depr ,000
subtract tax depr. (400,000)
subtract non-taxable interest ( 10,000)
Taxable income $290,000
tax rate x 40%
Tax Payable (per tax return) $ 116,000
next we need to compute how much tax we actually owe
we prepare a schedule just like the center column of the worksheet we looked at earlier
we start with accounting income and then add or subtract the necessary amounts to get us down to taxable income
the non-taxable interest income is a permanent difference so we don’t have to worry about any deferred tax balances related to it so now we have all the information we need to make the entry

28. Journal Entry tax expense (plug) 146,000 tax payable 116,000
deferred tax liability* ,000
*since we have a starting balance in DTL account, need to adjust to correct balance
the entry to record tax expense for the year is going to have to credit taxes payable for the amount we actually have to pay
it credits deferred taxes for the amount needed to adjust the deferred tax balance to the correct closing balance in this case $8,000
and the ‘plug’ to balance the entry is a debit to tax expense for $58,000
I want to stop here for now and hand back exams

29. Net Operating Losses (NOL)
20 years
Carry Forward
If a carryforward then
future deductible item
record deferred tax asset based on future enacted rate
2 years
Carry
Back
If a carryback then
receive a refund of previous tax paid
record tax receivable based on prior year rate
NOL
Year
the next topic we are going to look at is net operating losses
a net operating loss for tax purposes arises when a company has negative taxable income
when this occurs the company has a choice
it can carry the loss back an apply it against prior years taxable income
if the company does this they will receive a refund of taxes paid in the past so we will need to make an entry debiting a income tax refund receivable and crediting income tax expense
since we are getting a refund of prior year taxes paid the amount of the refund we are entitled to will be based on the tax rate that was in effect when the tax was paid originally
so for example, say the tax rate is currently 46% but prior to this year we were only paying at a rate of 34%
obviously if we carry back a loss of 100 and claim a refund of taxes previously paid the government is not going to give us $46 when we only paid $34 in the first place
now if the company carries the loss back but even going back the allowable three years does not have enough prior year taxable income to absorb the loss they can carry the loss forward and reduce future taxable income up to 15 years into the future
alternatively the company may choose not to carry the loss back at all even if they could but may choose to carry the full amount forward
why might a company do this? - if tax rates in the future are higher than tax rates in the past
well regardless when a company carries a NOL forward they have a future deductible amount which gives rise to a deferred tax asset

30. Deferred Tax Asset Valuation Allowance
Based on all available evidence it is more likely than not that some portion will not be realized
Intended to adjust Deferred Tax asset to expected net realizable value
tax expense xx
valuation allowance xx
Adjust to required ending balance each period
the next topic we are going to spend a few minutes with is the valuation allowance
valuation allowances apply to deferred tax assets only
a valuation allowance should be set up when based on all available evidence, it is more likely than not that some portion of the deferred tax asset will not be realized
for example, say we set up an accrual for litigation expenses but there is some reason to believe that the company may not have the opportunity to deduct all or a portion of the litigation expenses from taxable income
perhaps the company is not expected to report enough taxable income to absorb the expense
if this is the case we still go ahead and record the deferred tax asset associated with the litigation expense
but in addition, the company should set up a valuation allowance intended to reduce the deferred tax asset to its expected net realizable value
the entry to set up the valuation allowance debits tax expense and credits valuation allowance, a contra-account, contra to deferred tax asset
at the end of each period the valuation allowance is reconsidered and any adjustments to the balance are made by a debit or credit to the valuation allowance and an offsetting entry to tax expense

31. Deferred Tax Asset Valuation Allowance
In year of expected reversal future deductible amounts > future taxable amounts
Will there be sufficient future taxable income to absorb the excess?
Could the excess be carried back to prior years?
if answer is NO - valuation allowance required
how does the accountant go about determining if a valuation allowance is necessary and how much it should be?
well a good start would be to schedule out the future reversals of deductible and taxable amounts to see if future taxable amounts are sufficient to cover the future taxable amounts
if not, then the accountant should ask him or herself two questions
first, do I think there will be sufficient future taxable income to absorb the excess of deductible amounts?
in other words do I think there will be sufficient taxable income in the future to allow me to deduct these items that are giving rise to the deferred tax assets and if not would I be able to carry back any of the resulting loss associated with an excess of deductible amounts to the preceding three years
if the answer to these questions is no such that it does not look like the company will be able to use all of its future deductible amounts then a valuation allowance will be needed.
we are actually going to come back and look at valuation allowances in detail in P17-15 so unless you have specific questions we’ll leave it for now and come back to the detailed computations on Monday

32. Balance Sheet Presentation
Classify deferred tax balances based on
classification of related asset/liability
expected reversal date if not related
For reporting purposes
net current deferred tax balance
net non-current deferred tax balance
show deferred tax assets net of valuation allowance
one thing we haven’t talked about at all yet is how deferred tax balances should be disclosed on the balance sheet
deferred tax balances must be classified as current or long-term
if the deferred tax balance is related to a particular asset or liability then the classification of the deferred tax balance depends on the classification of the related item
for example - how would the following deferred tax balances be classified
deferred tax balance related to differences in depreciation (long-term)
deferred tax balance related to warranty liability classified as current (current)
deferred tax balance related to installment sales to be collected over a five year period (long-term), some current if there is a current portion
when a deferred tax item arises due to the difference between the tax basis of a particular asset or liability and its book basis it makes sense that the deferred taxes should be classified on the balance sheet according to the classification to the item but if the deferred tax balance is not associated with any particular asset or liability it is then classified according to the expected reversal date
loss carryforwards give rise to deferred tax assets which are not related to any particular reported asset or liability
as a result deferred tax assets arising from loss carryforwards are classified as current or long-term based on expected reversal date
for reporting purposes current deferred tax liabilities and assets should be netted together as are long-term deferred tax liabilities and assets
in addition, deferred tax assets should be reported net of a valuation allowance if such an allowance is deemed necessary

33. Intraperiod Tax Allocation
Allocation of tax across different sources of income/loss within a given period including:
income from continuing operations
discontinued operations
extraordinary items
cumulative changes in accounting policy
items charged directly to retained earnings, for example
prior period adjustments
mark-to-market adjustments under FAS 115
well we’re getting close to this hodge podge of deferred tax items that we had left to look at
the next thing I want to illustrate is intraperiod tax allocation
as I’ve stated before intra period tax allocation is the allocation of taxes within a given accounting period across various sources of income or loss
it is not to be confused with interperiod tax allocation which is the allocation of taxes through time and the reason why we have deferred tax balances
the kinds of items that need to have tax allocated to them include.....

34. Intraperiod Tax Allocation
A company has ordinary income of $50,000 and extraordinary income of $100,000
tax rate is 45%
no permanent or temporary differences
tax payable
on ordinary income = $22,500
on extraordinary income = $45,000
any way -- why do we do intraperiod tax allocation?
because our income statement would look pretty stupid if we didn’t!
to illustrate this consider the following simple example...

35. Intraperiod Tax Allocation
see how the income statement would appear both with and without intra period tax allocation
notice on the without column that it appears that the company had a whopping tax bill on its income from ordinary operations enough to wipe out income and leave them in a loss position
does this make any sense - no!
the problem is that the tax expense associated with the extra ordinary item is being matched on the statement against the ordinary income
this is a bit problematic because analysts and users like to rely on the income from continuing operations as a measure of sustainable income
charging the extra tax on the extraordinary item with is not expected to happen again by definition through tax expense muddies these waters considerably
so an easy way of getting around this is just to make sure that the tax associated with the extraordinary item gets netted out of the extraordinary item itself
this gives much better presentation although it does not change the net income figure for the year
any questions on this?