1. Accounting for Income Taxes

2. Objectives of the Chapter
To learn the permanent difference between the financial income and taxable income.
To learn the temporary difference between the financial income and taxable income.
To learn the accounting treatment for the temporary difference and permanent difference.
Accounting for Income Taxes

3. Permanent Difference versus Temporary Difference
A difference between financial income and taxable income in an accounting period that will never be reversed in later accounting periods.
This difference does not require an interperiod tax allocation.
Accounting for Income Taxes

4. Permanent Difference versus Temporary Difference (contd.)
Examples of Permanent Difference
1. Revenue recognized for F/R (financial report) but not taxable.
a. Interest on municipal bonds.
b. Life insurance proceeds payable to a corporation upon the death of an insured employee
Accounting for Income Taxes

5. Permanent Difference versus Temporary Difference (contd.)
Examples (contd.)
2. Expense recognized for F/R but not tax deductible:
Life insurance premium paid for employees.
3. Expense is tax deductible but not recognized for F/R purpose:
Percentage depletion in excess of Cost Depletion.
Accounting for Income Taxes

6. Permanent Difference versus Temporary Difference (contd.)
A difference between a taxable income and a financial income in an accounting period that will be reversed in later accounting periods.
This difference requires an intertperiod tax allocation.
Causes of Temporary Difference:
Different treatment between GAAP and IRC
Accounting for Income Taxes

7. Difference between IRC and GAAP
Depreciation
GAAP: any systematic depr. method
IRC : ACRS or MACRS
Installment Sales (future taxable)
GAAP: on accrual basis
IRC : on cash basis
Accounting for Income Taxes

8. Difference between IRC and GAAP (contd.)
Warranty Expense (future deductible)
GAAP: accrual basis (estimated and recognized at the end of each period)
IRC : cash basis (tax deductible when paid)
Bad Debt Expense (future deductible)
GAAP: estimated and recognized at the end of each period.
IRC : tax deductible when accounts defaulted.
Accounting for Income Taxes

9. Temporary Difference: an example
Depreciation method:
For tax filing purpose: ACRS, 4-year life For financial reporting purpose: straight-line method, 5-year life
The asset was purchased on 1/1/x1 with a cost of $10,000 and a zero residual value.
Accounting for Income Taxes

10. Temporary Difference: an example (contd.)
Financial depr. expense vs. tax depr.:
Year
S-L method Depr. exp.
Tax Depr.exp.
20x1
$2,000
$2,500a
20x2
$3,750b
20x3
$1,875c
20x4
$1,250d
20x5
$ 625
Accounting for Income Taxes

11. Temporary Difference: an example (contd.)
b. $7,500*50% = 3,750
c. $3,750*50% = 1,875
d. $1,875*50% = < (1,875/1.5 =1,250)
Accounting for Income Taxes

12. Temporary Difference: an example (contd.)
Assuming a 30% tax rate, the following table presents the annual temporary difference and the deferred tax liability:
Annual temp. diff.
Cum. Temp.diff
Ending deferred T/L
Beg. Deferred T/L
Change in defer. Liam.
500
150
1,750
2,250
675
525
(125)
2,125
637.5
(37.5)
(750)
1,375
412.5
(225)
(1,375)
(412.5)
Accounting for Income Taxes

13. Temporary Difference: an example (contd.)
T-account of the deferred tax liability
Deferred Tax Liability
20x3… ……..20x1
20x4… ……..20x2
20x5…
0…..20x5
Accounting for Income Taxes

14. Interperiod Income Tax Allocation
Example A: the following information is available for the year ended 12/31/x1: Accounting income = $10, Taxable income = $ 9,000 (AI > TI) Tax Rate = 30% The difference of $1,400 is resulting from using ACRS for I/T filing while using S-L for F/R purposes. This difference will be reversed as follows:
Accounting for Income Taxes

15. Interperiod Income Tax Allocation
Reversed Amount (F/R depr.>Tax Depr.)
20x1 $ x x Total 1,400
Tax payable for 20x1 = >
9,000 *30% =$2,700
Accounting for Income Taxes

16. Interperiod Income Tax Allocation (contd.)
Alternative Accounting Treatments
I. No Allocation of Deferred I/T Liam.
Income Tax Exp , Income Tax Payable ,700
II. With Allocation (comply with the matching principle) – Deferred Approach(APB No. 11)
Income Tax Expense 3, Income Tax Payable , Deferred Income Tax Liam *
Accounting for Income Taxes

17. Interperiod Income Tax Allocation (contd.)
Alternative Accounting Treatments (contd.)
III.With Allocation- Liability Approach (SFAS 109)
Income Tax Expense 3, Income Tax Payable , Deferred Income Tax Liam **
Accounting for Income Taxes

18. Interperiod Income Tax Allocation (contd.)
* Deferred tax lia. is calculated as income tax exp. minus income tax payable.
**Deferred tax lia.is calculated based on the reversed amount in the future times the future tax rate. If the future tax rate remains at 30%, the deferred tax lib. Is $420. Otherwise, the deferred tax lib. will not be $420 (see the example next).
Accounting for Income Taxes

19. Interperiod Income Tax Allocation (contd.)—Example B
Example B: The taxable income of 20x = $9, The accounting income of 20x1 =$10,400
Partial Income statement: Pretax financial income $10, Less: additional accelerated depr. Deducted for I/T (1,400) Taxable Income $9,000
Accounting for Income Taxes

20. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
At the beg. of 20x1, the deferred I/T has a balance of $0 (due to 20x1 is the first year of occurrence of difference in depr.) and the current tax rate is 30%.
There is no expectation of tax rate changes in the future.
Accounting for Income Taxes

21. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
The financial depr. exp. will exceed the taxable depr. by the following amount in the next three years:
a&b: assumed numbers.
Year
Acc.Depr.a
Tax depr.b
Diff.
20x2
$1,000
$500
20x3
1,000
300
700
20x4
800
200
Accounting for Income Taxes

22. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
The following table shows the annual temporary difference, accumulative temporary diff. and deferred liability (tax rate = 30%):
Year
Temp. Diff
Accu. Temp. Diff
End. Defer. I/T lia.
Beg. Defer. I/T lia.
Change in def. I/T lia.
20x1
$1,400
$420 $0
420
20x2
(500)
900
270
(150)
20x3
(700)
200 60
(210)
20x4
(200)
(60)
Accounting for Income Taxes

23. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
T-account of Deferred income tax lia.
Deferred I/T Liam.
20x2… …….20x1 20x3… x4… (bal)20x4
Accounting for Income Taxes

24. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
J.E. (for 20x1) (based on APB No.11; the deferred approach)
Income Tax Expense ,120a Income Tax Payable ,700 b Deferred Income Tax Liam ? c
a: $10,400 (accounting income)*30% b. $9,000 (taxable income)*30%
c. ?= 3,120-2,700
Accounting for Income Taxes

25. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
J.E. (for 20x1) (based on SFAS 109; the liability approach)
Income Tax Expense ?a Income Tax Payable ,700 b Deferred Income Tax Liam c
a. ? = b+c = 2, = 3, b.$9,000 (taxable income)*30% c.$420 = $500*30% +700*30% +200*30%
revered revered revered lia. Of 20x lia. Of 20x3 lia. Of 20x4
Accounting for Income Taxes

26. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
Note c is also presented in the following table:
a. Due to future taxable income > future acc. Income. It is a result of future tax depr. < future acc. Depr b. Future expected tax rate should be used. Example B assumed all future tax rates remain at 30%.
20x2
20x3
Total
Futurea taxable amount
$500
$700
$200
$1,400
I/T Rate
30%b
30%
Defer. Liam. reversed
$150
$210
$60
$420
Accounting for Income Taxes

27. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
Assuming taxable income of 20x2,20x3 and 20x4 are $7,000, $6,000 and $8,000, respectively, journal entries of income tax for those year are as follows (all future tax rate remains at 30%) (follow SAFS 109):
20x2
Deferred I/T Liam a I/T Expense ? b
I/T Payable ,100c
a. See the previous table for year 20x b. income tax expense = $2,100 – c. taxable income 7,000*30%
Accounting for Income Taxes

28. Interperiod Income Tax Allocation (contd.)—Example B (contd.)
20x3 Deferred I/T Liam a I/T Expense ? b
I/T Payable ,800c
20x4 Deferred I/T Liam d I/T Expense ? e
I/T Payable ,400f
a. See the previous table for year 20x b. income tax expense = $1,800 – c. taxable income 6,000*30%
d. See the previous table for year 20x e. income tax expense = $2,400 – f. taxable income 8,000*30%
Accounting for Income Taxes

29. Interperiod tax Allocation with Different Expected Tax Rate
Using the same information as in Example B except the tax rates are expected to change in the future as follows:
20x1 = 30% (the current year) x2 = 40% x3 = 40% x4 = 40%
The ending bal. of the deferred I/T lia. for year 20x1 would be $$560 instead of $420 as in Example B when future rate states at 30%.
Accounting for Income Taxes

30. Interperiod tax Allocation with Different Expected Tax Rate (cont.)
The computation of the ending balance of deferred I/T lia. For 20x1 is as follows:
20x2
20x 3
20x4
Total
Taxable amount
$500
$700
$200
$1,400
I/T rate
40%
Reversed tax lia.
$280
$80
$560
Accounting for Income Taxes

31. Interperiod tax Allocation with Different Expected Tax Rate (cont.)
Journal Entry for 20x1 is as follows based on a 40% expected tax rate for 20x2 to 20x4:
Income Tax Expense ?a Income Tax Payable ,700 b Deferred Income Tax Liam c
a. ? = b+c = 2, = 3, b.$9,000 (taxable income)*30% c.$560 = $500*40% +700*40% +200*40% or as shown in the previous table
Accounting for Income Taxes

32. Interperiod tax Allocation with Different Expected Tax Rate (cont.)
What if at the end of 20x2, the tax rate has been increased to 45% (instead of 40% as expected at the end of 20x1), the deferred liability at the end of 20x1 should have been $625a rather than $560 as using the 40% expected rate.
The following adjusting entry should be prepared on 12/31/20x2:
a. $500*45%+700*45%+200*45% = $625
Accounting for Income Taxes

33. Interperiod tax Allocation with Different Expected Tax Rate (cont.)
Loss on Adjustment of Deferred Taxes a Deferred I/T Liam
a. $ = $65
Accounting for Income Taxes

34. Interperiod tax Allocation – Example C
The following is a reconciliation of a pretax financial income with a taxable income for 20x3:
Financial Income $3,000
Add: estimated warranty exp. deducted for financial reporting in excess of actual warranty exp. deducted for I/T (a future deductible) Less:Additional accelerated depr deducted for I/T (a future taxable) (150) Taxable Income $2,950
Accounting for Income Taxes

35. Interperiod tax Allocation – Example C (contd.)
No expectation of tax changes in the future and the current tax rate is 30%. The beginning balance of deferred income tax lia. account is $495 due to the first year of depr. exp. difference occurred in 20x1.
Accounting for Income Taxes

36. Interperiod tax Allocation – Example C (contd.)
Additional information regarding depr. exp. Lib. as follows:
a. 20x3 is the current year.
year
Difference of tax depr. And financial depr.
20x1
$800 (tax dep>fin. Dep)
20x2
860 (tax dep>fin. Dep)
20x3a
150 (tax dep>fin. Dep)
20x4
(300) (fin.dep > tax dep)
20x5
20x6
(1,200) (fin.dep >taxdep)
Total
Accounting for Income Taxes

37. Interperiod tax Allocation – Example C (contd.)
The followings are projections regarding the temporary differences for years 20x4 to 20x6(future years):
a. Tax warranty cost in excess of financial warranty cost b. Financial depr. exp. In excess of tax depr. exp.
year
Diff. In warranty amounta
Diff. In depr. amountb
20x4
$50
$ 300
20x5 30
300
20x6 20
1,200
Total
$100
$1,800
Accounting for Income Taxes

38. Interperiod tax Allocation – Example C (contd.)
J.E. for the current year 20x3 (SFAS 109):
I/T Exp ?a
Deferred I/T assets b
I/T Payable c
Deferred I/T Liam d
a. $ = $ b. $50*30%+30*30%+20%30% = 100*30% =$ c. $2,950*30% = $ d. ( )*30% - $495 = $ = $45
Accounting for Income Taxes

39. Interperiod tax Allocation – Example C (contd.)
T-accounts of deferred tax lia. And deferred tax assets:
Deferred I/T Asset Deferred I/T Liam.
beg. bal beg.bal Adj. Of 20x adj.Of 20x3
30a b
a. $50*30%+30*30%+20%30% = 100*30% =$30 b.( )*30% =1,800*30% =$540
Accounting for Income Taxes

40. Interperiod tax Allocation – Example C (contd.)
Presentation of selected accounts on I/S:
Pretax Income $3, I/T exp (900) Net Income $2,100
Presentation of selected accounts on B/S:
Current Assets: Current Lia.:
Deferred Tax Assets 30 I/T Payable Deferred Tax Lia. 540
Accounting for Income Taxes

41. Interperiod tax Allocation – Example C (contd.)
Had APB No. 11 been followed (the deferred approach), the following entry will be prepareda:
I/T Exp. (3,000*30%)
I/T Payable (2,950*30%)
Deferred I/T Liam. ( )
a. This treatment is NOT acceptable.
Accounting for Income Taxes