Accounting for Income Taxes

Intraperiod tax allocation

Involves WHERE we present income tax expense during a single year. The "net of tax"
items are generally the same items for which we present an EPS number plus any prior
period adjustments.
Interperiod tax allocation
Related to temporary differences between accounting and taxable income

Deferral approach to tax allocation (APB Opinion 11)

Income tax expense = amount of taxes that would be paid if income statement numbers
appeared on the current year's tax return. Deferred taxes was the plug figure (difference
between taxes payable and tax expense). The effect of subsequent changes in tax rates on
deferred tax account were essentially ignored.
Liability approach to tax allocation (FASB 96, 109)
Income tax expense = taxes currently payable plus change in deferred taxes. If tax rates
change, the effect on deferred tax amounts affect income tax expense in the year the
change is enacted. If there are no changes in tax rates, income tax expense should be
approximately the same as under APB Opinion 11.

Permanent Differences
Permanent differences affect both the computation of taxable income and income tax
expense as reported on the income statement. Examples:
Interest revenue on Municipal Bonds
Life insurance premiums and proceeds when coporation is beneficiary
Fines and penalties
Dividend exclusion
Statutory depletion
Temporary Differences
Temporary differences occur when an item appears on financial statements in one year and
on the tax return in a different year.
Taxable temporary differences give rise to deferred tax liabilities
Deductible temporary differences give rise to deferred tax assets

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 1

 TEMPORARY DIFFERENCES
Examples
Taxable temporary differences
Revenues or gains that are taxable after they are recognized on books:

Installment method for tax returns, accrual method for financial accounting purposes

Completed contract method for tax returns, percentage of completion method for financial accounting purposes (now uncommon)

Expenses or losses that are deductible before they are recognized on books:

Accelerated depreciation for tax returns, straightline for financial accounting purposes
Business combinations (goodwill): if assigned values of identifiable assets are higher than their
tax basis, the difference is a taxable temporary difference and the related deferred tax
liability would increase the goodwill to be recorded
A reduction in the tax basis of depreciable assets because of tax credits (under 1982 law, it was possible to get a larger investment tax credit if the
depreciable basis of the assets were reduced),; similar result if we capitalize interest for book purposes but deduct it on tax return as paid.

Deductible temporary differences

Expenses or losses that are deductible after they are recognized on books:

Warranty expenses accrued in year of sale according to GAAP, deductible on tax return
only when paid

Unrealized losses/gains on marketable securities (FASB 115), deductible on tax return

only when the securities are actually sold (affects trading securities on income statement
and available for sale securities on statement of comprehensive income).

Losses related to contingent liabilities (compensated absenses, lawsuits, etc.) are

deductible on tax return only when actually paid.
Revenues or gains that are taxable before they are recognized on books:

Subscription revenue recognized when earned per GAAP but taxable when collected.

Rent revenue received in advance (deferred revenue under GAAP) is taxable when
received.
Investment tax credits accounted for by the deferral method
An increase in the tax basis of assets because of indexing whenever the local currency is the functional currency

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 2

Net operating carrybacks and carryforwards
Under current laws, a net operating loss in a particular year can be carried back for 2 years or
forward for 20 years. The NOL would be handled as a deduction on the tax return of the year it
is carried to. (Tax law keeps changing – it was back 3 and forward 15 for awhile – don’t take
my word for it!)
If you carry back an NOL, record "income tax refund receivable" using the tax rate in effect the
year you are carrying to. If you elect to carryforward, you would use the current tax rate (or
enacted future tax rate) and record a "deferred tax asset."
Unused Tax credits may also be carried forward and would affect the amounts in the
deferred tax accounts.

Other temporary differences:

Unremitted earnings of subsidiaries

We report share of subsidiary's reported net income on parent company's books -- this is not a
taxable item currently. However, if we collect dividends they are probably partially taxable
(assuming 80% exclusion is in effect).

Valuation Allowance for Deferred Tax Assets

Deferred tax assets must be reduced by a valuation allowance (contra asset account) if it is more
likely than not (50% probability) that they will not be realized.

CLASSIFICATION OF DEFERRED TAXES

Deferred tax assets and liabilities are classified as current or noncurrent as follows:
If the amount is associated with a balance sheet account, the deferred taxes are classified the same
way. For example, differences in depreciation methods would give rise to noncurrent deferred tax
liability because accumulated depreciation is noncurrent account.
If the amount is not associated with a balance sheet account, the deferred taxes are classified on
the basis of when the difference is expected to reverse (if they reverse during next year, classify as
current, otherwise as noncurrent).

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 3

First Place Inc.
Deferred Tax Problem

First Place Inc. was incorporated in 2000. Information related to its first five years of operation are shown below. Compute income
tax expense and the deferred tax liability/asset for each year. Prepare journal entries.

2000 2001 2002 2003 2004

Pre-tax accounting income 100,000 100,000 100,000 100,000 100,000

Taxable income (check figure) 80,500 (6,500) (1,500) 244,500 185,500

Depreciation schedule
Machinery with 5 year life, no salvage
Acquired 1-1-2000 for
600,000 2000 2001 2002 2003 2004 Total
Straight-line method (book) 120,000 120,000 120,000 120,000 120,000 600,000
MACRS method (tax) 150,000 228,000 222,000 600,000
Difference (30,000) (108,000) (102,000) 120,000 120,000 -

Accounting income includes:

Life insurance premiums on officers 500 500 500 500 500
Rent revenue (accrual basis) 25,000 25,000
Book depreciation 120,000 120,000 120,000 120,000 120,000
Warranty expense (accrual) 20,000 20,000 20,000 20,000 -

Taxable income includes:

Accelerate depreciation 150,000 228,000 222,000 - -
Rent revenue (cash basis) 50,000
Warranty costs paid 10,000 19,000 20,000 21,000 10,000

Income tax rates: 2000 2001 2002 2003 2004

No changes anticipated 34%
New law enacted 36%
Another new law passed with phased
in increases 38% 40% 40%

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 4

Deferred Tax Problems - worksheet

Pre-tax accounting income

Permanent Differences:

Book TI
Temporary Differences:

Taxable Income
Applicable Tax Rate
Income taxes payable/(receivable)
Inventory of TDs

Total net temporary differences

Applicable tax rate
Net ending balance (deferred tax
accounts)
Net balance fwd (deferred tax accounts)
Change in net deferred taxes
Taxes (payable)/receivable
Income tax expense

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 5

Deferred Tax Problems - worksheet

Pre-tax accounting income

Permanent Differences:

Book TI
Temporary Differences:

Taxable Income
Applicable Tax Rate
Income taxes payable/(receivable)
Inventory of TDs

Total net temporary differences

Applicable tax rate
Net ending balance (deferred tax
accounts)
Net balance fwd (deferred tax accounts)
Change in net deferred taxes
Taxes (payable)/receivable
Income tax expense

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 6

Deferred Tax Problems - worksheet

Pre-tax accounting income

Permanent Differences:

Book TI
Temporary Differences:

Taxable Income
Applicable Tax Rate
Income taxes payable/(receivable)
Inventory of TDs

Total net temporary differences

Applicable tax rate
Net ending balance (deferred tax
accounts)
Net balance fwd (deferred tax accounts)
Change in net deferred taxes
Taxes (payable)/receivable
Income tax expense

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 7

Partial Solution - First Place, Inc. – The “complicated method”
Note that when I created this problem and the solution, the tax rule was that net operating
losses could be carried back for three years and forward for 15 years.
If the current tax rate for 2000 is 34% and no new tax law has been enacted, we would make the
following journal entry:
2000
Income tax expense (100,500 * .34) 34,170
Deferred tax asset - current (10,000 * .34) 3,400
Income taxes payable (80,500 * .34) 27,370
Deferred tax liability - noncurrent (30,000 * .34) 10,200

If a new tax law is enacted in 2001 (36% tax rate) and no other rate changes have been enacted,
we would make the following entry if we elect to carry the NOL back to 2000 when the tax rate
was 34%:
2001
Income tax expense (plug figure) 36,710
Income tax refund receivable (6,500 * .34) 2,210
Deferred tax asset - current (1,000 * .36) 360
Deferred tax liability - noncurrent (108,000 * .36) 38,880
Deferred tax asset - current (10,000 * .02) 200
Deferred tax liability - noncurrent (30,000 * .02) 600
Alternate computation:
Accumulated taxable TDs (30,000 + 108,000) * .36 = 49,680
Accumulated deductible TDs (10,000 + 1,000) * .36 = - 3,960
Correct net amount for deferred taxes 45,720
Currently on books (10,200 - 3,400) 6,800
Change in deferred taxes 38,920
Add taxes payble, subtract tax refunds -2,210
Income tax expense for 1990 36,710
If we plan to carry the NOL forward, the entry would be: ($130 diff = 6,500 * .02)
2001
Income tax expense 36,580
[Book TI 100,500 * .36 = 36,180
+ change in previousl recorded dfd tax (20,000 * .02)]
Deferred tax asset - current (6,500 * .36) 2,340
Deferred tax asset - current (1,000 * .36) 360
Deferred tax asset - current (10,000 * .02) 200
Deferred tax liability - noncurrent (108,000 * .36) 38,880
Deferred tax liability - noncurrent (30,000 * .02) 600

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 8

First Place, Inc. - continued
If a new tax law is enacted 2002 which provides for 38% tax rates for 1991 and 40% thereafter,
the journal entry would look like this:
Accumulated taxable TDs (138,000 + 102,000) * .40 = 96,000
Accumulated deductible TDs (11,000 + 0) * .40 = - 4,400
Correct net amount for deferred taxes 91,600
Currently on books (10,200 + 38,880 + 600 - 3,400 -360 -200) 45,720
Change in deferred taxes 45,880
Add taxes payble, subtract tax refunds (1,500 * .34) - 510
Income tax expense for 1990 45,370

2002
Income tax expense (plug figure*) 45,370
Income tax refund receivable 510
Deferred tax asset - current (11,000 * .04) 440
Deferred tax liability - noncurrent (102,000 * .40) 40,800
Deferred tax liability - noncurrent (138,000 * .04) 5,520
*Approximately: 100,500 * .40 = 40,200 + change in deferred (138,000 - 11,000) * .04 = 5,080
(off $90 because carryback of NOL is at .34 rate instead of .40 {1,500 * .06})
As a practical matter, it may be easier to use just one account for "net deferred taxes" on the
books and reclassify as asset/liability, current/noncurrent on the balance sheet when you do your
external reporting. Using 4 accounts makes the entries look a lot more complicated! See next
page

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 9

The “easier” method – First Place, Inc.
To keep things simple, it is probably easier to do the “bookkeeping” using a single deferred
income taxes account and then reclassify that balance for proper display on the balance sheet
when financial statements are prepared. To illustrate:
2000
Income tax expense 34,170
Deferred income taxes 6,800
Income taxes payable 27,370
2001
Income tax expense 36,710
Deferred income taxes 38,920
Income tax refund receivable 2,210
2002
Income tax expense 45,370
Deferred income taxes 45,880
Income tax refund receivable 510
2003
Income tax expense 40,200
Deferred income taxes 57,600
Income taxes payable 97,800
2004
Income tax expense 40,200
Deferred income taxes 34,000
Income taxes payable 74,200

Displayed on Balance Sheet: 12/31/00 12/31/01 12/31/02 12/31/03

Deferred tax asset - current 3,400 3,960 4,400 14,000
Deferred tax asset - noncurrent
Deferred tax liability - current
Deferred tax liability - noncurrent (10,200) (49,680) (96,000) (48,000)
(6,800) (45,720) (91,600) (34,000)

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 10

First Place, Inc. 34% 36% 38% 40% 40%
2000 2001 2002 2003 2004
Pre-tax accounting income 100,000 100,000 100,000 100,000 100,000
Permanent differences 500 500 500 500 500
Book TI 100,500 100,500 100,500 100,500 100,500
Temporary differences:
Rent revenue - - - 25,000 (25,000)
Depreciation (30,000) (108,000) (102,000) 120,000 120,000
Warranty 10,000 1,000 - (1,000) (10,000)
80,500 (6,500) (1,500) 244,500 185,500
Applicable tax rate 34% 34% 34% 40% 40%
Income tax payable (recbl) 27,370 (2,210) (510) 97,800 74,200

Change in current year TDs 6,800 38,520 40,800 (57,600) (34,000)

Adj prior TDs for rate change 400 5,080 4,580 -

Income tax expense 34,170 36,710 45,370 44,780 40,200

Old deferral method expense: 34,170 36,180 38,190 40,200 40,200
Difference related to rate change - 530 7,180 4,580 -

Inventory of TDs 12/31/00 12/31/01 12/31/02 12/31/03 12/31/04

Rent revenue - - - 25,000 -
Depreciation (30,000) (138,000) (240,000) (120,000) -
Warranty 10,000 11,000 11,000 10,000 -

Total temp differences (20,000) (127,000) (229,000) (85,000) -

Applicable tax rate 34% 36% 40% 40% 40%
Net balance - deferred taxes (6,800) (45,720) (91,600) (34,000) -
Net balance fwd - (6,800) (45,720) (91,600) (34,000)
Change in net deferred taxes (6,800) (38,920) (45,880) 57,600 34,000
Taxes (payable)/receivable (27,370) 2,210 510 (97,800) (74,200)

Income tax expense 34,170 36,710 45,370 40,200 40,200

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 11

Second Best Corporation
Homework problem

Second Best Corporation was incorporated in 2000. Information related to its first five years of operation are shown below.
Compute income tax expense and the deferred tax liability/asset for each year. Prepare journal entries.

2000 2001 2002 2003 2004

Pre-tax accounting income 20,000 25,000 30,000 45,000 50,000

Depreciation schedule
Machinery with 5 year life, no salvage
Acquired 1-1-2000 for
30,000 2000 2001 2002 2003 2004 Total
Straight-line method (book) 6,000 6,000 6,000 6,000 6,000 30,000
MACRS method (tax) 7,500 11,400 11,100 30,000
Difference (1,500) (5,400) (5,100) 6,000 6,000 0

Accounting income includes:

Interest on municipal bonds (10,000) (10,000) (10,000) (10,000) -
Rent revenue (accrual basis) (40,000) (40,000) - - -
Book depreciation 6,000 6,000 6,000 6,000 6,000
Warranty expense (accrual) 20,000 20,000 20,000 20,000 20,000
Contingent liability 150,000

Taxable income includes:

Accelerate depreciation 7,500 11,400 11,100 -
Rent revenue (cash basis) (80,000)
Warranty costs paid 10,000 19,000 20,000 21,000 10,000
Actual court costs 75,000 75,000

Income tax rates: 2000 2001 2002 2003 2004

Enacted rate 2000 & 2001 34% 34%
New law enacted in 2002 40% 40% 40%
Second Best Corporation
Homework problem

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 12

Deferred Tax Problems - worksheet

Pre-tax accounting income

Permanent Differences:

Book TI
Temporary Differences:

Taxable Income
Applicable Tax Rate
Income taxes payable/(receivable)
Inventory of TDs

Total net temporary differences

Applicable tax rate
Net ending balance (deferred tax
accounts)
Net balance fwd (deferred tax accounts)
Change in net deferred taxes
Taxes (payable)/receivable
Income tax expense

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 13

Deferred Tax Problems - worksheet

Pre-tax accounting income

Permanent Differences:

Book TI
Temporary Differences:

Taxable Income
Applicable Tax Rate
Income taxes payable/(receivable)
Inventory of TDs

Total net temporary differences

Applicable tax rate
Net ending balance (deferred tax
accounts)
Net balance fwd (deferred tax accounts)
Change in net deferred taxes
Taxes (payable)/receivable
Income tax expense

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 14

Deferred Tax Problems - worksheet

Pre-tax accounting income

Permanent Differences:

Book TI
Temporary Differences:

Taxable Income
Applicable Tax Rate
Income taxes payable/(receivable)
Inventory of TDs

Total net temporary differences

Applicable tax rate
Net ending balance (deferred tax
accounts)
Net balance fwd (deferred tax accounts)
Change in net deferred taxes
Taxes (payable)/receivable
Income tax expense

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 15

Deferred Tax Problems - worksheet

Pre-tax accounting income

Permanent Differences:

Book TI
Temporary Differences:

Taxable Income
Applicable Tax Rate
Income taxes payable/(receivable)
Inventory of TDs

Total net temporary differences

Applicable tax rate
Net ending balance (deferred tax
accounts)
Net balance fwd (deferred tax accounts)
Change in net deferred taxes
Taxes (payable)/receivable
Income tax expense

Accounting for Income Taxes created by T. Gordon 1/25/09 Page 16