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10.1.A.

ANALYSIS OF INCOME TAXES


KEY TERMS
It is typical for corporations to keep two sets of books, one for the investors, which must comply
with GAAP, and the other for the taxation authorities, which must comply with the tax code. The
existence of two sets of rules will lead to different bottom line results.
Thus, "pre-tax income" is that before tax amount that is calculated using GAAP, whereas "taxable
income" is that before tax amount that is calculated using the tax code. It is important to note,
that actual taxes are based on the taxable amount whereas "tax expense", is an accounting entry
that is based on pre-tax income.
Question:
Which of the following terminologies is (are) correct with respect to the issue of accounting for
income taxes?
I.
II.

Taxable income is the figure that is derived by using GAAP rules.


Pretax income is the figure that is calculated by using the rules as required by the tax
code.

III.

Income taxes payable is the amount that the company would owe to the taxation
authorities had the GAAP method been used to calculate taxable income.

IV.

Income tax expense reported on the income statement is rarely equal to the actual amount
of income taxes paid.

Answer:
IV only.
Explanation:
(I) is incorrect since taxable income is the figure that is derived by using the rules as per the tax
code.
On the other hand, (II) is incorrect because pretax income is the figure that is calculated by using
the rules as required by GAAP.
(III) is incorrect because income taxes payable is the actual amount that the company owes to the
taxation authorities through the use of the rules as required by the tax code.

CREATION OF DERERRED TAX ASSET AND LIABILITY


Often times, firms employ the straight line form of depreciation to account for its long term assets
on its financial statements. However, the tax code mandates that a more accelerated form of
depreciation be used for tax purposes. Hence, in the early years, depreciation will be higher in
the tax books than it will be in the financial books. Correspondingly, taxable income will be
lower than pretax income, which means that the actual taxes paid or owed will be less than the tax
expense reported in the financial statements.

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However, over the life of the asset, the total amount that is depreciated should be the same
regardless of the method that is chosen. In other words, while the tax code resulted in higher
depreciation early on, eventually, the GAAP method of depreciation will result in higher
depreciation amounts later on. Therefore, in the ladder years, pretax income will become less
than taxable income. Thus, the actual taxes that must be paid will exceed what is reported as tax
expense.
This illustration demonstrates that the different method of depreciation employed simply resulted
in a "temporary" or a "timing" difference in taxes. Hence, early on, when the actual taxes paid
were less than the tax expense, we should know that eventually, the firm will have to pay a much
higher amount of tax than what it will report as tax expense. For this reason, a "deferred tax
liability" is established early on.
Question:
Which of the following statements is (are) true with respect to the liability method of accounting
for deferred taxes?
I.

II.

If a company were to use a different depreciation method for its financial statement and
its tax filing, the total depreciation expense over the life of the asset would still be the
same.
If a company was to use a straight-line depreciation method for its financial statement
and an accelerated depreciation method for its tax statement, pre-tax income will be
higher than taxable income in the latter years of the asset's life.

III.

Any income that is not subject to any taxation will result in a permanent difference
between reported taxes and actual taxes payable.

IV.

Permanent differences will not have any impact on future income taxes.

Answer:
I, III, and IV only.
Explanation:
(II) is incorrect since if a company were to use a straight-line depreciation method for its financial
statement and an accelerated depreciation method for its tax statement, pre-tax income will be
lower than taxable income in the latter year's of the asset's life. In the latter year's, for tax
purposes, there is very little depreciation left. Hence, taxable income will be higher than pre-tax
income.

Question:
Which of the following statements is (are) true with respect to the deferred tax liability account
that may arise through the use of the liability method of accounting for income taxes?
I.

A deferred tax liability represents that portion of the current reported income tax expense
that has not been paid.

II.

Deferred tax liability is a legal obligation for the company to pay taxes in excess of what
it will report in the future.

III.

If the deferred tax liability is expected to remain stable or increase over time, the account

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may actually be viewed as part of a company's equity capital.


IV.

If a deferred tax liability amount is expected to decline over time, then it may be ignored
for analytical purposes.

Answer:
I and III only.
Explanation:
(II) is incorrect because a deferred tax liability is NOT a legal obligation for the company to pay
taxes in excess of what it will report in the future. Technically, this amount is only an estimate
and it does not represent taxes that are actually owed to the government.
(IV) is incorrect because if a deferred tax liability amount is expected to decline over time, then it
should definitely not be ignored. This expected decline is an indication that future taxes actually
paid will exceed what is expected to be reported to the public.
On the other hand, if the firm pays a much higher amount of tax early on than what they report as
tax expense, then we should know that eventually, the taxes owed will be less than what will be
reported as a tax expense in the future. In such a case, a deferred tax asset is created.
Question:
Which of the following statements is (are) true with respect to the existence of a deferred tax
asset?
I.
II.

A deferred tax asset occurs when taxable income is less than the pre-tax income for the
period.
A deferred tax asset account can be viewed as a prepaid tax account.

III.

If a company's deferred taxes are categorized as an asset, it is an indication that in the


future the reported income tax expenses will be greater than the actual taxes owed at that
time.

IV.

A deferred tax asset may only be recognized in the balance sheet if management believes
that there is a greater than 50% chance that this particular timing difference will actually
reverse.

Answer:
II, III, and IV only.
Explanation:
(I) is incorrect because a deferred tax asset occurs when pre-tax income is less than the taxable
income for the period.

COMPUTING KEY VALUES


Deferred tax liability (DTL) is equal to the undiscounted amount of income tax that will have to
be paid in the future once these temporary differences between the GAAP method of accounting

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and the tax code reverse. Hence, if there is a permanent difference in the way an item is
accounted for, it will not be reflected in DTL.
Income tax expense, as is it reported on a GAAP compliant income statement, may be found as
follows:
Income Tax Expense = Actual Income Tax Owed + Change in DTL
Question:
Which of the following statements is (are) true with respect to the deferred tax liability (asset)
that is created under the liability method of accounting for income taxes?
I.
II.

Deferred tax asset is simply the extra income taxes that will be paid in the future once
timing differences reverse.
The value of a deferred tax liability or asset is simply equal to the undiscounted value of
all future taxes that are expected to be paid or credited once the timing differences are
reversed.

III.

The current period's income tax expense is determined only after the figure for the current
period's deferred tax liability or asset has been calculated.

IV.

Income tax expense for the period will be higher than the actual taxes owed if the
deferred tax liability at the beginning of the period was higher than the deferred tax
liability at the end of the period.

Answer:
II and III only.
Explanation:
(I) is incorrect because it is the deferred tax liability which is simply the extra income taxes that
will be paid in the future due to the reversal of timing differences.
(IV) is incorrect because the income tax expense for the period will be higher than the actual
taxes owed if the deferred tax liability at the beginning of the period was lower than the deferred
tax liability at the end of the period. In particular:
Income tax expense = Taxes owed + Ending deferred tax liability - Beginning deferred tax
liability

ACCOUNTING FOR A CHANGE IN THE TAX RATE


As we've seen, reported tax expense varies by the amount of the change in DTL. However, DTL
itself is the portion of reported income tax that's expected to be actually paid in the future.
Consequently, if future tax rates are expected to increase, when the timing differences reverse, the
amount by which the actual tax will exceed tax expense will be more than the current amount by
which tax expense exceeds actual tax payable. Hence, DTL must be increased in the current
period to account for this higher tax liability in the future. But, this increase in DTL will increase
income tax expense reported for the current period.

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Question:
Which of the following statements is (are) true with respect to the impact that a change in the
statutory tax rate would have on a company's financial statements?
I.
II.

If the tax rate is expected to change in the future, it will only impact future period
reported tax expenses.
The deferred tax liability will increase for the current period if the tax rate is expected to
increase in the future.

III.

Any changes in deferred tax liability will have no affect on the cash flows of the
company.

IV.

The effective tax rate for reporting purposes in the current period will shift upwards even
if actual tax rates are not expected to increase until some point in the future.

Answer:
II, III, and IV only.
Explanation:
(I) is incorrect because the current period's tax expense is dependent upon the firm's
deferred tax liability at the end of the period. However, the ending balance of deferred tax
liability will be affected by expected changes in the tax rate in the future.
(III) is correct because the cash flow is only affected by the actual taxes that are paid. The fact
that some timing differences arose will not change the amount of cash that was paid in taxes.

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