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Accounting Clinic VI

Prepared by: Nir Yehuda

With contributions by

Stephen H. Penman – Columbia University

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Deferred Taxes: Basics

Deferred taxes arise when income tax expense differs from income tax liability

The income tax liability is based on income determined under provisions of the United States Internal Revenue Code and foreign, state, and other taxes (including franchise taxes) based on income.

The tax expense is the amount of income taxes (whether or not currently payable or refundable) allocable to a period in the determination of net income.

Some of these differences are temporary and some are permanent

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Why do we need Deferred Taxes?

Main issue: the need to match tax expense

to related accounting income so appropriate

after-tax income is reported, independent of

when taxes on that income is assessed by

tax authorities.

Advantages of deferred taxes:

Smoothing of earnings

Better relationship between earnings

and income tax expense

effective tax rate reflects statutory rate

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Temporary and Permanent Differences

Temporary difference.

Differences between the taxable amount of a revenue or expense and its reported amount in the financial statements that result in taxable or deductible amounts in future years when the revenue or expense enters the tax return.

Permanent differences.

Permanent differences arise from statutory provisions under which specified revenues are exempt from taxation and specified expenses are not allowable as deductions in determining taxable income.

Other permanent differences arise from items entering into the determination of taxable income which are not components of pretax accounting income in any period.

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Examples of Permanent Differences

Interest received on municipal obligations

premiums paid on officers' life insurance.

Fines and other expenses that result from a

violation of law.

Deduction for dividend received from U.S.

corporations.

Percentage depletion of natural resources in

excess of their cost.

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Examples of Temporary differences

1. Revenues or gains that are taxable after they are recognized in financial income. An asset (for example, a receivable from an installment sale) may be recognized for revenues or gains that will result in future taxable amounts when the asset is recovered.

2. Expenses or losses that are deductible after they are recognized in financial income. A liability (for example, a product warranty liability) may be recognized for expenses or losses that will result in future tax deductible amounts when the liability is settled.

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Examples of Temporary differences

3. Revenues or gains that are taxable before they

are recognized in financial income. A liability

(for example, subscriptions received in advance)

may be recognized for an advance payment for

goods or services to be provided in future years.

For tax purposes, the advance payment is

included in taxable income upon the receipt of

cash. Future sacrifices to provide goods or

services (or future refunds to those who cancel

their orders) will result in future tax deductible

amounts when the liability is settled.

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Examples of Temporary differences

4. Expenses or losses that are deductible before they are

recognized in financial income. The cost of an asset (for

example, depreciable personal property) may have been

deducted for tax purposes faster than it was depreciated

for financial reporting. Amounts received upon future

recovery of the amount of the asset for financial reporting

will exceed the remaining tax basis of the asset, and the

excess will be taxable when the asset is recovered.

5. A reduction in the tax basis of depreciable assets because

of tax credits. Amounts received upon future recovery of

the amount of the asset for financial reporting will exceed

the remaining tax basis of the asset, and the excess will

be taxable when the asset is recovered.

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Deferred Tax Liability

A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years.

For example, a temporary difference is created between the reported amount and the tax basis of an installment sale receivable if, for tax purposes, some or all of the gain on the installment sale will be included in the determination of taxable income in future years. Because amounts received upon recovery of that receivable will be taxable, a deferred tax liability is recognized in the current year for the related taxes payable in future years.

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Deferred Tax Asset

A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards.

For example, a temporary difference is created between the reported amount and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated expenses are not deductible until a future year. Settlement of that liability will result in tax deductions in future years, and a deferred tax asset is recognized in the current year for the reduction in taxes payable in future years.

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Temporary Differences Effect

Revenue/

Expense

When recorded in

books relatively to the

taxable income

Deferred tax effect

Revenue Earlier Liability

Revenue Later Asset

Expense Earlier Asset

Expense Later Liability

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Basic Journal Entry to Record Deferred Taxes

Tax Liability

Income Tax Expense xxx

Def.Tax Liability xxx

Taxes Payable xxx

Tax Asset

Income Tax Expense xxx

Def. Tax Asset xxx

Taxes Payable xxx

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Recording a Valuation Allowance

for Doubtful Deferred Tax Assets

A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.

The net deferred tax asset should equal that portion of the deferred tax asset which, based on the current available evidence, will not be realized.

Journal entry: Income Tax Expense xxx Allowance to Reduce Deferred Tax Asset to Expected Realizable Value xxx

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Example – Deferred Tax Liability -

Depreciation

Bryant Corporation purchased a new

machine for $100,000 on January 1, 2004.

The machine has a four-year estimated

service life and no salvage value.

Bryant’s pretax income for each year

2004 - 2007 is 200,000 before depreciation

and taxes.

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Bryant Corp. uses straight-line depreciation

on its books and MACRS for tax reporting.

For tax purposes the machine is also

depreciated over 4 years using MACRS (an

accelerated depreciation method).

The depreciation percentages for each of the

years are 33%, 44%, 15% and 8%.

Assume a 40% tax rate.

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A. Compute financial (book) income after

depreciation but before taxes. What is

income tax expense?

B. Compute taxable income. What is income

tax payable?

C. Give the journal entries to record taxes.

D. Give the balance of the deferred tax

liability at the end of each of the years.

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Solution

Financial (book) income 2004 2005 2006 2007

Income before Depreciation

Depreciation Expense

($100,000/4)

Income after depreciation

but before taxes

Income Tax Expense (40%)

$200,000

(25,000)

$175,000

$70,000

$200,000

(25,000)

$175,000

$70,000

$200,000

(25,000)

$175,000

$70,000

$200,000

(25,000)

$175,000

$70,000

A.

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2004 2005 2006 2007

Pre-Tax Income before Depreciation

$200,000 $200,000 $200,000 $200,000

Depreciation Deduction: (33,000) (44,000) (15,000) (8,000)

Taxable Income

$167,000 $156,000 $185,000 $192,000

Income Taxable Payable (40%) $66,800 $62,400 $74,000 $76,800

B.

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C. Journal entries:

2004

Income Tax Expense

Tax Payable

Deferred Tax Liability

70,000

66,800

3,200

2005

Income Tax Expense

Tax Payable

Deferred Tax Liability

70,000

62,400

7,600

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2006

Income Tax Expense 70,000

Deferred Tax Liability

Tax Payable

4,000

74,000

2007

Income Tax Expense 70,000

Deferred Tax Liability

Tax Payable

6,800

76,800

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D. The deferred tax liability account

Dr. Cr.

3,200 2004 entry

3,200 12/31/2004

7,600 2005 entry

10,800 12/31/2005

4,000 2006 entry

6,800 12/31/2006

6,800 2007 entry

0 12/31/2007

The liability has reversed itself

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Example - Deferred Tax Liability –

Advances from Customers

Miller Co. received $30,000 of subscriptions in advance at the end of 2004.

Subscription revenue will be equally recognized in 2005, 2006, and 2007, for financial accounting purposes but all of the $30,000 will be recognized in 2004 for tax purposes.

Miller’s pretax income for each year 2004-2007 is $100,000 before taxes.

Assume a 40% tax rate.

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A. Compute Financial (book) income

including subscription revenue but

excluding taxes. What is income tax

expense?

B. Compute taxable income. What is income

tax payable?

C. Give the journal entries to record taxes.

D. Give the balance of the deferred tax asset

at the end of each of the years.

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E. For this requirement only, assume that as

a result of examining available evidence

in 2004, it is more likely than not that

$10,000 of the deferred tax asset will not

be realized. Give the journal entry to

record this reduction.

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Solution

2004 2005 2006 2007

Financial (book) income

Income before subscription 100,000 100,000 100,000 100,000

Subscription revenue received

in 2004

0 10,000 10,000 10,000

Income before taxes 100,000 110,000 110,000 110,000

Income tax expense (40%) 40,000 44,000 44,000 44,000

A.

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2004 2005 2006 2007

Pretax income 100,000 100,000 100,000 100,000

Subscription received in 2004 30,000 - - -

Taxable Income 130,000 100,000 100,000 100,000

Taxes Payable (40%) 52,000 40,000 40,000 40,000

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C. Journal entries

2004

Income tax expense 40,000

Deferred tax asset 12,000

Tax payable 52,000

2005 - 2007

Income tax expense 44,000

Deferred tax asset 4,000

Tax payable 40,000

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D. The deferred tax asset account

Db. Cr.

12,000 2004 entry

12,000 12/31/2004

4,000 2005 entry

8,000 12/31/2005

4,000 2006 entry

4,000 12/31/2006

4,000 2007 entry

0 12/31/2007

The asset has reversed itself.

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Income Tax Expense 10,000

Allowance to Reduce Deferred Tax Asset

To Expected Realizable Value 10,000

To record the reduction in the deferred tax asset

E.

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Example - Permanent Differences

Calculation

Hunter Corporation reports the following information for

2004:

Financial (Book) Income before Income Taxes $548,000

Income Taxes Payable (for 2004) 157,500

Income Tax Expense 210,000

Hunter Corp. has both temporary and permanent

differences between book income and taxable income.

The temporary difference results from depreciation.

The permanent difference results from a fine that the

company has to pay (but can not be deducted on its tax

return).

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What is the amount of the permanent difference

for the year?

The tax rate is 35%

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Solution

Step 1: Find the change in the deferred tax liability

Income Tax Expense (Book) $210,000

Income Taxes Payable 157,500

∆ Deferred Tax Liability 52,500

Step 2: Find the temporary difference

∆ Deferred Tax Liability/0.35 $52,500/0.35=

150,000

Step 3: Find taxable income

Income Taxes Payable (from current year)/0.35 $157,500/0.35=

450,000

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Solution (Cont.)

Step 4: Find the permanent difference

Taxable Income (IRS) $450,000

Temporary Differences 150,000

Financial (Book) Income before Taxes Excluding

Permanent Differences 600,000

Permanent Differences (P.N) 52,000

Financial (Book) Income before Taxes 548,000

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Financial Statement Presentation

On the balance sheet, an enterprise should

separate deferred tax liabilities and assets

into a current amount and a noncurrent

amount. (Under IFRS, the separation is not

made)

Deferred tax liabilities and assets should be

classified as current or noncurrent based on

the classification of the related asset or

liability for financial reporting.

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Financial Statement Presentation

A deferred tax liability or asset that is not

related to an asset or liability for financial

reporting, including deferred tax assets

related to carryforwards, should be

classified according to the expected

reversal date of the temporary difference.

The valuation allowance for a particular tax

jurisdiction should be allocated between

current and noncurrent deferred tax assets

for that tax jurisdiction on a pro rata basis.