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Chapter 16 Accounting for Income Taxes

DEFERRED TAX ASSETS AND DEFERRED TAX LIABILITIES



Fundamental Concepts

There are fundamental differences in the amount of income and expenses reported for GAAP and
income tax purposes. The objective for GAAP reporting is to report the economic activities of
the entity. The objective for income tax purposes is for the government to raise revenue. There
are two terms that identify the types of income subject to tax under each reporting system.

1 Pretax financial income
Pretax financial income is the income determined using GAAP. It is the amount of income
on which income tax is computed for financial statement purposed. It is formally presented
in the income statement as income before income taxes. We normally refer to it is pretax
income.

2 Taxable income
Taxable income is the income determined using Internal Revenue Code rules and regulations.
It is the amount of income on which the entity will actually pay income tax in the current
accounting period.

Temporary Differences

Deferred taxes arise as a result of temporary difference between income tax expense and
income tax payable. A temporary difference is the difference between the book value of an asset
or liability and the tax basis of the same asset or liability. If the income tax expense in the
income statement is larger than the current income tax liability the difference is called a
deferred tax liability. If the income tax expense in the income statement is smaller than the
current income tax liability the difference is called a deferred tax asset.

Deferred Tax Liabilities

A deferred tax liability is created as a result of the difference between the book value and the tax
basis of an asset or liability. The difference creates a tax liability in future periods.

EXAMPLE: Spencer Company has pretax financial statement income for the current year of
$700,000. The companys average income tax rate is 30% on taxable income. Spencer
Corporation calculates deprecation expense using the straight-line method for financial reporting
purposes and an ACRS (accelerated) method for tax purposes. The result will be a deferred tax
liability. There will be a smaller depreciation expense deduction in subsequent years because a
larger portion was taken in the year of purchase. Lets assume that the difference is $50,000 as
calculated below.

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Depreciation Expense Amount
Financial statements $25,000
IRS Form 1120 75,000
Difference ($50,000)

The above is a deferred liability as a result of expenses that will be recognized for tax purposed
in subsequent periods. Now lets look that an income item. Lets assume that Spencer Company
sold merchandise using the installment method for tax purposes but uses the accrual method for
financial statement reporting purposes. This means that there will be additional income in
subsequent periods on the tax return with results in an increase in the tax liability. The
difference is $200,000 as calculated below.

Installment Sale Amount
Financial statements $300,000
IRS Form 1120 100,000
Difference $200,000

Step #1: The first step in calculating and reporting deferred income taxes is the analysis of the
book to tax differences. The following is a computation of taxable income starting with pretax
accounting income.

Taxable Income Amount
Pretax accounting income $700,000
Temporary differences:
Accelerated depreciation (50,000)
Installment sales (200,000)
Taxable income $450,000

Step #2: Income tax payable is based on taxable income using the current average tax rate. The
following is a calculation of the income tax payable.

Income Tax Payable Amount
Taxable income $450,000
Tax rate 30%
Income tax payable $135,000

Step #3: Based on this information we are now ready to calculate the deferred tax liability for
the current year end. The liability is calculated as follows.

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Chapter 16 Accounting for Income Taxes

Temporary Difference
Future
Amounts Tax Rate Asset Liability
Depreciation $50,000 30% $15,000
Installment sale 200,000 30% 60,000
$250,000 $75,000
Deferred Tax

Step #4: The deferred tax expense is the deferred portion of the income tax that is reported on
the face of the income statement. It is calculated by analyzing the deferred tax liability T-
account. In this case we are assuming that there is no beginning balance. The T-account
analysis is as follows:

Description Debit Credit
Beginning balance $0
Adjusting journal entry 75,000
Ending balance $75,000
T-Account: Deferred Tax Liability


In this case the deferred tax expense is the change (adjusting journal entry) in the deferred tax
liability account. If there is a change in both the deferred tax asset account (deferred tax benefit)
and the deferred tax liability account (deferred tax expense) the amounts net to be netted together
to derive a single amount of deferred tax expense or deferred tax benefit.

Step #5: Now that we know the income tax payable from the taxable income and the deferred
tax expense from the timing differences we are ready to calculate the total income tax expense
that will be reported on the face of the income statement. The calculation of total income tax
expense is as follows.

Income Tax Expense Amount
Current tax expense $135,000
Deferred tax expense 75,000
Income tax expense $210,000


Step #6: So far all we have done is calculate the amounts required to prepare the year-end
adjusting journal entry to record income tax expenses. This journal entry sets up the income tax
expense that will be reported in the income statement, the income tax liability that will be paid to
the internal revenue service and the deferred tax liability.

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Chapter 16 Accounting for Income Taxes

Account Debit Credit
Income tax expense $210,000
Income tax payable $135,000
Deferred tax liability 75,000


Summary of income tax accounting objectives
There are two objectives in accounting for income taxes.
1 To recognize the income taxes payable for the current accounting period.
2 To record future tax liabilities as a result of items recognized in the income statement but not
the tax return or recognized on the tax return but not the income statement.

Deferred Tax Assets

So far all we have talked about it deferred tax liabilities. These were created as a result of
income reported in the income statement but deferred into future period on the tax return, and
expenses taken on the tax return in the current period which creates smaller deductions on the tax
return in future periods. Now we are going to exam the impact of deferred tax assets on the
financial statements.

A deferred tax asset is created as a result of the difference between the book value and the tax
basis of an asset or liability. The difference creates a tax asset in future periods. The net result is
a decrease in taxes in future periods. If we have and expense or loss in the income statement that
is not reported on the tax return this creates a deferred tax asset. The expense or loss will be
used on the tax return in some future period(s). Also, if we have revenue or gain reported on the
tax return that is not currently reported in the income statement this creates a deferred tax asset.
The revenue or gain will be reported in some future period(s) but it will not be taxable.

EXERCISE: Spencer Company has pretax financial statement income for the current year of
$700,000. The companys average income tax rate is 30% on taxable income. Spencer
Corporation has an estimated warranty liability of $125,000 which is recorded on the income
statement but is not deductible for income tax purposes. In addition, the company has leased a
piece of equipment for $100,000 per year for three years to a customer. The lessee paid the
entire three years rent in advance. At the end of the year Spencer Company has a deferred
liability (unearned rent) of $200,000 recorded in the balance sheet. The rent is reported on a
cash basis for income tax purposes. Each of these items creates a deferred tax asset.

Using the format provided calculate the book to tax difference as a result of the estimated
warranty liability.

Estimated Warranty Amount
Financial statements $
IRS Form 1120 $
Difference $


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Solution:

Estimated Warranty Amount
Financial statements $125,000
IRS Form 1120 0
Difference $125,000

Using the format provided calculate the book to tax difference as a result of the unearned rent.

Unearned Rent Amount
Financial statements $
IRS Form 1120 $
Difference $

Solution:

Unearned Rent Amount
Financial statements $100,000
IRS Form 1120 300,000
Difference ($200,000)

Based on the information above compute taxable income by starting with pretax accounting
income.

Pretax financial income $
Temporary differences:
Estimated warranty expense $
Unearned rent income $
Taxable income $
Taxable Income

Solution:

Pretax financial income $700,000
Temporary differences
Estimated warranty expense 125,000
Unearned rent income 200,000
Taxable income $1,025,000
Taxable Income



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Chapter 16 Accounting for Income Taxes

Now that you have taxable income you can calculate income tax payable.

Income Tax Payable Amount
Taxable income $
Tax rate %
Income tax payable $


Solution:

Income Tax Payable Amount
Taxable income $1,025,000
Tax rate 30%
Income tax payable $307,500

Based on the information provided in the above exercises prepare the schedule of deferred tax
assets.

Future Tax
Temporary Difference Amount Rate Asset Liability
Estimated warranty $ %$
Unearned rent $ %$
$ $
Deferred Tax


Solution:

Future Tax
Temporary Difference Amount Rate Asset Liability
Estimated warranty $125,000 30% $37,500
Unearned rent 200,000 30% 60,000
$325,000 $97,500
Deferred Tax


Instead of a deferred tax expense we will have a deferred tax benefit as a result of the deferred
tax assets.

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Chapter 16 Accounting for Income Taxes

Decsription Debit Credit
Beginning balance
Adjusting journal entry
Ending balance
T-Account: Deferred Tax Asset


Solution:

Decsription Debit Credit
Beginning balance $0
Adjusting journal entry 97,500
Ending balance $97,500
T-Account: Deferred Tax Asset

The deferred tax benefit, which is the change in the deferred asset account, reduces current
period income tax expense. Using the format calculate income tax expense.

Income Tax Expense Amount
Deferred tax benefit
Current tax expense
Income tax expense


Solution:

Income Tax Expense Amount
Current tax expense $307,500
Deferred tax benefit (97,500)
Income tax expense $210,000

Base on your experience with the deferred tax liability see if you can prepare the year-end
adjusting journal entry to record income tax expense, income tax payable, and the deferred tax
asset.

Account Debit Credit
Income tax expense $
Deferred tax asset $
Income tax payable $



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Solution:

Account Debit Credit
Income tax expense $210,000
Deferred tax asset 97,500
Income tax payable $307,500


Valuation Allowance

In accounting we are always careful that assets are not overstated. If the balance in the deferred
asset account is greater than the expected benefit to be realized we must establish a valuation
allowance account to that will reduce the amount reported in the balance sheet to the expected
realized value. This is a contra asset account off setting the deferred tax benefit. When
recording the valuation allowance we charge the reduction to current period income tax expense.

EXAMPLE: At December 31, 2002, Spencer Company has a deferred tax asset of $200,000.
After a careful review of all available evidence, it is determined that it is more likely than not
that the $80,000 of this deferred tax asset will not be realized. Prepare the necessary journal
entry.

Account Debit Credit
Income tax expense $
Allowance to reduce deferred tax asset to
expected realizable value $


Solution:

Account Debit Credit
Income tax expense $80,000
Allowance to reduce deferred tax asset to
expected realizable value $80,000


COMPREHENSIVE REVIEW

The above examples and exercises had you working with either a deferred tax liability or a
deferred tax benefit but not both in the same problem. Now we need to integrate what you have
learned into a more complete situation.

EXAMPLE: The following facts relate to Spencer Company:
(1) Deferred tax liability, J anuary 1, 2003, $40,000
(2) Deferred tax asset, J anuary 1, 2003, $0
(3) Taxable income for 2003, $95,000
(4) Pretax financial income for 2003, $200,000
(5) Cumulative temporary difference at December 31, 2003, giving rise to future taxable
amounts, $240,000
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(6) Cumulated temporary difference at December 31, 2003, giving rise to future deductible
amounts, $35,000
(7) Tax rate for all years, 40%
(8) The company is expected to operate profitability in the future.

1. Based on the information provided compute taxable income by starting with pretax
accounting income.

Financial statement income $
Temporary differences:
Deduct: future taxable amounts
Current period $
Prior period
Beginning deferred tax liability $
Enacted tax rate %
Prior period future taxable amount $ $
$
Add: future deductions $
Taxable income per tax return $
Taxable Income


SOLUTION:

Financial statement income $200,000
Temporary differences:
Deduct: future taxable amounts
Current period $240,000
Prior period
Beginning deferred tax liability $40,000
Enacted tax rate 40%
Prior period future taxable amount 100,000 140,000
60,000
Add: future deductions 35,000
Taxable income per tax return $95,000
Taxable Income


2. Calculate income tax payable based on the taxable income.

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Taxable income $
Enacted tax rate $
Income tax payable $
Income Tax Payable


SOLUTION:

Taxable income $95,000
Enacted tax rate 40%
Income tax payable $38,000
Income Tax Payable


3. Based on the above information prepare a schedule of deferred tax assets and deferred tax
liabilities.

Temporary difference
Future
Amounts Tax Rate Asset Liability
Future taxable amounts $ % $
Future deductable amounts $ % $
Totals $ $ $
Deferred Tax


SOLUTION:

Temporary difference
Future
Amounts Tax Rate Asset Liability
Future taxable amounts $240,000 40% $96,000
Future deductable amounts (35,000) 40% ($14,000)
Totals $205,000 ($14,000) $96,000
Deferred Tax

4. Prepare a t-account analysis of the deferred tax asset account.

Description Debit Credit
Beginning balance $
Adjusting journal entry $
Ending Balance $
T-Account: Deferred Tax Asset

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SOLUTION:

Description Debit Credit
Beginning balance $0
Adjusting journal entry 14,000
Ending Balance $14,000
T-Account: Deferred Tax Asset

5. Prepare a t-account analysis of the deferred tax liability account.

Description Debit Credit
Beginning balance $
Adjusting journal entry $
Ending Balance $
T-Account: Deferred Tax Liability


SOLUTION:

Description Debit Credit
Beginning balance $40,000
Adjusting journal entry 56,000
Ending Balance $96,000
T-Account: Deferred Tax Liability

6. Prepare a schedule of net deferred tax expense (benefit).

Amount
Deferred tax expense $
Deferred tax benefit $
Net deferred tax expense $
Net Deferred Tax Expense (Benefit)


SOLUTION:

Amount
Deferred tax expense $56,000
Deferred tax benefit (14,000)
Net deferred tax expense $42,000
Net Deferred Tax Expense (Benefit)

7. Prepare a schedule of income tax expense.

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Income Tax Expense Amount
Current tax expense $
Net deferred tax expense $
Income tax expense $


SOLUTION:

Income Tax Expense Amount
Current tax expense $38,000
Net deferred tax expense 42,000
Income tax expense $80,000

8. Prepare the journal entry to record income tax expense, income tax payable, the change in
deferred tax assets and deferred tax liabilities for the year.

Account Debit Credit
Income tax expense $
Deferred tax asset $
Deferred tax liability $
Income tax payable $


SOLUTION:

Account Debit Credit
Income tax expense $80,000
Deferred tax asset 14,000
Deferred tax liability $56,000
Income tax payable 38,000


9. Prepare a partial income statement starting with income before income tax.

Income before income taxes $
Income tax expense
Current $
Deferred $ $
Net income $
Partial Income Statement





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SOLUTION:

Income before income taxes $200,000
Income tax expense:
Current $38,000
Deferred 42,000 80,000
Net income $120,000
Partial Income Statement


Specific Differences

There are actually two kinds of book to tax differences. So far we have only talked about
temporary differences that will reverse in future accounting periods. There are also differences
that dont reverse and we call these permanent differences.

Temporary Differences

As we have discussed above there are taxable temporary differences and deductible temporary
differences.

1 Taxable temporary differences
a) Revenues and gains are recognized in the current income statement but taxable in
some future accounting period(s) on the tax return.
b) Expenses and losses are deducted on the current tax return but recognized on the
income statement in some future accounting period(s).

2 Deductible temporary differences
a) Revenue and gains are recognized on the current tax return but recognized in the
income statement in some future accounting period(s).
b) Expenses and losses are deducted on the current income statement but expensed in
some future accounting period(s) on the tax return.

Permanent differences

Permanent differences occur as a result of differences between GAAP and income tax law.
Income or expenses reported on the income statement are never reported on the tax return; or
income or expenses reported on the tax return are never reported on the income statement. There
are no deferred taxes involved here.

The book to tax differences are reconciled on the IRS Form 1120 which you will deal with in
your corporate tax class.

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