16

Income Taxes
Overview
Financial accounting for income taxes is far more complicated then what you have
experienced thus far. Previously, you probably saw income tax expense being simply
recorded as income before taxes multiplied by a given rate. Unfortunately, accounting
for income taxes isnt quite that easy. Otherwise, an entire chapterthis chapter
would, obviously, not be needed.
Having already taken a tax course before this chapter can be useful, but it is not
absolutely essential. This chapter will emphasize how financial accounting is affected by
different kinds of tax adjustments, rather than your knowledge of specific tax rules and
regulations.
Taxable income and financial income are almost always two different numbers. Hence,
merely multiplying financial income before taxes by a constant rate every year would
distort what is actually happening. Frequently, the differences between the two (financial
and taxable income) are made up of numerous, even dozens, of different adjustments.
There are two different kinds of adjustments. One kind is called temporary because the
adjustment will reverse itself in a different year. Temporary adjustments relate to timing
differences. The tax law requires a different timetable for the recognition of some
revenue and expense items. Over the life of a business, the total revenue and expenses
are the same for financial and taxable income when it comes to temporary adjustments.
The other kind of adjustment is called permanent. Permanent differences result when
an item of revenue or expense is never recorded for taxable income but is for financial
income or vice versa.
When a company has higher taxable income now (due to more revenue or fewer
expenses on a tax basis) relative to financial income, and it is due to temporary
differences, that means the company will have lower taxable income later (again,
relative to financial income). Lower taxable income and, hence, taxes later is a future
economic benefit, and that sounds like our definition of an asset. Hence, a company in
this situation will report a deferred tax asset.

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Chapter 16

If, on the other hand, a company has lower taxable income now, relative to financial
income, it means the time to pay the piper will come later. Future obligations sound like
liabilities, and indeed, that is the case here as well. Hence, a company in this situation
will report a deferred tax liability.
Thats not so difficult, right? Well, the prior discussion begins to scratch the surface, but
there is even more to it than that. We also have to consider changing tax rates, the
effect of net operating losses getting carried back and forward to offset taxable income,
and several other issues. Plus, most companies dont have just one adjusting item, so
things can get messy when there are many adjustments going different ways and on
differing schedules. Its time to roll up your sleeves and get a little mess on you because
this topic takes more than a bit of common sense and skimming over to master.

Learning Objectives
Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that
this section of the chapter is second nature to you before you attempt the homework, a
quiz, or exam. This important piece of the chapter serves as your CliffsNotes or cheat
sheet to the basic concepts and principles that must be mastered.
If after reading this section of the chapter you still dont feel comfortable with all of the
Learning Objectives covered, you will need to spend additional time and effort reviewing
those concepts that you are struggling with.
The following Tips, Hints, and Things to Remember are organized according to the
Learning Objectives (LOs) in the chapter and should be gone over after reading each of
the LOs in the textbook.

Tips, Hints, and Things to Remember

LO1 Describe the circumstances in which leasing makes more business
sense than does an outright sale and purchase.
How? There are three parts to a financial accounting entry dealing with income taxes.
For academic purposes, you are usually given enough information to solve for two of
the parts. The third is a plug to make the debits and credits equal. The two fixed parts
are sometimes a debit to Income Tax Expense and a credit to Income Tax Payable. The
third part is either a debit to Deferred Tax Asset or a credit to Deferred Tax Liability. The
two fixed parts can also be the Income Tax Payable and either the Deferred Tax Asset
or Deferred Tax Liability if that is the information provided. In that case, the Income Tax
Expense is the plug.

Chapter 16

16-3

If financial income before taxes is given, then that number multipled by the tax rate
(assuming the tax rate isnt changing) will give you Income Tax Expense as always. If
taxable income is given, or can be solved for, then that number multiplied by the tax rate
will give you Income Tax Payable. If the item that gives rise to the difference between
financial and taxable income is given, then that number multiplied by the tax rate will
give you your Deferred Tax Asset (Liability). If the tax rate is different in future years,
then Income Tax Expense will always be the plug and cant be as easily solved for.

LO2 Compute the amount of deferred tax liabilities and assets.

Why? What is the point of a valuation allowance? First, note that valuation allowances
only apply to deferred tax assets. If it is thought that a deferred tax asset will not be
used, or will only partially be used, then it shouldnt be listed, or should only be partially
listed, on the balance sheet. This is similar to the allowance for bad debts. The amount
of accounts receivable listed as an asset should be the amount that is expected to turn
into cash, not the full amount due.
When wont a deferred tax asset be used? Perhaps the most common situation is when
a company doesnt have taxable income year after year. Without taxable income, the
benefits of a deferred tax asset are no longer benefits. Many tax credits and losses that
can carry forward to offset future taxable income expire. If it isnt likely that the credits or
losses will be used, because of expiration or because the company isnt generating
taxable income, then the deferred tax asset is reduced with a contra account, known as
a valuation allowance.

LO3 Explain the provisions of tax loss carrybacks and carryforwards, and
be able to account for these provisions.
How? When a loss is carried back and used, the calculation is as simple as multiplying
the prior years rate(s) by the amount that was carried back and used. The entry is a
debit to a receivable and a credit to an income tax benefit account, which serves to
decrease (bring closer to zero) the current year loss that gave rise to the net operating
loss.
When a loss is carried forward, either because an election was made, there was no
prior income to offset, or because there wasnt adequate income in prior years to fully
absorb the entire current year loss, there is no immediate refund. Rather, an asset is
created (for the tax benefits of the future use of the net operating loss). Deferred Tax
Asset receives a credit and, similar to a carryback, an income tax benefit account
receives a credit.

16-4

Chapter 16

LO4 Schedule future tax rates, and determine the effect on tax assets
and liabilities.
How? Future tax liabilities and tax assets should be based on future, not current, rates.
If future, enacted rates change, then the current tax asset and/or liability need to be
adjusted according to the new rates.

LO5 Determine appropriate financial statement presentation and

disclosure associated with deferred tax assets and liabilities.
How? Classified balance sheets can have both current and noncurrent tax assets
and/or liabilities. The classification of the deferred tax items are different than for others
on the balance sheet. Other items are based on when they will be paid or when they will
be collected. For tax assets and liabilities, however, it is based on what the asset or
liability is that gives rise to the tax adjustment. Therefore, if depreciation, for instance, is
going to be reversed (for book versus income tax purposes) in the coming year, it is not
listed as current because it relates to property, plant, and equipment, which is a
noncurrent asset.
Tax assets and liabilities can only offset each other if they are both of the same
classification (i.e., both current or both noncurrent) and both for the same jurisdiction
(i.e., both federal or both a single states taxes).

LO6 Comply with income tax disclosure requirements associated with the
statement of cash flows.
How? Taxes will always be an operating activity. Usually, the amount of income taxes
paid in a period will be different than the amount of income taxes accrued. Therefore,
there is frequently an adjustment to net income, using the indirect method, to arrive at
the correct cash flow from operating activities as it pertains to income taxes paid. The
most common adjustment relative to net income is the change in the Income Taxes
Payable account. If there are changes in the Deferred Tax Asset, Deferred Tax Liability,
or Income Taxes Receivable accounts, then similar adjustments will need to be made
for them as well. The adustments relative to net income will move in the same directions
as those for current assets (for receivables and deferred tax asset changes) and for
current liabilities (for tax liability changes) as discussed back in Chapter 5.

Chapter 16

16-5

LO7 Describe how, with respect to deferred income taxes, international

accounting standards have converged toward the U.S. treatment.
Why? There is little to worry about here. The methods are nearly identical
internationally when it comes to the financial accounting for income taxes (even though
the tax laws and rates are very different in each country). It is doubtful that you will need
to know the historical differences since they no longer apply.

The following sections, featuring various multiple choice questions, matching exercises,
and problems, along with solutions and approaches to arriving at the solutions, is
intended to develop your problem-solving and critical-thinking abilities. While learning
through trial and error can be effective for improving your quiz and exam scores, and it
can be a more interesting way to study than merely re-reading a chapter, that is only a
secondary objective in presenting this information in this format.
The main goal of the following sections is to get you thinking, How can I best approach
this problem to arrive at the correct solutioneven if I dont know enough at this point to
easily arrive at the proper results? There is not one simple approach that can be
applied to all questions to arrive at the right answer. Think of the following approaches
as possibilities, as tools that you can place in your problem-solving toolkita toolkit that
should be consistently added to. Some of the tools have yet to even be created or
thought of. Through practice, creative thinking, and an ever-expanding knowledge base,
you will be the creator of the additional tools.

Multiple Choice
MC16-1 (LO1) The purpose of an interperiod income tax allocation is to
a. show separately stated items net of tax.
b. allow reporting entities whose tax liabilities vary significantly from year to
year to smooth payments to taxing agencies.
c. amortize the deferred tax liability shown on the balance sheet.
d. recognize an asset or liability for the tax consequences of temporary
differences that exist at the balance sheet date.

16-6

Chapter 16

MC16-2 (LO1) An example of a deductible temporary difference creating a deferred

tax asset occurs when
a. the installment sales method is used for income tax purposes, but the
accrual method of recognizing sales revenue is used for financial reporting
purposes.
b. accelerated depreciation is used for income tax purposes, but straight-line
depreciation is used for accounting purposes.
c. warranty expenses are recognized on the accrual basis for financial
reporting purposes, but recognized as the warranty conditions are met for
income tax purposes.
d. the completed-contract method of recognizing construction revenue is used
for income tax purposes, but the percentage-of-completion method is used
for financial reporting purposes.
MC16-3 (LO2) The Wayne Static Company had taxable income of $12,000 during 2011.
Wayne Static used accelerated depreciation for income tax purposes ($3,400) and
straight-line depreciation for financial accounting purposes ($2,000). Assuming Wayne
Static had no other temporary or permanent differences, what would the company's
pretax financial accounting income be for 2011?
a. $6,600
b. $10,600
c. $13,400
d. $17,400
MC16-4 (LO2) Monteblanco Corporation paid $20,000 in January 2011 for premiums on
a two-year life insurance policy which names the company as the beneficiary, an item
that is never deductible for income tax purposes. Additionally, Monteblanco
Corporation's financial statements for the year ended December 31, 2011, revealed the
company paid $105,000 in nondeductible taxes during the year and also accrued
estimated litigation losses of $200,000 which arent deductible until paid for income tax
purposes. Assuming the lawsuit was resolved in February 2012 (at which time a
$200,000 loss was recognized for income tax purposes) and that Monteblancos tax rate
is 30 percent for both 2011 and 2012, what amount should Monteblanco report as asset
for net deferred income taxes on its 2011 balance sheet?
a. $0
b. $57,000
c. $60,000
d. $66,000
MC16-5 (LO3) Recognizing tax benefits in a loss year due to a loss carryforward that
will likely be used requires
a. only a footnote disclosure.
b. creating a new carryforward for the next year.
c. creating a deferred tax liability.
d. creating a deferred tax asset.

Chapter 16

16-7

MC16-6 (LO3) In 2011, Boothe Corporation reported $90,000 of income before income
taxes. The tax rate for 2011 was 30 percent. Boothe had an unused $60,000 net
operating loss carryforward arising in 2010 when the tax rate was 35 percent. The
income tax payable Boothe would report for 2011 would be
a. $6,000.
b. $9,000.
c. $10,500.
d. $27,000.
MC16-7 (LO4) The following information is taken from Ibarra Corporation's 2011
financial records:
Pretax accounting income
Excess tax depreciation
Taxable income

$1,500,000
(45,000)
$1,455,000

Assume the taxable temporary difference was created entirely in 2011 and will reverse
in equal net taxable amounts in each of the next three years. If tax rates are 40 percent
in 2011, 35 percent in 2012, 35 percent in 2013, and 30 percent in 2014, then the total
deferred tax liability Ibarra should report on its December 31, 2011, balance sheet is
a. $13,500.
b. $15,000.
c. $15,750.
d. $18,000.
MC16-8 (LO5) A deferred tax liability arising from the use of an accelerated method of
depreciation for income tax purposes and the straight-line method for financial reporting
purposes would be classified on the balance sheet as a(n)
a. current liability.
b. noncurrent liability.
c. current liability for the portion of the temporary difference reversing within a
year and a noncurrent liability for the remainder.
d. offset to the accumulated depreciation reported on the balance sheet.
MC16-9 (LO6) On the statement of cash flows using the indirect method, an increase in
the deferred tax asset would be shown as a(n)
a. addition to net income.
b. deduction from net income.
c. increase in investing activities.
d. increase in financing activities.
MC16-10 (LO7) International accounting standards currently are moving toward the
a. no-deferral approach.
b. partial recognition approach.
c. comprehensive recognition approach.
d. discounted comprehensive recognition approach.

16-8

Chapter 16

Matching
Matching 16-1 (LO1) Listed below are the terms and associated definitions from the
chapter for LO1. Match the correct definition letter with each term number.
___ 1. financial
income
___ 2. taxable income
___ 3. deferred
income tax
asset
___ 4. permanent
differences
___ 5. temporary
differences
___ 6. taxable
temporary
differences
___ 7. deductible
temporary
differences
___ 8. interperiod tax
allocation
___ 9. deferred
income tax
liability

a. differences between financial and taxable income that

result in future taxable amounts
b. expected future benefits from tax deductions that have
been recognized as expenses in the income statement
but not yet deducted for income tax purposes
c. expected future income taxes to be paid on income
that has been recognized in the income statement but
not yet taxed
d. an accounting method that recognizes the tax effect of
temporary differences between financial and taxable
income in the financial statements rather than
reporting as tax expense the actual tax liability in each
year
e. income reported on the financial statements as
opposed to income that is reported to taxing
authorities in accordance with tax regulations
f. differences between financial and taxable income that
will result in deductible amounts in future years
g. income as defined by income tax regulations as the
basis for determining the income tax liability for a given
entity
h. differences between pretax financial income and
taxable income arising from business events that are
recognized for both financial and tax purposes, but in
different time periods; a common example is
depreciation expense on equipment
i. nondeductible expenses or nontaxable revenues that
are recognized for financial reporting purposes but that
are never part of taxable income

Chapter 16

16-9

Matching 16-2 (LO2, LO3, LO5) Listed below are the terms and associated definitions
from the chapter for LO2, LO3, and LO5. Match the correct definition letter with each
term number.
___ 1. asset and
liability method
of interperiod
tax allocation
___ 2. valuation
allowance
___ 3. net operating
loss (NOL)
carryback
___ 4. net operating
loss (NOL)
carryforward
___ 5. effective tax
rate

a. the amount of operating loss that can be carried back

and offset against the income of earlier profitable
years to obtain a refund of previously paid income
taxes
b. rate computed by dividing reported income tax
expense by earnings before income taxes
c. a method of income tax allocation that determines
deferred tax assets or tax liabilities based on the
expected future benefit or obligation associated with
temporary difference reversals; if tax rates change, the
asset or liability balances are adjusted to reflect the tax
rates legislated to be in effect in the year when
reversal is expected to occur
d. the amount of operating loss that can be carried
forward and offset against income of future profitable
years to reduce the tax liability for those years
e. a contra asset account that reduces an asset to its
expected realizable value; this type of account can be
used with accounts receivable and deferred tax assets

16-10

Chapter 16

Problems
Problem 16-1 (LO2) The following differences between financial and taxable income
were reported by Gibson Corporation for the current year:
Excess of tax depreciation over book depreciation
Interest revenue on municipal bonds (never taxable)
Excess of estimated warranty expense over actual
expenditures (only actual expenditures are deductible for
income tax purposes)
Unearned rent received (taxable when received)
Fines paid (never deductible for income tax purposes)
Excess of income reported under percentage-ofcompletion accounting for financial reporting over
completed-contract accounting used for income tax
reporting
Interest expense on indebtedness incurred to purchase
tax-exempt securities (never deductible for income tax
purposes)
Unrealized losses on marketable securities recognized
for financial reporting (deductible when sold for income
tax purposes)

$60,000
9,000

54,000
12,000
30,000

45,000

3,000

18,000

Assume that Gibson Corporation had pretax accounting income (before considering the
items listed above except the interest revenue on municipal bonds of $9,000, which is
never taxable) of $900,000 for the current year. Assume a constant tax rate of 35
percent.
1. Compute the taxable income for the current year.
2. Compute the net deferred tax asset or net deferred tax liability. (Ignore classification
issues.)

Chapter 16

16-11

Problem 16-2 (LO3) Acorn Squirrel, a corporation organized on January 1, 2003,

reported the following incomes (losses) for the ten-year period, 20032012:
Year
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

Income (Loss)
$ 16,000
(40,000)
16,000
24,000
(32,000)
16,000
32,000
64,000
80,000
(16,000)

Income Tax Rate

50%
50
48
48
45
42
42
34
34
30

Income Tax Paid

?
?
?
?
?
?
?
?
?
?

Applying the carryback and carryforward provisions in the tax law, compute the net
amount of taxes paid (amounts paid less refunds) for the ten-year period ending
December 31, 2012.
Problem 16-3 (LO4) Angus Associates computed a pretax financial income of $280,000
for the first year of its operations ended December 31, 2011. Included in financial
income was $20,000 of nondeductible expense and $70,000 gross profit on installment
sales that was deferred for income tax purposes until the installments were collected.
The temporary differences are expected to reverse in the following pattern:
2012
2013
2014

$20,000
30,000
20,000
$70,000

The enacted tax rates for this year and the next three years are as follows:
2011
2012
2013
2014

40%
35%
32%
30%

1. Prepare a schedule showing the reversal of the temporary differences and the
computation of income taxes payable and deferred tax assets or liabilities as of
December 31, 2011.
2. Prepare journal entries to record income taxes payable and deferred income taxes.
3. Prepare the income statement for Angus beginning with "Income from continuing
operations before income taxes" for the year ended December 31, 2011.
4. Discuss when a valuation should be placed against the deferred tax asset or
deferred tax liability that was created in part 2.

16-12

Chapter 16

Solutions, Approaches, and Explanations

MC16-1
Answer: d
Approach and explanation: Dont confuse interperiod income tax allocation with the
intraperiod income tax allocation discussed in a previous chapter. Choice a goes along
with intraperiod income tax allocation. Intra means within the same, and the placement
of taxes both as a separate line item and for separately stated items (discontinued
operations and extraordinary items) within the same income statement is intraperiod
income tax allocation.
Interperiod income tax allocation is what we are dealing with in Chapter 16. It is the
recognition of assets or liabilities for income tax consequences that will affect future
periods.
Choice b is nonsense. Choice c is also something that doesnt happen. If you
understand the difference in the meaning between intra and inter, then, hopefully,
this question wasnt too difficult for you.
MC16-2
Answer: c
Approach and explanation: Check with your professor to see if you need to understand
specific tax adjustments, some of which are listed in Exhibit 16-2. Some professors
dont require you to know any specific tax laws since many students may not have
previously had a tax course. Others may require such knowledge. Virtually all
professors will require you to understand adjustments related to this chapter when they
are spelled out like they are in this question. In other words, when the timing of the
revenue or expense recognition for both financial reporting and income tax reporting is
given in the problem, you need to know whether that results in a temporary or
permanent situation and whether it results in a taxable or a deductible difference.
Deductible temporary differences result in tax deductions, relative to financial income, in
later years. Hence, deferred tax assets are created out of them. Deductions, relative to
financial income, include not only expenses that can be taken for income tax purposes
later but also income items that are recognizable for financial accounting purposes later
(and dont have to be recognized for taxable income purposes later because they
already were).

Chapter 16

16-13

For you visual learners, the following strategy in keeping these kinds of items straight
may prove useful. Create a grid as follows:
Current
Year
(CY)

Future
Year(s)
(FY)

Effect on financial income (FI) relative to taxable income

Effect on taxable income (TI) relative to financial income
After you get used to what is on the grid and how the grid works, you may want to
shorten it to the following for quicker use on a quiz, exam, or just to help you think
through a given scenario:
CY FY
FI
TI
Using the grid for the first choice results in the following:
CY FY

FI +

+
TI
The first cell to fill in is either the CY FI or CY TI. If the accrual method is used for
financial reporting, that means that full recognition of profit will occur in the current year.
That results in the + in the CY FI cell. If the installment sales method is used for income
tax purposes, recognition of profit is going to occur as cash is collected for taxable
income. In other words, the taxable income is somewhat delayed compared to financial
income.
One of the nice things about the grid method is that you only need to come up with one
cells correct solution. The other cells will flow off of it. Adjacent cells will always be the
opposite sign and diagonal cells will be the same sign.
The most important part of using the grid method is understanding what it means once
you have it completed. A grid that looks like the one just completed for choice a means
that taxable income will be more in the future (relative to financial income). More income
tax in the future is, obviously, a liability situation. Therefore, choice a creates a deferred
tax liability. An easy way to remember this, if it isnt coming to you intuitively, is to
always create your grid alphabetically (C before F and F before T), as shown. Then,
look at your future column and if it shows a on the top, you have a deferred tax liability
( signs associate more readily with liabilities). If it shows a + on the top, then you have
a deferred tax asset (+ signs associate more readily with assets).

16-14

Chapter 16

With that framework in mind, lets apply the grid method to the other choices. Choice b
results in more income tax expenses now and, hence, lower taxable income now.
Therefore, our grid looks like this:

FI
TI

CY FY
+

Thus, choice b is another difference creating a deferred tax liability.

Choice c has us recognizing expenses sooner for financial income purposes than they
are recognized for income tax purposes. So, our grid looks like this:
CY FY
+
FI

TI +
Again, notice that adjacent cells will always be the opposite and diagonal cells will be
the same. The only cell we need to really think about is the middle one involving more
expenses and less financial income in the current year. The rest of the cells flow off of
the middle cell. In this case, we have a + sign under FY, so we have a deferred tax
asset and the correct choice. Lets look at choice d, before moving on to the next
question, just to be sure we dont come up with two possible deferred tax asset
scenarios.
In choice d, the first thing that jumps out at us is that more revenue is recognized in
future years for income tax purposes. So, we could start our grid off in a different cell
than the one we have been using like this:
CY FY
FI
TI

Then, we can fill in the rest of the cells as follows:

CY FY

FI +
+
TI
Once again, we have a deferred tax liability, with the negative sign under the FY. This
gives us something of a confirmation that our prior selection of choice c is a good one.

Chapter 16

16-15

MC16-3
Answer: c
Approach and explanation: The shortcut to this solution is to find out the difference
between the income tax and financial accounting number ($3,400 $2,000 = $1,400)
and then add or subtract it to the given taxable income number to arrive at the financial
accounting income solution. The problem in the shortcut is that you may add it when it
should be subtracted or subtract it when it should be added. Therefore, you should
probably not go the shortcut route. Instead, you should probably do a more thorough
analysis to make sure that you come up with the correct solution.
A question you should probably raise is, What is taxable income without consideration
of depreciation expense? The answer is $15,400 ($12,000 + $3,400). $15,400 is also
pretax financial accounting income before financial accounting depreciation expense
since there are no other temporary or permanent differences between the two sets of
books. Therefore, you can take the $15,400 and subtract financial accounting
depreciation expense to arrive at pretax financial accounting income, which yields
$13,400 ($15,400 2,000). Therefore, choice c must be correct.
MC16-4
Answer: c
Approach and explanation: For all the words in this question, the solution (and means to
it) is rather quite simple. Remember, just because a problem has loads of information in
it doesnt mean that you have to use it all. Lets look at the pieces of information that are
given and see which ones can be discarded.
The insurance premiums need not be used in any calculation because they are
permanent differences. Permanent differences do affect calculations of taxable income
versus financial income, but they have no bearing on deferred tax assets or liabilities.
The same goes for nondeductible taxes paid. They are permanent adjustments and
arent ever going to reverse for the calculations of taxable and financial accounting
income. Therefore, they dont give rise to deferred tax assets or liabilities.
That leaves us with just the litigation accrual. Using the grid method, described in the
explanation to MC16-2, yields the following:
CY FY
+
FI

TI +
Therefore, Monteblanco is going to have a deferred tax asset with respect to the
temporary difference of the lawsuit. Choice a can be safely ruled out.
The amount of the deferred tax asset depends on the future tax rate in the year that the
deferred item will be realized on the income tax return. The tax rate will be 30 percent
and the amount it is to be applied to is $200,000. Therefore, the deferred tax asset is
$60,000 (0.30 percent $200,000).

16-16

Chapter 16

MC16-5
Answer: d
Approach and explanation: A loss carryforward means that a company will obtain tax
deductions in the future and pay less in taxes. Future economic benefits are assets, so
more than a mere disclosure occurs under this circumstance. A deferred tax asset is
created with the following journal entry under this situation:
Deferred Tax Asset
Income Tax Benefit

xxx
xxx

The deferred tax asset shows up on the balance sheet if a valuation isnt placed against
it. Since this question stated that it would likely be used, no valuation is necessary. The
income tax benefit shows up on the income statement, for financial accounting
purposes, in the loss year. It will show up as a deduction on the income tax return in a
future, non-loss year(s).
MC16-6
Answer: b
Approach and explanation: The prior years rate means nothing for the 2011 calculation.
The calculation for income tax payable is ($90,000 $60,000) 0.30, or $9,000. If the
question was asking for the income tax expense, instead of the income tax payable, the
correct choice would become choice d.
The journal entry for the year, assuming no other differences between financial
accounting income and taxable income, would be:
Income Tax Expense
Income Tax Payable
Deferred Tax Asset

27,000*
9,000
18,000

*$90,000 0.30 = $27,000

MC16-7
Answer: b
Approach and explanation: The reversal of the depreciation and amount of the deferred
tax liability can be mapped out as follows:

Depreciation differences
Rate
Total

2011
$45,000

2012
$(15,000)
35%
$ (5,250)

2013
$(15,000)
35%
$ (5,250)

Deferred Tax Liability = $5,250 + $5,250 +$4,500 = $15,000

2014
$(15,000)
30%
$ (4,500)

Chapter 16

16-17

In practice, it is highly unlikely that you would ever know a tax rate more than a year in
advance with any certainty. But for these kinds of theoretical problems, which you will
possibly see on your course exam or the CPA Exam, make sure to use the future given
rates for the calculations and not the current year rate.
MC16-8
Answer: b
Approach and explanation: The answer to this question is not intuitive. Choice c sounds
like the most reasonable answeran answer that makes sense given the balance sheet
rules you learned in an earlier chapter.
However, as mentioned in the How? on page 16-4, deferred tax assets and liabilities
are classified based on the classification of the asset which gave rise to the temporary
difference. Since property, plant, and equipment is always a noncurrent asset, a
deferred tax asset or deferred tax liability associated with depreciation will always be
noncurrent.
MC16-9
Answer: b
Approach and explanation: Deferred tax assets and deferred tax liabilities are adjusted
for on the statement of cash flows in the same manner as current assets and current
liabilities. Therefore, an increase in a deferred tax asset will result in the same
adjustment, relative to net income, that an increase in accounts receivable would. For
example, if accounts receivable is increasing it means that less cash is coming in and,
hence, a negative adjustment to net income, by the amount of the increase, results.
Choices c and d would never be correct for a change in a deferred tax asset or liability
balance.
MC16-10
Answer: c
Approach and explanation: The current U.S. standards, under FAS 109, require the
comprehensive recognition approach. This whole chapter has been dealing with how to
account for deferred tax assets and deferred tax liabilities under the comprehensive
recognition approach.
The international standards have been moving closer to the U.S. standards since the
mid-1990s. Choice a is the opposite extreme of the comprehensive recognition
approach. It is where some countries were at just a decade or two ago. Under that
approach, no deferred tax assets or deferred tax liabilities are shown on the balance
sheet.

16-18

Chapter 16

Matching 16-1
1.
e
2.
g
3.
b
4.
i
5.
h
6.
a
7.
f
8.
d
9.
c
Complete these terminology matching exercises without looking back at the textbook or
on to the glossary. After all, you probably wont have those as a reference at test time.
Learning through trial and error causes the item to be learned better and to stick in your
memory longer than if you just look at the textbook, glossary, or a dictionary and cook
book the answers. Sure you may get the answer correct on your first attempt, but
missing something is sometimes best for retention. Dont be afraid of failure while
studying and practicing.
Matching 16-2
1.
c
2.
e
3.
a
4.
d
5.
b

Chapter 16
Problem 16-1
1. Pretax financial income
Add (Deduct) permanent differences:
Interest revenue on municipal bonds
Fines paid
Interest expense on indebtedness incurred to
purchase tax-exempt securities
Total
Add (Deduct) temporary differences:
Excess of tax depreciation over book depreciation
Excess of estimated warranty expense over actual
expenditures
Unearned rent received
Excess of income reported under percentage-ofcompletion accounting for financial reporting over
completed-contract accounting used for income tax
reporting
Unrealized losses on marketable securities
recognized for financial reporting
Total
Taxable income

16-19

$900,000
(9,000)
30,000
3,000
$924,000

$ (60,000)
54,000
12,000

(45,000)
18,000
$ (21,000)
$903,000

2. Net temporary differences equal $(21,000) (based on the difference between

$924,000 and $903,000 computed above). This means that there will be positive
adjustments to taxable income, relative to financial accounting income, of $21,000 in
future years. More taxes in future years indicate an obligation. The amount of the net
deferred tax liability is $7,350 ($21,000 0.35).
Problem 16-2
Income taxes paid through December 31, 2008, net to zero because the $40,000 net
operating loss in 2004 and the $32,000 net operating loss in 2007 are applied against
the entire income earned for the years 2003, 2005, 2006, and 2008.
Net taxes paid between January 1, 2009, and December 31, 2012, were:

Year
2009
2010
2011
2012
Total income taxes actually paid (20032012)

Net Taxes
Paid
$13,440
16,320*
27,200

$56,960

*After applying 2012 loss ($64,000 $16,000) = $48,000 0.34 = $16,320

16-20

Chapter 16

Problem 16-3
1.
2011
Pretax financial
income
Nondeductible
expense
Taxable financial
income
Temporary
differences:
Gross profit on
installment sales
Gross profit on
collections
Taxable income
(loss)
Enacted tax rate
Income taxes
payable
Deferred tax liability:
Current
Noncurrent

2012

2013

2014

$20,000

$30,000

$20,000

$230,000

$20,000

$30,000

$20,000

$280,000
20,000
$300,000

(70,000)

40%

35%

32%

30%

$ 92,000
$ 7,000
$ 9,600

$ 6,000

Under the provisions of FASB Statement No. 109, the classification of the deferred
tax liability into current and noncurrent portions follows the classification of the
underlying installment receivable.
2. Income Tax ExpenseCurrent
Income Taxes Payable
Income Tax ExpenseDeferred
Deferred Tax LiabilityCurrent
Deferred Tax LiabilityNoncurrent

92,000
92,000
22,600
7,000
15,600

Normally, as shown in the explanation to MC16-6, income tax expense is computed

as pretax income multiplied by the current tax rate. In this case, that would yield a
result of $112,000 ($280,000 0.40) instead of the $114,600 shown in the journal
entries. What makes up the difference? There are two items that will cause the
shortcut income tax expense calculation to not work.

Chapter 16

16-21

The first item is permanent differences. Instead of using $280,000, lets see what
happens when we use $300,000, the after-permanent-differences income number.
$300,000 0.40 = $120,000. We didnt get any closer. In fact, we overshot our mark
by $5,400 ($120,000 $114,600).
The second item is changing tax rates. The decreasing tax rates make up for the
$5,400 difference as follows:
$20,000 (0.40 0.35) = $1,000
$30,000 (0.40 0.32) = $2,400
$20,000 (0.40 0.30) = $2,000
Total
$5,400
It is perfectly OK to use the shortcut income tax expense calculation in many
situations. However, if permanent differences exist, they need to be adjusted for
before the calculation. If the tax rates are changing (instead of, or in addition to,
permanent differences), then it is probably easier to back into the income tax
expense number by computing the income tax payable and deferred tax asset
and/or deferred tax liability and then plugging the income tax expense number as the
missing debit in the entry.
3.
Income from continuing operations before income
taxes
Less income taxes:
Current provision
Deferred provision
Income from continuing operations

$280,000
$92,000
22,600

114,600
$165,400

4. No valuation is ever needed for a deferred tax liability. Therefore, no valuation is

necessary in this case.
A valuation allowance against a deferred tax asset would be needed if a deferred tax
asset was created and it was not more likely than not that all, or part of it, was going
to be used. This situation of it not being used might arise if the company is not
generating taxable income.

16-22

Chapter 16

Glossary
Note that Appendix C in the rear portion of the textbook contains a comprehensive
glossary for all of the terms used in the textbook. That is the place to turn to if you need
to look up a word but dont know which chapter(s) it appeared in. The glossary below is
identical with one major exception: It contains only those terms used in Chapter 16. This
abbreviated glossary can prove quite useful when reviewing a chapter, when studying
for a quiz for a particular chapter, or when studying for an exam which covers only a few
chapters including this one. Use it in those instances instead of wading through the 19
pages of comprehensive glossary in the textbook trying to pick out just those words that
were used in this chapter.
asset and liability method of interperiod tax allocation A method of income tax
allocation that determines deferred tax assets or tax liabilities based on the expected
future benefit or obligation associated with temporary difference reversals. If tax
rates change, the asset or liability balances are adjusted to reflect the tax rates
legislated to be in effect in the year when reversal is expected to occur.
deductible temporary differences Differences between financial and taxable income
that will result in deductible amounts in future years; expected benefits (tax savings)
are reported on the balance sheet as deferred tax assets.
deferred income tax asset Expected future benefits from tax deductions that have
been recognized as expenses in the income statement but not yet deducted for
income tax purposes.
deferred income tax liability Expected future income taxes to be paid on income that
has been recognized in the income statement but not yet taxed. Deferred income tax
liabilities often arise from the temporary tax shielding provided by accelerated
depreciation.
effective tax rate Rate computed by dividing reported income tax expense by
earnings before income taxes.
financial income Income reported on the financial statements as opposed to taxable
income that is reported to taxing authorities in accordance with tax regulations.
interperiod tax allocation An accounting method that recognizes the tax effect of
temporary differences between financial and taxable income in the financial
statements rather than reporting as tax expense the actual tax liability in each year.
The allocation may be made either by (1) the deferred method or (2) the asset and
liability method. The latter method is currently required by GAAP.
net operating loss (NOL) carryback The amount of operating loss that can be
carried back and offset against the income of earlier profitable years to obtain a
refund of previously paid income taxes.

Chapter 16

16-23

net operating loss (NOL) carryforward The amount of operating loss that can be
carried forward and offset against income of future profitable years to reduce the tax
liability for those years.
permanent differences Nondeductible expenses or nontaxable revenues that are
recognized for financial reporting purposes but that are never part of taxable income.
taxable income Income as defined by income tax regulations as the basis for
determining the income tax liability for a given entity.
taxable temporary differences Differences between financial and taxable income
that result in future taxable amounts; income taxes expected to be paid on future
taxable amounts are reported in the balance sheet as a deferred tax liability.
temporary differences Differences between pretax financial income and taxable
income arising from business events that are recognized for both financial and tax
purposes, but in different time periods. For example, it is common for a temporary
difference to result from depreciation expense on equipment.
uncertain tax position Might be taken by taxpayers but the tax benefits are not
immeidately recognized for financial accounting purposes because those benefits
are not yet more likely than not.
valuation allowance A contra asset account that reduces an asset to its expected
realizable value. This type of account is used, for example, in valuing accounts
receivable and deferred tax assets.