Chapter 16

Accounting for Income Taxes

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide 16-2

Deferred Tax Assets/Liabilities

GAAP is the set of rules for preparing financial statements. Results in . . . The Internal Revenue Code is the set of rules for preparing tax returns. Usually. . . Results in . . .

Financial statement income tax expense.

IRS income taxes payable.

The difference between tax expense and tax payable is referred to as deferred taxes.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-3

Deferred Tax Assets/Liabilities Example

Examine the December 31, 2003, information for X-Off Inc.
Revenues Depreciation Expense: Straight-line Accelerated Other Expenses $ 1,000,000 200,000 320,000 650,000

X-Off uses straight-line depreciation for financial reporting and accelerated depreciation for income tax reporting. X-Offs tax rate is 30%.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-4

Deferred Tax Assets/Liabilities Example

Compute X-Offs income tax expense and income tax payable.
Income Statement
Revenues Less: Depreciation Other expenses Income before taxes Tax rate Income taxes ? ? ? ? ? ?

Tax Return
? ? ? ? ? ?

Difference
? ? ? ? ? ?

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide 16-5

Deferred Tax Assets/Liabilities Example

Compute X-Offs income tax expense and income tax payable.
Income Statement
Revenues $ 1,000,000 Less: Depreciation 200,000 Other expenses 650,000 Income before taxes $ 150,000 Tax rate Income taxes 30% 45,000

Tax Return

Difference

The income tax amount computed based on financial statement income is income tax expense for the period.
2004 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin

Slide 16-6

Deferred Tax Assets/Liabilities Example

Compute X-Offs income tax expense and income tax payable.
Income Statement
Revenues $ 1,000,000 Less: Depreciation 200,000 Other expenses 650,000 Income before taxes $ 150,000 Tax rate Income taxes 30% 45,000

Tax Return

Difference

Next, compute income taxes for the tax return.

2004 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin

Slide 16-7

Deferred Tax Assets/Liabilities Example

Compute X-Offs income tax expense and income tax payable.
Income Statement
Revenues $ 1,000,000 Less: Depreciation 200,000 Other expenses 650,000 Income before taxes $ 150,000 Tax rate Income taxes

Tax Return
$ 1,000,000 320,000 650,000 30,000 30% 9,000

Difference

30% 45,000 $

Income taxes based on tax return income are the taxes payable for the period.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide 16-8

Deferred Tax Assets/Liabilities Example

Compute X-Offs income tax expense and income tax payable.
Income Statement Tax Return Difference
$ (120,000) 120,000 30% 36,000

Revenues $ 1,000,000 $ 1,000,000 The deferred tax for the period Less: of $36,000 is the 200,000 difference 320,000 Depreciation Other expenses 650,000 between income tax expense 650,000 of Income before taxes 150,000 $ 30,000 $45,000 and$income tax Tax rate Income taxes

payable of $9,000.
$

30% 45,000 $

30% 9,000 $

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide 16-9

Deferred Tax Assets/Liabilities Example

The entry to record the deferred taxes would appear as follows:
GENERAL JOURNAL
Page 77
Post. Ref. Debit 45,000 36,000 9,000
2004 The McGraw-Hill Companies, Inc.

Date 2003

Description

Credit

Dec. 31 Income Tax Expense Deferred Tax Liability Income Taxes Payable
McGraw-Hill/Irwin

Slide 16-10

Temporary Differences
Often, the difference between pretax accounting income and taxable income results from items entering the income computations at different times.

These are called temporary differences.

McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-11

Temporary Differences
Temporary differences will reverse out in one or more future periods.
Financial Income > Taxable Income Future Taxable Amounts Deferred Tax Liability Financial Income < Taxable Income Future Deductible Amounts Deferred Tax Asset

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide 16-12

Revenues (or gains) Installment sales of property (installment method for taxes)

Expenses (or losses) Estimated expenses and losses (tax deductible when paid) Unrealized loss from recording investments at fair value or inventory at LCM (tax deductible when asset is sold) Accelerated depreciation on tax return (straight-line on income statement) Prepaid expenses (tax deductible when paid)

Items reported on the tax return AFTER the Unrealized gain from income recording investments at statement fair value (taxable when asset is sold) Items reported on the tax return BEFORE the income statement Rent or subscriptions collected in advance Other revenue collected in advance

The temporary differences in the yellow boxes create deferred tax assets because they result in deductible amounts in the future. 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin

Slide 16-13

Revenues (or gains) Installment sales of property (installment method for taxes)

Expenses (or losses) Estimated expenses and losses (tax deductible when paid) Unrealized loss from recording investments at fair value or inventory at LCM (tax deductible when asset is sold) Accelerated depreciation on tax return (straight-line on income statement) Prepaid expenses (tax deductible when paid)

Items reported on the tax return AFTER the Unrealized gain from income recording investments at statement fair value (taxable when asset is sold) Items reported on the tax return BEFORE the income statement Rent or subscriptions collected in advance Other revenue collected in advance

The temporary differences in the gray boxes create deferred tax liabilities because they result in taxable amounts in the future. 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin

Slide 16-14

Deferred Tax Liabilities

In 2001, Baxter records $100,000 on its books resulting from revenue earned. The revenue will be taxed as the cash is collected in 2002 and 2003. Baxter expects to collect $70,000 in 2002 and the remaining $30,000 in 2003.
Financial Income $ Installment Sale Taxable Income $ 2001 2002 2003 300,000 $ 200,000 $ 200,000 (100,000) 70,000 30,000 200,000 $ 270,000 $ 230,000

The company is subject to a 32% tax rate. There are no other temporary differences.

Lets look at Baxters 2001 tax entry.

McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-15

Deferred Tax Liabilities

Financial Income $ Installment Sale Taxable Income $ 2001 2002 2003 300,000 $ 200,000 $ 200,000 (100,000) 70,000 30,000 200,000 $ 270,000 $ 230,000

Income tax expense = $300,000 32% = $96,000 Income tax payable = $200,000 32% = $64,000
General Journal Description Debit Income tax expense 96,000 Income tax payable Deferred tax liability
McGraw-Hill/Irwin

Credit 64,000 32,000

2004 The McGraw-Hill Companies, Inc.

Slide 16-16

Deferred Tax Liabilities

General Journal Description Debit Income tax expense 96,000 Income tax payable Deferred tax liability Credit 64,000 32,000

The Deferred Tax Liability represents the future taxes Baxter will pay in 2002 and 2003.

Deferred Tax Liability 32,000 2001

2002 2003 $ 30,000 32% $ 9,600
2004 The McGraw-Hill Companies, Inc.

Total $ 100,000 $ 32,000

Future taxable amounts Enacted tax rate

McGraw-Hill/Irwin

$ 70,000 32% $ 22,400

Deferred tax liability

Slide 16-17

Deferred Tax Liabilities

Recall this Financial Income information for Installment Sale Baxter for 2002. Taxable Income
$ $ 2001 2002 2003 300,000 $ 200,000 $ 200,000 (100,000) 70,000 30,000 200,000 $ 270,000 $ 230,000

Income tax expense = $200,000 32% = $64,000

Income tax payable = $270,000 32% = $86,400

General Journal Description Debit Income tax expense 64,000 Deferred tax liability 22,400 Income tax payable
McGraw-Hill/Irwin

Credit

86,400

2004 The McGraw-Hill Companies, Inc.

Slide 16-18

Deferred Tax Liabilities

General Journal Description Debit Income tax expense 64,000 Deferred tax liability 22,400 Income tax payable Credit

86,400

Deferred Tax Liability 2002 22,400 32,000 2001 9,600 Balance

Reversing difference
McGraw-Hill/Irwin

Originating difference
2004 The McGraw-Hill Companies, Inc.

Slide 16-19

Deferred Tax Liabilities

Future Taxable Amount Schedule
2003 Future taxable amounts Enacted tax rate Deferred tax liability $ 30,000 32% $ 9,600 $ 9,600 Total $ 30,000

Deferred Tax Liability 2002 22,400 32,000 2001 9,600 Balance

The Deferred Tax Liability represents the future taxes Baxter will pay in 2003. 2004 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin

Slide 16-20

Deferred Tax Liabilities

Recall the information for Baxter, Inc. for 2003:
Financial Income $ Installment Sale Taxable Income $ 2001 2002 2003 300,000 $ 200,000 $ 200,000 (100,000) 70,000 30,000 200,000 $ 270,000 $ 230,000

Income tax expense = $200,000 32% = $64,000

Income tax payable = $230,000 32% = $73,600

General Journal Description Debit Income tax expense 64,000 Deferred tax liability 9,600 Income tax payable
McGraw-Hill/Irwin

Credit

73,600

2004 The McGraw-Hill Companies, Inc.

Slide 16-21

Deferred Tax Liabilities

General Journal Description Debit Income tax expense 64,000 Deferred tax liability 9,600 Income tax payable Credit

73,600

Deferred Tax Liability 2002 22,400 32,000 2001 9,600 Balance 2003 9,600 0 Balance 2004 The McGraw-Hill Companies, Inc. Reversing difference McGraw-Hill/Irwin

Slide 16-22

Deferred Tax Assets

Health Magazine received $150,000 of subscriptions in advance during 2001. Subscription revenue will be earned equally in 2002, 2003 and 2004 for financial accounting purposes. The entire $150,000 will be taxed in 2001. There is additional income of $500,000 in each year. The company is subject to a 30% tax rate in each year.
Financial Income $ Subscription Rev. Taxable Income $
McGraw-Hill/Irwin

2001 2002 2003 2004 500,000 $ 550,000 $ 550,000 $ 550,000 150,000 (50,000) (50,000) (50,000) 650,000 $ 500,000 $ 500,000 $ 500,000
2004 The McGraw-Hill Companies, Inc.

Slide 16-23

Deferred Tax Assets

Financial Income $ Subscription Rev. Taxable Income $ 2001 2002 2003 2004 500,000 $ 550,000 $ 550,000 $ 550,000 150,000 (50,000) (50,000) (50,000) 650,000 $ 500,000 $ 500,000 $ 500,000

This is the computation for the Deferred Tax Asset.

Calculation of Deferred Tax Asset Future deductible amount Tax rate Deferred tax asset at year-end 2001 $ 150,000 30% $ 45,000 2002 $ 100,000 30% $ 30,000 2003 $ 50,000 30% $ 15,000 2004 $ 30% $ -

McGraw-Hill/Irwin

Now, lets record the income tax entry for 2001.

2004 The McGraw-Hill Companies, Inc.

Slide 16-24

Deferred Tax Assets

Financial Income $ Subscription Rev. Taxable Income $
Calculation of Deferred Tax 2001 2002 2003 2004 Asset 500,000 $ 550,000 $ 550,000 $ 550,000 Future deductible amount 150,000 (50,000) (50,000) (50,000) Tax rate 650,000 $ 500,000 $ tax 500,000 500,000 Deferred asset at$year-end 2001 $ 150,000 30% $ 45,000 $ $

Income tax expense = $500,000 30% = $150,000

Income tax payable = $650,000 30% = $195,000

Description Income tax expense Deferred tax asset Income tax payable
McGraw-Hill/Irwin

Debit 150,000 45,000

Credit

2004 The McGraw-Hill Companies, Inc.

195,000

Slide 16-25

Deferred Tax Assets

Description Income tax expense Deferred tax asset Income tax payable Debit 150,000 45,000 Credit

195,000

Aftertax posting this entry,165,000 the Deferred Tax Income expense Asset account will have a balance of $45,000. Deferred tax asset 15,000 Income tax payable 150,000 Deferred Tax Asset
2001 Balance
McGraw-Hill/Irwin

45,000 45,000
2004 The McGraw-Hill Companies, Inc.

Slide 16-26

Deferred Tax Assets

In 2002, Health Magazine earns $50,000 for financial reporting purposes.
Financial Income $ Subscription Rev. Taxable Income $ 2001 500,000 $ 150,000 650,000 $ 2002 550,000 $ (50,000) 500,000 $

2003 550, (50, 500,

Income tax expense = $550,000 30% = $165,000

Income tax payable = $500,000 30% = $150,000

In 2002, the balance in the Deferred Tax Asset should decrease to $30,000. McGraw-Hill/Irwin

Calculation of Deferred Tax Asset Future deductible amount Tax rate Deferred tax asset at year-end

2001 $ 150,000 30% $ 45,000

2002 $ 100,000 30% $ 30,000

2 $ $

Lets see the incometax entry for 2002. 2004 The McGraw-Hill Companies, Inc.

Slide 16-27

Deferred Tax Assets

Income tax expense = $550,000 30% = $165,000

Income tax payable = $500,000 30% = $150,000

Description Income tax expense Deferred tax asset Income tax payable

Debit 165,000

Credit 15,000 150,000

McGraw-Hill/Irwin

Originating difference

Deferred Tax Asset Income tax expense 165,000 2001 45,000 15,000 2002 Deferred tax asset 15,000 Balance 30,000 Income tax payable 150,000

Reversing difference 2004 The McGraw-Hill Companies, Inc.

Slide 16-28

Deferred Tax Assets

Financial Income $ Subscription Rev. Taxable Income $ 2001 2002 2003 2004 500,000 $ 550,000 $ 550,000 $ 550,000 150,000 (50,000) (50,000) (50,000) 650,000 $ 500,000 $ 500,000 $ 500,000

This is the computation for the Deferred Tax Asset.

Calculation of Deferred Tax Asset Future deductible amount Tax rate Deferred tax asset at year-end 2001 $ 150,000 30% $ 45,000 2002 $ 100,000 30% $ 30,000 2003 $ 50,000 30% $ 15,000 2004 $ 30% $ -

Can you finish Health Magazines income tax entries for 2003 and 2004?
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-29

Deferred Tax Assets

This would be the entry for 2003 and 2004.
Description Income tax expense Deferred tax asset Income tax payable Debit 165,000 Credit 15,000 150,000

tax expense 165,000 At the Income end of 2004, the balance in the15,000 Deferred Deferred tax asset Tax Asset would be zero. 150,000 Income tax payable Deferred Tax Asset 2001 45,000 15,000 2002 15,000 2003 15,000 2004 Balance McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-30

Sharpen Your Pencil . . . There Is Still More!!

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide 16-31

Valuation Allowance
A valuation allowance account

is required when it is more likely than not that some portion of the deferred tax asset will not be realized. The deferred tax asset is then reported at its net realizable value.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-32

Non-Temporary Differences
Created when an income item is included in taxable income or accounting income but will never be included in the computation of the other.
Example: Interest on tax-free municipal bonds is included in accounting income but is excluded from taxable income
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-33

Non-Temporary Differences
Also called permanent differences.
Disregarded when determining both taxes payable and the deferred tax asset or liability.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-34

Tax Rate Considerations

Deferred tax assets and liabilities

should be determined using the future tax rates, if known.

The deferred tax asset or liability

must be adjusted if a change in a tax law or rate occurs.

McGraw-Hill/Irwin

IRC

2004 The McGraw-Hill Companies, Inc.

Slide 16-35

Net Operating Losses (NOL)

Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or subsequent periods.

When used to offset earlier taxable income: Called: operating loss carryback. Result in a tax refund.
McGraw-Hill/Irwin

When used to offset future taxable income: Called: operating loss carryforward. Result in reduced tax payable.
2004 The McGraw-Hill Companies, Inc.

Slide 16-36

Carryback and Carryforward

Carryback Period Carryforward Period

-2

-1

Current Year

+1 +2 +3 +4 +5

. . . +20

The NOL may first be applied against taxable income from two previous years. Unused NOL may be carried forward for 20 years.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-37

Net Operating Losses (NOL)

In 2003 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a 30% tax rate. In 2001, Garson reported taxable income of $20,000, and in 2002, taxable income was $10,000. The company elects to carryback the NOL.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide 16-38

Net Operating Losses (NOL)

Tax year 2001 2002 Taxable Income $ 20,000 10,000 Tax rate 30% Taxes Paid 3,000 30% $ 6,000

In 2003, no taxes are paid and Garson claims a tax refund of $9,000 for taxes paid in 2001 and 2002.
General Journal Description Debit Income tax refund receivable 9,000 Benefits of NOL carryback
McGraw-Hill/Irwin

Credit 9,000

2004 The McGraw-Hill Companies, Inc.

Slide 16-39

Net Operating Losses (NOL)

Garsons Income Statement for 2003 looks like this . . .
Garson, Inc. Partial Income Statement For the Year Ended December 31, 2003 Operating loss before income taxes $ (85,000) Benefit of NOL carryback 9,000 Net loss $ (76,000)

Now lets look at the treatment of the remaining NOL of $55,000 ($85,000 - $20,000 - $10,000).
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-40

Net Operating Losses (NOL)

Garson prepares this estimate of taxable income based upon the best available evidence at 12/31/03.
Year 2004 2005 2006 Estimated Taxable Income $ 25,000 25,000 30,000 Enacted Taxes to Tax Rate be Paid 30% $ 7,500 30% 7,500 40% 12,000

The NOL carryforward will provide a tax benefit of $17,000.

Estimated Taxable NOL Future Tax Income Carryforward Savings $ 25,000 $ (25,000) $ 7,500 25,000 (25,000) 7,500 30,000 (5,000) 2,000 $ (55,000) $
2004 The McGraw-Hill Companies, Inc. 17,000

Year 2004 2005 2006

McGraw-Hill/Irwin

Slide 16-41

Net Operating Losses (NOL)

It is likely that Garson will receive the benefits of the NOL in future periods. As a result, the following journal entry is made . . .
General Journal Description Debit Deferred tax asset 17,000 Benefits of NOL carryforward Credit 17,000

Garsons income statement for 2003 will look like this . . .

McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-42

Net Operating Losses (NOL)

Garson, Inc. Partial Income Statement For the Year Ended December 31, 2003 Operating loss before income taxes $ (85,000) Benefit of NOL carryback 9,000 Benefit of NOL carryforward 17,000 Net loss $ (59,000)
The deferred tax asset account created by the benefit of the carryforward will be used to lower income taxes payable in future years.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-43

Balance Sheet Classification

Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability.
McGraw-Hill/Irwin

Disclose the following:

Total of all deferred tax

liabilities and assets. Total valuation allowance recognized. Net change in valuation account. Approximate tax effect of each type of temporary difference (and carryforward).

2004 The McGraw-Hill Companies, Inc.

Slide 16-44

Additional Disclosures
Current portion of tax expense (benefit) Deferred portion of tax expense (benefit),

with separate disclosure for

Portion that does not include the effect of the following separately disclosed amounts.
Operating

loss carryforwards. Adjustments due to changes in tax laws or rates. Adjustments to the beginning-of-the-year valuation allowance due to revised estimates. Investment tax credits.
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-45

Intraperiod Tax Allocation

SFAS No. 109 requires

intraperiod tax allocation for:

Income from continuing operations. Discontinued operations. Extraordinary items. Changes in accounting principle. Prior period adjustments (to the beginning retained earnings).

McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc.

Slide 16-46

End of Chapter 16

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.