Differences in the timing of the recognition of revenue and expense for financial reporting versus tax reporting cause differences between financial income and taxable income. These differences give rise to differences in income tax payable (per income tax return) and income tax expense (per income statement).
There are two categories of differences between financial income and tax income: (1) permanent differences and (2) temporary differences. Permanent differences are caused by provisions of the tax code which exempt certain types of revenues from taxation, e.g., interest income on municipal bonds, and prohibit the deduction of certain types of expenses, e.g., fines for violation of laws. Nontaxable revenues and nondeductible expenses are never included in the computation of taxable income for tax return purposes but are included in the computation of financial income on the income statement. Thus permanent differences cause no particular accounting problems.
On the other hand, temporary differences arise from timing differences as to the reporting of income or the deducting of expenses. A common example of a temporary difference is depreciation expense. The tax code allows accelerated depreciation on tax returns whereas most companies use straight line depreciation on their income statements. These temporary differences create deferred tax liabilities for future taxable amounts and deferred tax assets for future deductible amounts. See Exhibit 16-2, Page 958 for examples of common temporary differences. Accounting for temporary differences is referred to as inter-period tax allocation.
Example 1 on Page 955-6 is an example of a simple deferred income tax liability. In this example financial net income is $30,000 and taxable net income is only $10,000. At a 40% tax rate, income tax expense on the income statement is $12,000 but only $4,000 on the corporate tax return. The journal entry to record this event would be as follows:
Income Tax Expense $12,000
Income Taxes Payable $4,000
Deferred Tax Liability 8,000
Example 2 on Page 957 is an example of a simple deferred tax asset. In this example financial net income is $50,000 and taxable net income is $60,000 arising from the different treatment of warranty expense. At a 40% tax rate income tax expense on the income statement is $20,000 but totals $24,000 on the corporate tax return. The appropriate journal entry to record this event is as follows:
Income Tax Expense $20,000
Deferred Tax Asset 4,000
Income Taxes Payable $24,000
Deferred tax assets can be complicated by the following issues:
likelihood that a company will continue to show profits and
FASB Statement No. 109 uses the asset and liability method of inter-period tax allocation. The advantages of this method are that is it is conceptually consistent with other asset and liability standards and it is a flexible method that recognizes changes in circumstances and adjusts the reported amounts accordingly. The disadvantages of this method are it may be quite complicated and that some users disregard any deferred tax items when analyzing financial statements.
The computation of deferred tax assets and liabilities under FASB Statement No. 109 involves four steps as follows:
Example 3, Pages 961-4, involves Roland, Inc. and a deferred tax liability. The difference between depreciation expense for financial reporting and tax purposes creates a taxable temporary difference as is shown in the table covering the years 2008 through 2011 on Page 961.
In 2008 financial income is $75,000 using straight line depreciation but taxable income is $60,000 using accelerated depreciation. The appropriate journal entry to record this event in 2008, assuming a 40% tax rate, is as follows:
Income Tax Expense $30,000
Income Taxes Payable $24,000
In 2009 Roland again reports financial income of $75,000 but taxable income of $70,000. The appropriate journal entry is:
Tax Expense $30,000
In 2010 since the depreciation amounts are the same on the financial statement as on the tax return, the following entry should be made:
Tax Expense $30,000
Finally in 2011 when depreciation expense is $25,000 for financial reporting purposes but only $5,000 for tax purposes, the following entry should be made:
Tax Expense $30,000
Income Taxes Payable 38,000
As you can see, this final entry eliminates the deferred tax liability.
Example 4 involves Sandusky, Inc. and a deferred tax asset. In this example, the only difference between financial and taxable income is the treatment of warranty expense. Estimated amounts of warranty expense are deducted on the financial statement whereas only actual amounts can be deducted for income tax purposes. In 2208 financial income is $22,00 but taxable income is $40,000. At a 40% tax rate, the following journal entry would be made:
Income Tax Expense $8,800
Tax Asset – Current 2,400
Income Taxes Payable $16,000
Note that the total deferred tax asset is $7,200 (the difference between income tax expense and income taxes payable) and that because one-third of the tax benefit will be realized in 2009, one-third of the total benefit is shown as a current asset and two-thirds is shown as a non-current asset. Appropriate journal entries for 2009, 2010, and 2011 are shown on Page 965.
Example 5 involves the Hsieh Company and both deferred tax liabilities and assets. To make this example simpler, however, the authors have just combined Examples 3 and 4 mentioned above. For reporting purposes current deferred tax assets and current deferred tax liabilities are netted against each other and reported as a single account. Similarly, non-current deferred tax assets and liabilities are netted as a single amount. See Pages 965-8.
FASB Statement No. 109 requires the deferred tax asset be reduced by a valuation allowance if, based on all available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. The valuation allowance is a contra asset account that reduces the deferred tax asset to its expected realizable value.
Carry-back and Carry-forward operating losses are discussed beginning on Page 970. If you were profitable in prior periods and paid taxes, you can get a refund up to and including all those tax payments in the current period for which you incur an operating loss. An NOL carry-back is applied to the income of the two preceding years starting with the second preceding year and moving forward to the immediately preceding year. The effect of a carry-back is journalized by establishing a current receivable for the tax refund claim and reducing the operating loss of the current period (see Page 971).
If an operating loss exceeds income for the two preceding years, the remaining unused loss may be carried forward to income earned over the next twenty years. Under FASB No. 109 a deferred tax asset is recognized for the potential future tax benefits from a loss carry-forward.
Scheduling for enacted future tax rates is discussed on Pages 973-4. You are not responsible for this topic for exam purposes.
For disclosure purposes, the income statement must show, either in the body of the statement or in a note, the following selected components of income taxes relating to continuing operations:
ü Current tax expense or benefit
ü Deferred tax expense or benefit
ü Investment tax credits
ü Government grants recognized as tax reductions
ü Benefits of operating loss carry-forwards
ü Any adjustments of deferred tax liability or assets arising from changes in tax laws
ü Adjustments in the beginning of the year valuation allowance because of a change in circumstances
Companies must also disclose the specific accounting differences between the financial statements and the tax return that give rise to deferred tax assets and deferred tax liabilities.
FASB Statement No. 95 requires separate disclosure of the amount of cash paid for just two items:
1. Cash paid for income taxes
2. Cash paid for interest
Income taxes are reported in the operating activities section of the cash flow statement. In the direct method, cash paid for income taxes is shown as a separate line item. In the indirect method, adjustments to convert net income into cash from operations are needed for changes in income taxes payable and receivable accounts and for changes in deferred tax asset and liability accounts.
The United States uses the comprehensive recognition approach for income taxes that requires recognition of all temporary differences between financial accounting income and taxable income. The international community has moved to this approach and Revised IAS 12 is very similar to the U. S. standard for income taxes.