CHAPTER 19

ACCOUNTING FOR INCOME TAXES

ACCT5170
Corporate Financial Accounting II
Shiheng Wang@ HKUST

19-1
 Learning Objectives
1. Identify differences between pretax financial income and taxable income.

2. Describe a temporary difference that results in future taxable amounts.

3. Describe a temporary difference that results in future deductible amounts.

4. Explain the non-recognition of a deferred tax asset.

5. Describe the presentation of income tax expense in the income statement.

6. Describe various temporary and permanent differences.

7. Explain the effect of various tax rates and tax rate changes on deferred
income taxes.

19-2
 INTRODUCTION

19-3
Fundamentals of Accounting for Income Taxes

Corporations must file income tax returns following the

guidelines developed by the appropriate taxing authority,
thus they:
 calculate taxes payable based upon tax regulations,
 calculate income tax expense based upon accounting
standards.
Amount reported as tax expense will often differ from the
amount of taxes payable to the taxing authority.

19-4
Fundamentals of Accounting for Income Taxes

Illustration 19-1

19-5
Fundamentals of Accounting for Income Taxes

Pretax Financial Income ≠ Taxable Income

Two causes:

 Temporary (timing) differences

 Permanent differences

19-6
 TEMPORARY DIFFERENCES

over long horizon, the sum of tax payments are the same

19-7
Fundamentals of Accounting for Income Taxes

Illustration: Chelsea, Inc. reported revenues of $130,000 and

expenses of $60,000 in each of its first three years of operations.
For tax purposes, Chelsea reported the same expenses to the tax
authority in each of the years. Chelsea reported taxable revenues
of $100,000 in 2022, $150,000 in 2023, and $140,000 in 2024.
What is the effect on the accounts of reporting different amounts of
revenue for IFRS versus tax?

19-8
 Book vs. Tax Difference
Illustration 19-2
IFRS Reporting 2022 2023 2024 Total

Revenues $130,000 $130,000 $130,000 $390,000

Expenses 60,000 60,000 60,000 180,000
Pretax financial income $70,000 $70,000 $70,000 $210,000

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

Illustration 19-3
Tax Reporting 2022 2023 2024 Total

Revenues $100,000 $150,000 $140,000 $390,000

Expenses 60,000 60,000 60,000 180,000
Pretax taxable income $40,000 $90,000 $80,000 $210,000

Income tax payable (40%) $16,000 $36,000 $32,000 $84,000

19-9
 Future Taxable Amounts and Deferred Taxes

Deferred Tax Liability

Represents the increase in taxes payable in future years as a result

of taxable temporary differences existing at the end of the current
year.

Illustration 19-4

2022 2023 2024 Total

Income tax expense (IFRS) $28,000 $28,000 $28,000 $84,000

Income tax payable (tax authority) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

19-10
 Future Taxable Amounts and Deferred Taxes

Deferred Tax Liability

Illustration: Chelsea makes the following entry at the end of 2022

to record income taxes.

Income Tax Expense IFRS下 今年產生的 28,000

Income Tax Payable TAX RULE下 今年要比的
16,000
Deferred Tax Liability 淨低嗰啲歸比下年 12,000

19-11
 Future Taxable Amounts and Deferred Taxes

Deferred Tax Liability

Illustration: Chelsea makes the following entry at the end of 2023

to record income taxes.

Income Tax Expense 28,000

Deferred Tax Liability 8,000
Income Tax Payable 36,000

19-12
 Future Taxable Amounts and Deferred Taxes

Deferred Tax Liability

Illustration: Chelsea makes the following entry at the end of 2024

to record income taxes.

Income Tax Expense 28,000

Deferred Tax Liability 4,000
Income Tax Payable 32,000

Illustration 19-12

19-13
 Future Taxable Amounts and Deferred Taxes

E19-1: Starfleet Corporation has one temporary difference at the

end of 2021 that will reverse and cause taxable amounts of $55,000
in 2022, $60,000 in 2023, and $75,000 in 2024. Starfleet’s pretax
financial income for 2021 is $400,000, and the tax rate is 30% for all
years. There are no deferred taxes at the beginning of 2021.

Instructions
a) Compute taxable income and income taxes payable for 2021.
b) Prepare the journal entry to record income tax expense,
deferred income taxes, and income taxes payable for 2021.

19-14
 Future Taxable Amounts and Deferred Taxes

Ex. 19-1: Current Yr.

INCOME: 2021 2022 2023 2024
Financial income (GAAP) 400,000
55000+60000+75000=190000
Temporary Diff. (190,000) 55,000 60,000 75,000
Taxable income (IRS) a. 210,000 55,000 60,000 75,000
Tax rate 30% 30% 30% 30%
Income tax payable a. 63,000 16,500 18,000 22,500

b. Income tax expense 400000*0.3 120,000

Income tax payable by tax rule,210000*0.3 63,000
Deferred tax liability 16500+18000+22500 57,000

19-15
 Deferred Tax Liabilities Examples
exp話要比（incur左 np已經大左）但payable未需要比>>accrued
ILLUSTRATION 19-29

Revenues or gains are taxable after they are recognized in financial income.

An asset (e.g., accounts receivable or investment) may be recognized for

revenues or gains that will result in taxable amounts in future years when
the asset is recovered.
1. Sales accounted for on the accrual basis for financial reporting purposes
and on the installment (cash) basis for tax purposes.
2. Contracts accounted for under the percentage-of-completion method for
financial reporting purposes and the cost-recovery method (zero-profit
cost-recovery:計曬cost（計cost年份 cost=rev so np=0）之後年份再計
method) for tax purposes. revenue（突然多左好多np）
Percentage-of-completion: 按洗左幾多去計np&rev 不會出現np=0情況
3. Investments accounted for under the equity method for financial reporting
purposes and under the cost method for tax purposes.
4. Unrealized holding gains for financial reporting purposes (including use of
the fair value option) but deferred for tax purposes.
19-16 incur左再收錢
 Deferred Tax Liabilities Examples
payable已經扣左 payable細左 但np未計（因為未incur）所以np大啲 exp大啲 ILLUSTRATION 19-29
exp>payable = accrued

Expenses or losses are deductible before they are recognized in financial income.

The cost of an asset may have been deducted for tax purposes faster than it
was expensed for financial reporting purposes. Amounts received upon future
recovery of the amount of the asset for financial reporting (through use or
sale) will exceed the remaining tax basis of the asset and thereby result in
taxable amounts in future years. Examples:
1. Depreciable property, depletable resources, and intangibles.
2. Deductible pension funding exceeding expense.
3. Prepaid expenses that are deducted on the tax return in the period paid.
4. Development costs that are deducted on the tax return in the period paid.

比左錢先incur

19-17
 Book vs. Tax Difference

IFRS Reporting 2022 2023 2024 Total

Revenues $1,000,000 $1,000,000 $1,000,000 $3,000,000

Expenses 250,000 250,000 250,000 750,000
Pretax financial income $750,000 $750,000 $750,000 $2,250,000

Income tax expense (40%) $300,000 $300,000 $300,000 $900,000

Tax Reporting 2022 2023 2024 Total

Revenues $1,000,000 $1,000,000 $1,000,000 $3,000,000

Expenses 0 375,000 375,000 750,000
Pretax financial income $1,000,000 $625,000 $625,000 $2,250,000

Income tax payable (40%) $400,000 $250,000 $250,000 $900,000

19-18
 Future Deductible Amounts and Deferred Taxes

Deferred Tax Asset

Represents the increase in taxes refundable (or saved) in future

years as a result of deductible temporary differences existing at the
end of the current year.

2022 2023 2024 Total

Income tax expense (IFRS) $300,000 $300,000 $300,000 $900,000

Income tax payable (tax authority) 400,000 250,000 250,000 900,000
Difference $(100,000) $50,000 $50,000 $0

19-19
 Future Deductible Amounts and Deferred Taxes

Deferred Tax Asset

Illustration: entry at the end of 2022 to record income taxes.

Income Tax Expense 300,000

Deferred Tax Asset 100,000
Income Tax Payable 400,000

19-20
 Future Deductible Amounts and Deferred Taxes

Deferred Tax Asset

Illustration: entry at the end of 2023 to record income taxes.

Income Tax Expense 300,000

Deferred Tax Asset 50,000
Income Tax Payable 250,000

19-21
 Future Deductible Amounts and Deferred Taxes

Deferred Tax Asset

Illustration: entry at the end of 2024 to record income taxes.

Income Tax Expense 300,000

Deferred Tax Asset 50,000
Income Tax Payable 250,000

19-22
 Future Deductible Amounts and Deferred Taxes

Illustration: Columbia Corporation has one temporary difference at

the end of 2021 that will reverse and cause deductible amounts of
$50,000 in 2022, $65,000 in 2023, and $40,000 in 2024. Columbia’s
pretax financial income for 2021 is $200,000 and the tax rate is 34%
for all years. There are no deferred taxes at the beginning of 2021.
Columbia expects to be profitable in the future.

Instructions

a) Compute taxable income and income taxes payable for 2021.

b) Prepare the journal entry to record income tax expense,

deferred income taxes, and income taxes payable for 2021.

19-23
 Future Deductible Amounts and Deferred Taxes

Illustration Current Yr.

INCOME: 2021 2022 2023 2024
Financial income (GAAP) 200,000
Temporary Diff. 155,000 (50,000) (65,000) (40,000)
Taxable income (IRS) a. 355,000 (50,000) (65,000) (40,000)
Tax rate 34% 34% 34% 34%
a.
Income tax payable 120,700 (17,000) (22,100) (13,600)

b. Income tax expense 200000*0.34 68,000

Deferred tax asset 52,700
Income tax payable 120,700

19-24
 Deferred Tax Assets Examples
payable已經加大左 但未計rev, np細啲， exp都細啲
payable>exp = prepaid ILLUSTRATION 19-29

Revenues or gains are taxable before they are recognized in financial income.

A liability 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)
that settle the liability will result in deductible amounts in future years.
Examples:
1. Subscriptions received in advance.
2. Advance rental receipts.
3. Sales and leasebacks for financial reporting purposes (income deferral) but
reported as sales for tax purposes.
4. Prepaid contracts and royalties received in advance.
收左錢先incur

19-25
 Deferred Tax Assets Examples
np已經計左exp，np已經細左，exp都細左，但payable未扣住：exp<payable = prepaid ILLUSTRATION 19-29

Expenses or losses are deductible after they are recognized in financial income.

A liability (or contra asset) may be recognized for expenses or losses that will
result in deductible amounts in future years when the liability is settled.
Examples:
1. Product warranty liabilities.
2. Estimated liabilities related to discontinued operations or restructurings.
3. Litigation accruals.
4. Bad debt expense recognized using the allowance method for financial
reporting purposes; direct write-off method used for tax purposes.
5. Share-based compensation expense.
6. Unrealized holding losses for financial reporting purposes (including use of
the fair value option), but deferred for tax purposes.

incur左但未比錢
19-26
 Deferred Tax Asset (Non-Recognition)

A company should reduce a deferred tax asset if it is probable

that it will not realize some portion or all of the deferred tax asset,
i.e., it does not reduce or save future tax payable.

“Probable” means a level of likelihood of at least slightly more

than 50 percent.
if <50%, do nothing

19-27
 Deferred Tax Asset (Non-Recognition)

Illustration: Callaway Corp. has a deferred tax asset account with

a balance of €150,000 at the end of 2021 due to a single cumulative
temporary difference of €375,000. At the end of 2022, this same
temporary difference has increased to a cumulative amount of
€500,000. Taxable income for 2021 is €850,000. The tax rate is 40%
for all years.

Instructions:
Assuming that it is probable that €30,000 of the deferred tax asset
will not be realized, prepare the journal entry at the end of 2022 to
recognize this probability.

19-28
 Deferred Tax Asset (Non-Recognition)

Illustration: Current Yr.

INCOME: 2021 2022
Financial income (IFRS) 725,000
Temporary difference 375,000 125,000 (500,000)
Taxable income (TA) 375,000 850,000 (500,000) -
Tax rate 40% 40% 40% 40%
Income tax 150,000 340,000 (200,000) -

Income Tax Expense 725000*0.4 290,000

Deferred Tax Asset 50,000
Income Taxes Payable 340,000

Income Tax Expense 30,000

Deferred Tax Asset 30,000
19-29
 Temporary Differences

A Temporary Difference is the difference between the tax basis of an

asset or liability and its reported (carrying or book) amount in the
financial statements that will result in taxable amounts or deductible
amounts in future years.

Future Taxable Amounts Future Deductible Amounts

Deferred Tax Liability represents Deferred Tax Asset represents the
the increase in taxes payable in increase in taxes refundable (or
future years as a result of taxable saved) in future years as a result of
temporary differences existing at deductible temporary differences
the end of the current year. existing at the end of the current
accounting角度已經產生 未來要比的amount
year.
tax版的accrued expenses accounting角度未產生 但已經預先比左的amount
tax版的prepaid expenses

19-30
eg unearned revenue
received rev first, pay more tax now=deductible liabilities

eg account payable
pay later, so pay more later=pay less exp now,more tax now=prepaid=deductible liabilities
 PERMANENT DIFFERENCES

temporary: 遲啲會出現起計算裡面（cash flow未到）

permanent: 真係唔計起taxable/acct裡面 得一邊income有 一邊income無

19-31
 Permanent Differences

 Enter into pretax financial income but never into taxable

income or

 Enter into taxable income but never into pretax financial

income.

 Affect only the period in which they occur.

 Do not give rise to future taxable or deductible amounts.

有啲野係acct income會計 但taxable income唔計

反之亦然

19-32
 Permanent Differences
Interest received on certain types of government obligations
and expenses incurred in obtaining tax-exempt income

E.g., government issues bond to fund the construction of public

facilities, such as a new highway. Under accounting standards,
you add interest income of government bonds to net income.
Under tax rules, it may generally be tax-free (country-to-country
rules).

Likewise, any expenses incurred in obtaining such income

(such as transaction fees paid to purchase these bonds) are
deductible for accounting but not tax purposes.

19-33
 Permanent Differences
Penalties and fines

These expenses occur when a business breaks civil, criminal,

or statutory law (and gets caught!). E.g., an employee gets a
speeding ticket while driving the company car to conduct
company business. The company deducts any fines against
accounting income, but tax rules disallow the deduction of such
expenses.

Lobbying , political donation and other political expenses

It is fully deducted from accounting income, but not deductible

under tax rules.

19-34
 Permanent Differences
Meals and entertainment

Companies can expense 100 percent of the costs related to

providing business-related meals and entertainment in the
normal course of business for accounting purposes. However,
for tax purposes, companies can only deduct certain
percentage of that same costs (country-to-country rules)

19-35
 Permanent Differences
Special dividend received deduction
For dividends that a company receives from other companies, it may include
all dividends as accounting income (depending on accounting rules). Under
tax rules, the taxable amount is affected by the ownership (country-specific
rules):
take US as an example:

a. If the company has less than 20 percent ownership in the other business,
all dividends are included in accounting income, but only 30% of
dividends are taxable. E.g., if the dividend is $100, the company reports
only $30 as taxable income.

b. For 20 to 80 percent ownership, only 20% of dividends are taxable. If the

company uses equity method, all dividends are excluded from accounting
income.

c. For more than 80 percent ownership, the company doesn’t report any of
the dividends as taxable income or accounting income.

19-36
 Permanent Differences
E19-4: Havaci Company reports pretax financial income of €80,000
for 2022. The following items cause taxable income to be different
than pretax financial income.
1. Depreciation on the tax return is greater than depreciation on
the income statement by €16,000.
2. Rent collected on the tax return is greater than rent earned on
the income statement by €27,000.
3. Fines for pollution appear as an expense of €11,000 on the
income statement.
Havaci’s tax rate is 30% for all years, and the company expects to
report taxable income in all future years. There are no deferred taxes
at the beginning of 2022.

19-37
 Permanent Differences
E19-4: Current Yr. Deferred Deferred
INCOME: 2022 Asset Liability
Financial income (GAAP) € 80,000
Excess tax depreciation (16,000) € 16,000
Excess rent collected 27,000 (€ 27,000)
acct income扣左
Fines (permanent) 但tax income不能扣 11,000
所以加翻
Taxable income (IRS) 102,000 (27,000) 16,000 -
Tax rate 30% 30% 30%
Income tax € 30,600 (€ 8,100) € 4,800 -
(80000+11000)*0.3
fines都要計算起acct tax exp裡面 因為未來都
Income tax expense 27,300 唔會係deductible/taxable
tax exp都唔係直接加/減 要比幾多就係幾多
Deferred tax asset 而家比定先的稅=assets 8,100
Deferred tax liability 造成遲啲要比的稅=liability 4,800
Income tax payable 30,600
Tax assets & liability 不能combine因為會在不同時候reverse
19-38
 TAX RATE CHANGES

19-39
 Tax Rate Considerations

Future tax Rates

A company must consider presently enacted changes in the tax
rate that become effective for a particular future year(s) when
determining the tax rate to apply to existing temporary
differences.

Revision of Future Tax Rates

When a change in the tax rate is enacted, companies should

record its effect on the existing deferred income tax accounts
immediately.

19-40
 Tax Rate Considerations

E19-1 (modified): Starfleet Corporation has one temporary

difference at the end of 2021 that will reverse and cause taxable
amounts of $55,000 in 2022, $60,000 in 2023, and $75,000 in 2024.
Starfleet’s pretax financial income for 2021 is $400,000, and the tax
rate is 30% for 2021, 25% for 2022, 20% for 2023, and 15% for
2024. There are no deferred taxes at the beginning of 2021.

Instructions
a) Compute taxable income and income taxes payable for 2021.
b) Prepare the journal entry to record income tax expense,
deferred income taxes, and income taxes payable for 2021.

19-41
 Tax Rate Considerations
Ex. 19-1 (modified): Current Yr.
INCOME: 2021 2022 2023 2024
Financial income (GAAP) 400,000
Temporary Diff. (190,000) 55,000 60,000 75,000
Taxable income (TAX) 210,000 55,000 60,000 75,000
a.
Tax rate 30% 25% 20% 15%
Income tax payable a. 63,000 13,750 12,000 11,250

由未來的deferred tax liability組成 (balancing figure)

b. Income tax expense (plug) 100,000

Income tax payable 63,000
Deferred tax liability 37,000

19-42
 COMPREHENSIVE EXAMPLE

19-43
 Comprehensive Example of Interperiod
APPENDIX 19A
Tax Allocation

Fiscal Year-2021

Akai Ltd., which began operations at the beginning of 2021, produces

various products on a contract basis. Each contract generates an
income of ¥80,000 (amounts in thousands). Some of Akai’s contracts
provide for the customer to pay on an installment basis. Under these
contracts, Akai collects one-fifth of the contract revenue in each of the
following four years. For financial reporting purposes, the company
recognizes income in the year of completion (accrual basis); for tax
purposes, Akai recognizes income in the year cash is collected
(installment basis).

19-44
 Comprehensive Example of Interperiod
APPENDIX 19A
Tax Allocation

Presented below is information related to Akai’s operations for 2021.

1. In 2021, the company completed seven contracts that allow for

the customer to pay on an installment basis. Akai recognized the
related income of ¥560,000 for financial reporting purposes. It
reported only ¥112,000 of income on installment sales on the
2021 tax return. The company expects future collections on the
related receivables to result in taxable amounts of ¥112,000 in
each of the next four years.

have deferred tax liability

rev higher, tax exp > payable = accrued

19-45
 Comprehensive Example of Interperiod
APPENDIX 19A
Tax Allocation

Presented below is information related to Akai’s operations for 2021.

2. At the beginning of 2021, Akai purchased depreciable assets with

a cost of ¥540,000. For financial reporting purposes, Akai
depreciates these assets using the straight-line method over a
six-year service life. The depreciation schedules for both financial
reporting and tax purposes are shown as follows.

tax liability:
19-46 higher acct profit=higher tax exp than payable
 Comprehensive Example of Interperiod
APPENDIX 19A
Tax Allocation

Presented below is information related to Akai’s operations for 2021.

3. The company warrants its product for two years from the date of
completion of a contract. During 2021, the product warranty
liability accrued for financial reporting purposes was ¥200,000,
and the amount paid for the satisfaction of warranty liability was
¥44,000. Akai expects to settle the remaining ¥156,000 by
expenditures of ¥56,000 in 2022 and ¥100,000 in 2023.
lower acct np, lower tax exp<payable, assets

4. In 2021, non-taxable governmental bond interest revenue was

¥28,000. permanent difference, no tax payable for interest revenue

5. During 2021, non-deductible fines and penalties of ¥26,000 were

paid. permanent difference, no tax deductible for fines

19-47
 Comprehensive Example of Interperiod
APPENDIX 19A
Tax Allocation

Presented below is information related to Akai’s operations for 2021.

6. Pretax financial income for 2021 amounts to ¥412,000.

7. Tax rates enacted before the end of 2021 were:

2021 50%

2022 and later years 40%

8. The accounting period is the calendar year.

9. The company is expected to have taxable income in all future

years.

19-48
 Comprehensive Example of Interperiod
APPENDIX 19A
Tax Allocation

Taxable Income and Income Taxes Payable-2021

The first step is to determine Akai’s income tax payable for 2021 by
calculating its taxable income.

19-49
 Akai computes income taxes payable on taxable income for
¥100,000 as follows.

19-50
 Computing Deferred Income Taxes – End of 2018

19-51
 Comprehensive Example of Interperiod
APPENDIX 19A
Tax Allocation

Deferred Tax Expense (Benefit) and the Journal

Entry to Record Income Taxes - 2021
Computation of Total Income Tax Expense, 2021

Journal Entry for Income Tax Expense, 2021

Income Tax Expense 174,000
Deferred Tax Asset 62,400
Income Taxes Payable 50,000
Deferred Tax Liability 186,400
19-52
 Comprehensive Example of Interperiod
APPENDIX 19A
Tax Allocation

Financial Statement Presentation - 2021

Companies should classify deferred tax assets and liabilities as
current and non-current on the statement of financial position.
Deferred tax assets are therefore netted against deferred tax liabilities
to compute a net deferred asset (liability).

19-53
 Financial Statement Presentation - 2021
Statement of Financial Position Presentation for 2021.

19-54