Accounting for

Income Taxes
 Calculating Income
Two ways of calculating income and the
resulting amount of taxes that are owed:
1. US GAAP (Book Income).
2. The Internal Revenue Code (Taxable
Income).
The difference between these is
essentially a prepaid taxes or taxes
payable.
 Differences Between Incomes
Differences between book and taxable income are
caused by:
1. Temporary Differences: A timing difference as
to when a revenue or expense item will be
recognized (Prepaid income, Credit sales).
2. Permanent Differences: A difference between
taxable income and book income that will not
reverse because the item is not taxable or not
deductible.
 Example Journal Entry #1
The company “wants to pay” $90 but it
“has to pay” $100. It records taxes as
follows:

Dr Income tax exp. (want to pay) 90

Dr Prepaid taxes (deferred tax asset)10
CrCash (have to pay) 100
 Example Journal Entry #2
The company “wants to pay” $200, but it
“has to pay” $180. It records taxes as
follows:

Dr Income tax exp. (want to pay) 200

Cr Taxes payable (def. tax liability) 20
Cr Cash (have to pay) 180
 Total Tax Expense
Total tax expense is made up of two parts:
1. Current tax expense
2. Deferred tax expense or benefit
Deferred Tax
 Deferred Tax Asset or Liability
Caused by temporary timing
differences. Arises when a revenue or
expense item is recorded in different
periods for book and tax purposes.
Deferred Tax Assets (Prepaid Taxes)
Book Income < Taxable Income

• Revenue that is taxable before it is recorded in the

books.
• Expense that is recorded in the books before it is
deductible for taxes.

The company pays more than it wants to and this leads

to “prepaid taxes”.
 Deferred Tax Liabilities
Book Income > Taxable Income

• Revenue that is recorded in the books before it

is taxable.
• Expense that is deductible for taxes before it is
recorded in the books.

The company pays less than it wants to and this

leads to a “taxes payable”.
 Calculating the Amount of the
Deferred Asset or Liability
• The amount of the temporary difference in the
current period is multiplied by the enacted tax
rate that is in effect for the period the difference
will reverse in.
Difference
x Enacted tax rate for period of reversal
= Deferred tax asset or liability
• The rate that has been passed by
the government as the tax rate in the future.
Example Structure of Calculation
Deposits Enacted Def. Tax
Year Received Tax Rate Asset
Year 1 $50,000 25% $12,500
Year 2 $ (25,000) 30% $7,500
Year 3 $ (25,000) 35% $8,750
Total $16,250
 SINGLE Period of Creation and
SINGLE Period of Reversal
Multiply the current year difference by the
enacted tax rate for the next year.
 SINGLE Period of Creation and
MULTIPLE Period Reversal
1. Determine how much of the temporary
difference will reverse in each future period.
2. Multiply the amount of the temporary timing
difference that will reverse in each future period
by the enacted tax rate for that future period.
3. Sum all of the products from Step 2 to calculate
the amount of increase in the balance of the
deferred tax asset or liability at the end of the
year in which it was created.
Example: On December 31, 20X4, Bora Bora Manufacturing Co. leased a
factory building to Kaimana Co., a manufacturer of surfboards, for two years.
The lease expiration date was December 31, 20X6. The lease amount was
$100,000 for each of the two years. Kaimana Co. paid the full two years’ rent
of $200,000 in advance. The enacted tax rate for 20X4 was 25%; for 20X5 it
was 24%, and for 20X6 it was 22%.
Bora Bora reported the receipt as a 20X4 taxable receipt and paid tax of
$50,000 on it at the 25% rate.
The amount of the temporary timing difference is $200,000. Since the
difference will reverse over two periods with different tax rates, the amount that
will reverse in 20X5 is multiplied by the 20X5 tax rate and the amount that will
reverse in 20X6 is multiplied by the 20X6 tax rate:
20X5 $100,000 × 0.24 = $24,000
20X6 $100,000 × 0.22 = 22,000
Total $46,000
 When the Tax Rate Changes
• The new tax rate should be used to
adjust the deferred tax asset or liability.
• The deferred tax component of total
income tax expense should be adjusted
in the period when the change is
enacted, even if it has not yet become
effective.
Example: ABC Company has a net deferred tax liability of $60,000 due to net
temporary timing differences of $200,000 that will reverse next year at a
current tax rate of 30%.
At the end of the current year, the enacted tax rate for next year increases to
35%.
The deferred tax liability must be adjusted upward as of the end of the current
year to $70,000 (35% of $200,000), creating an increase of $10,000 in ABC’s
deferred tax expense for the current year due to the enacted tax rate change
for next year.
The increase to deferred tax expense increases total income tax expense for
the current year by $10,000.
Disclosure on the Balance Sheet
• Deferred tax assets and liabilities are net
together for a net deferred tax asset or
liability.

• This is shown on the balance sheet as

noncurrent.
 DTA Valuation Journal Entry

Dr Deferred Income Tax Benefit X

Cr Allowance for deferred tax asset X

If it is connected to a net operating loss, the

debit is to Benefit Due to Loss Carry
forward.
Permanent Differences
Permanent Timing Differences
Permanent timing differences do not
create a deferred tax item.

These items are recognized for book

income purposes, but are either not
taxable for tax purposes or not deductible
for tax purposes.
 Permanent Differences
• Municipal bond interest.
• The Dividends-Received Deduction
• Life insurance premiums paid and proceeds
received by the corporation.
• Expenses incurred as a result of the violation of
a law.
• The translation adjustment from foreign
currency financial statements.
 Example
This data pertains to Lally Corporation for 20X4 and 20X5.
20X5 20X4
Income before income taxes $5,000,000 $4,000,000
Interest income included above that
was not subject to income taxes 100,000 100,000
Income before income taxes in 20X4 included a gain of $80,000 for the sale of real property,
for which Lally financed the sale on a short-term note. Lally received full payment on the note
from the buyer in two installments during 20X5, reported the gain on its 20X5 income tax
return as an installment sale, and paid the tax on it. Lally was subject to an effective income
tax rate of 40% in 20X4 and 20X5.
The deferred tax asset or liability reported on Lally Corporation's statement of financial
position on December 31, 20X5 is
A. $0
B. $40,000
C. $32,000
Net Operating Losses
 DTA Valuation Allowance
If the company does not expect to have
enough future taxable income to enable it
to offset the deferred tax asset against
future income taxes due, then the company
should establish a valuation allowance for
the deferred tax asset to reduce it to the
amount the company expects to be able to
utilize.
 Net Operating Losses
• For operating losses before 2018, operating
losses could be carried back for 2 years to offset
prior period income, or carried forward for 20
years to offset future income.
• For operating losses in 2018 and going forward,
they may only be carried forward, but they may
be carried forward indefinitely. The amount
carried forward is limited to 80% of the taxable
income in a period.
 Loss Carryback
The refund amount is calculated and
recognized:
Dr Income tax refund receivable X
Cr Income tax benefit from loss carryback X
 Loss Carryforward
Need to recognize a deferred tax asset in
the period of the loss.
 Example
Bearings Manufacturing Company Inc. purchased a new machine on January 1, 20X0
for $100,000. The company uses the straight-line depreciation method with an
estimated equipment life of 5 years and a zero salvage value for financial statement purposes,
and uses the 3-year Modified Accelerated Cost Recovery System (MACRS) and the half-
year convention with an estimated equipment life of 3 years for income tax reporting
purposes. Bearings is subject to a 35% marginal income tax rate. Assume that the deferred
tax liability at the beginning of the year is zero and that Bearings has a positive earnings
tax position. The MACRS depreciation rates for 3-year equipment are shown below.
Year Rate Year Rate
1 33.33% 3 14.81%
2 44.45% 4 7.41%
What is the deferred tax liability at December 31, 20X0 (rounded to the nearest whole dollar)?
A. $7,000
B. $4,666
C. $11,666
D. $33,330