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1
Outline
1. Overview
2. Permanent vs. Temporary Differences
3. Two Common Sources of Temporary Differences
4. Deferred Tax Recognition Comprehensive Recognition
Approach
5. Deferred Tax Measurement Asset/Liability Method
6. Disclosure Rules for Temporary Differences
Income Taxes 3
Pre-tax financial income/Accounting profit:
Income before income tax expense based on generally
accepted accounting principles and standards (e.g., IFRS and
HKFRS).
The role of HKFRS is to provide users of financial
statements with information to help them in decision
making.
Revenues $ 1,000,000
Depreciation Expense:
Straight-line 200,000
Accelerated 320,000
Other Expenses 650,000
Income Taxes 6
Example 1 (Contd):
Compute ABCs income tax expense and income tax
payable.
Income Tax
The income tax
Statement Return Difference
amount computed
Revenues $ 1,000,000
Less:
based on financial
Depreciation 200,000 statement income
Other expenses 650,000 is income tax
Income before taxes $ 150,000 expense for the
Tax rate 30%
period.
Income taxes $ 45,000
Income Taxes 7
Example 1 (Contd):
Compute ABCs income tax expense and income tax
payable.
Income Tax
Statement Return Difference
Income taxes
Revenues $ 1,000,000 $ 1,000,000
based on tax
Less:
Depreciation 200,000 320,000 return
Other expenses 650,000 650,000 income are
Income before taxes $ 150,000 $ 30,000 the taxes
payable for
Tax rate 30% 30%
Income taxes $ 45,000 $ 9,000
the period.
Income Taxes 8
Example 1 (Contd):
The deferred tax for the period of $36,000 is the difference
between income tax expense of $45,000 and income tax payable
of $9,000.
Income Tax
Statement Return Difference
Revenues $ 1,000,000 $ 1,000,000 $ -
Less:
Depreciation 200,000 320,000 (120,000)
Other expenses 650,000 650,000 -
Income before taxes $ 150,000 $ 30,000 $ 120,000
Income Taxes 9
2. Permanent vs. Temporary Differences
Income Taxes 10
Permanent differences:
Arise when there are items included in the accounting
profit that will NEVER be taxed or allowed as tax
deductibles.
For example, in HK, dividend income is included in pre-
tax financial income but excluded from taxable income.
Permanent differences that occurred in a year do not give
rise to any further differences in future years. Therefore,
they have no impact on either current or future (deferred)
tax obligations.
If the only difference between taxable and pretax
incomes were a permanent one, then taxable income
(determines taxes payable) is equal to financial income
subject to tax (determines tax expense), which is pretax
financial income adjusted for the permanent differences,
and taxes payable equals tax expense.
Income Taxes 11
Temporary differences:
Arise when there are items included in the accounting
profit that will be taxed or allowed as tax deductibles in
different accounting periods.
Depreciation methods using accelerated depreciation
for the tax return and SL depreciation for the financial
statements.
Subscription revenue received in advance.
Bad debts.
Warranty expense.
Unrealized gains/losses on trading securities.
Temporary differences that originated in a year are capable
of reversal in later years. Eventually all items will be
treated the same for both tax and accounting purposes.
Income Taxes 12
Example 2 (The Effect of Permanent and Temporary
Differences on the Computation of Income Taxes):
A firm has reported income before taxes of $420,000,
which includes $20,000 of nontaxable revenues and $5,000
of nondeductible expenses, both permanent differences.
The firm also has two temporary differences: (1) the
depreciation (cost recovery) deduction on the tax return
exceeds depreciation expense on the income statement by
$30,000, and (2) subscription revenue included on the tax
return is $14,000 more than the amount recognized on the
income statement. The latter difference arises because
income tax laws require recognition of subscription revenue
when the payment is received, not when the subscription is
earned.
The tax rate is 35%.
Income Taxes 13
Example 2 (Contd):
Income taxes payable for the year would be computed as follows:
Pretax financial income (from income statement) $420,000
Add (deduct) permanent differences:
Nontaxable revenues $(20,000)
Nondeductible expenses 5,000 (15,000)
-------- ----------
Pretax financial income subject to tax $405,000
Add (deduct) temporary differences:
Excess of tax depreciation over book depreciation (30,000)
Excess of tax subscription revenue over book
subscription revenue 14,000
Taxable income $389,000
Tax on taxable income (income taxes payable):
$389,000 .35 $136,150
=======
Income tax expense: $405,000 .35 $141,750
=======
Income Taxes 14
Deferred tax accounts: arise if, and only if, there are
temporary differences. In this case, tax expense is not
equal to tax paid or payable, and a deferred tax account
is created. There are two kinds of deferred tax accounts:
Income Taxes 16
Deferred Tax Assets and the Valuation Allowance:
For deferred tax assets to be beneficial, the firm must have
future taxable income.
If a firm is more likely than not that a portion of deferred
tax asset will not be realized (insufficient future taxable
income to take advantage of the tax asset), then the
deferred tax asset must be reduced by a valuation
allowance, which reduces income from continuing
operations.
Income tax expense XXX
Valuation allowance XXX
Income Taxes 18
If tax rate is 20% for all three years, how do we account for
the tax associated with the $2 of taxable income in 2014?
Income tax expense 0.4
Tax payable 0.4
Now, how do we account for the tax associated with the extra
$1 of pretax financial income in 2014?
Income Taxes 21
Example 3:
Miller Co. had a pre-tax financial income in 2014 of $10,000
which includes a gain on trading securities of $6,000 that is
unrealized in 2014 and realized in future years. Therefore for
tax purposes the unrealized gain is not included in 2014 but in
future years when it is realized.
A timing difference arises in this example because
i. taxable income in 2014 = $4,000 < pre-tax financial income
in 2014 = $10,000;
ii. when Miller collects the $6,000 in the future, he has to pay
tax for that amount.
Income Taxes 22
(2) Fixed Asset Timing Differences:
These are the most common and important form of timing
difference where there is an excess of depreciation (capital)
allowances available in the profit tax computation over the
related book depreciation charges.
The reverse occurs in the future, when the depreciation
charges in financial statements exceed the depreciation
allowance available in the profits tax computation.
Over the life of the asset, the total depreciation charge will be
the same for both accounting and tax purposes.
Income Taxes 23
Example 4:
At the beginning of 2014, its first year of operations, Philip Co.
purchased a machine having an estimated 4-year life and no
residual value for $100,000. The depreciation schedules for
book purposes and for tax purposes were as follows:
Year Book Capital Current Cumulative
Depreciation Allowance Difference Difference
2014 25,000 40,000 -15,000 -15,000
2015 25,000 30,000 -5,000 -20,000
2016 25,000 20,000 5,000 -15,000
2017 25,000 10,000 15,000 0
Income Taxes 26
Two solutions:
Income Taxes 28
Comprehensive Recognition / Full Provision:
Income Taxes 29
Example 5 (The Creation of Deferred Tax Liabilities):
A firm acquires an asset for $9,000 with a three year useful life and
no salvage value. The firm uses straight-line depreciation method.
The asset will generate $5,000 of annual revenue for three years.
The tax rate is 40 percent each year.
The firm is allowed to depreciate the asset over two years for tax
purposes.
Tax Reporting
Year Year Year Total
1 2 3
Revenue $5,000 $5,000 $5,000 $15,000
Depreciation 4,500 4,500 0 9,000
Taxable income 500 500 5,000 6,000
Taxes payable 200 200 2,000 2,400
Net income 300 300 3,000 3,600
Income Taxes 30
Example 5 (Contd):
Financial Reporting
Year 1 Year 2 Year 3 Total
Revenue $5,000 $5,000 $5,000 $15,000
Depreciation 3,000 3,000 3,000 9,000
Pretax income 2,000 2,000 2,000 6,000
Tax expense 800 800 800 2,400
Net income 1,200 1,200 1,200 3,600
Total taxes and total net income over all 3 years are the same in both reports.
Over the life of this asset, the firm will report the following liabilities on the
balance sheet:
Year 1 Year 2 Year 3
Deferred tax liability $600 $1,200 $0
This example illustrates the creation of a deferred tax liability when taxable
income is less than pretax income early in the asset life. This timing
difference is reversed as the asset ages.
Income Taxes 31
Example 6 (The Creation of Deferred Tax Assets):
A firm has sales of $10,000 for each of two years.
The firm estimates that warranty expense will be 5 percent of year 1 sales
($500).
No warranty is given for year 2 sales.
The actual expenditure of $500 to meet warranty claims was not made until
the second year.
The tax rate is 40 percent each year.
Tax Reporting
Year 1 Year 2 Total
Revenue $10,000 $10,000 $20,000
Warranty expense 0 500 500
Taxable income 10,000 9,500 19,500
Taxes payable 4,000 3,800 7,800
Net income 6,000 5,700 11,700
Income Taxes 32
Example 6 (Contd):
Financial Reporting
Year 1 Year 2 Total
Revenue $10,000 $10,000 $20,000
Warranty expense 500 0 500
Pretax income 9,500 10,000 19,500
Tax expense 3,800 4,000 7,800
Net income 5,700 6,000 11,700
Total taxes and total net income over all 2 years are the same in both reports.
Over the two-year period, the firm will report the following assets on the
balance sheet:
Year 1 Year 2
Deferred tax asset $200 $0
This example illustrates the creation of a deferred tax asset when taxable
income is more than pretax income and the difference will reverse in future
years. Income Taxes 33
5. Deferred Tax Measurement Asset/Liability Method
Under the Asset/Liability Method, the tax rate to use when
calculating deferred tax balances is the rate at which the tax
will be paid when the timing differences reverse.
Usually this will be the current tax rate, but if you know the tax
rate is to change then you should use the new tax rate for the
deferred tax balance.
If the tax rate does change, deferred tax balances are adjusted
to reflect changes in tax rates.
This method recognizes that the deferred tax balance is a
liability (an asset) which will become payable (recoverable) at
some time in the future.
The provision represents the best estimate of the amount that
would be payable or recoverable when the relevant timing
differences reverse.
Income Taxes 34
Example 7 (Accounting for Income Taxes Using
the Asset/Liability Method):
During year one, the tax rate is 40 percent.
Starting in year two, the tax rate will fall to 35%
Assume taxable income is $20,000
Pretax income is $30,000
The $10,000 difference is temporary (reverses in the future)
The deferred tax liability is determined by the tax rate that will
exist when the reversal occurs (35%)
Results
The deferred tax liability is $3,500 [(0.35)($10,000)] not
[(0.40)($10,000)=]$4,000
The tax expense is [equal to current tax rate times taxable income
(0.40)($20,000) plus the deferred tax liability of $3,500] $11,500 and
not [(0.4)(30,000)=] $12,000.
Income Taxes 35
Example 8:
Continued with Example 3. Further assume the followings:
Income Taxes 36
Example 8 (Contd):
The journal entries to record Millers income taxes for 2014 would be as
follows:
* 35% 4,000 + 35% 2,000, which is the sum of the amounts need to be
settled in 2015 and 2016, respectively.
Income Taxes 38
Example 8 (Contd):
In each subsequent year, the ending deferred tax liability is
determined and compared with the beginning balance. The
difference between the beginning and ending balances is
recorded as an adjustment to the deferred tax liability
account. For example, at the end of 2015, we have :
Income Taxes 39
Example 8 (Contd):
The accumulated difference of $6,000 starts to reverse and,
therefore, the deferred tax liability account must be adjusted to a
balance of $700 ($2,000 .35). The amount of the adjustment
is $1,400 ($700 less the beginning balance of $2,100),
recorded as follows:
Moreover, the entry in 2015 to record the income tax would be:
Income Taxes 40
Example 8 (Contd):
Thus the reversed income tax expense (or the income tax
benefit) exactly offsets the current income tax expense for
2015 and reduces the net income tax to zero.
Income Taxes 41
Example 8 (Contd):
Again, the reversed income tax expense (or the income tax
benefit) exactly offsets the current income tax expense for 2016
and reduces the net income tax to zero.
Income Taxes 42
Effect of Tax Rate and Tax Law Changes
Under the asset/liability method all deferred tax assets
and liabilities are revalued using the new tax rate at the
date the rate is changed.
If tax rates fall; deferred tax liabilities fall, tax expense
decreases, net income increases.
If tax rates rise; deferred tax liabilities rise, tax expense
increases, net income decreases.
Income Taxes 43
Example 9 (Deferred Taxes and a Change in Tax
Rates):
A firm has a deferred tax asset of $1,000 and deferred tax liability
of $5,000 each deferred at a 40 percent tax rate.
Assume the tax rate is reduced to 36% (a 10 percent reduction in
tax rate).
Under the asset/liability method, the deferred tax asset and
liability must be revalued at the new tax rate; the asset and
liability is reduced by the 10 percent reduction in tax rates.
Results
The deferred tax asset is reduced by $100 to $900
The deferred tax liability is reduced by $500 to $4,500
Tax expense in the current period is reduced by $400 ($500
decrease in liability less $100 decrease in asset)
Income Taxes 44
Example 10 (Future Taxable Amount, Deferred Tax Liability,
Permanent and Temporary Differences, Multiple Years,
Comprehensive Recognition Approach and Asset and Liability
Method):
Praise Company began operation on January 1, 2014. At the end of
the first year of operations, Praise reported $1,000 income before
income taxes on its income statement, but only $700 taxable income
on its tax return. Analysis of the $300 difference revealed that $100
was a permanent difference and $200 was a temporary difference
related to a fixed asset. The enacted tax rate for 2014 and future
years is 35%. Praise uses the comprehensive recognition approach
and the asset and liability method to account for deferred tax items.
Income Taxes 45
Example 10 (Contd):
a. Does Praise have a Future Taxable Amount or Future Deductible
Amount, and how much?
Income Taxes 47
Example 10 (Contd):
d. If on Jan 1, 2015, the income tax rate is changed to 40% for 2015
and all future years. How would your answer in part c change?
Note:
This adjusting entry is NOT $600 40% = $240 because there is
also an increase in tax rate for the 2014 Future Taxable Amount of
$200 5% = $10 that is carried forward in 2015. Thus, the total =
$250 = $240 + $10.
Income Taxes 48
6. Disclosure Rules for Temporary Differences
Income Taxes 49