Income Taxes

RCJ Chapter 13

Key Issues
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.

Book (financial statement) vs. taxable income

Permanent differences
Effective vs. statutory tax rates
Temporary (timing) differences
Deferred taxes: Assets, Liabilities, Expense
Possible cases and examples
Components of income tax expense (current vs deferred)
Tax journal entries
Originating vs reversing differences
Asset, Liability (B/S) method vs I/S method
NOL carryback and carryforward
Deferred tax asset valuation allowance
Footnote disclosures:
Paul Zarowin

3 Parts of Tax Disclosure

1.

Current vs. deferred expense

2.

Reconciliation between statuary vs. effective tax

rates

3.

Changes in Deferred Tax (DT) assets/liabilities

and/or components of DT expense.

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Key Identity
Pre-tax book (accounting) income

Permanent differences

Temporary differences

pre-tax taxable income

ex. E13-7, E13-8 (Kent), P13-4 (Joy)

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Permanent Differences
Definition:
Items of revenue or expense that are in book (or
taxable) income of a period, but never part of
taxable (or book) income.
2 types:
1. non-taxable revenues

2.

(ex. interest income on

municipal bonds)

non-deductible expenses (ex. GW amortization)

ex. E13-7 Exhibit 13.2, Pg. 690

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Importance of Permanent Differences:

Effective vs. Statutory Tax Rate
def: effective tax rate (ETR) =

tax expense

pre-tax (book) income

def: statutory tax rate (STR) = rate set by government

permanent diffs cause ETR STR

non-taxable revenues lower the ETR
non-deductible expenses raise the ETR

ex. E13-7, E13-8 (Kent)

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Temporary (Timing) Differences

Temp. diff. cause deferred tax assets, liabilities, expense

Definitions:
Temp diff: item of revenue or expense that are part of book and
taxable income, in different periods

Deferred tax asset: future tax deductible due to current timing

Deferred tax liability: future tax payable due to current timing

difference
difference

Q: What is sum of temporary differences over firms life?

ex. E13-7
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4 Possible Types of Timing Differences

Revenues

Expenses

recognize for
books before
taxes

1. Accrued (asset)
revenue

3. Accrued (liab)
expense

recognize for
taxes before
books

2. Deferred
(unearned)
revenue

4. Deferred (prepaid)
expense

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Ex. 1. accrued asset, receivable

Books = accrual accounting
period 1:

period 2:

DR
A/R 100

CR
Rev 100

DR
Cash 100

CR
A/R 100

Taxes = cash accounting

DR

DR
Cash 100

CR

N/A

CR
Rev 100

Note: total revenue is the same, just timing differs

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Ex. 2. unearned revenue

Books = accrual accounting
period 1:

DR
Cash 100

CR
Liab 100

period 2:

DR
Liab 100

CR
Rev 100

Taxes = cash accounting

DR
Cash 100
DR

CR
Rev 100
CR

N/A

Note: total revenue is the same, just timing differs

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Ex. 3. accrued liability, payable

Books = accrual accounting
period 1:

period 2:

Taxes = cash accounting

DR
Exp 100

CR
Liab 100

DR

DR
Liab 100

CR
Cash 100

DR
Exp 100

CR

N/A

CR
Cash 100

Note: total expense is the same, just timing differs

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Ex. 4. prepaid expense

Books = accrual accounting

Taxes = cash accounting

period 1:

DR
Asset 100

CR
Cash 100

DR
Exp 100

CR
Cash 100

period 2:

DR
Exp 100

CR
Asset 100

DR

CR
N/A

Note: total expense is the same, just timing differs

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Timing Differences:
Relation to Deferred Tax Assets, Liab.
Revenues

Expenses

recognize for
books before
taxes

1. Deferred tax
liability

3. Deferred tax asset

recognize for
taxes before
books

2. Deferred tax
asset

4. Deferred tax
liability

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Components of Tax Expense and Tax JE

Components of tax expense: 1. current (pay now); and

2. deferred (paid before or after)

1.

DR current tax expensea

CR
Cash or taxes payable

Assumes positive
taxable income

a) Current tax expense = taxable inc.*current statutory tax rate

2.

DR deferred tax expenseb

CR
Deferred tax asset/liability
b) Deferred tax expense =
net in deferred tax asset/liability
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can DR or CR
deferred tax
expense, depending
on net deferred
tax asset/liability

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Components of Tax Expense (contd)

Alternatively,
3. DR
total tax expensec
CR
Deferred tax asset/liability
CR
Cash
c) Total tax expense = current + deferred

ex. E13-7

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Deferred Tax Accounting =

Inter-period Tax Allocation
Total income tax expense =
Current (paid now)
+ Deferred (paid both before or after)

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Originating vs. Reversing Timing Diff.

Originating differences create deferred tax assets

(DR); and liabilities (CR)
Reversing differences reduce deferred tax assets
(CR) and liabilities (DR)

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Examples of Deferred Tax Assets/Liab

1. Installment sale; revenue is recognized up front
for financial reporting, but is recognized for tax
purposes later, when cash is received each period.
2. Prepayment; revenue is recognized for tax
purposes up front as cash is received , while accrual
accounting delays revenue recognition until revenue
is earned later.
3. Bad debts expense. The allowance method for
books recognizes the expense in the period of sale
by the adjusting entry (matching principle), while
the direct write-off method recognizes the expense
in a later period, when the receivable is actually
written off.
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Examples of Deferred Tax Assets/ Liab (contd)

4.

depreciation expense; firms use an accelerated

method for taxes and SL for books. This
combination recognizes some depreciation for taxes
first and for books later.
RCJ give additional examples of revenues and
expenses that produce deferred tax assets and
liabilities in Exhibit 13.1, Pg. 689-90.

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Calculation of Deferred Tax Expense,

Asset, Liability: B/S Method
1.
2.

deferred tax asset/liability = cumulative timing difference * STR

deferred tax expense = net in deferred tax asset/liability

B/S method (also called asset/liability method)

use STR expected to be in effect when timing difference reverses

so, if STR changes, calculate deferred tax asset/liability as per

(2), and calculate deferred tax expense = deferred tax
asset/liability
I/S method

for constant STR only,

deferred tax expense = current years timing difference * STR

B/S method is or constant or changing STR

ex. E13-3 different rates over time, vs.

E13-2 change in rates
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Deferred Tax Asset, Liability and Expense

Depend on Tax Rate
Key point:
Deferred tax asset, deferred tax liability and deferred
tax expense depend on the tax rate.

Ex. E13-8, E13-9, E13-10

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Intuition

Deferred tax asset =

$ amount of future tax deduction (or tax saving)=
$ timing difference * STR

Deferred tax liability =

$ amount of future tax payable =
$ timing difference * STR

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Net Operating Loss (NOL)

NOL = negative taxable income

Book income may be either positive or negative

NOL can be carried back or forward

NOL carryback:
Get a refund of past taxes paid:
DR cash or tax refund receivable
CR
(current) income tax expense
The maximum carryback period is 2 years (offset the earlier
year first, as in FIFO)

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Net Operating Loss (contd)

NOL carryforward:
Offset future income (also FIFO), reducing future taxes payable:
DR deferred tax asset
CR
(deferred) income tax expense
This is another reason for deferred tax asset in addition to timing
differences.

A firm can carryforward an NOL for up to 20 years.

EX. E13-13, 14, 16

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Incentives for Carryback vs. Carryforward

1.

Cant carryback because of 2 years of losses

2.

Time value of money: get the cash ASAP

carryback

3.

If tax rates are expected to rise, a dollar of

deduction will be worth more carryforward

ex. P13-7

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Deferred Tax Asset Valuation Allowance

Contra-asset account (CR balance on the B/S ; eg, accd
depreciation or AUA) that reduces the deferred tax asset to
its expected realizable value
1.

2.

Record the deferred tax asset in the usual way (as if there
were no valuation allowance)
Make an additional entry:
DR
(deferred) income tax expense
CR
deferred tax asset valuation allowance
increasing (decreasing) the allowance increases (decreases)
deferred income tax expense
allowances existence and magnitude reveals managements
expectation of future earnings.
management can use changes in the allowance to manipulate
NI, by affecting income tax expense.

ex. E13-17

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Financial Statement Disclosures

I/S : total income tax expense
B/S: net current and net non-current deferred tax asset or
liability

Footnote disclosure:
1. Current and deferred components of total income tax
expense (from Income From Continuing Operations, because the
below the line components are shown net of tax).

2. Reconciliation between the federal statutory and

effective tax rates (in $ and/or %).
C13-1, 2, 3, 5, 6
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Financial Statement Disclosures (contd)

3a. components of deferred tax assets and liabilities
and/or
3b. Components of deferred tax expense
(e.g., revenue and expense items that cause the
deferred tax expense, assets, liabilities, such as
depreciation, bad debts, installment sales, etc.)

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