Income Tax Expense

Tax expense for current year consists of:

Current income tax expense (this year s tax bill) and Deferred income tax expense.

Income tax expense Taxes payable Deferred income taxes liability

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100 80 20

Book-to-Tax Differences
Arises because for some items tax accounting differs from book (GAAP). Taxable income: income reported to tax authorities to compute income tax. Pretax accounting income = pretax book income = income before taxes: income before tax under GAAP.

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Why Do Book and Taxable Income Differ?

Objective of tax accounting: raise taxes and encourage behavior, e.g. accelerated depreciation to encourage investment. Objective of GAAP/Financial reporting: Provide info useful to investors.

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Permanent Differences between Book and Tax

Do not reverse in future years. Expenses under GAAP that are not deductible. (e.g. fines.) Revenues excluded from taxable income. (e.g. revenue on municipal bonds) Does not create accounting issues.

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Temporary Difference between Book and Tax

Differences that reverse in a later period.
Revenues or expenses that are permitted or required to be reported in a different period. e.g. depreciation.

Creates accounting complexities in order to match income tax expense to period in which revenue or expense item is recognized.

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Deferred Tax Reporting

Asset and liability method. Deferred Income Taxes: liability account. Shown separately from Taxes payable.
Indicates amount that future tax expense will be reduced when differences between book and tax reverse. Interest free loan from the government. Increases as long as company grows.
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Deferred Tax Assets

Temporary differences resulting in Taxable income higher than book:
Subscription receipts recognized when received for tax, when earned for book.

Deferred tax assets (e.g. Tax-loss carryforwards) cannot exceed amount of expected future tax benefits.

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Permanent Deferrals
Company grows in size. Replacement costs of assets increases in periods of inflation. Accounts payable

Tax Rate Changes and Disclosures

Deferrals recorded based on rates currently in tax law. Disclosures:
Deferred tax asset and liability amounts shown separately. Must be classified appropriately as current or noncurrent.

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SILVER APPLIANCE COMPANY (In Thousands) 1989 1990 1991 1.Year-end installment receivables........................ $190.1 $351.9 $526.2 2.Gross margin % .................................................. 34.6% 35.1% 34.2% 3.Deferred gross margin (= 1 * 2) ......................... 65.77 123.52 179.96 4.Pretax profit, delivery basis ................................. 332.6 415.3 478.2 5.Income taxes, delivery basis (34% of 4)............. 113.08 141.20 162.59 6.Pretax profit, installment basis (= 4 - 3 + previous years 3) .................................................. 266.83 357.55 421.76 7.Income taxes, installment basis (34% of 6)........ 90.72 121.57 143.40 8.Tax deferred (5 - 7)............................................. 22.36 19.63 19.19 9.Cumulative tax deferred ...................................... 22.36 41.99 61.18

1992 $559.4 33.4% 186.84 492.5 167.45 485.62 165.11 2.34 63.52

1993 $489.1 32.2% 157.49 461.3 156.84 490.65 166.82 (9.98) 53.54

Bug Off Inc.

Leading pest extermination company in Cambridge, Massachussetts. Warranty stated that clients would be roach free for one year after an extermination treatment or their money back . Estimated warranty expense was 6% of total revenues collected for any given year. Tax laws permitted companies offering warranties to deduct expenses for tax purposes only as they actually incurred.

 Because of special weather conditions, the cockroach problem worsened in 2008. Prepare proforma income statements for Bug off inc. for 2008 through 2010 as they will appear in financial reports and in the company s tax returns. How should the deferred taxes be reported in each year.

Income statement for 2007

Revenues Expenses: Materials Salaries Depreciation Warranty expense $25,000 35,000 5,000 6,000 71,000 Income before taxes Income taxes @ 40% Income after taxes 29,000 11,600 17,400 $1,00,000

Pro Forma Revenues and Expenses

Revenues Expenses: Materials Salaries Depreciation Warranty expense (accrual) Warranty (tax return) Expected tax rate $ 50,000 55,000 5,000 12,000 25,000 35,000 5,000 6,000 25,000 35,000 5,000 6,000 2008 $ 2,00,000 2009 1,00,000 2010 1,00,000

6,000 40%

12,000 40%

6,000 40%

Revenue Expenses:
Materials Salaries Depreciation Warranty expense

Financial Reports Tax returns 2008 2009 2010 2008 2009 2010 $ 2,00,000 1,00,000 1,00,000 $ 2,00,000 1,00,000 1,00,000

$ 50,000 55,000 5,000 12,000

25,000 35,000 5,000 6,000

25,000 35,000 5,000 6,000

$ 50,000 55,000 5,000 6,000

25,000 35,000 5,000 12,000

25,000 35,000 5,000 6,000

Total expenses Income before taxes Taxes @ 40%

1,22,000

71,000

71,000

1,16,000

77,000

71,000

78,000

29,000

29,000

84,000

23,000

29,000

31,200

11,600

11,600

33,600

9,200

11,600

Journal Entries

Tax expense (Dr)

Deferred taxes

Cash (Cr)

2008 2009 2010

31,200 11,600 11,600

2400 (Dr) 2400 (Cr) 0

33,600 9200 11,600