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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-1
Accounting Clinic VI
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-3
Deferred Taxes: Basics
Deferred taxes arise when income tax expense differs from income tax liability
The income tax liability is based on income determined under provisions of the United States Internal Revenue Code and foreign, state, and other taxes (including franchise taxes) based on income.
The tax expense is the amount of income taxes (whether or not currently payable or refundable) allocable to a period in the determination of net income.
Some of these differences are temporary and some are permanent
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-4
Why do we need Deferred Taxes?
Main issue: the need to match tax expense
to related accounting income so appropriate
after-tax income is reported, independent of
when taxes on that income is assessed by
tax authorities.
Advantages of deferred taxes:
Smoothing of earnings
Better relationship between earnings
and income tax expense
effective tax rate reflects statutory rate
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-5
Temporary and Permanent Differences
Temporary difference.
Differences between the taxable amount of a revenue or expense and its reported amount in the financial statements that result in taxable or deductible amounts in future years when the revenue or expense enters the tax return.
Permanent differences.
Permanent differences arise from statutory provisions under which specified revenues are exempt from taxation and specified expenses are not allowable as deductions in determining taxable income.
Other permanent differences arise from items entering into the determination of taxable income which are not components of pretax accounting income in any period.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-6
Examples of Permanent Differences
Interest received on municipal obligations
premiums paid on officers' life insurance.
Fines and other expenses that result from a
violation of law.
Deduction for dividend received from U.S.
corporations.
Percentage depletion of natural resources in
excess of their cost.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-7
Examples of Temporary differences
1. Revenues or gains that are taxable after they are recognized in financial income. An asset (for example, a receivable from an installment sale) may be recognized for revenues or gains that will result in future taxable amounts when the asset is recovered.
2. Expenses or losses that are deductible after they are recognized in financial income. A liability (for example, a product warranty liability) may be recognized for expenses or losses that will result in future tax deductible amounts when the liability is settled.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-8
Examples of Temporary differences
3. Revenues or gains that are taxable before they
are recognized in financial income. A liability
(for example, subscriptions received in advance)
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) will result in future tax deductible
amounts when the liability is settled.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-9
Examples of Temporary differences
4. Expenses or losses that are deductible before they are
recognized in financial income. The cost of an asset (for
example, depreciable personal property) may have been
deducted for tax purposes faster than it was depreciated
for financial reporting. Amounts received upon future
recovery of the amount of the asset for financial reporting
will exceed the remaining tax basis of the asset, and the
excess will be taxable when the asset is recovered.
5. A reduction in the tax basis of depreciable assets because
of tax credits. Amounts received upon future recovery of
the amount of the asset for financial reporting will exceed
the remaining tax basis of the asset, and the excess will
be taxable when the asset is recovered.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-10
Deferred Tax Liability
A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years.
For example, a temporary difference is created between the reported amount and the tax basis of an installment sale receivable if, for tax purposes, some or all of the gain on the installment sale will be included in the determination of taxable income in future years. Because amounts received upon recovery of that receivable will be taxable, a deferred tax liability is recognized in the current year for the related taxes payable in future years.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-11
Deferred Tax Asset
A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards.
For example, a temporary difference is created between the reported amount and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated expenses are not deductible until a future year. Settlement of that liability will result in tax deductions in future years, and a deferred tax asset is recognized in the current year for the reduction in taxes payable in future years.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-12
Temporary Differences Effect
Revenue/
Expense
When recorded in
books relatively to the
taxable income
Deferred tax effect
Revenue Earlier Liability
Revenue Later Asset
Expense Earlier Asset
Expense Later Liability
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Basic Journal Entry to Record Deferred Taxes
Tax Liability
Income Tax Expense xxx
Def.Tax Liability xxx
Taxes Payable xxx
Tax Asset
Income Tax Expense xxx
Def. Tax Asset xxx
Taxes Payable xxx
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Recording a Valuation Allowance
for Doubtful Deferred Tax Assets
A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.
The net deferred tax asset should equal that portion of the deferred tax asset which, based on the current available evidence, will not be realized.
Journal entry: Income Tax Expense xxx Allowance to Reduce Deferred Tax Asset to Expected Realizable Value xxx
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Example – Deferred Tax Liability -
Depreciation
Bryant Corporation purchased a new
machine for $100,000 on January 1, 2004.
The machine has a four-year estimated
service life and no salvage value.
Bryant’s pretax income for each year
2004 - 2007 is 200,000 before depreciation
and taxes.
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Bryant Corp. uses straight-line depreciation
on its books and MACRS for tax reporting.
For tax purposes the machine is also
depreciated over 4 years using MACRS (an
accelerated depreciation method).
The depreciation percentages for each of the
years are 33%, 44%, 15% and 8%.
Assume a 40% tax rate.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-17
A. Compute financial (book) income after
depreciation but before taxes. What is
income tax expense?
B. Compute taxable income. What is income
tax payable?
C. Give the journal entries to record taxes.
D. Give the balance of the deferred tax
liability at the end of each of the years.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-18
Solution
Financial (book) income 2004 2005 2006 2007
Income before Depreciation
Depreciation Expense
($100,000/4)
Income after depreciation
but before taxes
Income Tax Expense (40%)
$200,000
(25,000)
$175,000
$70,000
$200,000
(25,000)
$175,000
$70,000
$200,000
(25,000)
$175,000
$70,000
$200,000
(25,000)
$175,000
$70,000
A.
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2004 2005 2006 2007
Pre-Tax Income before Depreciation
$200,000 $200,000 $200,000 $200,000
Depreciation Deduction: (33,000) (44,000) (15,000) (8,000)
Taxable Income
$167,000 $156,000 $185,000 $192,000
Income Taxable Payable (40%) $66,800 $62,400 $74,000 $76,800
B.
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C. Journal entries:
2004
Income Tax Expense
Tax Payable
Deferred Tax Liability
70,000
66,800
3,200
2005
Income Tax Expense
Tax Payable
Deferred Tax Liability
70,000
62,400
7,600
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-21
2006
Income Tax Expense 70,000
Deferred Tax Liability
Tax Payable
4,000
74,000
2007
Income Tax Expense 70,000
Deferred Tax Liability
Tax Payable
6,800
76,800
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D. The deferred tax liability account
Dr. Cr.
3,200 2004 entry
3,200 12/31/2004
7,600 2005 entry
10,800 12/31/2005
4,000 2006 entry
6,800 12/31/2006
6,800 2007 entry
0 12/31/2007
The liability has reversed itself
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Example - Deferred Tax Liability –
Advances from Customers
Miller Co. received $30,000 of subscriptions in advance at the end of 2004.
Subscription revenue will be equally recognized in 2005, 2006, and 2007, for financial accounting purposes but all of the $30,000 will be recognized in 2004 for tax purposes.
Miller’s pretax income for each year 2004-2007 is $100,000 before taxes.
Assume a 40% tax rate.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-24
A. Compute Financial (book) income
including subscription revenue but
excluding taxes. What is income tax
expense?
B. Compute taxable income. What is income
tax payable?
C. Give the journal entries to record taxes.
D. Give the balance of the deferred tax asset
at the end of each of the years.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-25
E. For this requirement only, assume that as
a result of examining available evidence
in 2004, it is more likely than not that
$10,000 of the deferred tax asset will not
be realized. Give the journal entry to
record this reduction.
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Solution
2004 2005 2006 2007
Financial (book) income
Income before subscription 100,000 100,000 100,000 100,000
Subscription revenue received
in 2004
0 10,000 10,000 10,000
Income before taxes 100,000 110,000 110,000 110,000
Income tax expense (40%) 40,000 44,000 44,000 44,000
A.
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2004 2005 2006 2007
Pretax income 100,000 100,000 100,000 100,000
Subscription received in 2004 30,000 - - -
Taxable Income 130,000 100,000 100,000 100,000
Taxes Payable (40%) 52,000 40,000 40,000 40,000
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C. Journal entries
2004
Income tax expense 40,000
Deferred tax asset 12,000
Tax payable 52,000
2005 - 2007
Income tax expense 44,000
Deferred tax asset 4,000
Tax payable 40,000
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D. The deferred tax asset account
Db. Cr.
12,000 2004 entry
12,000 12/31/2004
4,000 2005 entry
8,000 12/31/2005
4,000 2006 entry
4,000 12/31/2006
4,000 2007 entry
0 12/31/2007
The asset has reversed itself.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-30
Income Tax Expense 10,000
Allowance to Reduce Deferred Tax Asset
To Expected Realizable Value 10,000
To record the reduction in the deferred tax asset
E.
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Example - Permanent Differences
Calculation
Hunter Corporation reports the following information for
2004:
Financial (Book) Income before Income Taxes $548,000
Income Taxes Payable (for 2004) 157,500
Income Tax Expense 210,000
Hunter Corp. has both temporary and permanent
differences between book income and taxable income.
The temporary difference results from depreciation.
The permanent difference results from a fine that the
company has to pay (but can not be deducted on its tax
return).
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What is the amount of the permanent difference
for the year?
The tax rate is 35%
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Solution
Step 1: Find the change in the deferred tax liability
Income Tax Expense (Book) $210,000
Income Taxes Payable 157,500
∆ Deferred Tax Liability 52,500
Step 2: Find the temporary difference
∆ Deferred Tax Liability/0.35 $52,500/0.35=
150,000
Step 3: Find taxable income
Income Taxes Payable (from current year)/0.35 $157,500/0.35=
450,000
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Solution (Cont.)
Step 4: Find the permanent difference
Taxable Income (IRS) $450,000
Temporary Differences 150,000
Financial (Book) Income before Taxes Excluding
Permanent Differences 600,000
Permanent Differences (P.N) 52,000
Financial (Book) Income before Taxes 548,000
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Financial Statement Presentation
On the balance sheet, an enterprise should
separate deferred tax liabilities and assets
into a current amount and a noncurrent
amount. (Under IFRS, the separation is not
made)
Deferred tax liabilities and assets should be
classified as current or noncurrent based on
the classification of the related asset or
liability for financial reporting.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 6-36
Financial Statement Presentation
A deferred tax liability or asset that is not
related to an asset or liability for financial
reporting, including deferred tax assets
related to carryforwards, should be
classified according to the expected
reversal date of the temporary difference.
The valuation allowance for a particular tax
jurisdiction should be allocated between
current and noncurrent deferred tax assets
for that tax jurisdiction on a pro rata basis.