Accounting Clinic VIMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
With contributions byStephen H. Penman – Columbia UniversityClinic VI-2
Deferred Taxes: BasicsDeferred taxes arise when income tax expensediffers from income tax liabilityThe income tax liabilit...
Why do we need Deferred Taxes?Main issue: the need to match tax expenseto related accounting income so appropriateafter-ta...
Temporary and Permanent DifferencesTemporaryTemporary difference.difference.Differences between thetaxable amount of a rev...
Examples of Permanent DifferencesInterest received on municipal obligationspremiums paid on officers life insurance.Fines ...
Examples of Temporary differences1. Revenues or gains that are taxable after they arerecognized in financial income. An as...
Examples of Temporary differences3. Revenues or gains that are taxable before theyare recognized in financial income. A li...
Examples of Temporary differences4. Expenses or losses that are deductible before they arerecognized in financial income. ...
Deferred Tax LiabilityA deferred tax liability is recognized fortemporary differences that will result in taxableamounts i...
Deferred Tax AssetA deferred tax asset is recognized for temporarydifferences that will result in deductible amountsin fut...
Temporary Differences EffectRevenue/ExpenseWhen recorded inbooks relatively to thetaxable incomeDeferredtax effectRevenue ...
Basic Journal Entry to Record Deferred TaxesTax LiabilityTax LiabilityIncome Tax Expense xxxDef.Tax Liability xxxTaxes Pay...
Recording a Valuation Allowancefor Doubtful Deferred Tax AssetsA valuation allowance is recognized if, based onthe weight ...
Example – Deferred Tax Liability -DepreciationBryant Corporation purchased a newmachine for $100,000 on January 1, 2004.Th...
Bryant Corp. uses straight-line depreciationon its books and MACRS for tax reporting.For tax purposes the machine is alsod...
A. Compute financial (book) income afterdepreciation but before taxes. What isincome tax expense?B. Compute taxable income...
SolutionFinancial (book) income 2004 2005 2006 2007Income before DepreciationDepreciation Expense($100,000/4)Income after ...
2004 2005 2006 2007Pre-Tax Income before Depreciation $200,000 $200,000 $200,000 $200,000Depreciation Deduction: (33,000) ...
C. Journal entries:2004Income Tax ExpenseTax PayableDeferred Tax Liability70,00066,8003,2002005Income Tax ExpenseTax Payab...
2006Income Tax Expense 70,000Deferred Tax LiabilityTax Payable4,00074,0002007Income Tax Expense 70,000Deferred Tax Liabili...
D. The deferred tax liability accountDr. Cr.3,200 2004 entry3,200 12/31/20047,600 2005 entry10,800 12/31/20054,000 2006 en...
Example - Deferred Tax Liability –Advances from CustomersMiller Co. received $30,000 ofsubscriptions in advance at the end...
A. Compute Financial (book) incomeincluding subscription revenue butexcluding taxes. What is income taxexpense?B. Compute ...
E. For this requirement only, assume that asa result of examining available evidencein 2004, it is more likely than not th...
Solution2004 2005 2006 2007Financial (book) incomeIncome before subscription 100,000 100,000 100,000 100,000Subscription r...
2004 2005 2006 2007Pretax income 100,000 100,000 100,000 100,000Subscription received in 2004 30,000 - - -Taxable Income 1...
C. Journal entries2004Income tax expense 40,000Deferred tax asset 12,000Tax payable 52,0002005 - 2007Income tax expense 44...
D. The deferred tax asset accountDb. Cr.12,000 2004 entry12,000 12/31/20044,000 2005 entry8,000 12/31/20054,000 2006 entry...
Income Tax Expense 10,000Allowance to Reduce Deferred Tax AssetTo Expected Realizable Value 10,000To record the reduction ...
Example - Permanent DifferencesCalculationHunter Corporation reports the following information for2004:Financial (Book) In...
What is the amount of the permanent differencefor the year?The tax rate is 35%Clinic VI-32
SolutionStep 1: Find the change in the deferred tax liabilityStep 1: Find the change in the deferred tax liabilityIncome T...
Solution (Cont.)Step 4: Find the permanent differenceStep 4: Find the permanent differenceTaxable Income (IRS) $450,000Tem...
Financial Statement PresentationOn the balance sheet, an enterprise shouldseparate deferred tax liabilities and assetsinto...
Financial Statement PresentationA deferred tax liability or asset that is notrelated to an asset or liability for financia...
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Accounting clinic vi

  1. 1. Accounting Clinic VIMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. With contributions byStephen H. Penman – Columbia UniversityClinic VI-2
  3. 3. Deferred Taxes: BasicsDeferred taxes arise when income tax expensediffers from income tax liabilityThe income tax liability is based on incomedetermined under provisions of the United StatesInternal Revenue Code and foreign, state, andother taxes (including franchise taxes) based onincome.The tax expense is the amount of income taxes(whether or not currently payable or refundable)allocable to a period in the determination of netincome.Some of these differences are temporary andsome are permanentClinic VI-3
  4. 4. Why do we need Deferred Taxes?Main issue: the need to match tax expenseto related accounting income so appropriateafter-tax income is reported, independent ofwhen taxes on that income is assessed bytax authorities.Advantages of deferred taxes:Smoothing of earningsBetter relationship between earningsand income tax expenseeffective tax rate reflects statutory rateClinic VI-4
  5. 5. Temporary and Permanent DifferencesTemporaryTemporary difference.difference.Differences between thetaxable amount of a revenue orexpense and its reportedamount in the financialstatements that result in taxableor deductible amounts in futureyears when the revenue orexpense enters the tax return.Permanent differencesPermanent differences.Permanent differences arisefrom statutory provisions underwhich specified revenues areexempt from taxation andspecified expenses are notallowable as deductions indetermining taxable income.Other permanent differencesarise from items entering intothe determination of taxableincome which are notcomponents of pretaxaccounting income in anyperiod.Clinic VI-5
  6. 6. Examples of Permanent DifferencesInterest received on municipal obligationspremiums paid on officers life insurance.Fines and other expenses that result from aviolation of law.Deduction for dividend received from U.S.corporations.Percentage depletion of natural resources inexcess of their cost.Clinic VI-6
  7. 7. Examples of Temporary differences1. Revenues or gains that are taxable after they arerecognized in financial income. An asset (forexample, a receivable from an installment sale)may be recognized for revenues or gains that willresult in future taxable amounts when the asset isrecovered.2. Expenses or losses that are deductible after theyare recognized in financial income. A liability(for example, a product warranty liability) maybe recognized for expenses or losses that willresult in future tax deductible amounts when theliability is settled.Clinic VI-7
  8. 8. Examples of Temporary differences3. Revenues or gains that are taxable before theyare recognized in financial income. A liability(for example, subscriptions received in advance)may be recognized for an advance payment forgoods or services to be provided in future years.For tax purposes, the advance payment isincluded in taxable income upon the receipt ofcash. Future sacrifices to provide goods orservices (or future refunds to those who canceltheir orders) will result in future tax deductibleamounts when the liability is settled.Clinic VI-8
  9. 9. Examples of Temporary differences4. Expenses or losses that are deductible before they arerecognized in financial income. The cost of an asset (forexample, depreciable personal property) may have beendeducted for tax purposes faster than it was depreciatedfor financial reporting. Amounts received upon futurerecovery of the amount of the asset for financialreporting will exceed the remaining tax basis of the asset,and the excess will be taxable when the asset isrecovered.5. A reduction in the tax basis of depreciable assets becauseof tax credits. Amounts received upon future recovery ofthe amount of the asset for financial reporting willexceed the remaining tax basis of the asset, and theexcess will be taxable when the asset is recovered.Clinic VI-9
  10. 10. Deferred Tax LiabilityA deferred tax liability is recognized fortemporary differences that will result in taxableamounts in future years.For example, a temporary difference is createdbetween the reported amount and the tax basis ofan installment sale receivable if, for tax purposes,some or all of the gain on the installment sale willbe included in the determination of taxableincome in future years. Because amountsreceived upon recovery of that receivable will betaxable, a deferred tax liability is recognized inthe current year for the related taxes payable infuture years.Clinic VI-10
  11. 11. Deferred Tax AssetA deferred tax asset is recognized for temporarydifferences that will result in deductible amountsin future years and for carryforwards.For example, a temporary difference is createdbetween the reported amount and the tax basis ofa liability for estimated expenses if, for taxpurposes, those estimated expenses are notdeductible until a future year. Settlement of thatliability will result in tax deductions in futureyears, and a deferred tax asset is recognized in thecurrent year for the reduction in taxes payable infuture years.Clinic VI-11
  12. 12. Temporary Differences EffectRevenue/ExpenseWhen recorded inbooks relatively to thetaxable incomeDeferredtax effectRevenue Earlier LiabilityRevenue Later AssetExpense Earlier AssetExpense Later LiabilityClinic VI-12
  13. 13. Basic Journal Entry to Record Deferred TaxesTax LiabilityTax LiabilityIncome Tax Expense xxxDef.Tax Liability xxxTaxes PayablexxxTax AssetTax AssetIncome Tax Expense xxxDef. Tax Asset xxxTaxes Payable xxxClinic VI-13
  14. 14. Recording a Valuation Allowancefor Doubtful Deferred Tax AssetsA valuation allowance is recognized if, based onthe weight of available evidence, it is more likelymore likelythan notthan not that some portion or all of the deferredtax asset will not be realized.The net deferred tax asset should equal thatportion of the deferred tax asset which, based onthe current available evidence, will not berealized.Journal entry:Income Tax Expense xxxAllowance to ReduceDeferred Tax Asset to ExpectedRealizable Value xxxClinic VI-14
  15. 15. Example – Deferred Tax Liability -DepreciationBryant Corporation purchased a newmachine for $100,000 on January 1, 2004.The machine has a four-year estimatedservice life and no salvage value.Bryant’s pretax income for each year2004 - 2007 is 200,000 before depreciationand taxes.Clinic VI-15
  16. 16. Bryant Corp. uses straight-line depreciationon its books and MACRS for tax reporting.For tax purposes the machine is alsodepreciated over 4 years using MACRS (anaccelerated depreciation method).The depreciation percentages for each ofthe years are 33%, 44%, 15% and 8%.Assume a 40% tax rate.Clinic VI-16
  17. 17. A. Compute financial (book) income afterdepreciation but before taxes. What isincome tax expense?B. Compute taxable income. What is incometax payable?C. Give the journal entries to record taxes.D. Give the balance of the deferred taxliability at the end of each of the years.Clinic VI-17
  18. 18. SolutionFinancial (book) income 2004 2005 2006 2007Income before DepreciationDepreciation Expense($100,000/4)Income after depreciationbut before taxesIncome 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$70,000A.Clinic VI-18
  19. 19. 2004 2005 2006 2007Pre-Tax Income before Depreciation $200,000 $200,000 $200,000 $200,000Depreciation Deduction: (33,000) (44,000) (15,000) (8,000)Taxable Income $167,000 $156,000 $185,000 $192,000Income Taxable Payable (40%) $66,800 $62,400 $74,000 $76,800B.Clinic VI-19
  20. 20. C. Journal entries:2004Income Tax ExpenseTax PayableDeferred Tax Liability70,00066,8003,2002005Income Tax ExpenseTax PayableDeferred Tax Liability70,00062,4007,600Clinic VI-20
  21. 21. 2006Income Tax Expense 70,000Deferred Tax LiabilityTax Payable4,00074,0002007Income Tax Expense 70,000Deferred Tax LiabilityTax Payable6,80076,800Clinic VI-21
  22. 22. D. The deferred tax liability accountDr. Cr.3,200 2004 entry3,200 12/31/20047,600 2005 entry10,800 12/31/20054,000 2006 entry6,800 12/31/20066,800 2007 entry0 12/31/2007The liability has reversed itselfClinic VI-22
  23. 23. Example - Deferred Tax Liability –Advances from CustomersMiller Co. received $30,000 ofsubscriptions in advance at the end of 2004.Subscription revenue will be equallyrecognized in 2005, 2006, and 2007, forfinancial accounting purposes but all of the$30,000 will be recognized in 2004 for taxpurposes.Miller’s pretax income for each year 2004-2007 is $100,000 before taxes.Assume a 40% tax rate.Clinic VI-23
  24. 24. A. Compute Financial (book) incomeincluding subscription revenue butexcluding taxes. What is income taxexpense?B. Compute taxable income. What is incometax payable?C. Give the journal entries to record taxes.D. Give the balance of the deferred tax assetat the end of each of the years.Clinic VI-24
  25. 25. E. For this requirement only, assume that asa result of examining available evidencein 2004, it is more likely than not that$10,000 of the deferred tax asset will notbe realized. Give the journal entry torecord this reduction.Clinic VI-25
  26. 26. Solution2004 2005 2006 2007Financial (book) incomeIncome before subscription 100,000 100,000 100,000 100,000Subscription revenue receivedin 20040 10,000 10,000 10,000Income before taxes 100,000 110,000 110,000 110,000Income tax expense (40%) 40,000 44,000 44,000 44,000A.Clinic VI-26
  27. 27. 2004 2005 2006 2007Pretax income 100,000 100,000 100,000 100,000Subscription received in 2004 30,000 - - -Taxable Income 130,000 100,000 100,000 100,000Taxes Payable (40%) 52,000 40,000 40,000 40,000Clinic VI-27
  28. 28. C. Journal entries2004Income tax expense 40,000Deferred tax asset 12,000Tax payable 52,0002005 - 2007Income tax expense 44,000Deferred tax asset 4,000Tax payable 40,000Clinic VI-28
  29. 29. D. The deferred tax asset accountDb. Cr.12,000 2004 entry12,000 12/31/20044,000 2005 entry8,000 12/31/20054,000 2006 entry4,000 12/31/20064,000 2007 entry0 12/31/2007The asset has reversed itself.Clinic VI-29
  30. 30. Income Tax Expense 10,000Allowance to Reduce Deferred Tax AssetTo Expected Realizable Value 10,000To record the reduction in the deferred tax assetE.Clinic VI-30
  31. 31. Example - Permanent DifferencesCalculationHunter Corporation reports the following information for2004:Financial (Book) Income before Income Taxes $548,000Income Taxes Payable (for 2004) 157,500Income Tax Expense 210,000Hunter Corp. has both temporary and permanentdifferences between book income and taxable income.The temporary difference results from depreciation.The permanent difference results from a fine that thecompany has to pay (but can not be deducted on its taxreturn).Clinic VI-31
  32. 32. What is the amount of the permanent differencefor the year?The tax rate is 35%Clinic VI-32
  33. 33. SolutionStep 1: Find the change in the deferred tax liabilityStep 1: Find the change in the deferred tax liabilityIncome Tax Expense (Book) $210,000Income Taxes Payable 157,500∆ Deferred Tax Liability 52,500Step 2: Find the temporary differenceStep 2: Find the temporary difference∆ Deferred Tax Liability/0.35 $52,500/0.35=150,000Step 3: Find taxable incomeStep 3: Find taxable incomeIncome Taxes Payable (from current year)/0.35 $157,500/0.35=450,000Clinic VI-33
  34. 34. Solution (Cont.)Step 4: Find the permanent differenceStep 4: Find the permanent differenceTaxable Income (IRS) $450,000Temporary Differences 150,000Financial (Book) Income before Taxes ExcludingPermanent Differences 600,000Permanent Differences (P.N) 52,000Financial (Book) Income before Taxes 548,000Clinic VI-34
  35. 35. Financial Statement PresentationOn the balance sheet, an enterprise shouldseparate deferred tax liabilities and assetsinto a current amount and a noncurrentamount. (Under IFRS, the separation is notmade)Deferred tax liabilities and assets should beclassified as current or noncurrent based onthe classification of the related asset orliability for financial reporting.Clinic VI-35
  36. 36. Financial Statement PresentationA deferred tax liability or asset that is notrelated to an asset or liability for financialreporting, including deferred tax assetsrelated to carryforwards, should beclassified according to the expectedreversal date of the temporary difference.The valuation allowance for a particular taxjurisdiction should be allocated betweencurrent and noncurrent deferred tax assetsfor that tax jurisdiction on a pro rata basis.Clinic VI-36

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