Chap. 19
Chap. 19
Chap. 19
Chapter 19
Accounting for Income Taxes
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Learning Objectives
After studying this chapter, you should be able to:
1. Describe the fundamentals of accounting for income
taxes.
2. Identify additional issues in accounting for income
taxes.
3. Explain the accounting for loss carryforwards.
4. Describe the presentation of deferred income taxes in
financial statements.
2
Learning Objective 1
Describe the Fundamentals of
Accounting for Income Taxes
LO 1 3
Fundamentals of Accounting for
Income Taxes
Corporations must file income tax returns following the
guidelines developed by the Internal Revenue Service
(IRS).
Because GAAP and tax regulations differ in a number of
ways, the amounts reported for the following will differ:
• income tax expense (GAAP).
• income tax payable (Internal Revenue Code).
LO 1 4
Accounting for Income Taxes
LO 1 5
Accounting for Income Taxes
Illustration
Chelsea, Inc. reported revenues of $130,000 and expenses of
$60,000 in each of its first three years of operations. For tax
purposes, Chelsea reported the same expenses to the IRS in
each of the years. Chelsea reported taxable revenues of
$100,000 in 2020, $150,000 in 2021, and $140,000 in 2022.
What is the effect on the accounts of reporting different
amounts of revenue for GAAP versus tax?
LO 1 6
Book vs. Tax Differences
GAAP Reporting 2020 2021 2022 Total
Revenues $130,000 $130,000 $130,000 $130,000
Expenses 60,000 60,000 60,000 180,000
Pretax financial income $70,000 $70,000 $70,000 $210,000
Income tax expense (20%) $14,000 $14,000 $14,000 $42,000
LO 1 7
Book vs. Tax Differences
Comparison
Comparison of Differences 2020 2021 2022 Total
Income tax expense (GAAP) $14,000 $14,000 $14,000 $42,000
Income tax payable (IRS) 8,000 18,000 16,000 42,000
Difference $6,000 $(4,000) $(2,000) $0
LO 1 8
Financial Reporting for 2020
Where does the “deferred tax liability” get reported in the financial
statements?
LO 1 9
Future Taxable and Deferred Amounts
A temporary difference is the difference between the tax basis of
an asset or liability and its reported (carrying or book) amount in
the financial statements that will result in taxable amounts or
deductible amounts in future years.
LO 1 10
Future Taxable and Deferred Amounts
Illustration
In Chelsea’s situation, the only difference between the book
basis and tax basis of the assets and liabilities relates to
accounts receivable that arose from revenue recognized for
book purposes. Chelsea reports accounts receivable at
$30,000 in the December 31, 2020, GAAP-basis balance sheet.
However, the receivables have a zero tax basis.
LO 1 11
Future Taxable and Deferred Amounts
Reversal of Temporary Difference, Chelsea Inc.
LO 1 13
Deferred Tax Liability 2020
Comparison of Differences 2020 2021 2022 Total
Income tax expense (GAAP) $14,000 $14,000 $14,000 $42,000
Income tax payable (IRS) 8,000 18,000 16,000 42,000
Difference $6,000 $(4,000) $(2,000) $0
LO 1 14
Deferred Tax Liability 2021
Comparison of Differences 2020 2021 2022 Total
Income tax expense (GAAP) $14,000 $14,000 $14,000 $42,000
Income tax payable (IRS) 8,000 18,000 16,000 42,000
Difference $6,000 $(4,000) $(2,000) $0
LO 1 15
Deferred Tax Liability 2022
Comparison of Differences 2020 2021 2022 Total
Income tax expense (GAAP) $14,000 $14,000 $14,000 $42,000
Income tax payable (IRS) 8,000 18,000 16,000 42,000
Difference $6,000 $(4,000) $(2,000) $0
LO 1 16
Deferred Tax Liability
Deferred Tax Liability Account after Reversals
The entry to record income taxes at the end of 2022 reduces
the Deferred Tax Liability by $2,000. The Deferred Tax Liability
account appears as follows at the end of 2022.
LO 1 17
Financial Statement Effects
Balance Sheet and Income Statement
LO 1 18
Financial Statement Effects
LO 1 19
Future Deductible Amounts and
Deferred Taxes
Illustration: During 2020, Cunningham Inc. estimated its
warranty costs related to the sale of microwave ovens to be
$500,000, paid evenly over the next two years. For book
purposes, in 2020 Cunningham reported warranty expense and a
related estimated liability for warranties of $500,000 in its
financial statements. For tax purposes, the warranty tax
deduction is not allowed until paid.
LO 1 20
Future Deductible Amounts
Reversal of Temporary Difference
LO 1 22
Deferred Tax Asset
Illustration: Hunt Company has revenues of $900,000 for both
2020 and 2021. It also has operating expenses of $400,000 for
each of these years. In addition, Hunt accrues a loss and
related liability of $50,000 for financial reporting purposes
because of pending litigation. Hunt cannot deduct this
amount for tax purposes until it pays the liability, expected in
2021. As a result, a deductible amount will occur in 2021
when Hunt settles the liability, causing taxable income to be
lower than pretax financial information.
The following illustration shows the GAAP and tax reporting
over the two years.
LO 1 23
GAAP
and Tax
Reporting
LO 1 24
Deferred Tax Asset
Schedule of Future Deductible Amounts
Illustration: Hunt can compute the deferred tax asset by
preparing a schedule that indicates the future deductible
amounts due to deductible temporary differences.
LO 1 25
Deferred Tax Asset
Computation of Income Tax Expense, 2020
Assume that 2020 is Hunt’s first year of operations, and
income tax payable is $100,000, compute income tax expense.
LO 1 26
Deferred Tax Asset
Recording Income Tax Expense, 2020
Hunt makes the following journal entry at the end of 2020 to
record income tax expense, deferred income taxes, and
income taxes payable.
LO 1 27
Deferred Tax Asset
Computation of Income Tax Expense, 2021
At the end of 2021 (the second year), the difference between
the book value and the tax basis of the litigation liability is
zero. Therefore, there is no deferred tax asset at this date.
Assuming that income taxes payable for 2021 is $90,000,
compute income tax expense.
LO 1 28
Deferred Tax Asset
Recording Income Tax Expense, 2021
Hunt makes the following journal entry at the end of 2021 to
record income tax expense, deferred income taxes, and
income taxes payable.
LO 1 29
Financial
Statement
Effects
LO 1 30
Financial Statement Effects
Deferred Tax Asset Account after Reversals
The entry to record income taxes at the end of 2021
reduces the Deferred Tax Asset by $10,000.
LO 1 31
Accounting for Income Taxes
Deferred Tax Asset—Valuation Allowance
A company should reduce a deferred tax asset by a
valuation allowance if it is more likely than not that it
will not realize some portion or all of the deferred tax
asset.
“More likely than not” means a level of likelihood of at
least slightly more than 50 percent.
LO 1 32
Deferred Tax Asset—Valuation
Allowance
Illustration: Jennifer Capriati Corp. has a deferred tax asset
account with a balance of $75,000 at the end of 2019 due to a
single cumulative temporary difference of $375,000. At the
end of 2020, this same temporary difference has increased to
a cumulative amount of $500,000. Taxable income for 2020 is
$820,000. The tax rate is 20% for all years. No valuation
account related to the deferred tax asset is in existence at the
end of 2019.
Instructions: Assuming that it is more likely than not that
$15,000 of the deferred tax asset will not be realized, prepare
the journal entries required for 2020.
LO 1 33
Valuation Allowance
LO 1 34
Valuation Allowance
Balance Sheet Presentation
Assets: 2020
Deferred tax asset $100,000
Allowance for deferred tax (15,000)
Deferred tax asset, net $ 85,000
LO 1 35
Learning Objective 2
Identify Additional Issues in Accounting
for Income Taxes
LO 2 36
Additional Considerations
Income Statement Presentation
Formula to Compute Income Tax Expense
LO 2 38
Accounting for Income Taxes
Specific Differences
Temporary Differences
• Taxable temporary differences - Deferred tax liability
• Deductible temporary differences - Deferred tax
Asset
LO 2 39
Temporary Differences (Revenues or gains are
taxable after they are recognized in financial income)
An asset (e.g., accounts receivable or investment) may be recognized for revenues or
gains that will result in taxable amounts in future years when the asset is recovered.
Examples:
1. Sales accounted for on the accrual basis for financial reporting purposes and on
the installment (cash) basis for tax purposes.
2. Contracts accounted for under the percentage-of-completion method for
financial reporting purposes and a portion of related gross profit deferred for tax
purposes.
3. Investments accounted for under the equity method for financial reporting
purposes and under the cost method for tax purposes.
4. Gain on involuntary conversion of nonmonetary asset which is recognized for
financial reporting purposes but deferred for tax purposes.
5. Unrealized holding gains for financial reporting purposes (including use of the
fair value option), but deferred for tax purposes.
LO 2 40
Temporary Differences (Expenses or losses are
deductible after they are recognized in financial income)
A liability (or contra asset) may be recognized for expenses or losses that will result in
deductible amounts in future years when the liability is settled. Examples:
1. Product warranty liabilities.
2. Estimated liabilities related to discontinued operations or restructurings.
3. Litigation accruals.
4. Bad debt expense recognized using the allowance method for financial reporting
purposes; direct write-off method used for tax purposes.
5. Stock-based compensation expense.
6. Unrealized holding losses for financial reporting purposes (including use of the
fair value option), but deferred for tax purposes.
LO 2 41
Temporary Differences (Revenues or gains are
taxable before they are recognized in financial income)
A liability 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) that settle the liability
will result in deductible amounts in future years. Examples:
1. Subscriptions received in advance.
2. Advance rental receipts.
3. Sales and leasebacks for financial reporting purposes (income deferral) but
reported as sales for tax purposes.
4. Prepaid contracts and royalties received in advance.
LO 2 42
Temporary Differences (Expenses or losses are
deductible before they are recognized in financial
income)
The cost of an asset may have been deducted for tax purposes faster than it was
expensed for financial reporting purposes. Amounts received upon future recovery of
the amount of the asset for financial reporting (through use or sale) will exceed the
remaining tax basis of the asset and thereby result in taxable amounts in future
years. Examples:
1. Depreciable property, depletable resources, and intangibles.
2. Deductible pension funding exceeding expense.
3. Prepaid expenses that are deducted on the tax return in the period paid.
LO 2 43
Specific Differences
Originating and Reversing Aspects of Temporary
Differences.
• Originating temporary difference is the initial
difference between the book basis and the tax basis
of an asset or liability.
• Reversing difference occurs when eliminating a
temporary difference that originated in prior periods
and then removing the related tax effect from the
deferred tax account.
LO 2 44
Specific Differences
Permanent Differences
Permanent differences result from items that (1) enter
into pretax financial income but never into taxable
income or (2) enter into taxable income but never into
pretax financial income.
Permanent differences affect only the period in which
they occur. They do not give rise to future taxable or
deductible amounts. There are no deferred tax
consequences to be recognized.
LO 2 45
Permanent Differences
Items are recognized for financial reporting purposes
but not for tax purposes.
Examples:
1. Interest received on state and municipal obligations.
2. Expenses incurred in obtaining tax-exempt income.
3. Proceeds from life insurance carried by the company on
key officers or employees.
4. Premiums paid for life insurance carried by the company
on key officers or employees (company is beneficiary).
5. Fines and expenses resulting from a violation of law.
LO 2 46
Permanent Differences
Items are recognized for tax purposes but not for
financial reporting purposes.
Examples:
1. “Percentage depletion” of natural resources in excess of
their cost.
2. The deduction for dividends received from U.S.
corporations, generally 70% or 80%.
LO 2 47
Specific Differences
Illustration: Zurich Company reports pretax financial income of
$70,000 for 2020. The following items cause taxable income to be
different than pretax financial income.
1. Depreciation on the tax return is greater than depreciation on
the income statement by $16,000.
2. Rent collected on the tax return is greater than rent earned on
the income statement by $27,000.
3. Fines for pollution appear as an expense of $11,000 on the
income statement.
Zurich’s tax rate is 30% for all years, and the company expects to
report taxable income in all future years. There are no deferred
taxes at the beginning of 2020.
LO 2 48
Zurich Company
LO 2 49
Accounting for Income Taxes
Tax Rate Considerations
Future Tax Rates
A company must consider presently enacted changes in
the tax rate that become effective for a particular future
year(s) when determining the tax rate to apply to existing
temporary differences.
LO 2 50
Tax Rate Considerations
Revision of Future Tax Rates
When a change in the tax rate is enacted, companies
should record its effect on the existing deferred income
tax accounts immediately.
A company reports the effect as an adjustment to
income tax expense in the period of the change.
LO 2 51
Learning Objective 3
Explain the Accounting for Loss
Carryforwards
LO 3 52
Accounting for Net Operating Losses
Net operating loss (NOL) = tax-deductible expenses
exceed taxable revenues.
• Taxpayers use losses of one year to offset the profits
of other years.
• Company pays no income taxes for a year in which it
incurs a net operating loss.
• Company can reduce future taxes payable.
LO 3 53
Loss Carryforward
Company may carry the net operating loss forward
indefinitely to offset future taxable income and reduce
taxes payable in future years.
LO 3 54
Loss Carryforward Example
Carryforward without Valuation Allowance
Assume that Groh Inc. has no temporary or permanent
differences. Groh experiences the net operating loss of
$200,000 in 2020 and takes advantage of the carryforward
provision. In 2020, the company records the tax effect of the
$200,000 loss carryforward, assuming that the enacted future
tax rate is 20 percent, as follows.
LO 3 55
Loss Carryforward Example
Recognition of Benefit of the Loss Carryforward in the
Loss Year
LO 3 56
Loss Carryforward Example
Computation of Income Taxes Payable with Realized
Loss Carryforward
For 2021, assume that Groh returns to profitable operations
and has taxable income of $250,000 (prior to adjustment for
the NOL carryforward), subject to a 20 percent tax rate. Groh
then realizes the benefits of the carryforward for tax purposes
in 2021, which it recognized for accounting purposes in 2020.
Groh computes the income taxes payable for 2021 as shown
in illustration.
LO 3 57
Loss Carryforward Example
Computation and Journal Entry
LO 3 59
Loss Carryforward Example
Carryforward with Valuation Allowance
Assume that it is more likely than not that Groh will not
realize the entire NOL carryforward in future years. Groh
makes the following journal entries in 2020.
LO 3 60
With Valuation Allowance
Recognition of Benefit of Loss Carryforward Only
LO 3 61
With Valuation Allowance
2021 Journal Entries
In 2021, assuming that Groh has taxable income of $250,000
(before considering the carryforward) and a subject to a tax
rate of 20 percent, it realizes the deferred tax asset.
Income Tax Expense 50,000
Deferred Tax Asset 40,000
Income Tax Payable 10,000
LO 3 63
Valuation Allowance Revisited
A company should consider all positive and negative
information in determining whether it needs a valuation
allowance. Whether the company will realize a deferred
tax asset depends on whether sufficient taxable income
exists or will exist within the carryforward period
available under tax law.
LO 3 64
Valuation Allowance Revisited
Taxable Income Sources
a. Future reversals of existing taxable temporary differences.
b. Future taxable income exclusive of reversing temporary
differences and carryforwards.
c. Tax-planning strategies that would, if necessary, be
implemented to:
1. Accelerate taxable amounts to utilize expiring
carryforwards.
2. Change the character of taxable or deductible amounts
from ordinary income or loss to capital gain or loss.
3. Switch from tax-exempt to taxable investments.
LO 3 65
Valuation Allowance Revisited
Negative Evidence
a. A history of operating loss or tax credit carryforwards expiring
unused.
b. Losses expected in early future years (by a presently profitable
entity).
c. Unsettled circumstances that, if unfavorably resolved, would
adversely affect future operations and profit levels on a
continuing basis in future years.
d. A carryforward period that is so brief that it would limit
realization of tax benefits if (1) a significant deductible
temporary difference is expected to reverse in a single year or
(2) the enterprise operates in a traditionally cyclical business.
LO 3 66
Valuation Allowance Revisited
Positive Evidence
a. Existing contracts or firm sales backlog that will produce more
than enough taxable income to realize the deferred tax asset
based on existing sale prices and cost structures.
b. An excess of appreciated asset value over the tax basis of the
entity’s net assets in an amount sufficient to realize the
deferred tax asset.
c. A strong earnings history exclusive of the loss that created the
future deductible amount (tax loss carryforward or deductible
temporary difference) coupled with evidence indicating that
the loss is an aberration rather than a continuing condition (for
example, the result of an unusual or infrequent item, or both).
LO 3 67
Learning Objective 4
Describe the Presentation of Deferred
Income Taxes in Financial Statements
LO 4 68
Financial Statement Presentation
Balance Sheet
Income taxes payable and income tax refund receivable
are reported as a current liability and current asset,
respectively, on the balance sheet.
Companies should classify deferred tax accounts as a net
noncurrent amount on the balance sheet.
LO 4 69
Balance Sheet
To illustrate, assume that Scott Company has four deferred tax
items at December 31, 2020, as shown in the following table.
LO 4 70
Note Disclosure
Companies are required to disclose the total of all
deferred tax liabilities, the total of all deferred assets, and
the total valuation allowance in the notes to the financial
statements.
In addition, companies should disclose
1. any change during the year in the total valuation
allowance, and
2. the types of temporary differences or carryforwards
that give rise to significant portions of deferred tax
liabilities and assets.
LO 4 71
Financial Statement Presentation
Income Statement
Companies are required to report income before income taxes
and income tax expense on the income statement. PepsiCo
reported the following amounts related to tax expense.
LO 4 72
The Asset-Liability Method
The FASB believes that the asset-liability method
(sometimes referred to as the liability approach) is the
most consistent method for accounting for income taxes.
LO 4 73
The Asset-Liability Method
Basic Principles
a. A current tax liability or asset is recognized for the estimated taxes
payable or refundable on the tax return for the current year.
b. A deferred tax liability or asset is recognized for the estimated
future tax effects attributable to temporary differences and
carryforwards.
c. The measurement of current and deferred tax liabilities and assets
is based on provisions of the enacted tax law; the effects of future
changes in tax laws or rates are not anticipated.
d. The measurement of deferred tax assets is reduced, if necessary,
by the amount of any tax benefits that, based on available
evidence, are not expected to be realized.
LO 4 74
Procedures
for
Computing
and
Reporting
Deferred
Income
Taxes
LO 4 75