Accounting for Income Taxes

1. Accounting for Income Taxes

2. Objectives of the Chapter • To learn the permanent difference between the financial income and taxable income. • To learn the temporary difference between the financial income and taxable income. • To learn the accounting treatment for the temporary difference and permanent difference. Accounting for Income Taxes

3. Permanent Difference versus Temporary Difference • Permanent Difference: • A difference between financial income and taxable income in an accounting period that will never be reversed in later accounting periods. • This difference does not require an interperiod tax allocation. Accounting for Income Taxes

4. Permanent Difference versus Temporary Difference (contd.) • Examples of Permanent Difference • 1. Revenue recognized for F/R (financial report) but not taxable. • a. Interest on municipal bonds. • b. Life insurance proceeds payable to a corporation upon the death of an insured employee Accounting for Income Taxes

5. Permanent Difference versus Temporary Difference (contd.) • Examples (contd.) • 2. Expense recognized for F/R but not tax deductible: • Life insurance premium paid for employees. • 3. Expense is tax deductible but not recognized for F/R purpose: • Percentage depletion in excess of Cost Depletion. Accounting for Income Taxes

6. Permanent Difference versus Temporary Difference (contd.) • Temporary Difference: • A difference between a taxable income and a financial income in an accounting period that will be reversed in later accounting periods. • This difference requires an intertperiod tax allocation. • Causes of Temporary Difference: • Different treatment between GAAP and IRC Accounting for Income Taxes

7. Difference between IRC and GAAP • Depreciation • GAAP: any systematic depr. method • IRC : ACRS or MACRS • Installment Sales (future taxable) • GAAP: on accrual basis • IRC : on cash basis Accounting for Income Taxes

8. Difference between IRC and GAAP (contd.) • Warranty Expense (future deductible) • GAAP: accrual basis (estimated and recognized at the end of each period) • IRC : cash basis (tax deductible when paid) • Bad Debt Expense (future deductible) • GAAP: estimated and recognized at the end of each period. • IRC : tax deductible when accounts defaulted. Accounting for Income Taxes

9. Temporary Difference: an example • Depreciation method: • For tax filing purpose: ACRS, 4-year life For financial reporting purpose: straight-line method, 5-year life • The asset was purchased on 1/1/x1 with a cost of $10,000 and a zero residual value. Accounting for Income Taxes

10. Temporary Difference: an example (contd.) • Financial depr. expense vs. tax depr.: Accounting for Income Taxes

11. Temporary Difference: an example (contd.) • a. $10,000*50% *0.5 = 2,500 • b. $7,500*50% = 3,750 • c. $3,750*50% = 1,875 • d. $1,875*50% = 937.5 < (1,875/1.5 =1,250) Accounting for Income Taxes

12. Temporary Difference: an example (contd.) • Assuming a 30% tax rate, the following table presents the annual temporary difference and the deferred tax liability: Accounting for Income Taxes

13. Temporary Difference: an example (contd.) • T-account of the deferred tax liability • Deferred Tax Liability • 20x3….. 37.5 150……..20x1 • 20x4…. 225 525……..20x2 • 20x5…. 412.5 • 0…..20x5 Accounting for Income Taxes

14. Interperiod Income Tax Allocation • Example A: the following information is available for the year ended 12/31/x1: Accounting income = $10,400 Taxable income = $ 9,000 (AI > TI) Tax Rate = 30% The difference of $1,400 is resulting from using ACRS for I/T filing while using S-L for F/R purposes. This difference will be reversed as follows: Accounting for Income Taxes

15. Interperiod Income Tax Allocation • Reversed Amount (F/R depr.>Tax Depr.) • 20x1 $500 20x2 700 20x3 200 Total 1,400 • Tax payable for 20x1 = > • 9,000 *30% =$2,700 Accounting for Income Taxes

16. Interperiod Income Tax Allocation (contd.) • Alternative Accounting Treatments • I. No Allocation of Deferred I/T Liam. • Income Tax Exp. 2,700 Income Tax Payable 2,700 • II. With Allocation(comply with the matching principle) – Deferred Approach(APB No. 11) • Income Tax Expense 3,120 Income Tax Payable 2,700 Deferred Income Tax Liam. 420* Accounting for Income Taxes

17. Interperiod Income Tax Allocation (contd.) • Alternative Accounting Treatments (contd.) • III.With Allocation- Liability Approach (SFAS 109) • Income Tax Expense 3,120 Income Tax Payable 2,700 Deferred Income Tax Liam. 420** Accounting for Income Taxes

18. Interperiod Income Tax Allocation (contd.) • * Deferred tax lia. is calculated as income tax exp. minus income tax payable. • **Deferred tax lia.is calculated based on the reversed amount in the future times the future tax rate. If the future tax rate remains at 30%, the deferred tax lib. Is $420. Otherwise, the deferred tax lib. will not be $420 (see the example next). Accounting for Income Taxes

19. Interperiod Income Tax Allocation (contd.)—Example B • Example B: The taxable income of 20x1 = $9,000 The accounting income of 20x1 =$10,400 • Partial Income statement: Pretax financial income $10,400 Less: additional accelerated depr. Deducted for I/T (1,400) Taxable Income $9,000 Accounting for Income Taxes

20. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • At the beg. of 20x1, the deferred I/T has a balance of $0 (due to 20x1 is the first year of occurrence of difference in depr.) and the current tax rate is 30%. • There is no expectation of tax rate changes in the future. Accounting for Income Taxes

21. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • The financial depr. exp. will exceed the taxable depr. by the following amount in the next three years: • a&b: assumed numbers. Accounting for Income Taxes

22. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • The following table shows the annual temporary difference, accumulative temporary diff. and deferred liability (tax rate = 30%): Accounting for Income Taxes

23. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • T-account of Deferred income tax lia. • Deferred I/T Liam. • 20x2…..150 420…….20x1 20x3…..210 20x4….. 60 0 (bal)20x4 Accounting for Income Taxes

24. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • J.E. (for 20x1) (based on APB No.11; the deferred approach) • Income Tax Expense 3,120a Income Tax Payable 2,700 b Deferred Income Tax Liam. ? c • a: $10,400 (accounting income)*30% b. $9,000 (taxable income)*30% • c. ?= 3,120-2,700 Accounting for Income Taxes

25. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • J.E. (for 20x1) (based on SFAS 109; the liability approach) • Income Tax Expense ?a Income Tax Payable 2,700 b Deferred Income Tax Liam. 420c • a. ? = b+c = 2,700+420 = 3,120 b.$9,000 (taxable income)*30% c.$420 = $500*30% +700*30% +200*30% • revered revered revered lia. Of 20x2 lia. Of 20x3 lia. Of 20x4 Accounting for Income Taxes

26. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • Note c is also presented in the following table: • a. Due to future taxable income > future acc. Income. It is a result of future tax depr. < future acc. Depr. b. Future expected tax rate should be used. Example B assumed all future tax rates remain at 30%. Accounting for Income Taxes

27. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • Assuming taxable income of 20x2,20x3 and 20x4 are $7,000, $6,000 and $8,000, respectively, journal entries of income tax for those year are as follows (all future tax rate remains at 30%) (follow SAFS 109): • 20x2 • Deferred I/T Liam. 150 a I/T Expense ? b • I/T Payable 2,100c • a. See the previous table for year 20x2 b. income tax expense = $2,100 –150 c. taxable income 7,000*30% Accounting for Income Taxes

28. Interperiod Income Tax Allocation (contd.)—Example B (contd.) • 20x3 Deferred I/T Liam. 210 a I/T Expense ? b • I/T Payable 1,800c • 20x4 Deferred I/T Liam. 60 d I/T Expense ? e • I/T Payable 2,400f • a. See the previous table for year 20x3 b. income tax expense = $1,800 –210 c. taxable income 6,000*30% • d. See the previous table for year 20x4 e. income tax expense = $2,400 –60 f. taxable income 8,000*30% Accounting for Income Taxes

29. Interperiod tax Allocation with Different Expected Tax Rate • Using the same information as in Example B except the tax rates are expected to change in the future as follows: • 20x1 = 30% (the current year) 20x2 = 40% 20x3 = 40% 20x4 = 40% • The ending bal. of the deferred I/T lia. for year 20x1 would be $$560 instead of $420 as in Example B when future rate states at 30%. Accounting for Income Taxes

30. Interperiod tax Allocation with Different Expected Tax Rate (cont.) • The computation of the ending balance of deferred I/T lia. For 20x1 is as follows: Accounting for Income Taxes

31. Interperiod tax Allocation with Different Expected Tax Rate (cont.) • Journal Entry for 20x1 is as follows based on a 40% expected tax rate for 20x2 to 20x4: • Income Tax Expense ?a Income Tax Payable 2,700 b Deferred Income Tax Liam. 560c • a. ? = b+c = 2,700+560 = 3,260 b.$9,000 (taxable income)*30% c.$560 = $500*40% +700*40% +200*40% or as shown in the previous table Accounting for Income Taxes

32. Interperiod tax Allocation with Different Expected Tax Rate (cont.) • What if at the end of 20x2, the tax rate has been increased to 45% (instead of 40% as expected at the end of 20x1), the deferred liability at the end of 20x1 should have been $625a rather than $560 as using the 40% expected rate. • The following adjusting entry should be prepared on 12/31/20x2: • a. $500*45%+700*45%+200*45% = $625 Accounting for Income Taxes

33. Interperiod tax Allocation with Different Expected Tax Rate (cont.) • 12/31/20x2 • Loss on Adjustment of Deferred Taxes 65 a Deferred I/T Liam. 65 • a. $625-560 = $65 Accounting for Income Taxes

34. Interperiod tax Allocation – Example C • The following is a reconciliation of a pretax financial income with a taxable income for 20x3: • Financial Income $3,000 • Add: estimated warranty exp. deducted for financial reporting in excess of actual warranty exp. deducted for I/T (a future deductible) 100 Less:Additional accelerated depr. deducted for I/T (a future taxable) (150) Taxable Income $2,950 Accounting for Income Taxes

35. Interperiod tax Allocation – Example C (contd.) • No expectation of tax changes in the future and the current tax rate is 30%. The beginning balance of deferred income tax lia. account is $495 due to the first year of depr. exp. difference occurred in 20x1. Accounting for Income Taxes

36. Interperiod tax Allocation – Example C (contd.) • Additional information regarding depr. exp. Lib. as follows: • a. 20x3 is the current year. Accounting for Income Taxes

37. Interperiod tax Allocation – Example C (contd.) • The followings are projections regarding the temporary differences for years 20x4 to 20x6(future years): • a. Tax warranty cost in excess of financial warranty cost b. Financial depr. exp. In excess of tax depr. exp. Accounting for Income Taxes

38. Interperiod tax Allocation – Example C (contd.) • J.E. for the current year 20x3 (SFAS 109): • I/T Exp. ?a • Deferred I/T assets 30b • I/T Payable 885c • Deferred I/T Liam. 45d • a. $885+45-30 = $900 b. $50*30%+30*30%+20%30% = 100*30% =$30 c. $2,950*30% = $885 d. (800+850+150)*30% - $495 = $540-495 = $45 Accounting for Income Taxes

39. Interperiod tax Allocation – Example C (contd.) • T-accounts of deferred tax lia. And deferred tax assets: • Deferred I/T Asset Deferred I/T Liam. • beg. bal. 0 495..beg.bal. Adj. Of 20x3 30 45..adj.Of 20x3 • 30a 540b • a. $50*30%+30*30%+20%30% = 100*30% =$30 b.(800+850+150)*30% =1,800*30% =$540 Accounting for Income Taxes

40. Interperiod tax Allocation – Example C (contd.) • Presentation of selected accounts on I/S: • Pretax Income $3,000 I/T exp. (900) Net Income $2,100 • Presentation of selected accounts on B/S: • Current Assets: Current Lia.: • Deferred Tax Assets 30 I/T Payable 885 Deferred Tax Lia. 540 Accounting for Income Taxes

41. Interperiod tax Allocation – Example C (contd.) • Had APB No. 11 been followed (the deferred approach), the following entry will be prepareda: • I/T Exp. (3,000*30%) 900 • I/T Payable (2,950*30%) 885 • Deferred I/T Liam. (900-885) 15 • a. This treatment is NOT acceptable. Accounting for Income Taxes