03 Accounting for Income

Taxes
L E A R N IN G O B J E C T IV E S

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify differences between pretax 5. Describe various temporary and permanent
financial income and taxable income. differences.
2. Describe a temporary difference that 6. Apply accounting procedures for a loss
results in future taxable amounts. carryback and a loss carryforward.
3. Describe a temporary difference that 7. Describe the presentation of income taxes
results in future deductible amounts. in financial statements.
4. Describe the presentation of income tax
expense in the income statement.

19-1
 ACCOUNTING FOR INCOME TAXES

Income tax is a type of tax that governments impose on income

generated by business and individuals within their jurisdiction.

Income tax is used to fund public services, pay government

obligations and provide goods for citizens.

Corporations must file income tax returns following the

guidelines developed by the appropriate tax authority.

Because IFRS and tax regulations differ in a number of ways,

frequently the amounts reported for the following will differ:
 Income tax expense (IFRS)
 Income taxes payable (Tax Authority)
19-2
 ACCOUNTING FOR INCOME TAXES

Financial Statements Tax Return

vs.

Pretax Financial Income  Taxable Income

IFRS Tax Code
Income Tax Expense  Income Taxes Payable

19-3
 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 2015, $150,000
in 2016, and $140,000 in 2017.
Tax rate is 40%
What is the effect on the accounts of reporting different amounts of
revenue for IFRS versus tax?

19-4
 Book vs. Tax Differences ILLUSTRATION 19-2
Financial Reporting
Income

IFRS Reporting 2015 2016 2017 Total

Revenues $130,000 $130,000 $130,000 $390,000

Expenses 60,000 60,000 60,000 180,000
Pretax financial income $70,000 $70,000 $70,000 $210,000

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

ILLUSTRATION 19-3
Tax Reporting 2015 2016 2017 Total

Revenues $100,000 $150,000 $140,000 $390,000

Expenses 60,000 60,000 60,000 180,000
Taxable income $40,000 $90,000 $80,000 $210,000

Income taxes payable (40%) $16,000 $36,000 $32,000 $84,000

19-5
 Book vs. Tax Differences ILLUSTRATION 19-4
Comparison of Income
Tax Expense to Income
Taxes Payable

Comparison 2015 2016 2017 Total

Income tax expense (IFRS) $28,000 $28,000 $28,000 $84,000

Income tax payable (TA) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

Are the differences accounted for in the financial statements? Yes

Year Reporting Requirement

2015 Deferred tax liability account increased to $12,000
2016 Deferred tax liability account reduced by $8,000
2017 Deferred tax liability account reduced by $4,000

19-6
 Financial Reporting for 2015

Statement of Financial Position Income Statement

2015 2015
Assets:
Revenues:

Expenses:
Liabilities:
Deferred taxes 12,000
Income taxes payable 16,000
Income tax expense 28,000
Equity:
Net income (loss)

Where does the “deferred tax liability” get reported in the financial
statements?
19-7
 Future Taxable and Deductible 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.

Future Taxable Amounts Future Deductible Amounts

Deferred Tax Liability represents Deferred Tax Asset represents the
the increase in taxes payable in increase in taxes refundable (or
future years as a result of taxable saved) in future years as a result of
temporary differences existing at deductible temporary differences
the end of the current year. existing at the end of the current
year.

Illustration 19-22 provides Examples of Temporary Differences

19-8
 Future Taxable 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, 2015, IFRS-basis statement of financial position.
However, the receivables have a zero tax basis.

ILLUSTRATION 19-5
Temporary Difference,
Accounts Receivable

19-9
 Future Taxable Amounts

Illustration: Reversal of Temporary Difference, Chelsea Inc.

ILLUSTRATION 19-6

Chelsea assumes that it will collect the accounts receivable and report
the $30,000 collection as taxable revenues in future tax returns.
Chelsea does this by recording a deferred tax liability.

19-10
 Future Taxable Amounts

Deferred Tax Liability

A deferred tax liability represents the increase in taxes payable
in future years as a result of taxable temporary differences
existing at the end of the current year.

2015 2016 2017 Total

Income tax expense (IFRS) $28,000 $28,000 $28,000 $84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

ILLUSTRATION 19-4
Comparison of Income Tax Expense
to Income Taxes Payable
19-11
 Deferred Tax Liability

Illustration: Because it is the first year of operations for Chelsea,

there is no deferred tax liability at the beginning of the year.
Chelsea computes the income tax expense for 2015 as follows:

ILLUSTRATION 19-9
Computation of Income
Tax Expense, 2015

19-12
 Deferred Tax Liability ILLUSTRATION 19-4
Comparison of Income Tax Expense
to Income Taxes Payable

2015 2016 2017 Total

Income tax expense (IFRS) $28,000 $28,000 $28,000 $84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

Chelsea makes the following entry at the end of 2015 to record

income taxes.

Income Tax Expense 28,000

Income Taxes Payable 16,000
Deferred Tax Liability 12,000

19-13
 Deferred Tax Liability ILLUSTRATION 19-4
Comparison of Income Tax Expense
to Income Taxes Payable

2015 2016 2017 Total

Income tax expense (IFRS) $28,000 $28,000 $28,000 $84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

Chelsea makes the following entry at the end of 2016 to record

income taxes.

Income Tax Expense 28,000

Deferred Tax Liability 8,000
Income Taxes Payable 36,000

19-14
 Deferred Tax Liability

The entry to record income taxes at the end of 2017 reduces the
Deferred Tax Liability by $4,000. The Deferred Tax Liability account
appears as follows at the end of 2017 .

ILLUSTRATION 19-11
Deferred Tax Liability
Account after Reversals

19-15
 Future Deductible Amounts

Illustration: During 2015, 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 2015
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.

ILLUSTRATION 19-12
Temporary Difference,
Warranty Liability

19-16
 Future Deductible Amounts

Illustration: Reversal of Temporary Difference.

ILLUSTRATION 19-13

When Cunningham pays the warranty liability, it reports an expense

(deductible amount) for tax purposes. Cunningham reports this future
tax benefit in the December 31, 2015, statement of financial position as
a deferred tax asset.
19-17
 Future Deductible Amounts

Deferred Tax Asset

A deferred tax asset represents the increase in taxes
refundable (or saved) in future years as a result of deductible
temporary differences existing at the end of the current year.

19-18
 Deferred Tax Asset

Illustration: Hunt Co. accrues a loss and a related liability of

$50,000 in 2015 for financial reporting purposes because of
pending litigation. Hunt cannot deduct this amount for tax
purposes until the period it pays the liability, expected in 2016.

ILLUSTRATION 19-14
Computation of Deferred
Tax Asset, End of 2015

19-19
 Deferred Tax Asset

Assume that 2015 is Hunt’s first year of operations, and income tax
payable is $100,000, compute income tax expense. ILLUSTRATION 19-16
Computation of Income
Tax Expense, 2015

Prepare the entry at the end of 2015 to record income taxes.

Income Tax Expense 80,000
Deferred Tax Asset 20,000
Income Taxes Payable 100,000
19-20
 Deferred Tax Asset

Computation of Income Tax Expense for 2016. ILLUSTRATION 19-17

Computation of Income
Tax Expense, 2016

Prepare the entry at the end of 2016 to record income taxes.

Income Tax Expense 160,000
Deferred Tax Asset 20,000
Income Taxes Payable 140,000
19-21
 Deferred Tax Asset

The entry to record income taxes at the end of 2016 reduces the
Deferred Tax Asset by $20,000.

ILLUSTRATION 19-18
Deferred Tax Asset
Account after Reversals

19-22
 ACCOUNTING FOR INCOME TAXES

Specific Differences
Temporary Differences
 Taxable temporary differences - Deferred tax liability
 Deductible temporary differences - Deferred tax
Asset

19-23
 Taxable Temporary Differences ILLUSTRATION 19-22
Examples of 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 the cost-recovery method (zero-profit method) 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 non-monetary 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.
19-24
 Taxable Temporary Differences ILLUSTRATION 19-22
Examples of 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. Share-based compensation expense.
6. Unrealized holding losses for financial reporting purposes (including use of the fair
value option), but deferred for tax purposes.

19-25
 Deductible 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.

ILLUSTRATION 19-22
Examples of Temporary
Differences
19-26
 Deductible 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.
4. Development costs that are deducted on the tax return in the period paid.

ILLUSTRATION 19-22
Examples of Temporary
Differences

19-27
 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.

19-28
 Specific 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.

19-29
 Permanent Differences ILLUSTRATION 19-24
Examples of Permanent
Differences

Items are recognized for financial reporting purposes but not for tax purposes.

Examples:
1. Interest received on certain types of government obligations.
2. Expenses incurred in obtaining tax-exempt income.
3. Fines and expenses resulting from a violation of law.
4. Charitable donations recognized as expense but sometimes not deductible for tax
purposes.

Items are recognized for tax purposes but not for financial reporting purposes.

Examples:
1. “Percentage depletion” of natural resources in excess of their cost.

19-30
 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.

19-31
 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.

19-32
 ACCOUNTING FOR NET OPERATING
LOSSES

Net operating loss (NOL) = tax-deductible expenses exceed

taxable revenues.

Tax laws permit taxpayers to use the losses of one year to

offset the profits of other years (loss carryback and loss
carryforward).

19-33
 NET OPERATING LOSSES

Loss Carryback
 Back 2 years and forward 20 years
 Losses must be applied to earliest year first

ILLUSTRATION 19-29
Loss Carryback Procedure

19-34
 NET OPERATING LOSSES

Loss Carryforward
 May elect to forgo loss carryback and
 Carryforward losses 20 years

ILLUSTRATION 19-30
Loss Carryforward Procedure

19-35
 Loss Carryback Example

Illustration: Groh Inc. has no temporary or permanent differences.

Groh experiences the following.

19-36
 Loss Carryback Example
Illustration: 2011 2012 2013 2014
Financial income
Difference
Taxable income (loss) $ 50,000 $ 100,000 $ 200,000 $ (500,000)
Rate 35% 30% 40%
Income tax $ 17,500 $ 30,000 $ 80,000

NOL Schedule
Taxable income $ 50,000 $ 100,000 $ 200,000 $ (500,000)
Carryback (100,000) (200,000) 300,000
Taxable income 50,000 - - (200,000)
Rate 35% 30% 40% 0%
Income tax (revised) $ 17,500 $ - $ - $ -

Refund $ 30,000 $ 80,000 $110,000

19-37
 Loss Carryback Example
Illustration: 2011 2012 2013 2014
NOL Schedule
Taxable income $ 50,000 $ 100,000 $ 200,000 $ (500,000)
Carryback (100,000) (200,000) 300,000
Taxable income 50,000 - - (200,000)
Rate 35% 30% 40% 0%
Income tax (revised) $ 17,500 $ - $ - $ -

Refund $ 30,000 $ 80,000

Journal Entry for 2014:

Income Tax Refund Receivable 110,000

Benefit Due to Loss Carryback (Income Tax Expense)
110,000
19-38
 Loss Carryback Example

Illustration: Groh Inc. reports the account credited on the income

statement for 2014 as shown.

ILLUSTRATION 19-31
Recognition of Benefit of the Loss
Carryback in the Loss Year

19-39
 Loss Carryforward Example
Illustration: 2011 2012 2013 2014
NOL Schedule
Taxable income $ 50,000 $ 100,000 $ 200,000 $ (500,000)
Carryback (100,000) (200,000) 300,000
Taxable income 50,000 - - (200,000)
Rate 35% 30% 40% 40%
Income tax (revised) $ 17,500 $ - $ - $ (80,000)

In addition to recording the 110,000 Benefit Due to Loss Carryback,

Groh Inc. records the tax effect of the $200,000 loss carryforward as
a deferred tax asset of $80,000 assuming that the enacted future
tax rate is 40 percent. The entry is made as follows:

19-40
 Carryforward (Recognition)
Illustration: 2011 2012 2013 2014
NOL Schedule
Taxable income $ 50,000 $ 100,000 $ 200,000 $ (500,000)
Carryback (100,000) (200,000) 300,000
Taxable income 50,000 - - (200,000)
Rate 35% 30% 40% 40%
Income tax (revised) $ 17,500 $ - $ - $ (80,000)

Entry to recognize the benefit of the loss carryforward:

Deferred Tax Asset 80,000

Benefit Due to Loss Carryforward 80,000

19-41
 Carryforward (Recognition)

The two accounts credited are contra income tax expense items,
which Groh presents on the 2014 income statement shown.

ILLUSTRATION 19-32
Recognition of the Benefit of the Loss
Carryback and Carryforward in the Loss Year

19-42
 Carryforward (Recognition)

For 2015, assume that Groh returns to profitable operations and

has taxable income of $250,000 (prior to adjustment for the NOL
carryforward), subject to a 40 percent tax rate.

2014 2015
NOL Schedule
Taxable income $ (500,000) $ 250,000
Carryback (carryforward) 300,000 (200,000)
Taxable income (200,000) 50,000
Rate 40% 40%
Income tax (revised) $ (80,000) $ 20,000

19-43
 Carryforward (Recognition)

Groh records income taxes in 2015 as follows:

2014 2015
NOL Schedule
Taxable income $ (500,000) $ 250,000
Carryback (carryforward) 300,000 (200,000)
Taxable income (200,000) 50,000
Rate 40% 40%
Income tax (revised) $ (80,000) $ 20,000

Income Tax Expense 100,000

Deferred Tax Asset 80,000
Income Taxes Payable 20,000
19-44
 Carryforward (Recognition)

The 2015 income statement does not report the tax effects of
either the loss carryback or the loss carryforward because Groh
had reported both previously.

ILLUSTRATION 19-34
Presentation of the Benefit of Loss Carryforward Realized in 2015, Recognized in 2014

19-45
 FINANCIAL STATEMENT PRESENTATION

Statement of Financial Position

Deferred tax assets and deferred tax liabilities are also separately
recognized and measured but may be offset in the statement of
financial position.
The net deferred tax asset or net deferred tax liability is reported in
the non-current section of the statement of financial position.

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 END OF
CHAPTER

THANK YOU!!!
19-47