Accounting for income taxes. Although my parents may always think every CPA prepares tax returns, we know the truth. There are an awful lot of accountants and auditors in this world who spend a majority of their time avoiding the subject of income taxes! Why? It’s complicated. But as one of those people who used to avoid it, I’m here to tell you: it’s the complexities that make it so interesting…in fact, it is now one of my favorite topics to teach in the classroom! Show
If you’re one of those people who thinks they could use a refresher on ASC Topic 740 but haven’t made it out to see one of our live sessions yet, you’re in luck! Our three-part series on accounting for income taxes was just released on The Revolution, our new online learning platform! So, join me, and let’s take a quick tour of accounting for income taxes, starting with a general overview. Income Taxes: Overview of ASC Topic 740 The Basics U.S. GAAP, specifically ASC Topic 740, Income Taxes, requires income taxes to be accounted for by the asset/liability method. The asset and liability method places emphasis on the valuation of current and deferred tax assets and liabilities. The amount of income tax expense recognized for a period is the amount of income taxes currently payable or refundable, plus or minus the change in aggregate deferred tax assets and liabilities. Under this method, which focuses on the balance sheet, the amount of deferred income tax expense is determined by changes to deferred tax assets and liabilities.  We all know the general formula for the income tax provision: current tax expense or benefit + deferred tax expense or benefit = total income tax expense or benefit as reported in the financial statements. Let’s take a look at each of these components:
Pretax financial income (this is what shows up in the company’s financial statements) +/- Permanent differences (these are items recognized for book purpose, but never for tax purposes…or vice versa) +/- Temporary differences (these are differences between amounts reported for tax purposes and those reported for book purposes) x Enacted tax rate Current income tax expense
A temporary difference is the difference between the asset or liability provided on the tax return (tax basis) and its carrying (book) amount in the financial statements. This difference will result in a taxable or deductible amount in the future. For example, consider a product warranty liability. For book purposes, a company would record a liability related to a product warranty. However, that liability would not be recognized for tax purposes (i.e. a “zero tax basis”), because the expense related to the product warranty would not be deductible on the income tax return until it was paid. Therefore, the expense and associated liability are recognized for financial reporting purposes before they are recognized for tax purposes. Since GAAP is based on the accrual method of accounting, an asset or liability should be recognized for these differences that have future tax consequences. Deferred tax expense or benefit generally represents the change in the sum of the deferred tax assets, net of any valuation allowance, and deferred tax liabilities during the year. Companies first need to calculate their current income taxes payable or receivable, then figure out their deferred tax assets and liabilities. The calculation of deferred tax assets and liabilities should be based on enacted tax law, not future expectations/assumptions. Finally, deferred tax assets (like any other asset) need to be assessed for recoverability. Any amounts not deemed to be recoverable should be written off through expense. The current income tax payable or receivable is recorded with the offset to the P&L (current tax expense). Deferred tax assets and liabilities are normally recorded with the offsetting entry to the P&L (deferred tax expense). Introduction to the Course This interactive and engaging eLearning course, which is eligible for 1.0 CPE, walks you through the key principles of ASC Topic 740. In this course, you’ll learn:
Take me to this course! Income Taxes: Deferred Taxes and Valuation Allowance We discussed the idea of calculating deferred tax expense in the overview section above. Generally speaking, temporary differences can be divided into future taxable amounts and future deductible amounts. Future taxable amounts increase taxable income and result in deferred tax liabilities for financial reporting purposes; future deductible amounts decrease taxable income and result in deferred tax assets for financial reporting purposes. Deferred tax expense or benefit generally represents the change in the sum of the deferred tax assets, net of any valuation allowance, and deferred tax liabilities during the year. In this module, you'll dive into a five-step methodology for accounting for deferred taxes. After you learn about each step, you'll walk through a case study, so you can apply what you have just learned! Take me to this course! Income Taxes: Uncertainty in Income Taxes Is tax law black and white? No, definitely not! In fact, we wrote a blog on the subject not too long ago. There’s lots of gray area in tax law causing companies to take positions that may, or may not, be sustained if reviewed by taxing authorities. This uncertainty in income taxes has an impact on the financial statements as well as the tax return. ASC 740, Income Taxes, provides guidance on how to account for this uncertainty in the financial statements. In this module, you’ll explore the identification of, and accounting for, uncertainty in income taxes using the guidance in ASC 740. Take me to the course! We’ll explore identifying and calculating the impact of deferred taxes in the next blog post. In the meantime, if you’re ready to dive into accounting for income taxes, you can check out the entire collection of income tax courses here! Disclaimer This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.
A. Total income tax expense is the sum of the current and deferred portions.The current portion is the income tax liability for the year.The deferred portion is the net sum of the changes in the deferred tax accounts.
According to FASB Statement No. 109, Accounting for Income Taxes, justification for the method of determining periodic deferred tax expense is based on the concept of A. Matching of periodic expense to periodic revenue. B. Objectivity in the calculation of periodic expense. C. Recognition of assets and liabilities. D. Consistency of tax-expense measurements with actual tax-planning strategies.
C. FAS 109 adopted the asset/liability approach. The deferred tax expense is the net change in the deferred tax accounts for the year. Deferred tax accounts are measured at the enacted tax rate for the period in which the future temporary differences reverse.Rather than base income tax expense on accounting income adjusted for permanent differences, as was the case before 109, income tax expense is now the sum of current income tax expense (the income tax liability for the year) and the net change in deferred tax accounts. The expense is a residual amount, based on the changes in assets and liabilities. Matching is no longer the conceptual basis for measurement.
Rein Inc. reported deferred tax assets and deferred tax liabilities at the end of 2003 and at the end of 2004.According to FASB Statements No. 109 Accounting for Income Taxes, for the year ended 2004, Rein should report deferred income tax expense or benefit equal to the A. Decrease in the deferred tax assets. B. Increase in the deferred tax liabilities. C. Amount of the current tax liability, plus the sum of the net changes in deferred tax assets and deferred tax liabilities. D. Sum of the net changes in deferred tax assets and deferred tax liabilities.
D. The net amount of deferred tax expense or benefit is that amount that is not recognized in current period income.A simple equation describes the total tax effects for a period: income tax expense or benefit + deferred income tax expense or benefit = current tax liability. The deferred income tax expense or benefit can further be described as the net change in both types of deferred tax accounts.
T/F: Income tax expense reflects the amount of tax that will ultimately be payable on transactions for the period.
T/F: Income tax expense generally is the amount paid to the IRS in the period.
False.The amount reported in the IS that measures the income tax cost for the year's transactions. Income tax expense = the income tax liability +/- the net change in the deferred tax accounts for the period.
T/F: The current tax liability is called the current provision for income tax and equals taxable income multiplied by the current tax rate.
T/F: The deferred tax liability decreased during the year, and the deferred tax asset increased. Therefore, the current provision of income tax exceeds total income tax expense.
T/F: The income tax liability for a period equals the ending balance of income tax payable for most firms.
False.This is the amount of income tax the firm must pay on taxable income for a year. Firms pay this liability in estimated quarterly installments with the last installment due early in the year following the tax year.
T/F: The total amount of expense or revenue to be recognized under the two systems of reporting is the same for items causing temporary differences. Only the amounts recognized in particular periods are different.
T/F: A deduction for tax reporting is analogous to an expense for financial statement reporting.
T/F: The current portion of income tax expense is the same as the income tax liability for the period.
T/F: Income tax is the income tax liability for the year plus or minus the net change in the deferred tax accounts for the year.
T/F: The deferred portion of income tax expense is the same as the net change in the deferred tax accounts for the period.
T/F: Taxable income is income before tax for financial reporting purposes.
False.Taxable income is the income before tax for tax purposes. The pretax accounting income is the income before income tax for financial accounting purposes determined by applying GAAP.
T/F: The deferred tax liability increased during the year, and the deferred tax asset decreased. Therefore, income tax expense exceeds the current provision of income tax.
Which of the following is not considered a permanent difference:Tax-free interest incomeInterest incomeLife insurance expenseProceeds on Life insuranceDividends received deductionFines and penaltiesDepletion
T/F: The rule for permanent differences is: The effect of a permanent difference on income tax expense is the same as its effect on the income tax liability for the period.
T/F: Permanent differences are not considered in the process of interperiod tax allocation.
T/F: A firm receives dividends from stock investments that qualify for the dividends received deduction. The permanent difference is 80% (amount subject to change) of the amount of dividends received.
T/F: The proceeds from a life insurance policy on a key employee increases income for financial reporting purposes and is taxable on receipt.
False.These are not taxable, but are included as a gain for financial reporting purposes.
T/F: A permanent difference generally can be found in a balance sheet account.
False.The effect of a permanent difference on income tax expense is the same as its effect on the income tax liability for the period.True for temporary differences.
T/F: Firms may deduct "statutory" depletion under the tax code. This amount often exceeds "cost" depletion. The difference is a permanent difference for tax purposes.
T/F: A firm has pretax income of $19,000, which reflects $1,000 of insurance premiums on a life insurance policy for a key employee. If the tax rate is 30%, income tax expense for the year is $6,000.
T/F: Municipal bond interest is included in interest revenue for the books but is not taxed.
T/F: Casualty insurance premiums are deductible.
When accounting for income taxes, a temporary difference occurs in which of the following scenarios? A. An item is included in the calculation of net income, but is neither taxable nor deductible. B. An item is included in the calculation of net income in one year and in taxable income in a different year. C. An item is no longer taxable, owing to a change in the tax law. D. The accrual method of accounting is used.
B. This answer describes one category of temporary difference. In general, a temporary difference is one for which the item's recognition takes place at a different rate or time for financial reporting and the tax return. However, the total impact of the item is the same over its life, for both systems of reporting.
Orleans Co., a cash-basis taxpayer, prepares accrual-basis financial statements. Since 2002, Orleans has applied FASB Statement No. 109, Accounting for Income Taxes. In its 2005 balance sheet, Orleans' deferred income- tax liabilities increased compared to 2004.Which of the following changes would cause this increase in deferred income tax liabilities?I. An increase in pre-paid insurance.II. An increase in rent receivable.III. An increase in warranty obligations.
Deferred tax liabilities are the future tax effects of future taxable temporary differences. Such differences cause future taxable income to exceed future pre-tax accounting income.I. An increase in pre-paid insurance implies that future accounting insurance expense will exceed future tax insurance expense. Therefore, future taxable income will increase relative to future pre-tax accounting income. This increases the deferred tax liability.II. An increase in rent receivable implies that future tax-rent revenue will exceed future accounting-rent revenue. A rent receivable is recorded when accounting-rent revenue is recognized before cash is received. Cash will be received in the future, which will be recognized as rent revenue for tax, but no revenue will be recognized for accounting. Therefore, again, future taxable income will increase relative to future pre-tax accounting income.III. An increase in warranty obligations implies that future tax-warranty expense will exceed future accounting-warranty expense. Accounting has recognized the warranty expense in the year of sale, whereas tax-warranty expense is recognized in the year the repairs are made. This time, future taxable income will decrease relative to future pre-tax accounting income. This increases the deferred tax asset, rather than the deferred tax liability.Therefore, only I and II increase the deferred tax liability.
At the end of year one, Cody Co. reported a profit on a partially completed construction contract by applying the percentage-of-completion method.By the end of year two, the total estimated profit on the contract at completion in year three had been drastically reduced from the amount estimated at the end of year one.Consequently, in year two, a loss equal to one-half of the year-one profit was recognized. Cody used the completed-contract method for income tax purposes and had no other contracts.According to FASB Statement No. 109, Accounting for Income Taxes, the year-two balance sheet should include a deferred tax Asset Liability
No, YesMore profit will be recognized under completed contract in year three for tax purposes than will be recognized under percentage-of-completion in year three for accounting purposes. The entire profit will be recognized under completed contract (tax purposes) in year three. But a portion of income has already been recognized for accounting purposes before year three. Therefore, less income will be recognized in year three for accounting purposes.Consequently, at the end of year two, there is a future taxable difference because future taxable income will exceed future pre-tax accounting income. Taxable differences give rise to deferred tax liabilities.
T/F: A temporary difference in its first year is called an originating difference.
T/F: Accounts receivable represents a future taxable difference.
T/F: The ending deferred tax liability equals the sum of all future deductible differences.
False.The ending deferred tax liability equals the sum of all future taxable differences, multiplied by the enacted future tax rate.
T/F: A future deductible temporary difference causes pretax accounting income to exceed taxable income in the future.
T/F: A temporary difference causes future pretax income to decrease relative to taxable income. The difference is classified as taxable.
T/F: Revenues recognized more slowly for book purposes cause future taxable differences.
False.They cause current year differences.
T/F: A deductible temporary difference is associated with a deferred tax liability account.
False.It's associated with a deferred tax asset.
T/F: A taxable temporary difference is associated with a deferred tax liability account.
T/F: Pretax accounting income is $10. Fines and penalties are $2. Installment receivables recorded but not received in the current year amount to $5. Taxable income is $7.
T/F: Unearned rent causes a future deductible difference.
T/F: The temporary differences that are of most concern in interperiod tax allocation are the future temporary differences.
T/F: Pretax accounting income is $10. Municipal bond interest is $2. Unearned rent received in the current period is $4. Taxable income is $12.
T/F: Revenues recognized more quickly for financial reporting cause future deductible differences.
T/F: A temporary difference causes future pretax income to increase relative to taxable income. The difference is classified as deductible.
T/F: The ending deferred tax liability equals the sum of all future taxable differences, multiplied by the current tax rate.
False.multiplied by the future enacted tax rate.
T/F: Expenses that are recognized more quickly for financial reporting purposes cause future deductible differences.
T/F: Many temporary differences are reflected in balance sheet accounts.
According to FASB Statement No. 109, Accounting for Income Taxes, which of the following items should affect current income tax expense for 2005? A. Interest on a 1989 tax deficiency paid in 2005. B. Penalty on a 1989 tax deficiency paid in 2005. C. Change in income tax rate for 2005. D. Change in income tax rate for 2006.
C. Current income tax expense is the income tax liability for the year. A change in 2005's tax rate changes the tax on taxable income and therefore current income tax expense. A change in the 2006 tax rate, even if enacted in 2005, would not change current income tax expense. It would change deferred income tax, however.The other two answer alternatives are amounts that must be paid in 2005, but are not recognized as current income tax. These amounts are separately payable to the taxing authority and are not computed as part of taxable income for 2005. Therefore, current income tax for 2005, which is income tax liability for 2005, is unaffected by these items. |
Justification for the method of determining periodic deferred tax expense is based on the concept of
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