Calculation of Deferred Income Tax Expense or Benefit
The calculation of the amount of deferred tax expense or benefit that is actually shown on the income statement is very straightforward. It is the:
change of the total deferred tax asset and liability position of the company during the period.
In the following pages of this section we will cover how the deferred tax asset or liability is calculated at the beginning or end of the year. However, at this point you just need to be aware that the deferred tax expense or benefit to recognize in the income statement is the change in the deferred tax position of the company during the period.
This is done by determining the total deferred tax position at the end of the year (by adding all deferred tax assets and liabilities together) and comparing it to the same figure at the beginning of the year. If we are in a better position (meaning a smaller deferred tax liability or a larger deferred tax asset), it is a deferred tax benefit that is shown on the income statement. However, if we are in a worse position (meaning a smaller deferred tax asset or a larger deferred tax liability) the amount of the change will be the deferred tax expense.
Question 133: Rein reported deferred tax assets and deferred tax liabilities at the end of 2005 and at the end of 2006. For the year ended 2006, Rein should report deferred income tax expense or benefit equal to the:
a) Decrease in deferred tax assets.
b) Increase in 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. (CPA Adapted, November 1992)
Temporary Timing Differences
Deferred taxes arise because of what we call temporary timing differences (TTD). TTD occur when an item is not recognized for both Book and Taxable Income in the same period. In order for it to be a TTD, the item will need to be recognized at some point in both Taxable and Book Income, but not in the same period.
Note: If something is recognized only for book or tax purposes, but not both, it is a permanent timing difference. Permanent timing differences do not give rise to a deferred tax asset or liability and they are covered later in the materials.
133 d - By definition the deferred tax expense or benefit is equal to the total change in the deferred tax position on the balance sheet from the beginning of the year to the end of the year.
The primary reason that we have these timing differences is that GAAP income is calculated on the accruals basis while IRS income is calculated on the cash basis.
We call these differences temporary because they will Yeverse' over time. This reversal means that if an item is included in Taxable Income this period, but not in Book Income this period, in some future period the opposite will occur and the item will be included in Book Income, but not Taxable Income.
The reversal of these temporary differences over time means that over the life of a business there will be no difference between the total book income and the total taxable income. Unfortunately, this statement is actually not true when a company has permanent differences (discussed later), or if there are changes in the tax rate (also discussed later); but in principle it is true that the total Book and Taxable Incomes of the company over time will be the same.
The situations that lead to temporary timing differences and the type of timing differences that arise are listed in the table. Descriptions and examples of each type of timing difference follow the table.
Table of Temporary Differences and Their Results
| Revenues and Gains | Expenses and Losses |
Included in Taxable Income First | Deferred Tax Asset | Deferred Tax Liability |
Included in Book Income First | Deferred Tax Liability | Deferred Tax Asset |
Note: Discussed below are the temporary timing differences that lead to the deferred tax asset or liability. However, the amount of the temporary timing difference is not equal to the amount of the deferred tax asset or liability. After the determination of the amount of the temporary timing difference, the calculation of the deferred tax asset or liability requires an additional calculation. This calculation is looked at following the discussion of the different temporary timing differences.
Deferred Tax Asset, or Prepaid Taxes
These are items that cause the taxable income in the current period to be higher than the book income in the current period. This means that the company has had to pay more in taxes than it feels it should. Therefore, for book purposes this is a prepaid tax. The journal entry to record this is as follows:
Dr Income tax expense...................................................................................... 90
Dr Deferred tax asset (or prepaid taxes)..................................................... 10
Cr Cash................................................................................................................................. 100
Deferred tax assets are created by either
1) A revenue that is taxable, but not included in book income in the current period, or
2) An expense that is included In book income, but not deductible for tax purposes in the current period.
Note: Another term that is used for deferred tax asset is future deductible amount. This is because this item will cause taxable income to be lower than book income at some point in the future.
Deferred Tax Liability, or Taxes Payable
These are items that cause the taxable income in the current period to be lower than the book income in the current period. This means that the company does not pay as much as it thinks it should in taxes in the current period. However, because the company knows that these temporary timing differences will reverse, it understands that this tax (that was not paid this year) will need to be paid in the future. Therefore, for book purposes this difference is recorded as taxes payable. The journal entry to record this is as follows:
90 10 |
Dr Income tax expense............................................................................................ 100
Cr Cash..........................................................................
Cr Deferred tax liability (or Taxes payable)
Deferred tax liabilities are created by either:
1) A revenue that is included in book income, but is not taxable in the current period, or
2) An expense that is deductible for tax purposes, but is not an expense for book purposes in the current period.
Note: Another term that is used for deferred tax liabilities is future taxable amount. This is because this item will cause taxable income to be higher than book income at some point in the future.
We will now look in greater detail at the specific types of events that create these deferred tax assets and liabilities. You need to be familiar with what causes a deferred tax asset or liability to arise.
Deferred Tax Assets
Again, remember that deferred tax assets arise when the company needs to pay more in taxes to the government in the current period than it thinks it should. This happens when taxable income is greater than book income and this arises from two situations.
Revenues That Are Taxable Before They Are Included in Book Income
These are items for which the cash is received before the revenue or gain is recognized in the accounting records. Because Taxable Income is calculated on the cash basis, these items are taxable when the cash is received, but will not be recognized in the books as income until the service or product is provided to the customer.
The best example of this is unearned revenue, or deferred revenue. As soon as the cash is received, the entity must pay taxes on it. When the income is finally recognized in the books, it will not be taxable by the IRS since the tax on the cash received was paid in a previous period. This results in a lower tax payment (lower Taxable Income) in the future than the company wants to pay (higher Book Income).
Because the company is paying more in taxes than it feels it should based on book income, it will treat this overpayment as what is essentially a prepaid tax - and this will be recorded as a deferred tax asset.
Expenses That Are Included in Book Income Before They Are Taxable
When an expense is included in Book Income before it is included in Taxable Income, it means that taxable income in the current period will be higher than Book Income as a result of fewer expenses being deducted on the tax return. This means that the company is paying more in taxes than it feels it should in the current period; this is the prepaid tax, or deferred tax asset. However, in the future as that difference reverses, the Taxable Income will be lower than Book Income. In this future period the company will actually pay less than it feels it should, using that deferred tax asset.
An example of this type of deferred tax asset is any accrued expense (payables), such as warranty expense. Warranty expenses are deductible for Book Income in the year of the sale, but are not deducted for Taxable Income until the cash expenditure is made in some future period.
In summary, because the company is paying more in taxes than it feels it should based on Book Income, it will treat this overpayment as essentially a prepaid tax - and this will be recorded as a deferred tax asset on their books until that future period when the item reverses.
Deferred Tax Liabilities
Remember that deferred tax liabilities arise when the amount that the company needs to pay for taxes is less than it thinks it should be. From the company's standpoint it has a tax payable because it did not pay as much as it should. This occurs when Book Income is higher than Taxable Income, and there are two main events that will cause this to happen.
Expenses or Losses That Are First Deductible for Tax Income
When an item is deducted for tax purposes in the calculation of Taxable Income but not Book Income, it reduces Taxable Income below Book Income. Therefore, the company needs to pay less in taxes than it wants to, and a taxes payable is established. However, when the item is recognized in future periods in Book Income of the company, it will not be deductible for tax purposes.
Examples of these are prepaid expenses. For tax purposes they are deductible when the cash is spent, but for book purposes the event that was paid for actually needs to occur before it can be deducted in the calculation of book income. Therefore, for book purposes it will reduce income only in a future period.
Because the current period taxable income is lower than book income, the company has to pay a lower amount of taxes than it expected, based on its book income. The company knows, however, that these taxes, which were not required to be paid to the government today, will need to be paid in the future. The company sets up what is in essence a tax payable, but it will be called Deferred Tax Liability.
Revenues or Gains That Are First Included in Book Income
When an item is included in Book Income, but not in Taxable Income, it causes Book Income to be higher than Taxable Income. This means that in the current period, the amount of taxes that the company will need to pay will be less than the amount that it wants to pay. This difference will reverse in the future and the taxes that the company wanted to pay this period will be payable in the future. Therefore, the company will recognize a Tax Payable (Deferred Tax Liability) in the current period.
These items arise from receivables - either credit sales or when the company uses the Installment method of accounting for sales for tax purposes and the accrual method for book purposes. Under these methods the company does not recognize Taxable Income until cash is actually received, while on the books it recognizes the full sales price as income as soon as the sale is made.
Again, because the current period Taxable Income is lower than Book Income, the company has to pay a lower amount of taxes than it wanted to, based on its book income. The company knows, however, that this amount, which was not required to be paid to the government today, will need to be paid in the future. The company will set up what is in essence a tax payable, but this will be called Deferred Tax Liability.
Note: Depreciation will lead to a temporary difference if the method of depreciation for book purposes is different from the method for tax purposes. However, whether or not this will lead to a deferred tax asset or liability depends upon the specific situation and the determination of whether the book rate of depreciation is higher or lower than the tax rate of depreciation. Depreciation is looked at separately.
The table of the events that lead to deferred tax assets and deferred tax liabilities is presented again below. In this table, the specific types of events that cause deferred tax assets and liabilities are added.
| Revenues and Gains | Expenses and Losses |
Included in Taxable Income First | Deferred Tax Asset Unearned Revenues | Deferred Tax Liability Prepaid Expenses |
Included in Book Income First | Deferred Tax Liability Receivables | Deferred Tax Asset Payables |
You will notice that on this table the same transaction that causes a deferred tax asset for one company will cause a deferred tax liability for the other party of the transaction. For example, if one company has a deferred tax asset created because of an account receivable, the other party to the transaction has an account payable, which will create a deferred tax liability for them.
Question 134: Orleans Co., a cash basis taxpayer, prepares accrual basis financial statements. 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 prepaid insurance.
II. An increase in rent receivable.
III. An increase in warranty obligations.
a) I only.
b) I and II.
c) II and III.
d) III only.
_____ __________________________________ (CPA Adapted, May 1992)
134 b - Deferred tax liabilities arise from either an expense that is tax deductible, but not book deductible or a revenue that is book income, but not tax income. Item I is an expense that is tax deductible, but not a book expense. Item И is an item that is book income, but not tax income. Item III is a book expense, but not tax deductible. Only items I and II meet the definitions of deferred tax liabilities.
Calculation of the Deferred Tax Asset or Liability
The deferred tax expense or benefit that is reported on the income statement for the period is equal to the change in deferred tax asset or liability position during the year. In general, in order to calculate the amount of the deferred tax asset or liability, the temporary timing difference needs to be multiplied by the tax rate that will be applicable when the difference reverses.
The calculation of what the deferred tax asset or liability position is at any point in time is a fairly simple and straightforward calculation when there is only one deferred tax item and when the item is created in one period. This process becomes more complicated when the item is created over a number of years and is then reversed over a number of years (this is the case with depreciation).
We will look first at the steps of the calculation of this amount when the item is created in one period, and then we will look at the calculation when the item is created over a period of time and reverses over more than one period in the future.
Single Period of Creation
When the temporary timing difference is created in a single period, the calculation is simply to multiply the amount that will reverse in each future period by the enacted tax rate for that period. The number of calculations depends on the number of periods over which the difference reverses and future tax rates.
Single Period of Reversal
When the temporary difference reverses in a single period (whether it is the next period or five years in the future), the calculation is simply to multiply the temporary difference by the enacted tax rate for the period in which the item will reverse.
Example: Paterno Co. had one sale on account in 2005 for a total of $100,000. This amount will be paid in 2006. The enacted tax rate for 2006 is 25%.
The amount of the temporary timing difference is $100,000 and since it will reverse in 2006, it will be multiplied by the 2006 tax rate of 25%. This gives Patemo a deferred tax liability of $25,000.
Multiple Periods of Reversal and a Constant Future Tax Rate
When the future tax rate is constant, the calculation is very simple, no matter how many periods the item reverses over. The amount of the temporary timing difference is multiplied by the future tax rate. In this case when there is only one future tax rate, it does not matter in which period(s) the difference reverses as the tax rate is the same for all periods.
Example: Paterno Co. had one sale on account in 2005 for a total of $100,000. This amount will be paid over two years, with $50,000 to be paid in 2006 and $50,000 to be paid in 2007. The enacted tax rate for all years is 25%.
The amount of the temporary timing difference is $100,000. Since the tax rate is the same in all periods in which it will reverse, we simply need to multiply this $100,000 by the 25% tax rate. This gives Paterno a deferred tax liability of $25,000.
Multiple Periods of Reversal and Changing Future Tax Rates
When the temporary timing difference is created in a single period, but reverses over a number of periods that have different tax rates, the calculation is fundamentally the same, but is now a little bit more involved. Instead of having only one calculation as in the two previous situations, a separate calculation will need to be made for each year in which the temporary timing difference reverses. There are essentially two steps to this process:
1) Determine the amount of the temporary difference and how much of that difference will reverse in each future period.
2) Multiply the amount of the temporary timing difference that will reverse in each period by the enacted tax rate of that future period.
All of the calculations for each year in which the item reverses (the second step) are then added together for the deferred tax asset or liability.
Note: The enacted tax rate is the rate that has been passed by the government as the rate for the future period in question. If there are no laws that have been passed establishing the future tax rates, we assume that the current tax rate will be the enacted rate for any future periods.
As we have seen, for a question in which the future tax rates are all the same, this calculation is simple as it does not matter in which period the difference will reverse.
Example: Paterno Co. had one sale on account in 2005 for a total of $100,000. This amount will be paid over two years, with $50,000 paid in 2006 and $50,000 paid in 2007. The enacted tax rate is 25% for 2005, 30% for 2006 and 35% for 2007.
The amount of the temporary timing difference is $100,000. Since this difference will reverse equally over two future periods, we will need to multiply the $50,000 that will reverse in 2006 by the 2006 tax rate and the $50,000 that will reverse in 2007 by the 2007 tax rate:
2006: $50,000 *.30 = $15,000
2007: $50,000 *.35 = $17.500
Paterno has a $32,500 deferred tax liability at the end of 2005.
Multiple Periods of Creation and Reversal (Depreciation)
In a situation where the deferred tax item is created over more than one period and then eliminated over more than one period, the calculation becomes more involved, but it is still largely a mathematical operation. In an Exam question, this will likely be an issue when depreciation is the temporary difference, and when it is created and reverses over a number of periods. Depreciation is the best example of a difference that is created over a number of periods because of the length of the useful life of fixed assets.
A temporary difference is created whenever the company uses a different depreciation method for book purposes than is required for tax purposes. Tax depreciation is usually a very accelerated method, which means that in the early years of the asset's life, the tax depreciation expense will be larger than the book depreciation expense. This leads to a deferred tax liability. However, it is possible that the book depreciation expense will be larger than the tax depreciation expense in the early years of the asset and this will lead to a deferred tax asset.
Note: It is important to remember that the total amount of depreciation expense that will be recognized over the life of the asset will be the same, no matter which depreciation methods are used for book and tax purposes.
At the end of each period the company must calculate its deferred tax asset or liability position. This is done by going through the following steps. Keep in mind that all of these calculations are forward looking. By this, we mean that the company is essentially standing at the balance sheet date and looking into the future periods, and looking at the differences between book and tax depreciation in the future periods only.
Note: In this discussion, we are using depreciation as the example. If the temporary difference that is created over a number of periods is caused by something else, the process is the same - only the terms will be different.
The steps for calculating the amount of deferred tax assets or liabilities with multiple periods are (an example on the following page demonstrates this):
1) Identify the amount of the differences in each future period. In a depreciation question, it may take a few periods for the entire difference to be created so there may be a few periods of the deferred tax liability being created (getting larger each period) followed by its reversal over the last years of the asset's life.
2) Multiply the differences between tax and book depreciation in each future year by the enacted tax rate for that future year.
3) Add up all of the calculations from Step 2. This is the deferred tax asset or liability at the end of the period. Remember, this is not the deferred tax expense or benefit, but the deferred tax asset or liability. The deferred tax expense or benefit is calculated by looking at the change in the deferred tax asset or liability from the beginning of the year to the end of the year.
Example: On January 1, 2005, a company buys a fixed asset for $100,000 with no salvage value and a 5-year useful life. For book purposes the asset is depreciated on the straight- line basis, but for tax purposes the asset will be depreciated on the double-declining balance method for 3 years and then the straight-line method for the remaining 2 years.
Thus, the depreciation expense that will be recognized on the books and in the tax return for the life of the asset, as well as the enacted future tax rates, are as follows:
Yeer | Book Depn | Tax Dep" | Enacted Tax Rat? |
$20,000 | $40,000 | 25% | |
20,000 | 24,000 | 30% | |
20,000 | 14,400 | 30% | |
20,000 | 10,800 | 35% | |
20,000 | 10,800 | 40% |
The deferred tax position at the end of 2005 is determined by multiplying all of the future differences by the tax rate for that year. It will be done as follows:
Yqar Difference Enacted Tax Rate Deferred Tax Amount
|
($4,000) *
5,600 *
9,200 *
|
2008 2009 Total |
30% 30% 35% 40% |
9,200 * $20,000
($1,200) 1,680 3,220 3.680
$7,380 Deferred Tax Liability
|
This means that as of the end of 2005, the company has a deferred tax liability because the amount of the depreciation expense was greater for tax purposes than for book purposes. Given that the company had no deferred tax assets or liabilities at the end of the year, the company has a deferred income tax of $7,380. This is the amount of the change in the deferred tax position during the period (from a $0 beginning balance to a $7,380 liability at the end of the year).
Year |
Notice that the amount of future temporary differences ($20,000) is equal to the amount of the past temporary differences (also $20,000). This will always be the case. If we look ahead to 2006, we will have the following calculation for deferred tax liability.
Difference Enacted Tax Rate Deferred Tax Amount
$5,600 * | 30% | = | $1,680 | |
9,200 * | 35% | = | 3,220 | |
9,200 * | 40% | = | 3,680 |
Total $24,000 S8.580 Deferred Tax Liability
At the end of 2006, the company will show a deferred tax liability of $8,580. However, the amount of deferred Income tax expense will be only $1,200 as this is the difference between the deferred tax liability at the start of the year and at the end of the year.
Notice again that the amount of future temporary differences ($24,000) is equal to the amount of the past temporary differences (now $24,000 because the year 2006 is now in the past as well as 2005).
Question 135: West Corp. leased a building and received the $36,000 annual rental payment on June 15, 2005. The beginning of the lease was July 1, 2005. Rental income is taxable when received. West's tax rates are 30% for 2005 and 40% thereafter. West had no other permanent or temporary differences. West determined that no valuation account was needed. What amount of deferred tax asset should West report in its December 31, 2005 balance sheet?
a) $5,400.
b) $7,200.
c) $10,800.
d) $14,400.
__________________________________________________________________________________________ (CPA Adapted, May 1993)
Question 136: Mill, which began operations on January 1, 2003, recognizes income from long-term contracts under the percentage-of-completion method in its financial statements and completed contract method for income tax reporting. Income under each method follows:
Year Completed Contract Percentaqe-of-Completion
2003 $-- $300,000
2004 400,000 600,000
2005 700,000 850,000
The income tax rate is 30% for 2003 through 2005. For years after 2005, the enacted tax rate is 25%. There are no other temporary differences. Assuming Mill does not expect any tax losses in the near future, Mill should report on its December 31, 2005 balance sheet, a deferred tax liability of:
a) $87,500.
b) $105,000.
c) $162,500.
d) $195,000.
__________________________________________________________________________________ (CPA Adapted, November 1991)
135 b - In order to solve this problem we simply need to determine the amount of income that is recorded on the books and the amount that is taxable. The difference between these two numbers is then multiplied by the tax rate in which the difference will reverse, and that is the amount of the deferred tax asset. The taxable amount is $36,000, and the book income is only $18,000. Therefore, the difference is $18,000, and this will reverse in the following period when the tax rate is 40%. So, the deferred tax asset is $7,200 ($18,000 *.40).
136 с - This question is the same basic premise as earlier questions, but it is given in a different situation. Here the issue is long-term contracts. Because all of the future tax rates are the same, we do not care when these amounts will reverse. So all we need to do is determine the amount of gain under completed contract and the gain under percentage-of-completion. These two amounts are compared and the difference is multiplied by the future tax rate of 25%. Under completed contract, the company has $1,100,000 of income and under percentage-of-completion, there is $1,750,000 of income. This difference of $650,000 is multiplied by the tax rate of 25% to give us a deferred tax liability of $162,500.
Question 137: Tell Corp.'s 2005 income statement had pretax financial income of $38,000 in its | |
first year of operations. Tell uses an | accelerated cost recovery method on its tax return and |
straight-line depreciation for financial | reporting. The differences between the book and tax |
deductions for depreciation over the 5-year life of the assets acquired in 2005, and the enacted tax | |
rates for 2005 to 2009, are as follows: |
|
Year Book over (under) tax | T?x rate? |
2005 $(8,000) | 35% |
2006 $(13,000) | 30% |
2007 $(3,000) | 30% |
2008 $10,000 | 25% |
2009 $14,000 | 25% |
There are no other temporary differences. Taxable income is expected in all future years. In Tell's | |
December 31, 2005 balance sheet, the deferred income tax liability and the income taxes currently | |
payable should be: |
|
Deferred income tax liability | Income taxes currently payable |
a) $1,200 | $13,300 |
b) $1,200 | $10,500 |
c) $2,800 | $13,300 |
d) $2,800 | $10,500 |
| (Source Unknown) |
Question 138: On June 30, 2005, Ank Corp. prepaid a $19,000 premium on an annual insurance policy. The premium payment was a tax-deductible expense in Ank's 2005 cash basis tax return. The accrual basis income statement will report a $9,500 insurance expense in 2005 and 2006. Ank's income tax rate is 30% in 2005 and 25% thereafter. Taxable income is expected in all future years. In Ank's December 31, 2005 balance sheet, what amount should be reported as a deferred income tax liability?
a) $5,700.
b) $4,750.
c) $2,850.
d) $2,375.
__________________________________________________________________________________________ (CPA Adapted, May 1991)
Comprehensive Example
Below is a comprehensive example where we look at the effect of the temporary differences on the books of both parties.
Let us assume Tenant is going to rent an apartment from Landlord. Landlord does not have any source of income other than the rent of the apartment and Tenant has a job that paid her $500 for 2004, but she does not have a job and is not planning on working in 2005. On December 31, 2004 Tenant and Landlord agree that Tenant will rent the apartment during all of 2005 for a price of $120. The full rental amount for 2005 is paid on December 31, 2004. The tax rate is 30%.
Below are the balance sheets, income statements and tax returns for both Landlord and Tenant for 2004 and 2005.
Landlord - 2004 | |||
Balance Sheet |
| Balance Sheet |
|
Assets: |
| Assets: |
|
Cash | $84* | Cash | $84 |
Deferred Tax Asset | 364 | Deferred Tax Asset | |
Liabilities: |
| Liabilities: |
|
Unearned Revenue | Unearned Revenue | ||
|
| Retained Earnings | 843 |
Income Statement |
| Income Statement |
|
Revenue | $0 | Revenue | $120 |
Expenses | fl | Expenses | A |
Profit | Profit | ||
Current Income Tax Expense | (36) [1] | Current Income Tax Expense | 02 |
Deferred Income Tax Benefit | M | Deferred Income Tax Expense | № |
Net Income | Net Income | ||
Tax Return |
| Tax Return |
|
Revenue | $120 | Revenue | $0 |
Expenses | fl | Expenses | fl |
Profit | Profit | й | |
Taxes Payable (30% tax rate) | (36) | Taxes Payable |
Tenant - 2004 | |||
Bglange Sheet |
| Balance Sheet |
|
Assets: |
| Assets: |
|
Cash | $2661 | Cash | $266 |
Prepaid Rent |
|
| |
Liabilities: |
| Liabilities: |
|
Deferred Tax Liability | Deferred Tax Liability | ||
Retained Earnings | Retained Earnings | ||
Income Statement |
| Income Statement |
|
Revenue | $500 | Revenue | $0 |
Expenses | fl | Expenses | |
Profit | Profit | (120) | |
Current Income Tax Expense | (114) | Current Income Tax Expense | |
Deferred Income Tax Expense | №) | Deferred Income Tax Benefit | |
Net Income | Net Income | (84) | |
Тех Retyrn |
| Tex Retyrn |
|
Revenue | $500 | Revenue | $0 |
Expenses | Expenses | ||
Profit | Ш | Profit | Q |
Taxes Payable | (114) | Taxes Payable |
(1) $500 income - $120 paid for the rent - $114 for taxes.
If we look at the combined position, it makes sense. The total amount that has been recognized as after-tax income by Tenant is $266. This is calculated as $500 in income - $120 in expenses = $380 income - 30% taxes = $266 after tax profit. The difference is in the allocation (between the periods) that has occurred for financial accounting purposes and tax purposes.
Permanent Timing Differences
Permanent timing differences are those items that are differences between taxable and book income, but that do not reverse over time.
Permanent differences do not give rise to deferred tax assets or liabilities because of the fact that by definition a permanent timing difference is something that will be recognized for either book or tax purposes, but not both.
In a question you will need to be able to identify what items in a list are permanent differences and do not give rise to a deferred tax asset or liability. The most commonly tested examples of permanent differences are probably municipal bond interest and the dividend received deduction. These items are looked at individually, and then other permanent differences are listed.
Municipal Bond Interest
The most common example of a permanent difference is municipal bond interest (or any other tax exempt interest). A municipal bond, or muni-bond, is a bond that is issued by a local government. The fact that muni-bond interest is tax-free means that the income from the bond will be included in book income in the year it is earned, but it will never be included in taxable income because it is excluded from the definition of income for the tax return.
The Dividend Received Deduction
This is applicable when a company owns shares in another qualifying U.S. corporation*. When the company owns less than 20% of the qualifying company, 70% of the dividends received are not taxable. If the company owns between 20 and 80% of the qualifying company, 80% of the dividends received are not taxable. If the company owns more than 80% of the qualifying company, 100% of the dividends received are not taxable. Because in many cases some of the dividend will still be taxable, the dividend received deduction is only partially a permanent difference.
Other Permanent Differences
Other examples of items that lead to permanent differences are:
Expenses Incurred in the process of earning tax-exempt income are not deductible for tax purposes, but will be deducted for book purposes.
Life insurance premiums paid by the corporation are never deductible for tax purposes if the corporation is the beneficiary. However, for book purposes these are considered an expense.
Life insurance proceeds received by the corporation are never taxable, but will be considered income on the income statement.
Expenses incurred as a result of the violation of a law are not tax deductible.
w The criteria for being a qualified company are outside the scope of this Exam. For the Exam you need to know how the dividend received deduction works, not what qualifies for the dividends received deduction.
Question 139: Taft uses the equity method to account for its 25% investment in Flame, Inc. During 2005, Taft received dividends of $30,000 from Flame and recorded $180,000 as its equity in the earnings of Flame. Other information is:
All the undistributed earnings of Flame will be distributed in future periods.
The dividends from Flame are eligible for the 80% dividends received deduction.
There are no other temporary differences.
Enacted income tax rates are 30% for 2005 and thereafter.
In its 2005 balance sheet, what amount should Taft report for deferred income tax liability?
a) $9,000.
b) $10,800.
c) $45,000.
d) $54,000.
________________________________ (CPA Adapted, May 1993)
Question 140: In its 2005 income statement, Cere reported income before taxes of $300,000. Cere estimated that, because of permanent differences, taxable income for 2005 would be $280,000. During 2005, Cere made estimated tax payments of $50,000, which were debited to income tax expense. Cere is subject to a 30% tax rate. What amount should Cere report as total income tax expense?
a) $34,000.
b) $50,000.
c) $84,000.
d) $90,000.
__________________________________________________________________________________ (CPA Adapted, November 1994)
139 a - In this question we need to identify which of the differences are permanent, not temporary. There is, however, an element that relates to the dividend received deduction. Of its investment in Flame, Taft 'received' $180,000 of accounting profit. This is what will be recorded on the income statement. However, only $30,000 was received in cash. This $30,000 is the taxable amount for the year. Since they tell us that the other $150,000 will be distributed in the future, that makes it a temporary difference that must have a calculated deferred tax amount. However, 80% of the dividends received are not taxable. So, only 20% of the difference is actually temporary. So, $30,000 is the amount of the temporary difference, and since future tax rates are 30%, the deferred tax liability is only $9,000.
140 с - This is actually a very simple question since it asks for tax expense (total) and they give us taxable income and the tax rate: $280,000 *.30 = $84,000. The key is to remember that permanent differences are not considered in the calculation of total tax expense.
Question 141: In 2005, Lobo reported for financial statement purposes the following revenue and expenses that were not included in taxable income:
Premiums on officers' life insurance policies in which Lobo is the beneficiary - $5,000.
Interest revenue on qualified state municipal bonds - $10,000.
Estimated future warranty costs to be paid in 2006 and 2007 - $60,000.
Lobo's enacted tax rate for the current and future years is 30%. Lobo expects to operate profitably in the future. There were no temporary differences in prior years. The deferred tax benefit is:
a) $18,000.
b) $19,500.
c) $21,000.
d) $22,500.
__________________________________________________________________________________________ (CPA Adapted, May 1990)
141 a - Again, we need to determine what is and is not a permanent difference. Of these items, the premiums on officers' life insurance policies under which Lobo is the beneficiary and the municipal bond interest are permanent differences. The warranty expenses are the only temporary differences and this is what needs to be multiplied by the 30% future tax rate. This gives an $18,000 deferred tax benefit.
Calculation of a Valuation Allowance
When a company recognizes a deferred tax asset on the balance sheet, it must be certain that there will be future taxable income in order to be able to use this deferred asset. If it is more likely than not (a likelihood of more than 50%) that some or all of the deferred tax will not be realized, a valuation account should be set up for it. The key words that you need to look for are "more likely than not." If these words are used in a problem, you know that the issue is the valuation allowance.
Note: This is the same as the valuation process that we did with accounts receivables (allowance for doubtful debts), inventory (lower of cost or market) and fixed assets (impairment of fixed assets). It is done to make certain that assets are not overstated.
You will not be required to determine on the Exam if the likelihood is 50% or greater as this will be given to you in the question. If the question includes information that the deferred tax asset is more than likely to not be realized, you need to set up the valuation account for the amount of the deferred tax asset that will not be realized by the company.
Note: A history of operating losses is an indication that perhaps the entire deferred tax asset will not be able to be realized. This would be the case because the company would then not have any taxable income to use the 'prepaid' taxes to offset.
This idea of the valuation account is applicable only to company's that are not operating profitably, or do not expect to operate profitably in the future. If a company is operating, and expects to operate profitably, this valuation process is not needed.
If it is determined that some amount of the deferred tax asset will not be realized, the valuation account entry will increase total Income tax expense for the period as either an increase in the deferred tax expense or a reduction of the deferred tax asset that is being recognized during the period. This makes sense, because it is essentially the writing off of the deferred tax asset.
The journal entry to set up this valuation allowance is as follows:
Dr Income tax expense................................................................................................. X
Cr Valuation allowance..................................................................................................... X
When the amount used for setting up the valuation is Most' we will write off the deferred tax asset itself and the valuation account. However, until we actually 'lose' this amount, it will be reflected in the valuation account, and on the balance sheet as a reduction of the deferred tax asset.
In the future, if or when we are actually able to use this amount, we will simply reverse the entry that was made above to set up the valuation account.
Note: No valuation is set up or even considered relating to deferred tax liabilities.
Treatment of Net Operating Losses
When a company has the situation of a taxable loss for a period, it can apply that loss to previously paid taxes and receive a refund and/or carry that loss forward to reduce future payable taxes.
The company may carry the net operating loss back 2 years and receive refunds for up to 100% of income taxes paid in those years. The loss must be applied to the earlier year first (2 years ago) and then to the most recent year. Any loss that remains after the 2-year carryback may be carried forward up to 20 years to offset future taxable income.
The company may elect to forgo the loss carryback and carry the entire loss forward, offsetting only future taxable income for up to 20 years. This would be done if the company had no taxable income for the previous two tax years; or tax planning strategies may dictate that it is better for the company not to carry the loss back, if the expected tax rate for the future will be higher.
Companies that have suffered past losses are often attractive takeover candidates because in some cases, an acquirer can use the acquired company's loss carrybacks and loss carryforwards to reduce its own income taxes.
Treatment of Loss Carryback
If the company chooses to carry the loss back for 1 or 2 years, it must file amended tax returns for the affected previous tax year(s) and will receive a cash refund from the IRS for the amount of previously paid income taxes covered by the loss. If there were no taxes paid in the previous 2 years the company can carry the loss forward as a deferred tax asset for up to 20 years. The company will then use this carryforward to offset taxable income in a future period.
If the operating loss is carried back, the company determines the amount of the refund it is to receive, and the journal entry that the company will make to recognize this is as follows:
Dr Income tax refund receivable............................................................................... X
Cr Income tax benefit from loss carryback............................................................... X
Note: The income tax benefit from this journal entry is recognized on the income statement in the period in which the loss occurred.
The receivable is reported on the balance sheet as a current asset at year-end. The account credited is reported on the income statement for the current year, as follows:
Operating loss before income taxes $(XXX,XXX) Income tax benefit:
Benefit due to loss carryback XXX.XXX
Net loss $(XXX,XXX)
Treatment of Loss Carryforward
If the loss will be carried forward to offset future taxable income, the company needs to recognize a deferred tax asset in the period of the ioss. This deferred tax asset is for the amount of the loss that will be carried forward multiplied by the enacted tax rate when the loss is expected to be used. This deferred tax asset will be reported on the balance sheet and a 'gain' (or reduction of tax expense) recognized on the income statement.
137 b - This is the largest, worst-case scenario, multiple-choice question for deferred taxes. We need to determine the deferred tax position as of December 31, 2005. In order to calculate the deferred tax portion of the question, we need to simply multiply all future tax differences related to these fixed assets by the tax rate of that period. As such we get the following table:
Difference * fax Rate • Deferred Tax Amount
| 2006 I (13,000) ♦.30 | $(3,900) j
i 2007 (3,000) *.30 $(900) j
2008 '10,000 *.25 $2,500 '
j 2009 Г 14,000 *.25 T $3,500)
I Total [77Г1ГГ"................................ A $1,200 i
To calculate the currently payable taxes, we must determine taxable income. The book income for 2005 was $38,000. However, we also know that the amount of depreciation for book purposes was $8,000 less than the depreciation for tax purposes. This means that taxable income was only $30,000. With a 35% tax rate, this gives a tax payable of $10,500.
138 d - Again, this is similar to previous questions. For book purposes there is a $9,500 expense, but for tax purposes there is a $19,000 deduction. This difference is multiplied by the future tax rate of 25% to give a DTL of $2,375.
1) $120 of rent money - $36 that was paid for taxes.
3) From the income statement.
4) Calculated based on the $120 of unearned revenue that is taxable on the tax return, but not included on the income statement. This is the amount of taxes that Landlord will want to pay in 2005, but will not need to because it was paid in 2004.
[1] From the tax return.
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