ACCT 3021 Chapter 19

There are four types of temporary differences. For each type: (1) indicate the cause of the difference, (2) give an example, and (3) indicate whether it will create a taxable or deductible amount in the future.

(a) Revenues or gains are taxable after they are recognized in pretax financial income. Examples are installment sales, long-term construction contracts, and the equity method of accounting for investments. They result in future taxable amounts. (b) Revenues or gains are taxable before they are recognized in pretax financial income. Examples are subscriptions received in advance and rents received in advance. They result in future deductible amounts. (c) Expenses or losses are deductible before they are recognized in pretax financial income. Examples are extra depreciation, prepaid expenses, and pension funding in excess of pension expense. They result in future taxable amounts. (d) Expenses or losses are deductible after they are recognized in pretax financial income. Examples are warranty expenses, estimated litigation losses, and unrealized loss on marketable securities. They result in future deductible amounts.

Permanent Differences

- Items that never reverse (always different) -- Examples: Municipal interest income, penalties and fines, company-owned life insurance proceeds and life insurance premiums

Temporary Difference

- Items that reverse over time (net to zero eventually) -- Examples: tax/book depreciation expense, warranty expense, rent income (prepaid), rent expense (prepaid)

Examples of Permanent Differences

-tax free interest received on state and municipal obligations -expenses incurred in obtaining tax fee income -dividends received deductions -proceeds from life insurance on key executives - fines and expenses resulting form a violation of the law

Pretax Financial Income

>financial reporting term.>also often referred to as income before taxes, income for financial reporting purposes, or income for book purposes>determined according to GAAP>for financial reporting, companies use the full accrual method to report revenuesIncome tax expense = Pretax financial income x tax rate

Taxable Income

>income for tax purposes is a tax accounting term>indicates the amount used to compute income taxes payable>for tax purposes, they use a modified cash basisIncome taxes payable = Taxable income x tax rate

Apply accounting procedures for a loss carryback and a loss carryforward.

A company may carry a net operating loss back two years and receive refunds for income taxes paid in those years. The loss is applied to the earlier year first and then to the second year. Any loss remaining after the two-year carryback may be carried forward up to 20 years to offset future taxable income. A company may forgo the loss carryback and use the loss carryforward, offsetting future taxable income for up to 20 years.

valuation allowance

A company should reduce a deferred tax asset by a ____________________ if it is more likely than not that it will not realize some portion or all of the deferred tax asset.

purpose of a deferred tax asset valuation allowance

A deferred tax asset should be reduced by a valuation allowance if, based on all available evidence, it is more likely than not (a level of likelihood that is at least slightly more than 50 percent) that it will not realize some portion or all of the deferred tax asset. The company should carefully consider all available evidence, both positive and negative, to determine whether, based on the weight of available evidence, it needs a valuation allowance.

Temporary Difference

A difference between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when recovering or settling the reported amount of the asset or liability, respectively.

Pretax Financial Income

A financial reporting term, determined according to GAAP and with the purpose of providing useful information to investors and creditors. Also often referred to as income before income taxes, income for financial reporting purposes, or income for book purposes. Pretax financial income is not the same as taxable income, which is income calculated for tax purposes and determined according to the U.S. tax code. The main difference is that companies use the accrual method to report revenues for financial reporting and they use a modified cash basis to report revenues for tax purposes.

More likely than not

A level of likelihood of at least slightly more than 50 percent. This measure is used in connection with a deferred tax asset for all deductible temporary differences. If it is more likely than not that a company will not realize some portion of the deferred tax asset, the company should reduce the deferred tax asset by a valuation allowance.

Net Operating Loss (NOL)

A loss that occurs for tax purposes in a year when tax-deductible expenses exceed Ntaxable revenues. Under certain circumstances, the federal tax laws permit companies to use the losses of one year to offset the profits of other years, through use of the carryback and carryforward of net operating losses.

Deductible Amounts

A temporary difference between the tax basis of an asset/liability and its reported (carrying or book) amount in the financial statements that will decrease taxable income in future years.

Taxable Amounts

A temporary difference between the tax basis of an asset/liability and its reported (carrying or book) amount in the financial statements that will increase taxable income in future years.

interperiod tax allocation

Accounting for deferred taxes involves the following steps: Calculate taxable income and income taxes payable for the year. Compute deferred income taxes at the end of the year. Determine deferred tax expense (benefit) and make the journal entry to record income taxes. Classify deferred tax assets and liabilities as current or noncurrent in the financial statements.

temporary difference that results in future deductible amounts

An accrued warranty expense that a company pays for and deducts for tax purposes, in a period later than the period in which it incurs and recognizes it for book purposes, results in future deductible amounts. The future deductible amounts will occur in the periods during which the company settles the related liability for book purposes. This results in a deferred tax asset.

Tax-Planning Strategy

An action that meets certain criteria and that a company implements to realize a tax benefit for an operating loss or tax credit carryforward before it expires. Companies consider tax-planning strategies when assessing the need for and amount of a valuation allowance for deferred tax assets.

Valuation Allowance

An amount by which a company should reduce the valuation of a deferred tax asset if it is more likely than not that the company will not realize some portion of the deferred tax asset.

Average Tax Rate

An average of the graduated rates at which the IRS taxes U.S. corporations. The first $50,000 of taxable income at 15 percent, the next $25,000 at 25 percent, with higher incremental levels of income at rates as high as 39 percent.

Loss Carryback

An income-averaging provision in the U.S. tax code that enables companies to carry a net operating loss back two years and receive refunds for income taxes paid in those years. A company must apply the loss to the earlier year first and then to the second year.

Loss Carryforward

An income-averaging provision in the U.S. tax code that enables companies to carry forward any loss remaining after a two-year carryback up to 20 years to offset future taxable income. Or, a company may forgo the loss carryback and use only the loss carryforward option, offsetting future taxable income for up to 20 years.

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An individual deferred tax asset or liability is classified as current or noncurrent based on the classification of the related asset/liability for financial reporting purposes. (Answer=ok)

basic principles of the asset-liability method

Companies apply the following basic principles in accounting for income taxes at the date of the financial statements: (1) Recognize a current tax liability or asset for the estimated taxes payable or refundable on the tax return for the current year. (2) Recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards using the enacted tax rate. (3) Base the measurement of current and deferred tax liabilities and assets on provisions of the enacted tax law. (4) Reduce the measurement of deferred tax assets, if necessary, by the amount of any tax benefits that, based on available evidence, companies do not expect to realize.

Differences in Pretax Financial Income and Taxable Income

Companies compute pretax financial income (or income for book purposes) in accordance with generally accepted accounting principles. They compute taxable income (or income for tax purposes) in accordance with prescribed tax regulations. Because tax regulations and GAAP differ in many ways, so frequently do pretax financial income and taxable income. Differences may exist, for example, in the timing of revenue recognition and the timing of expense recognition.

effect of various tax rates and tax rate changes on deferred income taxes

Companies may use tax rates other than the current rate only after enactment of the future tax rates. When a change in the tax rate is enacted, a company should immediately recognize its effect on the deferred income tax accounts. The company reports the effects as an adjustment to income tax expense in the period of the change.

presentation of deferred income taxes in financial statements

Companies report deferred tax accounts on the balance sheet as assets and liabilities. These deferred tax accounts are classified as a net current and a net noncurrent amount. Companies classify an individual deferred tax liability or asset as current or noncurrent based on the classification of the related asset or liability for financial reporting. A deferred tax liability or asset that is not related to an asset or liability for financial reporting, including a deferred tax asset related to a loss carryforward, is classified according to the expected reversal date of the temporary difference.

Carrybacks

Deductions or credits that cannot be utilized on the tax return during a year and that may be carried back to reduce taxable income or taxes paid in a prior year. An operating loss carryback is an excess of tax deductions over gross income in a year. A tax credit carryback is the amount by which tax credits available for utilization exceed statutory limitations.

Carryforwards

Deductions or credits that cannot be utilized on the tax return during a year and that may be carried forward to reduce taxable income or taxes payable in a future year. An operating loss carryforward is an excess of tax deductions over gross income in a year. A tax credit carryforward is an amount by which tax credits available for utilization exceed statutory limitations.

Alternative minimum tax (AMT)

Designed by the IRS to curb excessive tax avoidance, this provision allows companies to compute their potential tax liability under the AMT, adjusting for various preference items that reduce their tax bills under the regular tax code (e.g., accelerated depreciation methods). Companies must then pay the higher of the two tax obligations computed under the AMT and the regular tax code.

How are these differences between taxable income and financial accounting income categorized?

Differences between taxable income and financial accounting income are categorized as PERMANENT differences and TEMPORARY differences.

Why is there a difference between taxable income and financial income?

Differences between taxable income and financial accounting income occur because tax regulations and GAAP are frequently different.

Income Taxes

Domestic and foreign federal (national), state, and local (including franchise) taxes based on income.

Deferred Tax Asset

Due to the fact that deductible amounts can arise in the future as a result of temporary differences at the end of the current year, the deferred tax consequences of these deductible amounts should be recognized as a

Temporary and Permanent Differences

Examples of temporary differences are: (1) revenue or gains that are taxable after recognition in financial income; (2) expenses or losses that are deductible after recognition in financial income; (3) revenues or gains that are taxable before recognition in financial income; (4) expenses or losses that are deductible before recognition in financial income. Examples of permanent differences are: (1) items recognized for financial reporting purposes but not for tax purposes, and (2) items recognized for tax purposes but not for financial reporting purposes.

Financial income is measured and reported in accordance with what?

Financial income is measured and reported in accordance with GAAP

The formula to compute income tax expense (benefit)

In the income statement or in the notes to the financial statements, the significant components of income tax expense attributable to continuing operations should be disclosed.

Taxable Income

Income for tax purposes, determined according to the Internal Revenue Code (the tax code). It is measured as the excess of taxable revenues over tax-deductible expenses and exemptions for the year.

Temporary difference, deferred tax asset.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Advance rental receipts.

Temporary difference, deferred tax asset.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Estimated future warranty costs.

Temporary difference, deferred tax liability.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Excess of contributions over pension expense.

Temporary difference, deferred tax liability.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Excess tax depreciation over accounting depreciation.

Permanent difference.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Expenses incurred in obtaining tax-exempt revenue.

Permanent difference.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Fine for polluting.

Temporary difference, deferred tax liability.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Installment sales.

Temporary difference, deferred tax liability.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Investments accounted for by the equity method.

Temporary difference, deferred tax liability.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Long-term construction contracts.

Permanent difference.

Listed below are items that are treated differently for accounting purposes than they are for tax purposes. Indicate whether the items are permanent differences or temporary differences. For temporary differences, indicate whether they will create deferred tax assets or deferred tax liabilities. Premiums paid on life insurance of officers (company is the beneficiary).

Asset-liability method

Method of accounting for income taxes. Sometimes referred to as the liability approach. Companies recognize on the current-year return a current tax liability/asset for the estimated taxes payable/refundable, and they recognize a deferred tax liability/asset for estimated future tax effects due to temporary differences and tax carryforwards. The measurement of current/deferred tax liabilities/assets is based on provisions of the tax law. Companies establish a valuation allowance account if it is more likely than not that some/all of the deferred tax asset will not be realized.

Indicate and explain whether each of the following independent situations should be treated as a temporary difference or a permanent difference. Pretax accounting income and taxable income differ because 80% of dividends received from U.S. corporations was deducted from taxable income, while 100% of the dividends received was reported for financial statement purposes.

Permanent difference. This difference in pretax financial income and taxable income will never reverse because present tax laws allow a company that owns stock in another U.S. corporation to deduct 80% of the dividends it receives from that company. Taxes will not be paid on the dividends deducted and there are no tax consequences for those dividends, even though they are recognized as income for book purposes.

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Recognize income taxes using the asset/liability method. (Answer=ok)

income taxes currently payable (refundable)

Refer to current tax expense (benefit).

temporary difference that results in future taxable amounts

Revenue recognized for book purposes in the period earned but deferred and reported as revenue for tax purposes when collected results in future taxable amounts. The future taxable amounts will occur in the periods the company recovers the receivable and reports the collections as revenue for tax purposes. This results in a deferred tax liability.

presentation of income tax expense in the income statement

Significant components of income tax expense should be disclosed in the income statement or in the notes to the financial statements. The most commonly encountered components are the current expense (or benefit) and the deferred expense (or benefit).

Uncertain Tax Positions

Tax positions for which the tax authorities may disallow in whole or in part, often the result of an aggressive approach in tax planning.

Indicate and explain whether each of the following independent situations should be treated as a temporary difference or a permanent difference. Estimated warranty costs (covering a three-year warranty) are expensed for accounting purposes at the time of sale but deducted for income tax purposes when paid.

Temporary difference. The full estimated three years of warranty expenses reduce the current year's pretax financial income, but will reduce taxable income in varying amounts each year as paid. Assuming the estimate for each warranty is valid, the total amounts deducted for accounting and for tax purposes will be equal over the three-year period for each warranty. This is an example of an expense that, in the first period, reduces pretax financial income more than taxable income and, in later years, reverses and reduces taxable income without affecting pretax financial income.

Indicate and explain whether each of the following independent situations should be treated as a temporary difference or a permanent difference. For accounting purposes, a company reports revenue from installment sales on the accrual basis. For income tax purposes, it reports the revenues by the installment-sales method, deferring recognition of gross profit until cash is collected.

Temporary difference. This difference in the timing of revenue recognition for pretax financial income and taxable income will initially increase pretax financial income, but will increase taxable income by the amount of deferred gross profits as cash is collected in subsequent years. Assuming the estimate as to collectibility of installment receivables is valid, the total amounts reported as gross profits for accounting purposes and for tax purposes will be equal over the life of a group of installment receivables. The time lag between the accrual for accounting purposes and the recognition for tax purposes will result in credit entries to a company's deferred tax liability as long as installment sales are level or increasing. The credit entries related to particular installment receivables will be "drawn down," or reversed, however, when the receivables are collected.

Deductible Temporary Difference

Temporary differences that will result in deductible amounts in future years, when the related book liabilities are settled. They give rise to recording deferred tax assets. Examples are: (1) expenses or losses that are deductible after they are recognized in financial income, and (2) revenues or gains that are taxable before they are recognized in financial income.

Taxable Temporary Difference

Temporary differences that will result in taxable amounts in future years. They give rise to recording deferred tax liabilities. Examples are: (1) revenues or gains that are taxable after they are recognized in financial income, and (2) expenses or losses that are deductible before they are recognized in financial income.

Income Tax Refund Receivable

The account to which a company records a tax benefit. The company reports this account on the balance sheet as a current asset and reports it on the income statement as an income tax benefit.

Current Tax Expense (Benefit)

The amount of income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year.

Deferred Tax Expense (Benefit)

The change during the year in a company's deferred tax liabilities and assets.

Deferred Tax Asset

The deferred tax consequences attributable to deductible temporary differences and carryforwards.

Net Current Amount

The difference between the amounts of deferred tax assets and deferred tax liabilities that are classified as current. If the net result is an asset, report it on the balance sheet as a current asset; if a liability, report it as a current liability.

Net Noncurrent Amount

The difference between the amounts of deferred tax assets and deferred tax liabilities that are classified as noncurrent. If the net result is an asset, report it on the balance sheet as a noncurrent asset; if a liability, report it as a noncurrent liability.

Temporary Difference

The difference between the amounts reported for tax purposes and the book (carrying) amounts reported in the financial statements. The temporary difference will result in taxable amounts or deductible amounts in future years. Taxable amounts increase taxable income in future years; deductible amounts decrease taxable income in future years.

Reversing Difference

The elimination of a temporary difference that originated in prior periods and removal of the related tax effect from the deferred tax account.

Deferred Tax Consequences

The future effects on income taxes as measured by the enacted tax rate and provisions of the enacted tax law resulting from temporary differences and carryforwards at the end of the current year.

Originating Temporary Difference

The initial difference between the book basis and the tax basis of an asset/liability, regardless of whether the tax basis of the asset/liability exceeds or is exceeded by the book basis of the asset or liability. An originating temporary difference may be changed by a later reversing difference, which results in deferred tax expense.

Valuation Allowance

The portion of a deferred tax asset for which it is more likely than not that a company will not realize a tax benefit.

Tax Effect (Tax Benefit)

The result, for accounting as well as tax purposes, of a loss carryback. When a company recognizes a tax loss that gives rise to a tax refund, the company should recognize the associated tax benefit by reporting it as a current asset on the balance sheet and as a benefit due to loss carryback on the income statement.

Income Tax Expense (Benefit)

The sum of current tax expense (benefit) and deferred tax expense (benefit).

Effective Tax Rate

The tax rate a company actually pays, computed as total income tax expense for the period divided by pretax financial income. It differs from the enacted tax rate because of deductions and provisions allowed by the tax code.

Enacted Tax Rate

The tax rate, passed by Congress, that is expected to apply to future periods. When determining the tax rate to apply to existing temporary differences, a company must consider presently enacted changes in the tax rate that become effective for a particular future year(s).

Deferred Tax Asset

What is created when a temporary difference causes a decrease in future taxes payable?

Future Tax Rates

When recording deferred income taxes consideration must be given to the tax rate in effect when the timing differences reverse. Normally, the current tax rate is used to compute deferred income taxes. However, future tax rates, other than the current rate should be used only when such rates have been enacted into law. When an unexpected change in the tax rate has been enacted into law, its effect on deferred income tax and related tax expense should be recorded immediately. The effects are reported as an adjustment to tax expense in the period of the change

Temporary Difference

arise when the tax basis of an asset or liability and its reported amount in the financial statements differ. This difference will reverse and result in taxable or deductible amounts in future years as the asset is recovered or the liability is settled at its reported amount.

Deferred Tax Liability

deferred tax consequences attributable to taxable temporary differences.

Permanent Differences

do not give rise to future taxable or deductible amounts

Current period tax liability

is recorded based on current period taxable income.

Deferred Tax Liability

is the amount of deferred tax consequence attributable to the temporary differences that will result in taxable amounts in future years. The liability is the amount of taxes payable on these taxable amounts in future years based on existing provisions of the tax law.

Deferred Tax Asset

is the amount of taxes (computed in accordance with provisions of the tax law) that will be refundable in future years as a result of these deductible amounts. A key issue in accounting for income taxes is whether a deferred tax asset should be recognized in the financial records. Based on the conceptual definition of an asset, a deferred tax asset meets the definition of an asset and should be reported in the financial statements. The three main conditions for an item to be reported as an asset are: (a) it results from past transactions; (b) it gives rise to a probable benefit in the future; and (c) the company controls access to the benefits. These conditions are met by the deferred tax asset.

Temporary Difference

is the difference between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable amounts (increase in taxable income) or deductible amounts (decrease in taxable income) in future years when the reported amount of the asset is recovered or when the reported amount of the liability is settled

Temporary Difference

originate in one period and reverse or "turn around" in one or more subsequent periods. For example, when a company records a product warranty liability, an expense is recognized for accounting purposes but not for tax purposes. In future years when the product warranty liability is settled, tax deductible amounts result which reverse the effect of the original timing differences.

What are permanent difference items? (2 conditions)

permanent differences are items that (a) enter into financial income but NEVER into taxable income or (b) enter into taxable income but NEVER into financial income (cant ever enter both)

Future Taxable Amounts (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.

Future Deductible Amounts (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.

Taxable income is calculated in accordance with what?

taxable income is calculated in accordance with prescribed tax regulations and rules