Combo with "Classification of Deferred Tax Accounts" and 7 others

Compute the ending valuation allowance if the total future deductible difference is $4,000, tax rate is 30%, and only $1,000 of future taxable income is assured.

$900 (deferred tax asset balance is $1,200, but only $300 is expected to be realized).

List the sources for realizing a deferred tax asset.

1. Expectation of future taxable income; 2. Taxable income in prior years w/i carryback period; 3. Future taxable differences; 4. Tax planning strategies.

List the evidence suggesting the need of a valuation allowance.

1. History of unused net operating losses; 2. History of operating losses; 3. Losses expected in future years; 4. Very unfavorable contingencies; 5. Very brief carryback or carryforward period.

Resolution of the Uncertainty

1. If the deduction is disallowed, the journal entry in the year of resolution is: Dr:Liability for unrecognized tax benefit 600 Cr:Cash 600 Additional amounts may be due for interest and penalties. These amounts are recognized as an expense in the year of payment.

List some common permanent differences.

1. Tax-Free Interest Income; 2. Life Insurance Expense Premiums on key employee; 3. Proceeds from life insurance on key employee; 4. Dividends Received Deduction; 5. Fines and penalties.

List the two categories of temporary differences.

1. Taxable Temporary Differences; 2. Deductible Temporary Differences.

Define "deferred income tax provision".

1. The amount of income tax expense that is not currently due; 2. Equals the net sum of the change in the deferred tax accounts.

Nature of Temporary Differences Continued

1. The only difference between the two reporting systems (GAAP and tax) is one of timing of recognition. 2. The concept of future temporary differences is one way to refer to the underlying differences leading to the deferred tax accounts. Another is in reference to an item's tax basis compared with its amount for financial reporting purposes. For example, the cost of a plant asset is $100,000 and for financial reporting the asset has been depreciated $15,000 through the current balance sheet date (book value $85,000). The asset has been depreciated $25,000 for tax purposes through the balance sheet date. For tax purposes, this asset is said to have a tax basis of $75,000. The difference between the book value and tax basis is $10,000, which also is the future taxable difference. The $10,000 difference is the amount taht enters into the computation of the deferred tax liability at the end of the current year.

Sources for Realizing the Deferred Tax Asset (Second Source)

2. Example of source 2 and journal entry -- A firm has a $20,000 future deductible difference at the end of 20x8. The difference is expected to reverse in 20x9. The future tax rate is 30%. Thus, a $6,000 deferred tax asset is recorded. However, the firm has little prospect for future taxable income, has no available tax strategies, and has no future taxable temporary differences (i.e. no other sources of realization). But assume the firm earned $6,000 taxable income in both 20x7 and 20x8. a. Therefore, $12,000 of prior years' taxable income can be used to support the deferred tax asset. If the only item on the tax return in 20x9 is the reversing deductible difference, then 20x9 will report a net operating loss of $20,000 which can be carried back to the previous two years to obtain a refund of the tax paid on the $12,000 of taxable income. The tax accrual entry for 20x8 assuming no beginning deferred tax balances for 20x8: Dr:Deferred Tax Asset ($20,000 x .3) 6,000 Cr:Valuation Allowance ($8,000 x .3) 2,400 Cr:Income Tax Payable ($6,000 x .3) 1,800 Cr:Income Tax Benefit 1,800 b. Of the $20,000 deductible difference, $12,000 is supported by prior taxable income within the carryback period. The remaining $8,000 is unsupported. The valuation allowance reduces the net reported deferred tax asset to $3,600 ($12,000 x .30). The income tax expense is negative in this year and is labeled Income Tax Benefit. This amount increases net income for 20x8.

Resolution of the Uncertainty

2. If all or a portion of the deduction is allowed, income tax expense is reduced in the year of payment (change in estimate). Assume that $667 of the deduction was allowed (1/3 of the $2,000 deduction taken) yielding a $200 reduction in the amount of tax due, and income tax expense ($667 x .30 = $200). Dr:Liability for unrecognized tax benefit 600 Cr:Cash 400 Cr:Income tax expense 200

Example: Internal Classification - Deferred Tax Accounts

2. Net operating losses -- This topic is covered in a later lesson. It is a loss for tax purposes that can be carried forward to future years. The loss is not associated with any particular asset or liability. The related deferred tax asset is classified according to the period of expected reversal.

Categorizing Temporary Differences Two Categories Continued

2. The second category, called Deductible Temporary Differences, involves differences that initially cause a prepayment of taxes. a. In the year of origination, the item causes taxable income to increase relative to pretax accounting income. b. When the item reverses, the item causes future taxable income to be less than pretax accounting income. This is why these differences are called deductible differences. They reduce taxable income relative to pretax accounting income in the future. c. Future deductible differences give rise to deferred tax assets.

West Corp. leased a building and received the $36,000 annual rental payment on June 15, 2004. The beginning of the lease is July 1, 2004. Rental income is taxable when received. West's tax rates are 30% for 2004 and 40% thereafter. West has elected early adoption of FASB Statement No. 109, Accounting for Income Taxes. West had no other permanent or temporary differences. West determined that no valuation allowance was needed. What amount of deferred tax asset should West report in its December 31, 2004 balance sheet?

2004 rent revenue recognized for financial-accounting purposes is $18,000 (.50 x $36,000). Rent revenue to be recognized for financial-accounting purposes after 2004 (remaining rent revenue) $18,000 Less rent revenue taxable after 2004 (the entire $36,000 is taxable in 2004) ( 0) Equals future deductible difference (future taxable income will be less than future pre-tax accounting income by this amount) $18,000 Times future enacted tax rate x .40 Equals ending deferred tax asset balance $7,200 The future enacted tax rate is used to measure the deferred tax asset, because that is the tax rate that will be in effect when the deferred tax asset is realized.

Miro Co. began business on January 2, 2000. Miro uses the double-declining balance method of depreciation for financial statement purposes for its building, and the straight-line method for income taxes. On January 16, 2002 Miro elected to switch to the straight-line method for both financial statement and tax purposes. The building cost $240,000 in 2000, which has an estimated useful life of 15 years and no salvage value. Data related to the building are as follows: Year Double-declining depreciation Straight-line depreciation 2000 $30,000 $16,000 2001 $20,000 $16,000 Miro's tax rate is 40%

A change in method of depreciation is treated as an estimate change. The remaining book value is allocated over the remaining useful life of the asset. Therefore, the total future difference between book and tax depreciation as of the beginning of 2002 remains unchanged. That difference is $18,000, the difference between book and tax depreciation through the end of 2001. The pattern of reversal of this difference in the future has changed owing the change in method, but the total difference remains unchanged. Therefore, there is no reduction in the deferred tax asset at the beginning of 2002.

Define "deferred tax asset".

A current temporary difference that causes current book income to be less than taxable income.

Define "uncertain tax position".

A position taken on the Firm's tax return that reduces income tax but which may be challenged by the Taxing Authorities.

Define "deductible difference".

A temporary difference that causes future taxable income to be less than future book income is what type of temporary difference.

Assessing Whether a Valuation Allowance Valuation Account is Needed

A. A valuation account is suggested if any of the following are present: 1. A history of unused net operating losses; 2. A history of operating losses; 3. Losses expected in future years; 4. Very unfavorable contingencies. 5. A very brief carryback or carryforward period should raise serious doubts about the realization of the deferred tax asset. For example, a significant deductible temporary difference may be expected to reverse in a single year. Alternatively, the enterprise might operate in a traditionally cyclical business that would limit the length of the carryback or carryforward time period.

Depreciation, an Example of a Difference Reversing Over More than One Period

A. Depreciable plant assets often require more than one year for the full temporary difference to originate. In early years, future temporary differences appear to be deductible but should not be treated as such. The entire net future temporary difference for a depreciable asset is treated as a taxable temporary difference.

Classification for Balance Sheet Reporting

A. For external reporting, the current deferred tax accounts are netted together to form one current deferred tax asset or liability, and the noncurrent deferred tax accounts are likewise netted to form one noncurrent deferred tax asset or liability.

Relationship Between Pretax Accounting Income and Taxable Income

A. Frequently, examination problems provide only one of the two income measures. Also, some firms maintain only one set of records and adjust pretax accounting income to derive taxable income. The adjustment process is shown below: Pretax accounting income $ xx Plus and minus originating temporary differences xx Plus and minus permanent differences for the period xx Equals taxable income $ xx B. This approach simplifies the process of computing taxable income because it focuses only on the differences between the two income measures.

Sources for Realizing the Deferred Tax Asset

A. If any one of the following sources is present in sufficient amount (to achieve the 50% threshold), then no valuation allowance is required. More than one source can be used to support a deferred tax asset. 1. Expectation of future taxable income; 2. Taxable income in prior years within the two-year carryback period for net operating losses; 3. Future taxable differences; 4. Tax planning strategies.

Probability > 50%

A. If it IS "more likely than not" that the position will be sustained upon audit by the IRS, then the firm must estimate specific outcomes of the audit and probabilities associated with each. The amount of benefit recognized is the largest amount for which the cumulative probability of realization exceeds 50%.

Probability Less Than or Equal To 50%

A. If it is NOT "more likely than not" that the position will be sustained upon audit by the IRS, then income tax expense is not reduced and an additional tax liability is recognized. No benefit is recognized in the current year.

Effect of Changes in Law on Deferred Tax Accounts

A. In addition to a tax rate change, the tax law or other law or administrative agency ruling can change the tax status of an item previously included in the projected future temporary differences that are the basis for the deferred tax account balances. The resulting change in deferred taxes is recognized in income tax expense in the year of change.

Nature of Temporary Differences

A. In contrast with permanent differences which never reverse over time, temporary differences do reverse. The temporary differences are actually timing differences. These are the differences involved with the process of interperiod tax allocation - the recognition of deferred tax accounts.

General Steps for Interperiod Tax Allocation: Adjusting the Deferred Tax Accounts

A. In the previous examples, only one temporary difference was used, and there were no beginning deferred tax account balances. This section completes the discussion by including more than one temporary difference and beginning deferred tax account balances. A general process leading to the tax accrual entry is used.

Four Deferred Accounts

A. Internal deferred tax accounts are kept separate. It is therefore possible to have four deferred tax accounts internally: Current Noncurrent Deferred Tax Asset x x Deferred Tax Liability x x B. Each of the four balances is the sum of the relevant future differences as defined above, multiplied by the future enacted tax rate. For example, the current deferred tax liability balance is the sum of future taxable differences across all items giving rise to a taxable difference expected to reverse the following year, multiplied by the enacted tax rate.

Categorizing Temporary Differences A. Originating/Reversing

A. Originating/Reversing -- 1. When an item causing a temporary difference first occurs, the difference is called an originating difference. 2. In later years, the difference attributable to the item is called the reversing difference.

Specific Permanent Differences

A. Tax-Free Interest Income B. Life Insurance Expense C. Proceeds on Life Insurance D. Dividends Received Deduction E. Fines and Penalties F. Depletion

Specific Permanent Differences

A. Tax-Free Interest Income -- An example of this difference is the interest income earned on an investment in a state or municipal bond. The interest income is included in pretax accounting income, but not in taxable income. B. Life Insurance Expense -- The insurance premiums on a life insurance policy for a key employee where the firm is the beneficiary are not deductible from taxable income, but are an expense for financial reporting. C. Proceeds on Life Insurance -- In the event of the death of the key employee, the proceeds from the insurance policy are not taxable, but are included as a gain for financial reporting purposes.

Internal Classification - Deferred Tax Accounts

A. The classification of the deferred tax account is based on the classification of the item giving rise to it. 1. If a temporary difference is related to a current liability or asset, then the associated deferred tax account is also classified as current. 2. If a temporary difference is related to a noncurrent liability or asset, then the associated deferred tax account is also classified as noncurrent.

Reporting the Deferred Tax Asset and Valuation Allowance

A. The full deferred tax asset and valuation allowance are reported in the balance sheet. Alternatively, the deferred tax asset is reported net in the balance sheet with the footnotes reporting the full asset and the valuation allowance.

Nature of Permanent Differences

A. The permanent differences are those, due to the existing tax laws, that will not reverse themselves over an extended period of time. In other words, these differences never reverse, and the passage of time will not cause the differences to disappear. The treatment of permanent differences under the two reporting systems is permanently different. Some of the more common permanent differences follow.

Uncertainty in Income Tax - The Issue

A. The preparation of a firm's tax return is affected by many estimates and uncertainties. Uncertain tax positions are those that may not be sustainable on audit by the IRS. Examples include uncertain deductions, tax credits, and revenue exemptions. The firm includes the uncertain position in its tax return thus reducing its income tax liability but there remains uncertainty as to the actual benefit of that deduction. If there is at least a 1/3 probability that the tax position will be sustained, there is no legal or professional censure for taking that position.

General Tax Accrual Entry

A. The previous definitions and categorization of differences as permanent and temporary are used in this lesson to develop the year-end tax accrual entry. B. The following entry is a generalization of the year-end tax accrual entry assuming that the year's full tax liability is paid early the following year. Income Tax Expense a "plug" figure Deferred Tax Asset * see below Deferred Tax Liability ** see below Income Tax Payable taxable income x current tax rate * The amount to increase the deferred tax asset to its required ending balance, which is the total future deductible temporary difference multiplied by the future enacted tax rate. Estimated tax rates are not used, only enacted tax rates. If the required change is a decrease, the asset would be credited. ** The amount to increase the deferred tax liability to its required ending balance which is the total future taxable temporary difference multiplied by the future enacted tax rate. If the required change is a decrease, the liability would be debited. Future tax rates are used to measure the deferred tax accounts because the future tax consequences will be settled or recovered at the future tax rate. Note:The future and current tax rates are the same if Congress has not enacted a new rate for future years by the end of the current year.

Accounting for Income Taxes - Theoretical Considerations

A. The theoretical considerations of accounting for income taxes include the accrual basis of accounting, the matching principle, and the proper recognition of assets and liabilities. B. Income tax expense is recognized when it is incurred, regardless of when the payment is actually made to the Internal Revenue Service. The process of recognizing income tax expense is called interperiod tax allocation. This process ensures proper matching of income tax expense with revenues.

Define "permanent difference".

An amount that appears in the tax return or income statement but never both.

Define "temporary difference".

An item of revenue or expense that, over the total life of the item, will affect pretax accounting income and taxable income in the same total amount but will be recognized in different amounts in any given year for financial reporting and tax purposes.

If the tax rate changes as income levels change, what rate is used to determine the change in deferred tax accounts?

Average future enacted tax rate is used to determine the change in deferred tax accounts.

(Start of CPAexcel Exam Questions) 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. An item is included in the calculation of net income in one year and in taxable income in a different year. 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.

Assessing Whether a Valuation Allowance Valuation Account is Needed

B. Evidence suggesting that a valuation account is not needed must also be considered, as exemplified by the following: 1. Existing contracts or sales backlog will produce more than enough taxable income to realize the deferred tax asset; 2. An excess of appreciated asset value over the tax basis of the entity's net assets will produce more than enough taxable income to realize the deferred tax asset; 3. A strong earnings history that suggests that taxable income in the future will be enough to realize the deferred tax asset. C. Both positive and negative evidence is used when making the decision about whether to recognize a valuation allowance.

Sources for Realizing the Deferred Tax Asset

B. First Source -- The first source is the one most popularly used. If sufficient future taxable income is expected, then the deferred tax asset most likely will be realized. The deferred tax asset is credited upon realization, rather than crediting additional income taxes payable. No valuation account is necessary.

Nature of Permanent Differences

B. For purposes of the CPA exam, our recommendation is to be familiar with the most common specific permanent differences. There are far fewer of these relative to temporary differences. Also, be able to identify a new difference as permanent, if given sufficient information about how the item is treated for financial reporting and for tax.

Categorizing Temporary Differences B. Future Differences

B. Future Differences -- The classification of temporary differences is based on the future reversal rather than the originating amount because deferred tax asset and liability balances reflect the future tax consequences of transactions that have already occurred.

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.

B. I and II. Correct! 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.

Effect of Changes in Law on Deferred Tax Accounts

B. One example is the 2010 Patient Protection and Affordable Care Act, as amended (the US comprehensive health care reform act), which eliminated the tax deduction for the portion of prescription drug costs for which the employer receives a subsidy. The change is effective for taxable years beginning after December 31, 2012. 1. The cost to provide prescription drug coverage to retirees is part of postretirement benefit expense which is projected on an accrual basis at the end of each reporting year (this topic is covered at length in another lesson). This cost was previously projected at the presubsidy amount because the entire cost was deductible. Now, with the elimination of the deduction for the portion subsidized, the future projected deductible difference is reduced. 2. The firm must immediately recompute the future projected deductible difference for this portion of postretirement benefit expense (actuaries provide this computation). The result is a reduction in the firm's deferred tax asset and an immediate increase in income tax expense, reducing earnings, in the year the Act was finalized by Congress (2010). The recalculation is for periods after the effective date of the Act.

Depreciation, an Example of a Difference Reversing Over More than One Period

B. Other examples include prepaids and warranties covering more than one year. In each case, the full future difference at the end of each year is treated the same - either as a future taxable difference (prepaid) or deductible difference (warranty).

General Steps for Interperiod Tax Allocation: Adjusting the Deferred Tax Accounts

B. Steps Leading to the Tax Accrual Entry: 1. Compute taxable income and multiply by current tax rate. Result = income tax payable -------------- to tax accrual entry --------------------------> XX 2. Analyze all future individual temporary differences, separating them into taxable and deductible categories. 3. Apply the future enacted rate(s) to the taxable differences and aggregate. Result = required ending deferred tax liability balance = xx Subtract beginning deferred tax liability balance (xx) Equals required increase or decrease in deferred tax liability ---------------------------> XX 4. Apply the future enacted rate(s) to the deductible differences and aggregate. Result = required ending deferred tax asset balance = xx Subtract beginning deferred tax asset balance (xx) Equals required increase or decrease in deferred tax asset -----------------------------> XX 5. Net sum equals income tax expense XX

Probability > 50% (Continued)

B. The process of identifying outcomes and estimating probabilities must assume that the taxing authority will have full knowledge of the tax situation. C. The classification of the liability for unrecognized tax benefit is based on the period of expected settlement. Tax cases often require more than one year for resolution. Therefore, the liability is often classified as noncurrent.

Classification for Balance Sheet Reporting

B. The rationale for this offsetting is that a future deductible difference reversing next year naturally cancels a future taxable difference reversing next year. For example, a future taxable difference of $10,000 reversing next year cancels a $7,000 deductible difference reversing next year leaving future taxable income exceeding book income by $3,000. The net current deferred tax liability is $900 assuming a tax rate of 30%.

Uncertainty in Income Tax - The Issue

B. This section explains how the financial benefit of such uncertain tax positions is reported. Income tax expense is reduced (benefit recognized) for an uncertain tax position only if it is "more likely than not" (> 50%) that the position will be sustained upon audit by the IRS. C. A two-step approach is applied: (1) Is the uncertain position more likely than not to be sustained?, (2) If yes, then a probabilistic approach is applied to determine the amount of benefit recognized in the current year.

Resolution of the Uncertainty

B. When the benefit recognized in income tax expense in a prior year is not the same amount as the final actual benefit determined upon resolution, the difference is recognized in income tax expense in the year of resolution (change in estimate). 1. If no deduction is allowed: Dr:Income tax expense 420 Dr:Liability for unrecognized tax benefit 180 Cr:Cash ($2,000 x .30) 600 2. If a $1,600 deduction is allowed: Dr:Liability for unrecognized tax benefit 180 Cr:Income tax expense ($1,600 - $1,400) x .30 60 Cr:Cash ($2,000 - $1,600).30 120 3. If the entire $2,000 deduction is allowed: Dr:Liability for unrecognized tax benefit 180 Cr:Income tax expense ($2,000 - $1,400).30 180

(The Start of CPAexcel Flashcards) How are temporary differences with no balance sheet account association classified?

Based on expected year of reversal.

Black Co., organized on January 2, 2004, had pre-tax financial statement income of $500,000 and taxable income of $800,000 for the year ended December 31, 2004. The only temporary differences are accrued product-warranty costs, which Black expects to pay as follows: 2005 $100,000 2006 $50,000 2007 $50,000 2008 $100,000 The enacted income tax rates are 25% for 2004, 30% for 2005 through 2007, and 35% for 2008. Black believes that future years' operations will produce profits. In its December 31, 2004 balance sheet, what amount should Black report as deferred tax asset?

Black will recognize a deferred tax asset, rather than a deferred liability, because its current taxable income is greater than its current pre-tax financial income. This occurs because Black cannot deduct product warranty cost for tax purposes until the costs are incurred (paid), but, for financial reporting, it must recognize those estimated costs as an expense in the period of the related sales. The result is an amount that will be deductible in the future for tax purposes: a deferred tax asset. Because it is deductible now for financial reporting and will be deductible in the future for tax purposes, it is a temporary difference. The amount of deferred tax asset (or, in another case, deferred tax liability) on temporary differences is calculated by multiplying the amount of the temporary differences by the enacted tax rate for the period(s) during which the deferred asset (or liability) is expected to be realized. Therefore, Black's deferred tax asset would be calculated as: 2005 $100,000 x .30 = $30,000 2006 $50,000 x .30 = $15,000 2007 $50,000 x .30 = $15,000 2008 $100,000 x .35 = $35,000 Total deferred tax asset = $95,000 Please note: This was the first year of operation for Black. Therefore, there was no previously recorded tax asset or liability. Since Black expects operating profits in future years, it implicitly expects to realize the benefit of the deferred tax asset and no valuation allowance is necessary. A, B, and C are incorrect. The tax benefit (asset) is the amount to be recognized as deductible in each future year times (multiplied by) the enacted tax rate applicable to each future year.

If future enacted tax rates are not the same as the current rate and future temporary differences originated in the current period, which rate(s) do(es) income tax expense reflect?

Both current and future enacted tax rates are reflected.

Lake Corp., a newly organized company, reported pre-tax financial income of $100,000 for 2005. Among the items reported in Lake's 2005 income statement are the following: Premium on officer's life insurance with Lake as owner and beneficiary $15,000 Interest received on municipal bonds 20,000 Lake elected early application of FASB Statement No. 109, Accounting for Income Taxes. The enacted tax rate for 2005 is 30% and 25% thereafter. In its December 31, 2005 balance sheet, Lake should report a deferred income tax liability of

Both listed items are permanent differences. These are differences that never reverse and are not used in the determination of deferred tax accounts. Both income tax expense and income tax liability are affected the same way by these items. A deferred income tax liability is based on future taxable differences at the end of the reporting year. There are no such differences. Therefore, there is no deferred tax liability.

Example: Internal Classification - Deferred Tax Accounts

C. For some items, the future temporary difference is not associated with a specific balance sheet account. For these items, the classification of the deferred tax account is based on the expected period of reversal. For the portion expected to reverse in the year following the current year, the deferred tax account is classified as current. Otherwise the classification is noncurrent. 1. Organization costs -- This cost is related to the entire firm's early activities and is expensed immediately for financial reporting purposes. The cost is deducted for tax purposes over a relatively short period. In the period of incurrence, a future deductible difference is generated for the portion deductible in future periods. The amount of the deduction for the next year is included in the future deductible differences leading to current deferred tax asset. The remainder leads to the noncurrent deferred tax asset.

Accounting for Income Taxes - Theoretical Considerations

C. However, GAAP deemphasizes the matching concept. Rather, it adopted the asset/liability approach for measurement of income tax effects. 1. The emphasis is on the correct measurement of the income tax assets and liabilities. 2. Deferred tax assets and liabilities are now measured directly, along with the income tax liability. 3. Income tax expense is now a derived amount - a plug figure. D. This does not mean that income tax expense for a period does not reflect the income tax cost of transactions in the period. Rather, it means that greater emphasis is placed on measuring the changes in balance sheet accounts than in the income statement account - income tax expense.

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. Recognition of assets and liabilities. Correct! 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.

Sources for Realizing the Deferred Tax Asset

C. Second Source -- The second source involves carrybacks of net operating losses. If a future deductible amount (giving rise to the deferred tax asset) were the only item to appear in the future tax return, a net operating loss would occur. A net operating loss may be carried back 2 years for a refund of taxes paid earlier. Thus, if a firm has a deferred tax asset at 12/31/x7 and the associated future deductible difference is scheduled to reverse in 20x8, that deductible difference could be carried back first to 20x6 and reduce taxable income in that year causing a refund of taxes. 1. If large enough, the remainder then could be carried back to 20x7 for additional refund. Thus, prior year taxable income within the carry-back period is a source of realizing the deferred tax asset, and, if present, alleviates the need for a valuation allowance.

Reporting the Deferred Tax Asset and Valuation Allowance

C. The tax rate used to measure the deferred tax asset is based on the source of realization. For example, if the only source of realization of the deferred tax asset is the carryback of the relevant deductible difference, the tax rate in the years available for carryback is used to measure the deferred tax asset.

Classification for Balance Sheet Reporting

C. Therefore, a firm will report at most two net deferred tax accounts in the balance sheet. The current and non-current deferred tax assets are not added together, nor are the current and non-current deferred tax liabilities.

Categorizing Temporary Differences Two Categories

C. Two Categories -- For purposes of interperiod tax allocation and recording the annual income tax accrual entry, temporary differences are classified into two categories. 1. The first category, called Taxable Temporary Differences, involves differences that initially cause a postponement in the payment of taxes. a. In the year of origination, the item causes taxable income to decline relative to pretax accounting income. b. When the item reverses, the item causes future taxable income to exceed pretax accounting income. This is why these differences are called taxable differences. They increase taxable income relative to pretax accounting income in the future. c. Future taxable differences give rise to deferred tax liabilities.

General Steps for Interperiod Tax Allocation: Adjusting the Deferred Tax Accounts

Caution -- Occasionally the CPA exam has asked questions requiring the candidate to determine the income tax payable ending balance after the payment of estimated tax payments. Assume the current tax liability is $50,000 (taxable income x current tax rate). If the firm has made a total of $35,000 of estimated tax payments, then the income tax liability to be reported in the balance sheet is $15,000 ($50,000 - $35,000). This aspect has little effect on the main issue at hand: completing the tax accrual entry.

On January 1, 2003, Warren Co. purchased a $600,000 machine, with a five-year useful life and no salvage value. The machine was depreciated by an accelerated method for book and tax purposes. The machine's carrying amount was $240,000 on December 31, 2004. On January 1, 2005, Warren changed retroactively to the straight-line method for financial-statement purposes. Warren can justify the change. Warren's income tax rate is 30%. On January 1, 2005, what amount should Warren report as deferred income tax liability as a result of the change?

Changes in depreciation method are treated prospectively. Prior-year depreciation amounts are unchanged. Therefore, as of the beginning of the year of change, no future temporary difference is generated. But starting at the end of the year of change, a deferred tax liability will be recorded for the future difference between book and tax depreciation, now that the methods are different for those reporting systems.

List the four deferred tax accounts possible.

Classified separately, therefore: 1. Current deferred tax asset; 2. Noncurrent deferred tax asset; 3. Current deferred tax liability; 4. Noncurrent deferred tax liability.

(Start of CPAexcel Exam Questions) On June 31, 2004, Ank Corp. pre-paid a $19,000 premium on an annual insurance policy. The premium payment was a tax-deductible expense in Ank's 2004 cash-basis tax return. The accrual-basis income statement will report a $9,500 insurance expense in 2004 and 2005. Ank elected early application of FASB Statement No. 109, Accounting for Income Taxes. Ank's income tax rate is 30% in 2004 and 25% thereafter. In Ank's December 31, 2004 balance sheet, what amount related to the insurance should be reported as a deferred income tax liability?

Correct! The future temporary difference at December 31, 2004 is $9,500, the amount of insurance expense to be recognized for financial-reporting purposes. The entire $19,000 deduction was taken for tax purposes in 2004. Therefore, no further deduction will be taken beyond 2004. The difference is taxable, because future taxable income exceeds future pre-tax accounting income from transactions through 2004. The deferred tax liability uses the future tax rate, because that is the rate at which the deferred taxes will be paid. The ending deferred tax liability for 2004 = $2,375 = .25($9,500).

Current Income Tax Provision

Current Income Tax Provision -- Also called current portion of income tax expense and current provision for income tax. This term is used in the income statement to refer to the amount of income taxes due for the year. This amount is the same as the income tax liability for the year.

How are deferred tax accounts offset for reporting?

Current accounts are offset; noncurrent accounts are offset; two net accounts remain for reporting.

Thorn Co. applies Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. At the end of 2005, the tax effects of temporary differences are as follows: Tax Assets (Liabilities) Deferred Related Asset Classification Accelerated tax depreciation ($75,000) Non-current asset Additional costs in inventory for tax purposes $25,000 Current asset ($50,000) ======== A valuation allowance was not considered necessary. Thorn anticipates that $10,000 of the deferred tax liability will reverse in 2006. In Thorn's December 31, 2005 balance sheet, what amount should Thorn report as non-current deferred tax liability?

Current and non-current deferred tax accounts are not netted together for balance sheet disclosure. In this case, there is a non-current deferred tax liability, and a current deferred tax asset. Therefore, the full $75,000 of non-current deferred tax liability is separately disclosed in the balance sheet. Even though a portion of the liability is expected to reverse within one year of the balance sheet date, that does not change the classification of any of the deferred tax liability account. It is the related asset classification that determines current or non-current classification. Because the deferred tax liability is related to a non-current asset, the entire amount is classified as non-current.

How are deferred tax accounts reported on the balance sheet?

Current assets and liabilities are netted. Noncurrent assets and liabilities are netted.

Short-term prepaid rent gives rise to what type of deferred tax account and how is it classified?

Current deferred tax liability.

(Start of CPAexcel Exam Questions) According to FASB Statement No. 109, Accounting for Income Taxes, which of the following items should affect current income tax expense for 2005?

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.

What tax rate is used for computing tax liability?

Current tax rate is the rate to apply.

Are current year or future permanent differences used in the current year tax accrual entry?

Current year is used.

Specific Permanent Differences

D. Dividends Received Deduction -- The dividends received deduction is a deduction for tax purposes equal to 80% (amount subject to change) of qualified dividends received. It is an amount of dividends received that is not subject to tax. However, the entire amount of dividends received is included in pretax accounting income. There is no similar deduction for financial reporting purposes. E. Fines and Penalties -- Many fines, penalties and expenses resulting from a violation of law are not deductible for tax purposes, but are recognized as an expense or loss for financial reporting purposes. F. Depletion -- GAAP depletion (cost depletion) is based on the cost of a natural resource used up. Tax depletion is based on revenues of resource sold. The difference in any year is a permanent difference.

Categorizing Temporary Differences Examples of Taxable Temporary Differences

D. Examples of Taxable Temporary Differences -- (future taxable income > future pretax accounting income):

Sources for Realizing the Deferred Tax Asset (Third Source)

D. Third Source -- The third source involves the ability of future taxable differences and the future deductible differences (giving rise to the deferred tax asset) to cancel within the carryback or carryforward period. Assume a firm has a future $4,000 deductible temporary difference (giving rise to a $1,200 deferred tax asset assuming a 30% tax rate), and it also has a $6,000 future taxable difference. The deductible difference can be carried back 2 years or forward 20 years. If the taxable difference is within that total carryback or carryforward period, then the deductible difference will cancel $4,000 of the taxable difference, which realizes the deferred tax asset.

What effect does a reversing taxable difference have on the tax accrual entry?

Decreases the required ending deferred tax liability balance.

Deductible After Recognized for the Books

Deductible After Recognized for the Books -- Expenses or Losses that are Deductible after they are Recognized in Financial Income

Deductible Before Recognized for the Books

Deductible Before Recognized for the Books -- Expenses or Losses that are Deductible before they are Recognized in Financial Income

Deductible Items

Deductible Items -- Amounts that cause income tax to decrease. This is an Internal Revenue Code term and typically refers to expenses that cause taxable income to decrease.

What type of differences are temporary differences caused by regular warranties?

Deductible differences.

Deferred Income Tax Provision

Deferred Income Tax Provision -- The amount of income tax expense that is not currently due. This amount equals the net sum of the change in the deferred tax accounts.

Deferred Tax Asset

Deferred Tax Asset -- The recognized tax effect of future deductible temporary differences. These differences, caused by transactions that have occurred as of the balance sheet date, will cause future taxable income to decrease relative to pretax accounting income.

Deferred Tax Liability

Deferred Tax Liability -- The recognized tax effect of future taxable temporary differences. These differences, caused by transactions that have occurred as of the balance sheet date, will cause future taxable income to increase relative to pretax accounting income.

Organization costs give rise to what type of deferred tax account and how is it classified?

Deferred tax asset; classification depends on expected period of reversal.

(Start of CPAexcel Flashcards) Define "taxable temporary differences".

Differences that initially cause a postponement in the payment of taxes.

Define "deductible temporary differences".

Differences that initially cause a prepayment of taxes.

Note

Do TBS, there is one.

Sources for Realizing the Deferred Tax Asset (Fourth Source)

E. Fourth Source -- The fourth source, tax planning strategies, are actions that (1) must result in the realization of deferred tax assets, (2) might not be taken otherwise, and (3) are prudent and feasible. An example of such a strategy is to accelerate the timing of a future deductible difference so that it falls within the carryback period to enable a tax refund of prior year taxes. Another is the ability to sell a building at a taxable gain (and leasing it back to avoid the disruption of moving the business) to avoid the expiration of a deductible difference in the current year. The resulting increase in taxable income will help to cancel (use) the deductible difference before it expires.

Illustrative Example (No beginning deferred tax balances)

E. Income tax expense is the sum of the increase in the deferred tax liability and income taxes payable. This is the only way to compute income tax expense. It is not the product of the current tax rate and pretax accounting income. The $24,250 income tax expense is the total amount of tax expected to be paid on transactions occurring in Year 1. This total amount is allocated via interperiod tax allocation to the current provision of $22,500 (the income tax liability for Year 1) and $1,750 (the amount deferred to Year 2). The $1,750 is the amount of tax payable in the future based on transactions that occurred by the end of Year 1. Abbreviated income statement for year 1: Operating Income Before Rent Expense $100,000 Rent Expense (20,000) Municipal Bond Interest 10,000 Pretax Accounting Income 90,000 Income Tax Expense (from tax accrual entry) (24,250) Net income $ 65,750

Accounting for Income Taxes - Theoretical Considerations

E. Summary -- The main effects of applying the asset/liability approach are: 1. Income tax expense for the period reflects the amount that will ultimately be payable on the year's transactions. 2. The income tax payable account, deferred tax asset account, and deferred tax liability account report the remaining tax receivables and obligations facing the firm from transactions that have already occurred as of the balance sheet date. 3. Income tax expense is an amount derived from the changes in the tax-related assets and liabilities. It is no longer a directly computed value.

"DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - Classification -

Carryforward of net operating loss (more likely than not realizable) "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTA Classification - Both current and noncurrent

Estimated warranty expense "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTA Classification - Both current and noncurrent

Unearned revenue "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTA Classification - Current

Bad debt expense (allowance method for the books) "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTA Classification - Current

Recognized estimated lawsuit loss for books "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTA Classification - Current

Installment sales (point of sale recognition for books) "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTL Classification - Both current and noncurrent

Completed contract method for tax, percentage of completion method for the books "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTL Classification - Current

Prepaid expenses "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTL Classification - Current

Unrealized gain on trading securities "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTL Classification - Current

(Start of CPAexcel Task Based simulation) Straight-line depreciation for financial reporting, MACRS for tax reporting "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTL Classification - Noncurrent

Accounts receivable "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - DTL Classification - Current

Tax receivable from net operating loss carryback "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - None Classification - N/A

Excess of statutory depletion over cost depletion "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - Perm Classification - N/A

Fines for violation of law "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - Perm Classification - N/A

Municipal bond interest "DTA" if the item causes an increase in deferred tax assets "DTL" if the item causes an increase in deferred tax liabilities "Perm" if the item is a permanent difference "None" if the item is not one of the above

Effect - Perm Classification - N/A

What tax rate should be used when computing the change in the deferred tax accounts?

Enacted future tax rates (which could be the same as the current tax rate if rates have not been changed).

How is the amount of a valuation allowance determined?

Enough to reduce deferred tax asset to amount that has a better than 50% chance of being realized.

What does a history of unused net operating losses suggest?

Evidence suggesting that the deferred tax asset will not be realized.

Example - Beginning Deferred Tax Account Balances, Multiple Differences

Example: Year 1 Pretax accounting income: $60,000 Ending prepaid insurance balance (coverage for Year 2) 10,000 Recognized lawsuit contingent liability (recognized loss) (to be resolved in Year 2) 15,000 Tax rates: current (30%), enacted for Year 2 and later (35%) Steps: To tax accrual entry 1. Taxable income = $60,000 - $10,000 + $15,000 = $65,000 The prepaid insurance is subtracted because it is an amount paid in Year 1, but not recognized as expense for the books. The contingent loss is added because it is a recognized loss for the books but is not deductible for taxes until paid. Income tax payable = $65,000(.30) = $19,500 2. Future taxable difference: $10,000 prepaid insurance. (Future pretax accounting income will decrease relative to taxable income when the insurance expense is recognized for the books.) Future deductible difference: $15,000 contingent liability. (Future taxable income will recognize the loss as a deduction when paid reducing taxable income relative to pretax accounting income.) 3. Required ending deferred tax liability = $10,000(.35) = $3,500 Beginning deferred tax liability (0) Increase in deferred tax liability 3,500 4. Required ending deferred tax asset = $15,000(.35) = $5,250 Beginning deferred tax asset (0) Increase in deferred tax asset (5,250) 5. Income Tax Expense $17,750 Year 1 Tax Accrual Entry: Income Tax Expense 17,750 Deferred Tax Asset 5,250 Deferred Tax Liability 3,500 Income Tax Payable 19,500 Current Provision of Income Tax Expense $ 19,500 Less Deferred Provision ($5,250 - $3,500) (1,750) Equals Total Income Tax Expense $17,750

Example: Some Temporary Differences

Example: 1. An example of this type of difference involves the use of the Installment Sales Basis of Accounting for income tax purposes. The accrual basis of accounting is used by the entity for financial reporting purposes, while a version of the cash basis, the Installment Sales Basis, is used for income tax purposes. The net installment accounts receivable at year-end reflects the future temporary difference. 2. The use of the equity method to recognize income from investments in equity securities is another example. The equity method is used for financial reporting purposes, and the amount of income reported on the income statement corresponds to the percentage of stock owned in the investee multiplied by the reported earnings of the investee. Investment income recognized for tax purposes will be equal to the dividends received in a given year (after the dividends received deduction, if applicable).

Example - Beginning Deferred Tax Account Balances, Multiple Differences

Example: Year 2 Pretax Accounting Income $80,000 Depreciation for financial reporting and tax purposes on a plant asset purchased Year 2 will be: Year Book Depreciation Tax Depreciation 2 $10,000 $16,000 3 10,000 9,000 4 10,000 5,000 Totals $30,000 $30,000 $5,000 of municipal bond interest was received. $8,000 worth of goods were sold on the installment basis. The entire amount is recognized in revenue for book purposes. No cash is collected in Year 2. $11,000 of estimated warranty expense is recognized; $4,000 was spent to service claims. Tax rates have not changed. Current and future years are taxed at 35%. Steps: To tax accrual entry 1. Taxable Income: Pretax Accounting Income $80,000 Municipal Bond Interest (5,000) Expiration of Prepaid Insurance from Year 1 10,000 Lawsuit Loss from Year 1, Paid in Year 2 (15,000) Excess of Tax Depreciation over Book Depreciation (6,000) Installment Sales Revenue Recognized for Books (8,000) Excess of Warranty Expense over Warranty Deduction 7,000 Taxable Income $63,000 Income Tax Payable = $63,000 x (.35) = 22,050 The expiration of the prepaid insurance from Year 1 reduced pretax accounting income but does not reduce taxable income in Year 2 because the entire prepayment was deducted in Year 1. The lawsuit loss was not recognized in pretax accounting income because it was recognized in Year 1. It is paid in Year 2 and therefore deducted in Year 2. 2. Future taxable differences: To tax accrual entry Excess of book depreciation over tax depreciation $ 6,000 Installment sales revenue to be recognized for tax 8,000 Total future taxable differences $14,000 Future deductible difference: Excess of warranty expense over warranty deduction 7,000 (Note that the temporary differences from Year 1 have reversed and no longer are "future" differences with respect to the end of Year 2.) To tax accrual entry 3. Required Ending Deferred Tax Liability = $14,000(.35) = $4,900 Beginning Deferred Tax Liability (3,500) Increase in Deferred Tax Liability 1,400 4. Required ending deferred tax asset = $7,000(.35) = $2,450 Beginning deferred tax asset (5,250) Decrease in deferred tax asset 2,800 5. Income tax expense $26,250 Year 2 Tax Accrual Entry Income Tax Expense 26,250 Deferred Tax Asset 2,800 Deferred Tax Liability 1,400 Income Tax Payable 22,050 Current provision of income tax expense $22,050 Plus deferred provision ($1,400 + $2,800) 4,200 Equals total income tax expense $26,250

Example: Depreciation, an Example of a Difference Reversing Over More than One Period

Example: A plant asset is purchased at the beginning of Year 1 and will be depreciated as indicated: Year Tax Depreciation Book Depreciation 1 $400 $200 2 300 200 3 200 200 4 100 200 5 0 200 Totals $1,000 $1,000 At the end of Year 1, the total future temporary difference is $200, the difference between Years 2-5 depreciation for the two systems ($200 + $200 + $200 + $200) - ($300 + $200 + $100). More depreciation ($200 more) in the future (after Year 1) will be recognized for book purposes than for tax purposes. Thus, future taxable income will exceed pretax accounting in the future in total causing the difference to be classified as taxable at the end of Year 1. Although the difference for Year 2 (only) appears to be a deductible difference (because Year 2 taxable income will be less than pretax accounting income by $100), that difference is an originating difference, not a reversing difference. Thus, the correct approach is to treat the entire future difference at the end of Year 1 as a taxable difference.

Examples of Taxable Temporary Differences Installment Sales

Example: During Year 1, a firm sells $6,000 worth of goods on the installment basis. For financial reporting purposes, the firm uses the point-of-sales method to record revenue and recognizes the entire $6,000 in Year 1. For tax purposes, the firm uses the installment method, which postpones revenue recognition until cash is received. No cash is received in Year 1 on the sale and the firm has no tax liability for this amount. At the end of Year 1, the firm has a future taxable difference of $6,000. In a later year, when cash is received, the firm's taxable income will exceed pretax accounting income by $6,000 because of transactions that have occurred through the end of Year 1. The future temporary difference is found on the balance sheet in the Installment Receivable account, which has a balance of $6,000, the amount not yet collected.

Examples of Taxable Temporary Differences

Example: For financial reporting and tax purposes, depreciation on a plant asset purchased Year 1 will be: Year Book Depreciation Tax Depreciation 1 $10,000 $16,000 2 10,000 9,000 3 10,000 5,000 Totals $30,000 $30,000 At the end of Year 1, the firm has a future taxable difference of $6,000, the difference between depreciation for Years 2 and 3 under the two systems. ($20,000 - $14,000). At the end of Year 1, the firm knows that its future taxable income will exceed pretax accounting income by $6,000 because of transactions that have occurred through the end of Year 1. At the end of Year 1, the tax basis of the asset is the book value for tax purposes and equals $14,000 (cost of $30,000 - $16,000 depreciation in Year 1). The net book value for balance sheet purposes is $20,000 ($30,000 - $10,000). The difference between the two book value amounts is the future temporary difference of $6,000.

Example: Probability Less Than or Equal To 50%

Example: Taxable income is $20,000 and the tax rate is 30%. Taxable income reflects an uncertain deduction of $2,000. The firm believes there is less than a 50% chance of the $2,000 deduction being allowed. Dr:ncome tax expense 6,600 Cr:Income tax payable ($20,000 x .30) 6,000 Cr:Liability for unrecognized tax benefit ($2,000 x .30) 600 Income tax expense is not reduced in this case - the deduction is not recognized in the financial statements. Upon resolution however, future income tax expense is reduced if the deduction is upheld. The liability for unrecognized tax benefits should not be netted against deferred tax accounts. The reason for this second liability is that the firm is proceeding with the uncertain benefit on its tax return; thus the income tax payable reflects the uncertain deduction. The firm will pay only the smaller amount in the current year with resolution of the unrecognized benefit later. The above entry reflects the expectation that the firm will have to pay the additional $600 at a later date.

Example: Probability > 50%

Example: Taxable income is $20,000 and the tax rate is 30%. Taxable income reflects an uncertain deduction of $2,000. The firm believes there is more than a 50% chance of a deduction in some amount being allowed. Estimated amounts of allowable deductions along with their probabilities appear below: Amount Allowed Probability Cumulative Probability $2,000 .15 .15 1,600 .20 .35 1,400 .30 .65 400 .20 .85 200 .15 1.00 The tax benefit recognized is based on the $1,400 amount, which is the largest amount for which the cumulative probability exceeds 50%. No reduction in income tax expense is recognized for the remaining portion of the deduction ($600). Dr:Income tax expense 6,180 Cr:Income tax payable ($20,000 x .30) 6,000 Cr:Liability for unrecognized tax benefit ($600 x .30) 180 Income tax expense is reduced by $420 as a result of the recognition of the current tax benefit associated with the $1,400 amount ($1,400 x .30 = $420).

Example: Relationship Between Pretax Accounting Income and Taxable Income

Example: The four temporary differences in the previous examples are repeated below, along with additional information for Year 1. Year 1 Information Pretax accounting income $100,000 Fines and penalties 9,000 Municipal bond interest received 14,000 Depreciation deduction 16,000 Depreciation expense recognized for books 10,000 Taxable installment sales 0 Installment sales revenue recognized for books 6,000 Warranty deduction 1,000 Warranty expense recognized for books 8,000 Taxable service revenue 22,000 Service revenue recognized for books 10,000 Computation of taxable income: Balance sheet account: Pretax accounting income $100,000 Plus nondeductible fines and penalties 9,000 Less nontaxable municipal bond interest received (14,000) Excess of tax over book depreciation (6,000) Equipment book value Excess of book over tax sales revenue (6,000) Installment receivable Excess of book over tax warranty expense 7,000 Warranty liability Excess of tax over book service revenue 12,000 Unearned revenue Taxable income $102,000 The first two adjustments, fines and penalties, and municipal bond interest are permanent differences. Pretax accounting income was reduced by fines and penalties but they are not deductible for tax purposes and therefore must be added back in computing taxable income. The opposite is true for municipal bond interest. It is included in pretax accounting income but is not taxable and therefore is subtracted in computing taxable income. The remaining adjustments are all temporary differences. The originating differences are used to convert pretax accounting income to taxable income. The reversing differences will enter into the recognition of deferred tax accounts. For example, $16,000 of depreciation is deducted for tax purposes but pretax accounting income reflects only $10,000 of depreciation. Thus, an additional $6,000 must be subtracted in computing taxable income.

Example: Classification for Balance Sheet Reporting

Example: After recording the year's tax accrual entry, the firm's ending deferred tax balances are: Current Noncurrent Deferred Tax Asset $300 $600 Deferred Tax Liability 900 400 On the balance sheet, this firm would report: Current Deferred Tax Liability $600 Noncurrent Deferred Tax Asset 200

Example: Taxable Before Recognized for the Books

Example: An example of this type of difference involves the recognition of rent revenue or subscription revenue. For financial reporting purposes, the rent revenue or subscription revenue is recognized in the year that it is earned. For tax purposes, the rent revenue or subscription revenue is recognized in the year that the related cash payment is received. The unearned subscription revenue account reflects the future temporary difference. On September 1, 20x7, the Dolphin Company rented a vacant warehouse to the Raider Company. The lease term was one year, from September 1, 20x7 through August 31, 20x8. The warehouse annual rental fee was $24,000, which was paid in full on September 1, 20x7. For financial reporting purposes, $8,000 rental revenue will be reported in 20x7, and $16,000 rental revenue will be reported in 20x8. For tax purposes, the entire $24,000 will be reported on the 20x7 tax return. The total rent revenue is the same under the two systems of reporting but the timing of recognition is different in each year affected. At the end of 20x7, the $16,000 balance in unearned rent (a liability) equals the future temporary difference to reverse in 20x8.

Example: Deductible After Recognized for the Books

Example: An example of this type of difference involves the recognition of warranty expense. For financial reporting purposes, warranty expense is usually estimated and recognized in the year the related merchandise is sold. For tax purposes, warranty expense is recognized in the year the defective products are returned by the customers. The warranty liability reflects the future temporary difference.

Example: Deductible Before Recognized for the Books

Example: An example of this type of difference is depreciation recorded for income tax purposes. For financial reporting purposes, depreciation is recorded over the estimated useful life of an asset. For tax purposes, depreciation is recorded over shorter time frames called recovery periods. In addition, for tax purposes, an accelerated depreciation method is typically employed.

Example: Internal Classification - Deferred Tax Accounts

Example: Assume in year 1 that $50,000 of organization costs are incurred. They are deductible over years 1-5 at even amount per year. The future deductible difference is $40,000 at the end of year 1 (the first $10,000 is deductible in year 1). Of that amount, $10,000 will reverse in year 2. This $10,000 amount is included in the determination of the firm's ending current deferred tax asset for year 1. With a tax rate of 30%, the current deferred tax asset is increased $3,000. The noncurrent deferred tax asset is increased $9,000 ($30,000 x .30).

Example: Accounting for Income Taxes - Theoretical Considerations

Example: If future enacted tax rates have changed, the measurement of the deferred tax assets and liabilities will reflect the future tax rates because those are the rates that will be in effect when the deferred tax assets and liabilities are realized and paid. A pure matching approach would apply the current tax rate to a measure of pretax accounting income and directly measure income tax expense. The deferred tax asset and liability would be derived concepts.

Excel: General Rule for Accounting for Permanent Differences

Example: Pretax accounting income is $20,000 and taxable income is $22,000. The only difference is a $2,000 fine that is recognized for accounting purposes but is not deductible for tax purposes. If the tax rate is 30%, the income tax accrual entry is: Dr:Income Tax Expense ($22,000 x .30) 6,600 Cr:Income Tax Payable 6,600 The fine will never be deductible for tax purposes. Therefore, financial reporting treats the item giving rise to the permanent difference (through income tax expense) in the same way the tax code treats the item - it is not deductible. Permanent differences are not considered when computing the balances of deferred tax accounts. Permanent differences are not allocated - they do not affect the process of interperiod tax allocation.

Examples of Deductible Temporary Differences

Example:1. Warranty expense. On sales for Year 1, the firm recognizes $8,000 of estimated warranty expense. Also during Year 1, $1,000 was spent servicing warranty claims. The firm can deduct only the $1,000 on its Year 1 tax return because tax law limits the deduction to the actual cost of claims service. At the end of Year 1, the firm has a $7,000 future deductible difference. Next year, when the remaining claims are serviced, the firm's taxable income will fall by $7,000 relative to pretax accounting income. The future temporary difference is found in the warranty liability, which has a balance of $7,000, the amount of future claims expected. 2. Revenue received in advance. During Year 1, the firm collected $22,000 in advance of providing its services to customers. By the end of the year, the firm had performed $10,000 worth of service. The full $22,000 is taxable in Year 1 but only $10,000 of revenue is recognized in the income statement. At the end of Year 1, the firm has a $12,000 deductible difference. Next year, when the remaining service is provided, the firm's pretax accounting income will increase $12,000 with no effect on taxable income. Future taxable income will be less than pretax accounting income. The future temporary difference is found in the unearned revenue account, which has a balance of $12,000, the amount of paid services yet to be provided.

Examples: Nature of Temporary Differences

Example:A firm provides services for a client for a fee of $4,000. The service is provided near the end of the year. The client is expected to remit the fee early the following year. For financial accounting purposes, the $4,000 of revenue is recognized in the year the service is provided but for tax purposes is taxable in the year the fee is received. Over the two years, both systems recognize the same amount of revenue. The temporary difference of $4,000 originated in the first year, and reversed in the second. At the end of the first year, the firm has a future difference of $4,000. That is the basis for the recorded deferred tax account at the end of the first year.

Example: Accounting for Income Taxes

Example:Assume the following year-end income tax accrual entry. For simplicity, we assume that the entire year's tax liability is paid early the following year. Dr:Income Tax Expense 40,000 Dr:Deferred Tax Asset 6,000 Cr:Deferred Tax Liability 9,000 Cr:Income Tax Payable 37,000 Current income tax provision: $ 37,000 (income tax liability) Plus deferred income tax provision 3,000 * Equals total income tax expense $ 40,000 * $9,000 increase in deferred tax liability less $6,000 increase in deferred tax asset

Example: Classification for Balance Sheet Reporting

Example:The following future temporary differences have been identified in the process of preparing the tax accrual entry for the current year (future enacted tax rate is 30%): Amount of (Deductible) Resulting Deferred Tax Account (*) or Taxable Temporary Difference Associated with $4,000 Noncurrent Asset NDTL $1,200 (3,000) Noncurrent Liability NDTA 900 12,000 Current Asset CDTL 3,600 (8,000) Current Liability CDTA 2,400 (12,000) NonCurrent Liability NDTA 3,600 7,000 NonCurrent Asset NDTL 2,100 * Key: C = Current N = Noncurrent DTA = Deferred Tax Asset DTL = Deferred Tax Liability The deferred tax account balance is the tax rate times the temporary difference. Aggregating by type, the totals are: Current Deferred Tax Liability (CDTL) ($3,600) Current Deferred Tax Asset (CDTA) 2,400 Net current deferred tax liability reported in balance sheet ($1,200) Noncurrent Deferred Tax Asset (NDTA) $4,500 Noncurrent Deferred Tax Liability (NDTL) (3,300) Net noncurrent deferred tax asset reported in balance sheet $1,200

Example: Internal Classification - Deferred Tax Accounts

Examples -- 1. The taxable temporary difference arising from depreciable plant assets is related to a non-current asset. Therefore, the associated deferred tax liability is classified as a non-current liability. 2. The deductible temporary difference arising from a warranty liability (1-year warranty) is related to a current liability. Therefore the associated deferred tax asset is classified as a current asset. 3. If the warranty were a two-year warranty, the portion of the temporary difference relating to the current warranty liability would result in a current deferred tax asset, and the portion relating to the noncurrent warranty liability would result in a noncurrent deferred tax asset. 4. The taxable temporary difference arising from prepaid rent (1-year coverage) is related to a current asset. Therefore, the associated deferred tax liability is classified as a current liability. However, for prepaids covering more than one year, the deferred tax liability pertaining to the noncurrent prepaid is classified as a noncurrent liability.

Examples of Deductible Temporary Differences

Examples of Deductible Temporary Differences -- (future taxable income < future pretax accounting income)

Practice Example (Permanent and temporary difference) Continued

F. Solution: With no beginning deferred tax balances, the ending balance in the deferred tax liability equals the change in the deferred tax liability for the period. The change in the deferred tax liability is the future tax effect of the amount of income from the investment that is expected to be taxable in the future, using enacted tax rates. That amount is $9,000 = .30(.20)($180,000 - $30,000). The ($180,000 - $30,000) factor is the total future earnings difference between tax and book accounting. The .20 is the amount taxable after considering the dividends received deduction. The tax rate is 30%. The final result, $9,000, is the anticipated future tax liability, based on current transactions.

Illustrative Example (No beginning deferred tax balances) (total income tax expense)

F. The total income tax expense is classified into two parts, which must be reported either on the face of the income statement or in the footnotes: Current Provision of Income Tax $22,500 Plus Deferred Provision of Income Tax 1,750 Total Income Tax Expense $24,250

What percentage is used for determining realization of a deferred tax asset?

Fifty percent used.

The Same Approach is Applied to Future Temporary Differences

For example, if there is uncertainty about the deductibility of a future deductible difference giving rise to a deferred tax asset, the same two step approach is applied. The result is a reduced deferred tax asset, increased deferred tax liability, or both.

Are originating or future reversing temporary differences used in determining the change in deferred tax accounts?

Future reversing temporary differences are used.

As a result of differences between depreciation for financial-reporting purposes and tax purposes, the financial-reporting basis of Noor Co.'s sole depreciable asset, acquired in 2005, exceeded its tax basis by $250,000 at December 31, 2005. This difference will reverse in future years. The enacted tax rate is 30% for 2005, and 40% for future years. Noor has no other temporary differences. In its December 31, 2005 balance sheet, how should Noor report the deferred tax effect of this difference?

Future tax rates are used to measure the future tax consequences (balances in deferred tax accounts) of transactions through the balance sheet date. This firm faces a 40% tax rate in the future and therefore measures the deferred tax account as $250,000(.40) = $100,000. The future difference of $250,000 is taxable, because the financial-reporting basis exceeds the tax basis at the balance sheet date. This means that the firm has recognized more depreciation for tax purposes as of December 31, 2005, than it has for financial reporting. Therefore, in the future, more depreciation will be recognized for financial reporting than for tax reporting, causing future taxable income to exceed pre-tax financial income. Hence, a deferred tax liability is recognized at December 31, 2005. This liability is recognized now, at the end of 2005, because it resulted from transactions through this date. When the difference reverses in the future, the deferred tax liability will be reduced, causing taxes payable to increase.

Hut Co. has temporary taxable differences that will reverse during the next year and add to taxable income. These differences relate to non-current assets. Deferred income taxes based on these temporary differences should be classified in Hut's balance sheet as a

Future taxable differences cause taxable income in the future to exceed pre-tax accounting income. Therefore, deferred tax liabilities are the result of taxable differences. Classification of deferred tax accounts is based on the item giving rise to the temporary differences. In this case, the underlying item is non-current. Therefore, the deferred tax liability is also classified as non-current.

Notice

G. Notice that the income tax expense recognized is not equal to the current tax rate times pretax accounting income (.30 x $90,000 = $27,000). In other words, the current tax rate of 30% is not the effective tax rate for this firm. The effective tax rate is the ratio of income tax expense to pretax accounting income. For this firm, that rate is 26.95% ($24,250/$90,000)

Practice Example (Permanent and temporary difference) Continued

G. This problem has both permanent and temporary differences. The permanent difference is the 80% dividends received deduction. Of the $180,000 earnings, 80% or $144,000 will never be taxed. Therefore, 20% or $36,000 will be taxed. By the end of 20x2, .20($30,000 dividends received) or $6,000 has been taxed leaving $30,000 as the future temporary difference. The $30,000 is the amount recognized in 20x2 earnings but will not be taxed until later years. The tax effect of this difference, $9,000 (.30 x $30,000) is the ending deferred tax liability.

Practice Example (Permanent and temporary difference)

Gem has no beginning deferred tax balances and uses the equity method to account for its 25% investment in Gold. During 20x2, Gem received dividends of $30,000 from Gold and recorded $180,000 as its equity in the earnings of Gold. Additional information follows: A. All the undistributed earnings of Gold will be distributed as dividends in future periods. B. The dividends received from Gold are eligible for the 80% dividends received deduction. C. There are no other temporary differences. D. Enacted income tax rates are 30% for 20x2 and thereafter. E. In its December 31, 20x2 balance sheet, what amount should Gem report for deferred income tax liability?

General Rule for Accounting for Permanent Differences

General Rule for Accounting for Permanent Differences For each of the differences listed above, an item is recognized in one system of reporting but not in the other. The difference never reverses as it does with temporary differences. But the income tax law is what ultimately determines whether an item is considered for tax purposes. Hence the rule for permanent differences: The effect of a permanent difference on income tax expense is the same as its effect on the income tax liability for the period.

Note

Go to CPAexcel and finish questions and Task based simulation) 23 questions and 1 TBS

What is the minimum probability of sustaining an uncertain tax position to reduce income tax expense for an uncertain tax position?

Greater than 50%.

Two factors

H. Two factors explain the difference: (1) the municipal bond interest is included in pretax accounting income but is not taxed (this lowers the effective tax rate), and (2) the higher rate of 35% is applied to the future temporary difference and is reflected in income tax expense (this raises the effective rate). Because of these types of differences, a tax reconciliation footnote is a required disclosure. That footnote would show: Statutory Tax Rate: .3000 Effect of Nontaxable Municipal Bond Interest (.0333) $10,000(.3)/$90,000 Effect of Future Rate Increase on Future Temporary Differences .0028 $5,000(.35-.30)/$90,000 Effective Tax Rate .2695 $24,250/$90,000

Illustrative Example (No beginning deferred tax balances)

Illustrative Example (No beginning deferred tax balances) A. A firm in its first year has $100,000 of operating income composed of items that are recognized in the same amounts for both financial reporting and tax purposes. In addition, the firm has: 1. $10,000 of municipal bond interest; 2. Rent expense of $20,000 for book purposes; and 3. Rent expense of $25,000 for tax purposes. B. The $5,000 difference in rent expense is the ending prepaid rent. This amount is deductible in Year 1 but is not recognized as rent expense until Year 2. The tax rate for year 1 is 30% but the Year 2 rate, enacted at the close of Year 1, was increased to 35%. C. Tax accrual entry for Year 1: Dr:Income Tax Expense 24,250 Cr:Deferred Tax Liability ($5,000 x .35) 1,750 Cr:Income Tax Payable($75,000 x .30) 22,500* * Taxable income = $100,000 - $25,000 = $75,000. The municipal bond interest is not taxable. It is not included in the $100,000 amount common to the two reporting systems. Taxable income applies the current (Year 1) tax rate, while the computation of the deferred tax liability uses the future enacted tax rate.

Illustrative Example (No beginning deferred tax balances)

Illustrative Example (No beginning deferred tax balances) D. The future temporary difference of $5,000 is a taxable temporary difference because taxable income in Year 2 will increase relative to pretax accounting income by this amount when the prepaid rent is recognized as expense for book purposes only. The resulting deferred tax liability is measured using the future enacted tax rate at which the tax will be paid.

Income Tax Expense

Income Tax Expense -- The account reported in the income statement that measures the income tax cost for the year's transactions. Income tax expense equals the income tax liability plus or minus the net change in the deferred tax accounts for the period.

Income Tax Liability

Income Tax Liability -- 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.

Define "pretax accounting income".

Income before income tax for financial accounting purposes determined by applying GAAP.

Define "taxable income".

Income before tax for tax purposes.

(Start of CPAexcel Flashcards) What is the effect of a nontaxable revenue on income tax expense?

Income tax expense is not increased.

What is the effect of a nondeductible expense on income tax expense?

Income tax expense is not reduced.

What is the effect of a nontaxable revenue on income tax liability?

Income tax liability is not increased.

What is the general formula for computing income tax expense?

Income tax liability plus or minus the change in the deferred tax accounts.

What effect does an originating deductible difference have on the tax accrual entry?

Increases the required ending deferred tax asset balance.

Interperiod Tax Allocation

Interperiod Tax Allocation -- The process of measuring and recognizing the total income tax consequences of transactions in the year. Only temporary differences and net operating loss carryforwards enter into this process. Interperiod tax allocation gives rise to deferred tax accounts because the total tax consequence of the period's transactions is not equal to the current income tax liability. The current tax liability (measured at the current tax rate) measures a part of that total, but there will be additional tax consequences in the future because of transactions that have occurred as of the balance sheet date. Hence the need for the deferred tax accounts. Deferred tax accounts are measured at the future enacted tax rate.

What differences does the computation of income tax liability consider in terms of differences between book and tax?

It considers current period temporary and permanent differences.

How is income tax expense for a period computed?

It is a derived amount or "plug" figure, the net change caused by the changes in deferred tax accounts and the income tax liability.

Why is the procedure for offsetting deferred tax accounts reasonable given the nature of the underlying differences?

It is reasonable because future deductible and taxable differences will naturally cancel in the relevant future periods.

Limitation on Deferred Tax Assets

Limitation on Deferred Tax Assets A. A deferred tax asset, like any other asset, is an asset only if it has future benefit. A deferred tax asset will reduce income tax payments in the future, if there is taxable income in the future to reduce. (A few other sources of benefit exist as well but future taxable income is the main one). B. When there is not a sufficient probability of realizing the deferred tax asset, a valuation allowance (contra account) is recorded to reduce the deferred tax asset to the amount expected to be realized.

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 and or liability

More 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.

Net Amount of Deferred Tax Asset Reported

Net Amount of Deferred Tax Asset Reported A. Definition: Realization of a deferred tax asset means that the asset will provide its expected benefits. B. When there is better than a 50% chance of realizing the deferred tax asset, it is reported free of any valuation account. C. When there is a 50% or less chance of the deferred tax asset being fully realized, it is reported but also is reduced by a valuation allowance (contra to deferred tax asset) to the amount that has a better than 50% chance of being realized. D. Another way to say this is: If based on available evidence it is more likely than not that some portion of the deferred tax asset will not be realized, the deferred tax asset is reduced by a valuation allowance to the amount more likely than not to be realized. E. The valuation allowance account, if needed, is treated as a negative deferred tax asset account. The ending balance is the amount needed at the end of a period, and the change in the valuation account is the required increase or decrease from the previous period. Thus, the same process for updating deferred tax accounts applies to the valuation allowance account.

Net Operating Loss

Net Operating Loss -- Negative taxable income (strictly a tax term). A net operating loss can be carried back 2 years to reduce taxable income in those years for a refund of taxes, and carried forward 20 years to reduce taxable income and therefore the tax liability in future years.

Permanent Difference

Permanent Difference -- An amount that appears in the tax return or income statement but never both. These include items of revenue or expense that are never taxable or deductible; also taxable and deductible items that never appear in the income statement. This type of difference is also called a nontemporary difference. Example: A fine or penalty is never deductible but is treated as an expense or loss for income statement purposes. Permanent differences do not enter into the process of interperiod tax allocation. They have no deferred tax consequences.

Pretax Accounting Income

Pretax Accounting Income -- Income before income tax for financial accounting purposes determined by applying GAAP. This subtotal title is not used on the income statement (which uses subtotals such as income from continuing operations, income before extraordinary items, and others). Rather, for convenience and to focus on the issues, pretax accounting income traditionally has been used as a single measure of income before tax for accounting purposes. "Pretax financial income" is the term used by FASB for this amount.

(Start of CPAexcel Flashcards) List the formula for computing the effect of a permanent difference on the effective tax rate.

Product of permanent difference and stated rate, divided by pretax accounting income.

How is the required ending deferred tax liability balance expressed?

Product of sum of future taxable differences and the future enacted tax rate.

Describe the accounting effect when the probability of sustaining an uncertain tax position is equal to or greater than the minimum for reducing income tax expense.

Recognize a reduction in income tax expense for the largest amount for which the cumulative probability of realization exceeds 50%, and an additional liability for the unrecognized portion.

Describe the accounting effect when actual tax benefit is less than expected in a later year.

Recognize income tax expense for the difference between benefit recognized in previous year and the actual benefit.

Describe the accounting effect when actual tax benefit is greater than expected in a later year.

Reduce income tax expense for the difference between benefit recognized in previous year and the actual benefit.

(Start of CPAexcel Flashcards) Describe the account effect when the probability of sustaining an uncertain tax position is less than the minimum for reducing income tax expense.

Report a liability for the uncertain tax position in addition to the income tax liability.

(Start of CPAexcel flashcards) How is the change in the deferred tax liability account for a period expressed?

Required ending deferred tax liability balance less beginning deferred tax liability balance.

Resolution of the Uncertainty

Resolution of the Uncertainty A. In a later year, if the expected $1,400 deduction is allowed: Dr:Liability for unrecognized tax benefit 180 Cr:Cash ($2,000 - $1,400).30 180

How is the classification of a deferred tax account determined?

Same as asset/liability that caused the temporary difference.

Some Temporary Differences

Some Temporary Differences Some of the more frequently observed temporary differences are listed and described below. In most cases, a balance sheet account reflects the amount of the difference to reverse in the future. A. Taxable After Recognized for the Books -- Revenues or Gains that are Taxable after they are Recognized in Financial Income

Tax Rate Considerations

Tax Rate Considerations A. As already discussed, the future enacted tax rate is used to measure the change in the deferred tax accounts for the year-end tax accrual entry. B. When the tax rate is changed during the year, the new rate is applied as of the beginning of the year (estimate change) to recompute the deferred tax balances. This results in an immediate change to income tax expense. For annual reporting, the normal year-end tax accrual entry automatically accomplishes this effect. C. Corporations are taxed at an increasing rate as taxable income increases. The average tax rate is used for computing the changes in the deferred tax accounts. D. When a future temporary difference is expected to reverse at a different rate than the regular tax rate (for example, a capital gains rate), then the specific rate applying to the difference is used when measuring that portion of the change in the deferred tax account.

Taxable Before Recognized for the Books

Taxable Before Recognized for the Books -- Revenues or Gains that are Taxable before they are Recognized in Financial Income

Taxable Income

Taxable Income -- Income before tax for tax purposes. This is the analogue of pretax accounting income. Taxable income is the amount to which the tax rates are applied in determining the income tax liability for the year.

Taxable Items

Taxable Items -- Amounts that cause income tax to increase. This is an Internal Revenue Code term and typically refers to revenues that cause taxable income to increase.

What type of differences are temporary differences caused by depreciation?

Taxable differences.

How do permanent differences affect the tax accrual entry?

Taxable income excludes them; this exclusion is reflected in income tax expense - a plug figure.

(Start of CPAexcel Flashcards) What causes income tax to increase?

Taxable items.

What temporary difference causes future taxable income to exceed future book income?

Taxable temporary difference.

Temporary Difference

Temporary Difference -- An item of revenue or expense that, over the total life of the item, will affect pretax accounting income and taxable income in the same total amount, but will be recognized in different amounts in any given year for financial reporting and tax purposes. Example:Depreciation can be different in any given year for income reporting and tax purposes, but total depreciation is the same over the life of the asset under the two reporting systems.

On January 2, 2004, Ross Co. purchases a machine for $70,000. This machine has a five-year useful life, a residual value of $10,000, and is depreciated using the straight-line method for financial-statement purposes. For tax purposes, depreciation expense was $25,000 for 2004 and $20,000 for 2005. Ross elected early application of FASB Statement No. 109, Accounting for Income Taxes. Ross' 2005 income, before income tax and depreciation expense, was $100,000 and its tax rate was 30%. If Ross had made no estimated tax payments during 2005, what amount of current income tax liability would Ross report in its December 31, 2005 balance sheet?

The $24,000 current tax liability is the current tax rate times taxable income: $24,000 = .30($100,000 - $20,000).

Define "income tax expense".

The account reported in the income statement that measures the income tax cost for the year's transactions.

If book depletion is $4,000 and tax depletion is $12,000, what is the amount of the permanent difference?

The amount is $8,000.

Define "deferred income tax".

The amount of income tax expense that is not currently due.

Define "income tax liability".

The amount of income tax the firm must pay on taxable income for a year.

Define "current income tax provision".

The amount of income taxes due for the year (same as income tax liability).

What is the classification of the valuation allowance for deferred tax assets?

The classification is contra deferred tax asset.

In its first four years of operations ending December 31, 2002, Alder, Inc.'s depreciation for income tax purposes exceeds its depreciation for financial-statement purposes. This temporary difference is expected to reverse in 2003, 2004, and 2005. Alder had no other temporary difference and elected early adoption of FASB 109. Alder's 2002 balance sheet should include

The classification of deferred tax accounts is based on the classification of the underlying account giving rise to the deferred tax effect. In this case, depreciable assets are non-current assets, therefore the deferred tax account is also classified as non-current. Because the future temporary differences are taxable (future tax depreciation will be less than book depreciation, causing future taxable income to exceed pre-tax accounting income), the deferred tax account is a liability. Future taxable temporary differences give rise to deferred tax liabilities.

At December 31, 2005, Bren Co. has the following deferred income tax items: A deferred income tax liability of $15,000 related to a non-current asset A deferred income tax asset of $3,000 related to a non-current liability A deferred income tax asset of $8,000 related to a current liability Which of the following should Bren report in the non-current section of its December 31, 2005 balance sheet?

The classification of deferred tax accounts is based on the underlying account to which they are related. The $15,000 income tax liability is related to a non-current asset. Therefore, that deferred tax liability is classified as non-current. Balance-sheet presentation of deferred tax accounts nets the non-current accounts and nets the current accounts, for a maximum of two net deferred accounts reported. This firm would net the $15,000 non-current deferred tax liability with the $3,000 non-current deferred tax asset, to yield a net non-current deferred tax liability of $12,000.

Because Jab Co. uses different methods to depreciate equipment for financial statement and income tax purposes, Jab has temporary differences that will reverse during the next year and add to taxable income. Deferred income taxes that are based on these temporary differences should be classified in Jab's balance sheet as a

The classification of deferred tax accounts is the same as the accounts giving rise to the deferred taxes. The temporary differences referred to in the question are future taxable differences, which cause a deferred tax liability. The account giving rise to the difference is equipment, which is classified as long-term. Therefore, the deferred tax liability is also classified as long-term (non-current).

Reporting the Deferred Tax Asset and Valuation Allowance

The classification of the valuation allowance follows the classification of the related deferred tax asset. For example, if 70% of the relevant deferred tax asset is noncurrent, then 70% of the valuation allowance is so classified.

Kent, Inc.'s reconciliation between financial statement and taxable income for 2005 follows: Pre-tax financial income $150,000 Permanent difference ($12,000) $138,000 Temporary difference - depreciation ($9,000) Taxable income $129,000 ======= Additional information: At ___________________ 12/31/04 12/31/05 Cumulative temporary differences (future taxable amounts) $11,000 $20,000 The enacted tax rate was 34% for 2004, and 40% for 2005 and years thereafter. In its 2005 income statement, what amount should Kent report as current portion of income tax expense?

The current portion of income tax expense is the tax liability for the year. The tax rate for the current year is applied to taxable income to compute this amount: .40($129,000) = $51,600.

Ram Corp. prepared the following reconciliation of income per books with income per tax return for the year ended December 31, 2005: Book income before income taxes $750,000 Add temporary difference construction contract revenue, which will reverse in 2009 $100,000 Deduct temporary difference depreciation expense, which will reverse in equal amounts in each of the next four years ($400,000) Taxable income $450,000 ======= Ram's effective income tax rate is 34% for 2005. What amount should Ram report in its 2005 income statement as the current provision for income tax?

The current provision for income tax, also called the tax liability for the year, is the current tax rate multiplied by taxable income: .34 x $450,000 = $153,000.

Leer Corp.'s pre-tax income in 2005 is $100,000. The temporary differences between amounts reported in the financial statements and the tax return are as follows: Depreciation in the financial statements is $8,000 more than tax depreciation. The equity method of accounting resulted in financial statement income of $35,000. A $25,000 dividend is received during the year, which is eligible for the 80% dividends received deduction. Leer's effective income tax rate was 30% in 2005. In its 2005 income statement, Leer should report a current provision for income taxes of

The current provision for income taxes is the tax liability for the year: taxable income times the tax rate. Taxable income = $100,000 + $8,000 - $35,000 + .20($25,000) = $78,000. Therefore, current income tax expense (also the firm's tax liability) is $23,400 ($78,000 x .30). The $8,000 is added to pre-tax accounting income, because the latter income amount reflects $8,000 more depreciation than should be reflected in taxable income. The $35,000 is subtracted, because it is included in pre-tax accounting income, but is not included in taxable income. Only 20% of the dividends received is taxable owing to the 80% dividends-received deduction. The equity in income of the investee is not taxable income.

Tara Corp. uses the equity method of accounting for its 40% investment in Flax, Inc.'s common stock. During 2005, Flax reports earnings of $750,000 and pays dividends of $250,000. Assume that: All the undistributed earnings of Flax will be distributed as dividends in future periods. The dividends received from Flax are eligible for the 80% dividends-received deduction. There are no other temporary differences. Tara's 2005 income tax rate is 30%. Enacted income tax rates after 2005 are 25%. Tara elected early application of FASB Statement No. 109, Accounting for Income Taxes. In its December 31, 2005 balance sheet, the increase in the deferred income tax liability from the above transactions would be

The deferred tax liability ending balance in this problem equals the change in the deferred tax liability for the period, because the firm adopted SFAS No. 109 in this period. The change in the deferred tax liability is the future tax effect of the amount of income from the investment that is expected to be taxable in the future, using enacted tax rates. That amount is $10,000 = .25(.20)(.40)($750,000 - $250,000). The ($750,000 - $250,000) amount represents the total future earnings difference between tax and book accounting. The .20 represents the proportion of income that will ultimately be taxed, and the .25 is the future enacted tax rate. The .40 is the proportion ownership. The final result, $10,000, is the anticipated future tax liability, based on current transactions.

Taft Corp. uses the equity method to account for its 25% investment in Flame, Inc. During 2004, Taft receives dividends of $30,000 from Flame and records $180,000 as its equity in the earnings of Flame. Additional information follows: All the undistributed earnings of Flame will be distributed as dividends in future periods. The dividends received from Flame are eligible for the 80% dividends-received deduction. There are no other temporary differences. Enacted income tax rates are 30% for 2004 and thereafter. Taft elected early application of FASB Statement No. 109, Accounting for Income Taxes. In its December 31, 2004 balance sheet, what amount should Taft report for deferred income tax liability?

The deferred tax liability ending balance in this problem equals the change in the deferred tax liability for the period, because the firm adopted SFAS No. 109 this period. The change in the deferred tax liability is the future tax effect of the amount of income from the investment that is expected to be taxable in the future, using enacted tax rates. That amount is $9,000 = .30(.20)($180,000 - $30,000). The ($180,000 - $30,000) amount represents the total future earnings difference between tax and book accounting. The .20 represents the proportion of income that will ultimately be taxed, and the 30% is the tax rate. The final result, $9,000, is the anticipated future tax liability, based on current transactions.

Stone Co. begins operations in 2004 and reports $225,000 in income before income tax for the year. Stone's 2004 tax depreciation exceeds its book depreciation by $25,000. Stone also has non-deductible book expenses of $10,000 related to permanent differences. Stone's tax rate for 2004 is 40%, and the enacted rate for years after 2004 is 35%. Stone elects early adoption of FASB Statement No. 109, Accounting for Income Taxes. In its December 31, 2004 balance sheet, what amount of deferred income tax liability should Stone report?

The deferred tax liability is based solely on the depreciation temporary difference. Permanent differences do not enter into the determination of deferred tax accounts. This is the first year of operations. Therefore, the depreciation difference in this year must equal the net future temporary difference. The deferred tax liability balance at the end of the year is therefore $8,750 ($25,000 x .35). Future enacted tax rates are used because they are the rates that will be in effect when the future tax consequences will be realized.

In its 2005 income statement, Noll Corp. reports depreciation of $400,000 and interest revenue on municipal obligations of $60,000. Noll reports depreciation of $550,000 on its 2005 income tax return. The difference in depreciation is the only temporary difference, and it will reverse equally over the next three years. Noll's enacted income tax rates are 35% for 2005, 30% for 2006, and 25% for 2007 and 2008. Noll elects early application of FASB Statement No. 109, Accounting for Income Taxes. What amount should be included in the deferred income tax liability in Noll's December 31, 2005 balance sheet?

The deferred tax liability is the future tax effect of the depreciation difference reversals measured using the future enacted tax rates. The amount of the reversal each year is $50,000 [($550,000 - $400,000)/3]. The difference will cause taxable income to exceed pre-tax accounting income. This is a taxable difference that gives rise to a deferred tax liability. The municipal-bond interest is a permanent difference and does not affect deferred tax accounts. Deferred tax liability balance = .30($50,000) + .25($50,000 + $50,000) = $40,000.

What general effect does income tax expense have on permanent differences?

The effect of a permanent difference on income tax expense is the same as its effect on the income tax liability for the period.

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

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.

Define "interperiod tax allocation".

The process of measuring and recognizing the total income tax consequences of transactions in the year.

Dunn Co.'s 2005 income statement reported $90,000 income before provision for income taxes. To compute the provision for federal income taxes, the following 2005 data are provided: Rent received in advance $16,000 Income from exempt municipal bonds 20,000 Depreciation deducted for income tax purposes in excess of depreciation reported for financial-statement purposes 10,000 Enacted corporate income tax rate 30% If the alternative minimum tax provisions are ignored, what amount of current federal income tax liability should be reported in Dunn's December 31, 2005 balance sheet?

The tax liability is 30% of taxable income. Pre-tax accounting income $90,000 Plus advance rent (taxable, but not included in pre-tax accounting income) $16,000 Less municipal bond income (this is included in pre-tax accounting income, but is not taxable) ($20,000) Less depreciation for tax in excess of depreciation for the books (10,000) Equals taxable income $76,000 Times tax rate x .30 Equals income tax liability $22,800

For the year ended December 31, 2004, Mont Co.'s books showed income of $600,000 before provision for income tax expense. To compute taxable income for federal income tax purposes, the following items should be noted: Income from exempt municipal bonds $60,000 Depreciation deducted for tax purposes in excess of depreciation recorded on the books $120,000 Proceeds received from life insurance on death of officer $100,000 Estimated tax payments 0 Enacted corporate tax rate 30% Ignoring the alternative minimum tax provisions, what amount should Mont report at December 31, 2004 as its current federal income tax liability?

The tax liability is the tax rate times taxable income = .30($600,000 - $60,000 - $120,000 - $100,000) = $96,000. The municipal- bond interest is tax exempt, but included in pre-tax accounting income of $600,000 and therefore is subtracted when computing taxable income. The excess depreciation is also subtracted, because pre-tax accounting income reflects only depreciation recorded for financial accounting purposes. The proceeds on life insurance are included in pre-tax accounting income, but are not taxable and are therefore subtracted in computing taxable income.

Kent, Inc.'s reconciliation between financial statement and taxable income for 2005 is as follows: Pre-tax financial income $150,000 Permanent difference ($12,000) $138,000 Temporary difference - depreciation ($9,000) Taxable income $129,000 ======== Additional information: At ___________________ December 31, 2004 December 31, 2005 Cumulative temporary differences (future taxable amounts) $11,000 $20,000 The enacted tax rate was 34% for 2004, and 40% for 2005 and years thereafter. In its December 31, 2005 balance sheet, what amount should Kent report as deferred income tax liability?

The total future taxable difference at the end of 2005 is $20,000. Therefore, the balance in the deferred tax liability account is .40($20,000) = $8,000. Taxes payable in the future (after 2005) will increase $8,000 as a result of transactions in 2005 and earlier.

What type of deferred tax accounts do deductible temporary differences cause?

They cause Deferred tax assets.

At the end of the current year, Swen Inc. prepares its tax return, which reflects an uncertain amount, reducing the firm's tax liability by $40,000. Swen estimates that, upon audit by the IRS, there is a 20% chance that the full $40,000 benefit will be upheld, and a 40% chance that the benefit will be only $25,000. As a result of the required recognition and measurement principles for uncertain tax positions, current-year income tax expense is reduced by what amount?

This is the largest amount, which has at least a 50% probability of occurring. The cumulative probability through this amount is 60%. A liability is recognized for the $15,000 of the total $40,000, which has less than a 50% chance of occurring.

Three Types of Differences - Between GAAP and Income Tax Law

Three Types of Differences - Between GAAP and Income Tax Law A. The three main categories of differences between the two reporting systems in terms of their effect on accounting for income taxes are: 1. Permanent differences; 2. Temporary differences; and 3. Net operating losses. B. For interperiod tax allocation, temporary differences are the most important.

(Start of CPAexcel Exam Questions) Mill, which began operations on January 1, 2003, recognizes income from long-term construction contracts under the percentage-of-completion method in its financial statements and under the completed-contract method for income tax reporting. Income under each method follows: Year Completed-contract Percentage-of-completion 2003 $ - $300,000 2004 $400,000 $600,000 2005 $700,000 $850,000 The income tax rate was 30% for 2003 through 2005. For years after 2005, the enacted tax rate is 25%. There are no other temporary differences. Mill elected early application of FASB Statement No. 109, Accounting for Income Taxes. Mill should report in its December 31, 2005 balance sheet, a deferred income tax liability of

Total income for the three years under the two methods is: Percentage-of-completion: $1.75mn ($300,000 + $600,000 + $850,000) Completed-contract: $1,100,000 ($400,000 + $700,000) Difference $650,000 This difference is also the future difference in earnings to be recognized under the two methods, because both methods ultimately recognize the same total amount of income. Completed contract (for tax purposes) will recognize $650,000 more income than percentage of completion (for book purposes) after 2005. Therefore, the difference is taxable and gives rise to a deferred tax liability of $162,500 ($650,000 x .25). The future enacted tax rate is applied, because that is the rate at which the deferred tax liability will be paid.

(Start of CPAexcel Exam Questions) Nala Inc. reported deferred tax assets and deferred tax liabilities at the end of 2004 and at the end of 2005. According to FASB 109, for the year ended 2005, Nala should report deferred income tax expense or benefit equal to the

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. Consider the tax-accrual entry for a year, assuming no estimated tax payments have been made: Dr:income tax expense 20 Dr:Deferred tax asset 3 Cr:Deferred tax liability 5 Cr:income tax payable 18 Total income tax expense = 20 = current tax expense + deferred tax expense Deferred tax asset = $18 + $2 The $2 deferred tax expense equals the increase in the deferred tax liability of $5, less the increase in the deferred tax asset of $3.

True or False. Taxable temporary differences are differences which cause deferred tax liabilities.

True. They cause Deferred tax liabilities.

(The Start of CPAexcel Flashcards) When is a valuation allowance created for a deferred tax asset?

When there is a 50% or less chance of the deferred tax asset being fully realized.

On its December 31, 2005 balance sheet, Shin Co. has income tax payable of $13,000 and a current deferred tax asset of $20,000, before determining the need for a valuation account. Shin had reported a current deferred tax asset of $15,000 at December 31, 2004. No estimated tax payments are made during 2005. At December 31, 2005, Shin determines that it is more likely than not that 10% of the deferred tax asset would not be realized. In its 2005 income statement, what amount should Shin report as total income tax expense?

income tax expense is the net sum of the income tax liability for the year, the changes in the deferred tax accounts, and the change in the valuation account for deferred tax assets. Tax liability (current portion of income tax expense): $13,000 Less increase in deferred tax asset: $20,000 - $15,000 ($5,000) Plus increase in valuation account: .10($20,000) $2,000 Equals income tax expense $10,000 The increase in the deferred tax asset causes income tax expense to decrease relative to the tax liability, because, as a result of transactions through the end of the current year, future taxable income will be reduced. This reduction is not realized in the current year as a reduction in the tax liability. Therefore, the anticipated future reduction is treated as an asset at the end of the current period. When realized, the asset is reduced in a future year. The increase in the valuation allowance, which is contra to the deferred tax asset, reduces the deferred-tax-asset effect, because it is an amount of the deferred tax asset not likely to be realized.

In its 2005 income statement, Cere Co. reported income before income 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 income tax expense?

income tax expense reflects the tax effects of permanent differences as measured by the tax code. Because there are no temporary differences, income tax expense equals the income tax liability for the period or: $.30($280,000) = $84,000. This reflects the tax ultimately payable on 2005 transactions. Therefore, income tax expense should also reflect that amount, in the absence of temporary differences.

Two years ago, Aggre Inc. recognized the tax benefit of an uncertain tax position. income tax expense in that year was reduced by $20,000 as a result. In addition, Aggre recorded a $5,000 tax liability for unrecognized benefits for the same tax position. During the current year, the uncertainty is resolved and a benefit of $22,000 is upheld. By what amount is current-year income tax expense affected by the resolution of the prior uncertainty?

income tax expense was reduced two years ago by $20,000, but the final benefit upon resolution is $22,000. The $2,000 increase in benefit is recognized in the year of resolution.