Accounting for Income Taxes

GAAP vs. Tax Differences

Financial accounting (GAAP) and tax accounting (IRC) have different rules for recognizing revenues and expenses. These differences create variations between book income (pretax financial income) and taxable income.

$$\text{Taxable Income} = \text{Pretax Financial Income} \pm \text{Permanent Differences} \pm \text{Temporary Differences}$$

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Permanent vs. Temporary Differences

Permanent Differences

Permanent differences never reverse. They affect either book income or taxable income, but not both. They do not create deferred taxes.

Example	Effect
Municipal bond interest	Book income ↑, not taxable
Life insurance premiums (company-owned)	Book expense ↑, not deductible
Fines and penalties	Book expense ↑, not deductible
Life insurance proceeds (company-owned)	Book income ↑, not taxable

Temporary Differences

Temporary differences will reverse in future periods, creating deferred tax assets or liabilities.

Example	Book vs. Tax	Creates
Depreciation (SL vs. MACRS)	Book expense < Tax deduction now	DTL
Estimated warranty liability	Book expense now > Tax deduction later	DTA
Bad debt expense (allowance method)	Book expense now > Tax deduction later	DTA
Prepaid rent (received in advance)	Book income later < Taxable now	DTA
Installment sales	Book income now > Taxable later	DTL
:::info Key Principle

• Future taxable amounts → Deferred Tax Liability (DTL)
• Future deductible amounts → Deferred Tax Asset (DTA) :::

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Computing Tax Expense

Total income tax expense has two components:

$$\text{Total Tax Expense} = \text{Current Tax Expense (CTE)} + \text{Deferred Tax Expense (DTE)}$$

Current Tax Expense

$$\text{CTE} = \text{Taxable Income} \times \text{Enacted Tax Rate}$$

Deferred Tax Expense

$$\text{DTE} = \Delta DTL - \Delta DTA$$

Where $\Delta$ represents the change in the balance during the period.

DTL and DTA Calculations

Deferred Tax Liability Example

Bear Co. purchases equipment for $100,000. Book depreciation is straight-line over 5 years ($20,000/year). Tax depreciation uses MACRS with Year 1 deduction of $33,000. The enacted tax rate is 21%.

	Book	Tax	Difference
Year 1 depreciation	$20,000	$33,000	$13,000
The $13,000 excess tax deduction means Bear Co. will pay more tax in the future when the depreciation reverses.

$$\text{DTL} = \$13{,}000 \times 21\% = \$2{,}730$$

Debit

Credit

Income tax expense

$2,730

Deferred tax liability

$2,730

Deferred Tax Asset Example

Gies Co. records an estimated warranty liability of $50,000. For tax purposes, warranty costs are deductible only when paid. The tax rate is 21%.

$$\text{DTA} = \$50{,}000 \times 21\% = \$10{,}500$$

Debit

Credit

Deferred tax asset

$10,500

Income tax expense

$10,500

Bad Debt Example

MAS Inc. uses the allowance method and records bad debt expense of $30,000. For tax purposes, bad debts are deductible only when written off (direct write-off method). None were written off this year.

$$\text{DTA} = \$30{,}000 \times 21\% = \$6{,}300$$

Debit

Credit

Deferred tax asset

$6,300

Income tax expense

$6,300

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Comprehensive Example

Kingfisher Industries has pretax financial income of $500,000. The following differences exist:

Item	Amount	Type
Municipal bond interest	$20,000	Permanent
Excess tax depreciation	$40,000	Temporary (DTL)
Warranty accrual (not yet paid)	$15,000	Temporary (DTA)
Step 1 — Taxable income:

$$\$500{,}000 - \$20{,}000 - \$40{,}000 + \$15{,}000 = \$455{,}000$$

Step 2 — Current tax expense:

$$\$455{,}000 \times 21\% = \$95{,}550$$

Step 3 — Deferred taxes:

$$\text{DTL increase} = \$40{,}000 \times 21\% = \$8{,}400$$ $$\text{DTA increase} = \$15{,}000 \times 21\% = \$3{,}150$$

Step 4 — Total tax expense:

$$\$95{,}550 + \$8{,}400 - \$3{,}150 = \$100{,}800$$

Verification: ($500,000 − $20,000) × 21% = $100,800 ✓

Debit

Credit

Income tax expense

$100,800

Income tax payable

$95,550

Deferred tax liability

8,400

Deferred tax asset

3,150

Corrected entry:

Debit

Credit

Income tax expense

$100,800

Deferred tax asset

3,150

Income tax payable

$95,550

Deferred tax liability

8,400

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Valuation Allowance

A valuation allowance reduces the DTA to the amount that is more likely than not (greater than 50% probability) to be realized.

warning

If it is more likely than not that some or all of the DTA will not be realized, a valuation allowance must be established.

Factors suggesting a valuation allowance is needed:

• History of operating losses
• Losses expected in the near future
• Expiring carryforwards
• Lack of future taxable income sources BIF Partners has a DTA of $60,000 but determines that only $40,000 is more likely than not to be realized:

Debit

Credit

Income tax expense

$20,000

Valuation allowance

$20,000

The DTA is presented net: $60,000 − $20,000 = $40,000.

Enacted Tax Rate Changes

Deferred tax balances are adjusted when enacted tax rates change. The adjustment is recognized in income from continuing operations in the period of enactment.

$$\text{Adjustment} = \text{Temporary Difference Balance} \times (\text{New Rate} - \text{Old Rate})$$

Bear Co. has a cumulative temporary difference of $200,000 creating a DTL. The rate changes from 35% to 21%:

$$\text{Old DTL} = \$200{,}000 \times 35\% = \$70{,}000$$ $$\text{New DTL} = \$200{,}000 \times 21\% = \$42{,}000$$ $$\text{Reduction} = \$70{,}000 - \$42{,}000 = \$28{,}000$$

Debit

Credit

Deferred tax liability

$28,000

Income tax expense

$28,000

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Net Operating Losses (NOL)

NOL Rules by Period

Period of Loss	Carryback	Carryforward
Tax years before 2018	2 years back	20 years forward
2018 – 2020 (CARES Act)	5 years back	Indefinite, 80% limit
2021 and later	No carryback	Indefinite, 80% of taxable income limit

:::tip Exam Tip

For losses arising in 2021 and later, the NOL carryforward can offset only 80% of taxable income in any given year. The remaining 20% is taxable.

::: Example: Illini Security has a 2024 NOL of $100,000 and taxable income of $150,000 in 2025:

$$\text{Usable NOL} = \$150{,}000 \times 80\% = \$120{,}000 \text{ (but only \$100,000 available)}$$ $$\text{Taxable income after NOL} = \$150{,}000 - \$100{,}000 = \$50{,}000$$

When the NOL is generated, a DTA is recognized:

Debit

Credit

Deferred tax asset

$21,000

Income tax benefit

$21,000

When utilized:

Debit

Credit

Income tax expense

$21,000

Deferred tax asset

$21,000

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Uncertain Tax Positions

Under ASC 740-10, a tax position is recognized only if it is more likely than not (>50%) to be sustained upon examination. The amount recognized is the largest amount that is greater than 50% likely to be realized upon settlement.

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Balance Sheet Presentation

Under current GAAP (ASU 2015-17), all deferred tax assets and liabilities are classified as noncurrent on the balance sheet. DTAs and DTLs of the same tax jurisdiction are netted.

Component	Classification
Income tax payable	Current liability
Deferred tax asset	Noncurrent asset
Deferred tax liability	Noncurrent liability

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Investee Undistributed Earnings

When an investor uses the equity method, the investor's share of investee earnings creates book income, but dividends create taxable income. The undistributed earnings create a temporary difference and a DTL.

$$\text{DTL} = \text{Undistributed Earnings} \times \text{Tax Rate}$$

note

An exception exists if the investor can demonstrate the undistributed earnings will be reinvested indefinitely (the "indefinite reversal" criterion).

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Summary

:::note Chapter Checklist

• Distinguish permanent from temporary differences
• Calculate current tax expense from taxable income
• Determine DTL and DTA from temporary differences
• Apply the more-likely-than-not test for the valuation allowance
• Adjust deferred taxes for enacted rate changes
• Apply NOL carryback/carryforward rules by time period
• Evaluate uncertain tax positions using the two-step approach
• Present all deferred taxes as noncurrent :::