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Accounting for Deferred Taxes

Income Tax Expense


Tax expense for current year consists of:
Current income tax expense (this years tax bill)
and
Deferred income tax expense.

Income tax expense


Taxes payable
Deferred income taxes liability
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100
80
20

Book-to-Tax Differences
Arises because for some items tax accounting
differs from book (GAAP).
Taxable income: income reported to tax
authorities to compute income tax.
Pretax accounting income = pretax book
income = income before taxes: income before
tax under GAAP.

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Why Do Book and Taxable Income


Differ?
Objective of tax accounting: raise taxes and
encourage behavior, e.g. accelerated
depreciation to encourage investment.
Objective of GAAP/Financial reporting:
Provide info useful to investors.

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Why Do Book and Taxable Income


Differ?

Temporary (Timing) Difference


between Book and Tax
Differences that reverse in a later period.
Revenues or expenses that are permitted or
required to be reported in a different period. e.g.
depreciation.

Creates accounting complexities in order to


match income tax expense to period in which
revenue or expense item is recognized.

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Temporary (Timing) Difference


between Book and Tax

Permanent Differences between Book


and Tax
Do not reverse in future years.
Expenses under GAAP that are not deductible.
(e.g. fines.)
Revenues excluded from taxable income. (e.g.
revenue on municipal bonds)
Does not create accounting issues.

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Permanent Differences between Book


and Tax

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Deferred Tax Reporting


Asset and liability method.
Deferred Income Taxes: liability account.
Shown separately from Taxes payable.
Indicates amount that future tax expense will be
reduced when differences between book and tax
reverse.
Its like Interest free loan from the government.
Increases as long as company grows.
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Deferred Tax Assets


Temporary differences resulting in Taxable
income higher than book:
Subscription receipts recognized when received
for tax purposes, and when earned for accg
purposes.

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Permanent Deferrals
Company grows in size.
Replacement costs of assets increases in
periods of inflation.

Tax Rate Changes and Disclosures


Deferrals recorded based on rates currently in
tax law.
Disclosures:
Deferred tax asset and liability amounts shown
separately.
Must be classified appropriately as current or
noncurrent.

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Example 1

Example 1

Example 1

Example 2

Example 2

Example 2

Example 3

Example 3

Example 3

SILVER APPLIANCE COMPANY


(In Thousands)
1989
1990
1991
$190.1 $351.9 $526.2
1.Year-end installment receivables................................
2.Gross margin % ................................................................
34.6%
35.1%
34.2%
3.Deferred gross margin (= 1 * 2) ................................65.77 123.52 179.96
4.Pretax profit, delivery basis ................................ 332.6
415.3
478.2
5.Income taxes, delivery basis (34% of 4)................................
113.08 141.20 162.59
6.Pretax profit, installment basis (= 4 - 3 +
previous years 3) ................................................................
266.83 357.55 421.76
7.Income taxes, installment basis (34% of 6) ................................
90.72 121.57 143.40
8.Tax deferred (5 - 7)................................................................
22.36
19.63 19.19
9.Cumulative tax deferred ................................................................
22.36
41.99
61.18

1992
$559.4
33.4%
186.84
492.5
167.45

1993
$489.1
32.2%
157.49
461.3
156.84

485.62
165.11
2.34
63.52

490.65
166.82
(9.98)
53.54

B Off Inc.
Leading pest extermination company in
Cambridge, Massachussetts.
Warranty stated that clients would be roach free
for one year after an extermination treatment or
their money back.
Estimated warranty expense was 6% of total
revenues collected for any given year.
Tax laws permitted companies offering
warranties to deduct expenses for tax purposes
only as they actually incurred.

Because of special weather conditions, the


cockroach problem worsened in 2008.
Prepare proforma income statements for Bug
off inc. for 2008 through 2010 as they will
appear in financial reports and in the
companys tax returns.
How should the deferred taxes be reported in
each year.

Income statement for 2007


$1,00,000

Revenues
Expenses:
Materials
Salaries
Depreciation
Warranty expense

$25,000
35,000
5,000
6,000
71,000

Income before taxes

29,000

Income taxes @ 40%


Income after taxes

11,600
17,400

Pro Forma Revenues and Expenses


2008
$ 2,00,000

2009
1,00,000

2010
1,00,000

Materials
Salaries
Depreciation
Warranty expense
(accrual)

$ 50,000
55,000
5,000
12,000

25,000
35,000
5,000
6,000

25,000
35,000
5,000
6,000

Warranty (tax return)

6,000

12,000

6,000

Revenues
Expenses:

Expected tax rate

40%

40%

40%

Revenue

Financial Reports
Tax returns
2008
2009
2010
2008
2009
2010
1,00,000
1,00,000
$ 2,00,000
1,00,000
1,00,000
$ 2,00,000

Expenses:
Materials
Salaries
Depreciation
Warranty
expense

$ 50,000
55,000
5,000
12,000

25,000
35,000
5,000
6,000

25,000
35,000
5,000
6,000

$ 50,000
55,000
5,000
6,000

25,000
35,000
5,000
12,000

25,000
35,000
5,000
6,000

Total
expenses

1,22,000

71,000

71,000

1,16,000

77,000

71,000

Income
before taxes

78,000

29,000

29,000

84,000

23,000

29,000

Taxes @
40%

31,200

11,600

11,600

33,600

9,200

11,600

Journal Entries

Tax expense (Dr)

Deferred taxes

Cash (Cr)

2008
2009
2010

31,200
11,600
11,600

2400 (Dr)
2400 (Cr)
0

33,600
9200
11,600

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