Income Taxes

I. General Objectives
A. Matching Provide a proper matching of
earnings and income tax expense
This means the financial statements
convey an accurate picture of the
relationship between earnings and the
cash actually paid out for income taxes

B. Recognition and Valuation Report on the

Balance Sheet
1. Current Year Cash Flows for Taxes
a. Tax Refund Receivable
b. Tax Payable

I.B. Recognition and Valuation (continued)

2. Future Years Tax-Related Cash Flows (Out/In)
a. Business events that have already occurred
and are recorded in financial income
i. Tax law excludes event from income until later
ii. Example: Credit Sales
GAAP records when revenue earned
Event taxed when cash is received
Causes Deferred Tax Liability
(similar to an accrued tax payable)
b. Business events that have already occurred
and are recorded in taxable income
i. GAAP excludes event from income until later
ii. Example: Rent Collected In Advance
GAAP does not record income until earned
Event taxed when cash is received
Causes Deferred Tax Asset
(similar to a prepaid tax)

I. C. Disclosure
1. Disclose components of tax expense\benefit
a. Current portion Total Tax From current
year tax return
b. Deferred portion Change in deferred tax
accounts during the year
2. Allocate total tax expense to a. Income Statement
i. Operations
ii. Extraordinary Items
iii. Discontinued Operations
b. Statement of Retained Earnings
i. Retroactive Adjustment to RE for Effect
of Change in Accounting Principle
( effect of accounting changes on tax liab. )

II. Background Information

A. Most firms keep at least 2 sets of records
1. Financial Reporting
a. GAAP rules followed
Revenues recorded when earned
Expenses recorded when incurred
b. Publish financial statements
c. Compute: Pretax Financial Income (PFI)
2. Federal tax return
a. Federal tax law followed (cash basis taxpayer)
Revenues taxable when cash collected
Certain revenues are not taxable (ever)
Expenses deductible when cash paid
Certain expenses are not deductible (ever)
b. File tax return (Form 1120 for corporations)
c. Compute: Taxable Income (TI)
Note: Tax Records are maintained for each
jurisdiction (State or Country) that imposes
an income tax. So a company will actually
maintain more than 2 sets of records.
In this class we will limit our discussion to
GAAP basis records and Federal tax records.
4

II. B. Accounting Problem

1. Differences in GAAP and Tax Law result in
Pretax Financial Income Taxable Income
2. Result Actual cash paid for taxes in a given year
does not usually provide a good
matching between PFI and Tax Expense
3. Types of Differences
a. Permanent Nature of the item (rev. or exp.) is
such that over the life of the firm
cumulative PFI cumulative TI.
(difference never reverses out)
Examples: Nontaxable interest income
Nondeductible fines
b. Temporary - Nature of the item (rev. or exp.) is
such that over the life of the firm
cumulative PFI = cumulative TI
(difference reverses out)
Examples: Revenue earned but not collected
Revenue collected but not earned
Expenses incurred but not paid
Expenses paid but not incurred
5

II.B. 4. Significance of Type of Difference

a. Permanent Difference
Do not cause Taxes Paid to yield a
misleading relationship between
PFI and Tax Expense
Result: Acceptable Matching
b. Temporary Differences
Cause Taxes Paid to yield a
misleading relationship between
PFI and Tax Expense
Result: Poor Matching
Note: If all differences between PFI and TI were
permanent differences, then Total Tax
from the tax return would be a good measure
of financial Tax Expense

II.B. 5. Example: Temporary Difference

For year ended December 31, X1
Jones Co. had sales as follows: Cash = $100
Credit= $ 80
Total Sales = $180
Expenses paid (in cash) during year = $40
At year end the credit sale has not been
collected
Federal Tax Law (Cash Basis Taxpayer)
Revenue reported on tax return (taxed) when
cash is received
Note: This provision of Tax Law makes the
uncollected credit sale a
Temporary Difference.
Expenses reported on tax return when cash is
paid out
Tax rate is a flat 50% for the current and all
future years

II.B. 5. Example: Temporary Difference (continued)

Tax Return Year X1: Federal Tax Law
Taxable Sales
Deductible Expenses
Taxable Income
Tax at 50%
Federal Tax

100
(40)
60
x .50
30

If we use Tax Paid as Tax Expense

Income Statement Year X1 GAAP
Sales
Expenses
Pretax Financial Income
Tax Expense
Net Income

180
(40)
140
(30)
110

Question: Do we really expect Tax Expense

to be 21% (30/140) of PFI in future?
Answer:

Result:

No... When the Credit Sale is collected

Federal Taxes will increase
significantly!
This Income Statement presents a
misleading relationship between
PFI and Tax Expense
8

II.B. 6. Example: Permanent Difference

For year ended December 31, X1
Jones Co. had sales as follows: Cash = $100
Credit= $ 80
Total Sales = $180
$100
Jones Co. owns municipal bonds and
received in cash (nontaxable) interest = $80
Expenses paid (in cash) during year = $40
At year end the credit sale has not been
collected
Federal Tax Law (Cash Basis Taxpayer)
Revenue reported on tax return (taxed) when
cash is received
Interest earned on municipal bonds is not
subject to tax (ever).
Note: This feature of Tax Law makes the $80
of interest income a Permanent Diff.
Expenses reported on tax return when cash is
paid out
9

II.B. 6. Example: Permanent Difference (continued)

Tax Return Year X1: Federal Tax Law
Taxable Sales
Deductible Expenses
Taxable Income
Tax at 50%
Federal Tax

100
(40)
60
x .50
30

If we use Tax Paid as Tax Expense

Income Statement Year X1 GAAP
Sales
Interest Income
Expenses
Pretax Financial Income
Tax Expense
Net Income

100
80
(40)
140
(30)
110

Question: Do we really expect Tax Expense

to be 21% (30/140) of PFI in future?
Answer:

Yes... Because the Interest Income

is not taxable (ever)!

Result: This Income Statement presents an

accurate picture of the relationship
between PFI and Tax Expense
10

II. C. Solution to Problem Caused by Temporary Diff.

1. Interperiod Tax Allocation
a. Definition The process of estimating actual
taxes that will be paid over multiple years
and then allocating the total back to
individual years to achieve a proper
matching of earnings (PFI) and taxes
(Tax Expense)

11

II. C. Solution to Problem Caused by Temporary Diff.

1. Interperiod Tax Allocation
b. Strategy - For events that have occurred
i. Calculate actual taxes for current year
(from current tax return)
Record as: Tax Payable (cr)
Tax Refund Receivable (dr)
ii. Estimate future cash outflows for taxes arising
from amounts taxable on future tax return
(Future Taxable Amounts)
Record as: Deferred Tax Liability (cr)
(like tax payable)
iii. Estimate future reductions in cash outflows
for taxes arising from amounts deductible on
future tax return (Future Deductible Amounts)
Record as: Deferred Tax Asset (dr)
(like prepaid tax)

12

II.C.1. c. How to calculate amounts

i. Actual Taxes for Current Year
Complete Federal Tax Return
ii. Future Tax Cash Flows Attributable to
Temporary Differences
Identify if the business transaction creates a
future taxable amount (FTA) or
future deductible amount (FDA)
(Need this information since a taxable
amount [revenue] causes a cash outflow
while a deductible amount [expense] yields
a reduction in cash outflow
Determine (estimate) when the
revenue difference or expense difference
will appear on a future tax return
(Need this information to determine the
correct tax rate to use since tax rates vary
by tax year)

13

II.C.1.c. ii. Future Cash Flows (calculating)

Calculate the incremental cash flow that will
be caused by the revenue difference or
expense difference when it appears on the
future tax return
Estimated
Revenue
Tax
= Future Tax
Difference x Rate
Payment (DTL)
Expense
Tax
Difference x Rate

Estimated
= Reduction in
Future Tax
Payments (DTA)

Note 1: Use the tax rate that will apply on the

future tax return based on current
law (ignore proposed changes in law)
Note 2: Incremental means the additional
cash flows for taxes, over and above
those already included on the tax
return (Total Tax) of the current and
prior years.
Note 3: When estimating future cash flows
we do not include those that will
arise in future business activity.
We only consider business events
that have already occurred.
14

II.C. 2. Example: Interperiod Tax Allocation for

Jones Co. (first set of facts)
Temporary Difference is: Credit Sale of $80
Next year (Year X2) when collected Jones will pay
taxes of: .50 x $80 = $40
So... We have an estimated future tax payable
related to this Temporary Difference
This estimated future tax payable is recorded
as a Deferred Tax Liability
The Year X1 journal entry is:
[From Year X1 Tax Return]
Tax Payable
30
Deferred Tax Liability
40
Tax Expense
70

Get B/S
Correct
[plug]

Notice the strategy here is to get the

Balance Sheet accounts correct and
then compute Tax Expense as the
balancing amount.
This is called the Asset/Liability Method
15

II.C. 2. Example: Interperiod Tax Allocation (continued)

So Year X1 Income Statement GAAP is:
Sales
Expenses
Pretax Financial Income
Tax Expense
Net Income

180
(40)
140
(70)
70

Now.... We have a proper matching of

PFI and Tax Expense.
Caution: In the above example another
way to calculate the Tax Expense
would appear to be
Tax Expense = Tax Rate x PFI
=
.50 x 140
= 70
Problem: This simplified approach to calculating
Tax Expense will not reliably calculate
the correct amount of Tax Expense
because of
o Variations in tax rates across years
o Presence of Permanent Differences
o Time limits for certain deductions
16

III. More Complex Example of Interperiod Tax Allocation

A. Facts: Chelsea Inc.
Pretax Financial Income (GAAP)
Year 1 Year 2 Year 3
Revenues
Cash Sales
Credit Sales
Expenses
Pretax Financial Income

100
30
130
(60)
70

130
0
130
(60)
70

130
0
130
(60)
70

Taxable Income (Tax Law)

Year 1 Year 2 Year 3
Cash Revenues From:
Current Year Sales
100
130
130
Credit Sales of Prior Yrs.
0
20
10
100
150
140
Expenses
(60)
(60)
(60)
Taxable Income
40
90
80
Tax Liability at 40%

16

36

32

Question: What amounts should be reported

as Tax Expense each year?
17

III. B. Solution to Chelsea Inc.

1. Year 1
We will use a worksheet format to help calculate
current period taxes and future cash flows for taxes
This worksheet presents a reconciliation between
PFI and TI
This reconciliation helps to identify all Temporary
and Permanent Differences
Note 1: In this reconciliation, each item is the
difference between the financial record
amount and the amount for tax purposes
Note 2: Students often have difficulty determining
the correct sign of reconciling items.
So ... I offer the following cookbook rule.
Comparison of
Sign of Reconciling
Current Year
Item is
Financial Amount versus
For
For
Tax Return Amount
Revenues Expenses
Financial Amount Larger
+
Tax Return Amount Larger
+
-

18

III. B. Solution to Chelsea Inc.

1. Year 1 (continued)
Pretax Financial Income

Current
Year 1
70

Future Years
Year 2 Year 3

Reconciling Items:
Credit Sales

Taxable Income
Tax Rate
Income Tax
Less: Payments
Tax Payable
FTA= Future Taxable Amount
O=Originating Difference
R=Reversing Difference

(30)
40
x . 40
16
(0)
16

FTA
R 20

FTA
R 10

x . 40
8

x . 40
4

[Year end BS balances]

Note 1: Reconciling items are always the difference
between the amount for Financial purposes
and the amount for Tax purposes.
Note 2: In the first year that a Temp. Diff. arises, the sum
of the originating and reversing differences is 0
(as in the above example)

19

III. B. Solution to Chelsea Inc.

1. Year 1 (continued)
Calculation of AJE amounts
Tax
Deferred Tax
Payable
Liability
Desired G/L Balance
16 cr
12 cr
Unadjusted G/L Balance
0 cr
0 cr
AJE amount
16 cr
12 cr
AJE:
Tax Payable
16 [from above]
Deferred Tax Liability
12 [from above]
Tax Expense
28
[plug]

20

III. B. Solution to Chelsea Inc.

2. Year 2

Pretax Financial Income

Current
Year 2
70

Future Years
Year 3

Reconciling Items:
Credit Sales
Taxable Income
Tax Rate
Income Tax
Less: Payments
Tax Payable
FTA= Future Taxable Amount
R=Reversing Difference

20

FTA
R 10

90
x . 40
36
(0)
36

x . 40
4

[Year end BS balances]

Note 1: Reconciling items are always the difference
between the amount for Financial purposes
and the amount for Tax purposes.

21

III. B. Solution to Chelsea Inc.

2. Year 2 (continued)
Assume: Year 1 taxes were paid
Calculation of AJE amounts
Tax
Deferred Tax
Payable
Liability
Desired G/L Balance
36 cr
4 cr
Unadjusted G/L Balance
0 cr
12cr
AJE amount
36 cr
8 dr
AJE:
Tax Payable
Deferred Tax Liability
Tax Expense

8
28

36 [from above]
[from above]
[plug]

22

III. B. Solution to Chelsea Inc.

3. Year 3

Pretax Financial Income

Current
Year 3
70

Reconciling Items:
Credit Sales

10

Taxable Income

80

Tax Rate
Income Tax
Less: Payments
Tax Payable

Future Years

x . 40
32
(0)
32

[Year end BS balance]

Note 1: Reconciling items are always the difference
between the amount for Financial purposes
and the amount for Tax purposes.
Note 2: At the end of Year 3 the company has no
future taxable or future deductible amounts.
Hence, there is no longer a need for any
deferred tax balances on the Balance Sheet.
23

III. B. Solution to Chelsea Inc.

3. Year 3 (continued)
Assume: Year 2 taxes were paid
Calculation of AJE amounts
Tax
Deferred Tax
Payable
Liability
Desired G/L Balance
32 cr
0 cr
Unadjusted G/L Balance
0 cr
4 cr
AJE amount
32 cr
4 dr
AJE:
Tax Payable
Deferred Tax Liability
Tax Expense

4
28

32 [from above]
[from above]
[plug]

24

III. C. Recap of 3-year results

Total
Year 1 Year 2 Year 3 All Years
Taxes Paid
Tax Expense

16
28

36
28

32
28

PFI

70

70

70

84
84

Comments:
1. Cumulative Taxes Paid = 84 (this is reality)
2. Cumulative Tax Expense = 84
3. Relationship between
Tax Expense and PFI makes sense
Every year that has the same PFI should have
the same expense (assuming same tax rate)

25

IV. Accounting for Net Operating Losses (NOL)

A. Definition: NOL = Negative Taxable Income (loss)
for a specific year
B. Treatment Under Federal Tax Law
1. Pay no taxes in loss year
2. Firm Permitted to Carryforward Loss
a. Reduce taxes owed in future years
i. Deduction Claimed on form 1120-Line 29
b. Current Federal Law
i. Carryforward period is 20 years (maximum)
ii. Must start with nearest year and work forward
until loss is fully offset by TI or
carryforward period expires

26

IV.B.
3. May Elect to Carryback Loss
a. Claim a refund of prior taxes paid
i. File amended return for each prior year, or
ii. File form 1139 (best approach)
b. Current Federal Law
i. Carryback period is 2 years
ii. Must start with earliest year first and work
forward until loss is fully offset by TI or
carryforward period expires

27

IV. C. Accounting Treatment of NOL in Loss Year

1. For Carryback
a. Record income benefit of the tax refund
i. Benefit Due To Loss Carryback (cr)
ii. This is the expected cash inflow from
the refund claimed
iii. Report as Negative Tax Expense
iv. Calculation of refund amount Carryback
Amount

Tax Rate in Effect

for Prior Tax Returns

b. Record as an asset
i. Income Tax Refund Receivable (dr)
ii. This is the amount of the tax refund claimed

28

IV.C.1. (Accounting for NOL Carryback)

c. Journal Entry
Income Tax Refund Receivable
Benefit Due To Loss Carryback

X
X

[A component of Tax Expense]

29

IV. C. Accounting Treatment of NOL in Loss Year

2. For Carryforward
a. Record maximum income benefit of claiming
NOL CF on future tax returns
i. Benefit Due To Loss Carryforward (cr)
ii. This is a the tax savings (reduction
in future cash outflows for taxes) from using
the remaining carryforward assuming all
of the CF is used (none of the CF expires)
iii. Report as Negative Tax Expense
iv. Calculation of maximum benefit amount Tax
Carryforward
Amount

Tax Rate in Effect

When CF Claimed
on future Tax Return

Note: The tax rate used in this calculation is

the rate which is specified in currently
enacted law.
Proposed or expected changes in future
tax rates are not considered.
30

IV.C.2.
b. Record as an asset
i. Deferred Tax Asset (dr)
ii. This is the maximum tax savings from using
the NOL CF on future tax returns
Note: DTA is recorded only when there is an
existing Temporary Difference between
Financial records and Tax records.
Question: What Temporary Difference Exists?
Answer:

For Financial purposes the firm records

all the expected income benefit of the
CF in the loss year (CF used up)
For Tax purposes, none of the CF
income benefit is claimed on the loss year
tax return
Tax use of the CF must wait until income
is earned and future tax returns are filed
This creates a Temporary Difference
in the amount of the CF used for
Fin. purposes versus Tax Purposes
31

IV.C.2.
c. Journal Entry
Deferred Tax Asset
Benefit Due To Loss Carryforward

X
X

[A component of Tax Expense]

32

IV.C.2.
d. Reduce DTA to Expected Value if needed
i. If it is More likely than not that some portion
of the CF benefit will expire before use
ii. Estimate how much of the tax savings from
the CF will not be used in the carryforward
period
iii. Calculation
Carryforward
Amount
Lost

Tax Rate in Effect

When CF Claimed
on future Tax Return

iv. Journal Entry

Benefit Due To Loss Carryforward
Allowance to Reduce DTA to
Expected Realizable Value

X
X

[Contra-Asset account]

33

IV. D. Accounting Treatment of NOL After Loss Year

1. Strategy - At the end of each year update
estimated values of the DTA and
Allowance .
2. For DTA
a. Estimate the maximum future tax savings from
using the remaining CF on future tax returns
b. Adjust the DTA to the estimated maximum
value
Note: As the CF is used on the Tax Return the
Temporary Difference between the
Financial and Tax Carryforwards will
diminish.
This will require a reduction in the DTA.
c. Journal Entry
Deferred Tax Expense
Deferred Tax Asset

XX
XX

Company has expense because it has

used up an asset --- the DTA
34

IV.D.
3. For the Allowance account
a. Estimate how much of the tax savings from
the remaining CF will expire in the remaining
carryforward period
b. Adjust the Allowance account to the amount
of the tax savings that is expected to be lost.
Note: This adjustment might increase or
reduce the allowance depending on the
circumstances

35

IV.D.3.
c. Journal Entry
i. Allowance Decreases
Allowance to reduce.

XX

Adjustment to Tax Expense

for change in Valuation
Allowance of DTA

XX

[A part of Tax Expense]

ii. Allowance Increases
Adjustment to Tax Expense
for change in Valuation
Allowance of DTA
Allowance to reduce

XX
XX

36

IV. E. NOL Example

1. Facts: Operations began in Year X1
No Temporary Differences Exist
No Permanent Differences Exist
At X4 future income highly uncertain
Tax law carryback period = 2 years
Year
X1
X2
X3
X4
X5

TI or Loss
Tax
(also PFI) Rate Tax Paid
50
.35
17.5
100
.30
30.0
200
.40
80.0
(500)
.45
0
?
.40
?

2. Loss Year: X4
a. JE for Carryback
With loss of (500) company elects to carryback.
Start with X2 and work forward.
Refund Claimed:

X2 = 30
X3 = 80
110

Entry:
Income Tax Refund Receivable
Benefit of NOL Carryback

110
110
37

IV.E.2. Loss Year: X4 (continued)

b. JE for Carryforward
Carryback used up 300 of NOL
Remaining NOL CF is 200
If used on X5 Tax Return benefit =
.4 x 200 = 80
GAAP requires booking of maximum benefit
whether or not we expect to realize the
maximum benefit.
Entry:
Deferred Tax Asset
80
Benefit of NOL Carryforward
80

Note:
If we do not expect to utilize the maximum
benefit we will establish an Allowance to
reduce the DTA to the expected benefit.

38

IV.E.2. Loss Year: X4 (continued)

c. JE for Allowance Account
Since future income is highly uncertain
There is significant doubt that any benefit
attributable to the NOL CF will be realized
So the realizable value of the DTA may
be much less than its recorded amount ($80)
Company needs to fully reserve the DTA
with an Allowance
This means reduce the DTA to its expected
realizable value via use of an Allowance
Entry:
Benefit due to NOL Carryforward
Allowance to Reduce DTA
to Expected Realizable Value

80
80

39

IV.E.2. Loss Year: X4 (continued)

d. Financial Statement Presentation
i. 12-31-X4 Balance Sheet
Income Tax Refund Receivable

110

Deferred Tax Asset

Allowance to reduce DTA
to Expected Realizable Value

80
(80)
0

ii. Income Statement

Operating loss before income tax (500)
Income Tax Benefit
Net Loss

110
(390)

40

IV.E.2. Loss Year: X4 (continued)

d. Financial Statement Presentation
iii. Footnote Disclosure
Calculation of Deferred Tax Expense\Benefit

Ending Balance
Beg. Balance

Allowance
DTA to Reduce
DTA
80 dr
80 cr
0 dr
0 cr

DTL
0 cr
0 cr
Change

Net
0 cr
0 dr
0 cr

A net 0 change means deferred tax

expense\benefit = 0

41

IV.E.2. Loss Year: X4 (continued)

d. Financial Statement Presentation
iii. Footnote Disclosure
Components of Tax Expense:
Component
Amount
Current Tax Expense
before Use of NOL CB
0
Tax Benefit of NOL CB
110
Current Tax Benefit
110
Deferred Tax Benefit
0
Total Income Tax Benefit
110
Note: If the company had been confident that the full
benefit of the CF would be realized on future tax
returns then there would have been no need for
the Allowance to reduce the DTA to its
expected realizable value.
In that case, there would have been a net dr
increase in the deferred tax accounts during
the year and the company would report a
deferred tax benefit (due to NOL CF) of $80.
This benefit would represent the expected
tax savings on future tax returns from using
the NOL CF.
42

IV.E.
3. Year following Loss Year: X5
a. Facts:
At start of year - Unused NOL CF is 200
Additional Facts: PFI =TI = 250 income
Tax law carryforward period = 20 years
b. Journal Entries
Calculation of Current and Deferred Tax Amounts

PFI
Temp. Diff
TI (before use of NOL CF)
NOL CF used on tax return
TI
Tax rate for Year X5
Tax
Less: Payments
Tax Payable

Current
Year
Future
X5
Years
250
0
250
(200)
50
X .40
20
(0)
20

Note: Carryforward is used up so no need for the DTA

or Allowance to reduce DTA (no future benefit)
43

IV.E.3.b. Journal Entries for X5

Calculation of X5 Year End AJE

Temp. Diff.
Tax Owed
Desired Balance
Unadjusted Bal.
AJE Amount

Allowance
To Reduce
DTA
DTA
0 dr
80 dr
80 cr

Tax
Payable

DTL
-

0 cr
80 cr
80 dr

0 cr
0 cr
0 cr

20 cr
20 cr
0 cr
20 cr

Year End Entries:

DTA
Allowance to reduce DTA
Tax Payable
Tax Expense

80
80

Adjust
Accounts

20
20

[plug]

44

IV.E.3. Year following Loss Year: X5

c. Financial Statement Presentation
i. 12-31-X5 Balance Sheet
Income Tax Payable

20

ii. Income Statement

Operating income before income tax 250
Income Tax Expense
Net Income

(20)
230

45

IV.E.3. Year following Loss Year: X5 (continued)

c. Financial Statement Presentation
iii. Footnote Disclosure
Calculation of Deferred Tax Expense\Benefit
DTA
Ending Balance
Beg. Balance

Allowance
to Reduce
DTA
0 dr
0 cr
80 dr
80 cr

DTL
0 cr
0 cr
Change

Net
0 cr
0 dr
0 cr

Note: Net change of 0 means deferred tax expense=0

Components of Tax Expense:
Component
Amount Comment
Current Tax Expense
before Use of NOL CF
100 .4 x 250
Tax Benefit of CF
(80) .4 x 200
Current Tax Expense
20
Deferred Tax Expense
0
Total Income Tax Expense
20

46

V. Accounting for Tax Credits

A. Description - Federal Law provides a direct
reduction in income taxes if firm
purchases certain assets,
hires certain employees, or engages
in activities encouraged by the
Federal government
If entire credit cannot be used, the
unused portion can be used on
future tax returns
1. Investment Tax Credit Example
a. Tax Law - If firm purchases new PPE that meets
certain requirements of law, firm
receives a credit on income taxes
b. Example: Tax Credit Rate
= 10%
Qualifying purchase = $1,000
Credit = .10 x 1,000 = $100
So tax liability in year PPE purchased
is reduced by $100

47

V.
B. Alternative Accounting Methods
1. Flow-Through Method a. Firm treats credit as reduction of tax expense
in year credit earned and adjusts JE to record
taxes payable
b. Most common method used due to simplicity
c. Example - Income Tax before credit = $500
Credit
= ($100)
Net Owed
= $400
Journal Entry Tax Expense
Income Tax Payable

400
400

48

V. B. Alternative Accounting Methods

2. Deferred Method
a. Firm prorates the reduction in tax expense over
the life of the asset whose purchase led to the
credit being earned
Theory - Credit is really a reduction in the price
of the asset (but not recorded as such)
So cost of using asset each year has
been reduced, and this benefit should
be spread over asset life to get proper
matching.
b. Method preferred by FASB due to belief that
it provides a better matching

49

V. B. Alternative Accounting Methods

2. Deferred Method
c. Example - Income Tax before credit = $500
Credit
= ($100)
Net Owed
= $400
Credit relates to PPE with 10 yr life
Set up Journal Entry (1st year only) Tax Expense
Deferred Tax Credit
Income Tax Payable

500
100
400

Yearly AJE to Tax Expense (for life of asset)

Deferred Tax Credit
10
Deferred Tax Expense
[Reduces DTC]

10

[Reduces Tax Expense]

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V. Accounting for Tax Credits

C. Accounting When Entire Credit Cannot Be Used
1. Description - Taxable Income is too low in the year
the credit is earned, so the company
cannot fully use the benefit of the
tax credit in the year earned
2. Example: ABC Co. earns $100 credit in year X1
X1 taxable income
Tax Rate
Tax before credit

= $80
= x .50
= $40

Credit Used in X1

= (40)

Final X1 tax liability

Tax credit carryforward = $ 60

[Future reduction in cash outflow]

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V. Accounting for Tax Credits

C. Accounting When Entire Credit Cannot Be Used
3. Expected future cash flow benefit of unused
tax credit is recorded as a Deferred Tax Asset
and
Tax expense on the Income Statement is reduced
to reflect the expected benefit of the tax credit
Note: The general ledger account for the expected
future benefit of the tax credit is Benefit of Tax Credit Carryforward
4. Journal entries
i. Year credit earned record DTA
Deferred Tax Asset
60
Benefit of Tax Credit Carryforward
60
[Negative Tax Expense]

52

V.C.4. Journal Entries (continued)

ii. Future years As credit is used on tax return
reduce DTA and record
corresponding increase in
Deferred Tax Expense
Example: ABC Co. has X2 income of $70
X2 taxable income
Tax Rate
Tax before credit

= $70
= x .50
= $35

Credit Used in X2

= (35)

Final X2 tax liability

Tax credit carryforward = $ 25

Deferred Tax Expense
Deferred Tax Asset

35
35

So X2 Income Statement is ...

Income before Tax
$70
Income Tax Expense (35)
Net Income
$35
53

VI. Miscellaneous Issues

A. Tax Rates Used in Calculations
The measurement of current and deferred tax
liabilities and assets is based on provisions of the
enacted tax law; the effects of future changes in
tax laws or rates are not anticipated.
B. Discounting Amounts of Deferred Taxes
The deferred tax liability or asset shall not be
accounted for on a discounted basis.
C. Computation of Deferred Tax Expense
Deferred tax expense or benefit is the change
during the year in an enterprise's deferred tax
liabilities and assets.
D. Computation of Total Tax Expense
Total income tax expense (or benefit) for the year
is the sum of deferred tax expense (or benefit)
and the total tax (payable or refundable) from the
income tax return.

54

VI. Miscellaneous Issues

E. Accounting for Change in the Beginning
Valuation Allowance
1. The effect of a change in the beginning
balance of a valuation allowance that results
from a change in circumstances
(tax rates, expected future income, etc.)
that causes a change in judgment about the
realizability of the related deferred tax asset in
future years ordinarily shall be included in
income from continuing operations.
2. This will be reported as a separate component
of tax expense.
Note: This just means treat the adjustment as
a change-in-estimate and record in current
year income
Do not restate prior years recorded amounts

55

VI. Miscellaneous Issues

F. Accounting for an Enacted Change in Tax Law
or Rates
1. Deferred tax liabilities and assets shall be
adjusted for the effect of a change in tax laws or
rates.
2. The effect shall be included in income from
continuing operations for the period that includes
the enactment date.
3. This will be reported as a separate component
of tax expense
Note: If tax rates change, this means that the
DTAs and DTLs will change. Treat such
changes as a change-in-estimate and record
in current year income.

56

VI. Miscellaneous Issues

G. Procedures for Identifying Temporary and
Permanent Differences
1. Do a reconciliation between PFI and TI
2. Consult Schedule M-1 on tax form 1120
and other tax records

57

VI. Miscellaneous Issues

H. Balance Sheet Presentation
1. An enterprise shall separate deferred tax liabilities
and assets into a current amount and a
noncurrent amount.
2. Deferred tax liabilities and assets shall be
classified as current or noncurrent based on the
classification of the related asset or liability for
financial reporting.
3. A deferred tax liability or asset that is not related
to an asset or liability for financial reporting
including deferred tax assets related to
carryforwards, shall be classified according to the
expected reversal date.
4. The valuation allowance for a particular tax
jurisdiction shall be allocated between current
and noncurrent deferred tax assets for that tax
jurisdiction on a pro rata basis.

58

VI. Miscellaneous Issues

H. Balance Sheet Presentation (continued)
5. For a particular tax-paying component of an
enterprise and within a particular tax jurisdiction,
a. All current deferred tax liabilities and assets
shall be offset and presented as a single
amount and
b. All noncurrent deferred tax liabilities and assets
shall be offset and presented as a single amount.

59

VI. Miscellaneous Issues

I. Income Statement Presentation
1. The significant components of income tax
expense shall be disclosed in the financial
statements or footnotes. Those components
would include, for example:
a. Current tax expense or benefit
b. Deferred tax expense or benefit
(exclusive of the following components)
c. Investment tax credits
d. The benefits of operating loss carryforwards
e. Adjustments of a deferred tax liability or asset
for enacted changes in tax laws or rates or a
change in the tax status of the enterprise
f. Adjustments of the beginning-of-the-year
balance of a valuation allowance because of a
change in circumstances that causes a change
in judgment about the realizability of the related
deferred tax asset in future years.

60

VII. Steps in Recording Tax Expense

A. Prepare reconciliation between PFI and TI to
identify Temporary and Permanent Differences
B. Use the reconciliation as a basis for computing
the desired year end balances in:
1. Income Tax Refund Receivable
2. Income Tax Payable
3. Deferred Tax Accounts (current and noncurrent)
a. Deferred Tax Asset
b. Allowance to Reduce DTA to Expected
Realizable Value
c. Deferred Tax Liability
C. Compute the year end adjusting journal entry by
differencing the desired and unadjusted G/L
balances
D. Compute the amount of deferred tax expense by
differencing the beginning and ending deferred
tax accounts

61