Deferred Income Taxes
Practice as You Learn
Intermediate Accounting 2
Practice as You Learn
Follow these steps when working a deferred tax problem:
1) Write the format:
Book |
Tax |
Cumulative Difference |
||
| Income before Differences: | = | |||
| + – Items that are different for book & tax name name |
______ | ______ | ______ | |
| = Taxable Income | ||||
| + – permanent differences (tax) | ||||
| x Tax Rate | ______ | ______ | ||
| = Tax | Expense | Payable |
2) Write the information that you are given in the problem in the format
3) Remember that the “Income before Differences” will always be the same for the book column and the tax column. Compute all other amounts given what you know.
4) Begin your journal entry: record the tax expense and the tax payable, leave space in between
5) Determine if the items that are different are deferred tax assets or liabilities
6) Multiply the cumulative book/tax difference x future tax rate = deferred tax asset or liability balance at the end of this period
7) Record a deferred tax asset or liability to get the deferred tax asset or liability account balance to equal the amount computed in 6)
8) Plug tax expense to make the journal entry balance: You will have to change the tax expense amount if there are permanent differences or a future tax rate change.
Other issues:
1) Valuation Allowance:
Multiply the % not likely to be realized by the deferred tax asset balance
This is the amount that the Valuation Allowance account must be
Adjust the valuation account and tax expense to get to the valuation allowance account balance you determined
2) NOL Carry back / Carry forward:
Occurs when you have a taxable loss
The carry back / forward amount is equal to the loss time the tax rate paid for past or future years (limited to taxable income and taxes actually paid in the prior years)
Record a receivable for the carry back amount
Record a deferred tax asset for the carry forward amount
3) When you are given a current balance in a deferred tax account, the current balance is always equal to the cumulative book/tax difference x the future tax rate
4) Remember that the current year journal entry always records the change in the total deferred tax asset and deferred tax liability balance.
Do not record the cumulative difference x tax rate except in the first year.
Practice Problem – Deferred Taxes
The accountant has the following information to use to record the tax entries for the company:
| Year 1 | Year 2 | |
| Warranty Expense Accrued | 20,000 | 40,000 |
| Warranty Claims Paid | 12,000 | 30,000 |
| Depreciation Expense for Books | 35,000 | 38,000 |
| Deprecation Expense for Tax | 55,000 | 22,000 |
| Book Taxable Income/(Loss) | 312,000 | |
| Taxable Income/(Loss) | (150,000) | |
| Tax Rate | 30% | 40% |
A. Record the tax expense entry for year 1
B. Record the tax expense entry for year 2 given the company elects to carry back first.
C. Record the valuation allowance for year 2 given 25% of deferred tax assets is more likely than not to be unrealizable.
Answer
A. Year 1
Set up the format and drop in the amounts that you know. The items that are book tax differences are warranties and depreciation. (Follow steps 1 & 2)
| 1) Write the format: | Cumulative | ||
| Book | Tax | Difference | |
| Income before Differences: | = | ||
| + – Items that are different for book & tax | |||
| Warranties | (20,000) | (12,000) | |
| Depreciation | (35,000) | (55,000) | |
| = Taxable Income | 312,000 | ||
| x Tax Rate | 30% | 30% | |
| = Tax | Expense | Payable |
Note:
For differences, expenses are negative and revenues are positive
Paid or Collected is “tax” and recorded or accrued is “book
Step 3) Plug to finish the computation – remember that the “income before differences” must be
the same number for book and for tax. You know the book taxable income so work up, to the right and then back down the tax column
| Cumulative | |||
| Book | Tax | Difference | |
| Income before Differences: | 367,000 = | 367,000 | |
| + – Items that are different for book & tax | |||
| Warranties | (20,000) | (12,000) | 8,000 |
| Depreciation | (35,000) | (55,000) | 20,000 |
| = Taxable Income | 312,000 | 300,000 | |
| x Tax Rate | 30% | 30% | |
| = Tax | 93,600 | 90,000 | |
Step 4) Begin the Journal Entry:
Tax Expense 93,600
Tax Payable 90,000
Step 5) Determine if the items that are different are deferred tax assets or liabilities
Warranties –
Expensed less for tax now, so will expense more for tax in future
More tax expense deduction in future, less taxable income,
Pay less tax in future = ASSET
Depreciation –
Expensed more for tax now, so will expense less for tax in future
Less tax expense deduction in future, more taxable income,
Pay more tax in future = LIABILITY
Step 6)
Multiply the cumulative difference x future tax rate to get the deferred tax asset or liability balance at the end of this period
| Cumulative Difference x Future tax rate = Deferred Tax | ||
| Warranties: | 8,000 | x 40% = 3,200 Asset |
| Depreciation: | 20,000 | x 40% = 8,000 Liability |
Step 7) Record deferred tax asset or liability to get the deferred tax asset or liability account to equal the balance computed in 6)
This is the first year of operations, so the balance in the deferred tax asset and deferred tax liability accounts = 0
To get the balance to be the amount computed, record the amount computed
| Tax Expense 93,600 |
| Deferred Tax Asset 3,200 |
| Deferred Tax Liability 8,000 |
| Tax Payable 90,000 |
Step 8) The journal entry in step 7 does not balance – Change tax expense to the amount that will balance the journal entry
| Tax Expense 94,800 |
| Deferred Tax Asset 3,200 |
| Deferred Tax Liability 8,000 |
| Tax Payable 90,000 |
B. Year 2
Set up the format and drop in the amounts that you know. The items that are book tax
differences are warranties and depreciation. (Follow steps 1 & 2)
| 1) Write the format: | Cumulative | ||
| Book | Tax | Difference | |
| Income before Differences: | = | ||
| + – Items that are different for book & tax | |||
| Warranties | (40,000) | (30,000) | |
| Depreciation | (38,000) | (22,000) | |
| = Taxable Income | (150,000) | ||
| x Tax Rate | 40% | 40% | |
| = Tax | Expense | Payable | |
Note:
For differences, expenses are negative and revenues are positive
Paid or collected is “tax” and recorded or accrued is “book
Step 3) Plug to finish the computation – remember that the “income before differences” must be the same number for book and for tax.
Use the taxable income and work up, to the left and then back down the book column
| Cumulative | ||||||
| Book | Tax | Difference | ||||
| Income before Differences: | (98,000) = | (98,000) | ||||
| + – Items that are different for book & tax | ||||||
| Warranties | (40,000) | (30,000) | 8,000 + 10,000 | |||
| Depreciation | (38,000) | (22,000) | 20,000 – 16,000 | |||
| = Taxable Income | (176,000) | (150,000) | ||||
| x Tax Rate | 40% | 40% | ||||
| = Tax | 70,400 | (60,000) | ||||
| Benefit | NOL | |||||
Step 4) Begin the Journal Entry:
No tax payable, record tax payable later for a taxable loss
Step 5) Determine if the items that are different are deferred tax assets or liabilities
Warranties: An initial asset that remains an asset.
Book expense is greater than tax expense again, so there is more asset
| Book | Tax | |
| Year 1 | 20,000 | 12,000 |
| Year 2 | 40,000 | 30,000 |
| Cumulative | 60,000 | 42,000 |
18,000 cumulative difference
Depreciation – An initial liability remains a liability.
Tax expense is less than book expense this time, so it is the opposite of last year and this year the liability is decreased.
| Book | Tax | |
| Year 1 | 35,000 | 55,000 |
| Year 2 | 38,000 | 22,000 |
| Cumulative | 73,000 | 77,000 |
4,000 cumulative difference
Step 6)
Multiply the cumulative difference x future tax rate = deferred tax asset or liability balance at the end of this period
Cumulative Difference x Future tax rate = Deferred Tax
| Warranties: | 18,000 | x 40% = 7,200 D/T Asset |
| Depreciation: | 4,000 | x 40% = 1,600 D/T Liability |
This is the balance in the deferred tax account
Step 7) Record a deferred tax asset or liability to get the deferred tax asset or liability account to equal the balance computed in 6)
| D/T Asset | D/T Liability | |
| Year 1 balance | 3,200 | 8,000 |
| Year 2 balance must be | 7,200 | 1,600 |
| Adjustment to make | +4,000 | – 6,400 |
Deferred Tax Asset 4,000
Deferred Tax Liability 6,400
Tax Expense 10,400
No tax payable since there is a taxable loss.
Plug the adjustment to the deferred tax accounts to tax expense.
Tax expense can be a debit or credit.
Step 8) Record the NOL. The company elects to carry back and then carry forward.
Prior year taxable income is limited to this years NOL x prior year tax rate = IRS refund
150,000 x 30% = 45,000
Record this amount as tax receivable because a refund of past taxes paid will be received
Tax Receivable 45,000
Tax Expense 45,000
All of the loss is used to offset prior year gains and get a refund
Nothing left to carry forward.
C. Record the valuation allowance for year 2 given 25% of deferred tax assets is more likely than not to be unrealizable.
The balance in the deferred tax account is now 7,200
Multiply the cumulative balance by 25% to get the amount that is not expected to be realized
7,200 x 25% = 1,800 balance in valuation allowance account needed
The current balance in the valuation allowance account is 0, so record 1,800 to get to the 1,800 required.
Tax Expense 1,800
Valuation Allowance 1,800
Under the revised rules, no allowance will be needed because the DT asset can be carried forward indefinitely as long as profit is eventually expected.