Overview

Accounting for Income Taxes

Taxable income can often differ from net income reported under GAAP or IFRS due to different rules from government taxing authorities. As such, companies will
define the differences as either temporary or permanent depending on why these differences occur. This lesson will define permanent and temporary differences in
book and taxable income as well as give examples and illustrations of these differences.

Upon completion of this lesson, candidates should be able to:

Differentiate between temporary differences and permanent differences and identify examples of each (1.A.2.s).

Distinguish between deferred tax liabilities and deferred tax assets (1.A.2.r).

Demonstrate an understanding of interperiod tax allocation/deferred income taxes (1.A.2.q).

Study Guide
Accounting for Income Taxes

I. Net income under U.S. generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) can differ from taxable income
reported to government taxing authorities such as the United States Internal Revenue Service (IRS).
A. Differences are defined as either temporary or permanent depending on the reasons why the GAAP to Tax accounting differences occur.
1. Permanent differences occur when GAAP revenues are not taxable or GAAP expenses are not deductible under the tax law. These differences will
never reconcile because the underlying definition of what constitutes income and deductions for tax differ from the definition of what constitutes
GAAP revenue and expense.
a. Examples of non-taxable revenues:
i. Interest received from investments in bonds issued by state and municipal governments
ii. Life insurance proceeds on the death of an insured executive
iii. Portion of dividends received from U.S. corporations that is not taxable due to the dividends received deduction
b. Examples of non-deductible expenses:
i. Investment expenses incurred to obtain tax-exempt income
ii. Premiums paid for life insurance policies when the payer is the beneficiary
iii. Compensation expense pertaining to some employee stock option plans
iv. Fines or penalties due to violations of the law
v. 50% of meals and entertainment expenses
c. Permanent differences do not result in deferred tax assets or liabilities, because the book to tax differences will never be reconciled in future
periods.
d. Illustration: X Company reported $200,000 in pretax book income, which included $15,000 of municipal bond interest and $10,000 in
expenses for environmental fines paid by the company. No other book to tax differences exist in the organization's results and the tax rate is
40%. Income tax expense for X Company is $78,000 [($200,000 − $15,000 + $10,000) × 40%].
2. Temporary differences occur when revenue or expenses are recorded in different periods for book purposes compared to tax purposes.
a. Examples of temporary differences:
i. Long-term construction contracts or other revenue arrangements (i.e. installment sales, cash received in advance of service) are
recognized on a modified cash basis for tax and an accrual basis for GAAP
ii. Estimated expenses (i.e., warranties, bad debts, contingencies) not deducted until paid for tax but accrued under GAAP
iii. Depreciation usually accelerated for tax but often straight line for books
iv. Deferred compensation deducted when paid for tax but accrued over the employee service period for GAAP
v. Investment gains and losses recognized when realized (sold) for tax but recognized using fair value measurement during the holding
period for GAAP
b. Taxable income recognized before book income generally results in a Deferred Tax Asset: Company A sells 2-year magazine subscriptions. For
book purposes, Company A records unearned revenue when received and recognizes revenue over the subscription period. For tax purposes
the subscription is recognized as revenue when it is received (wherewithal-to-pay concept). In the year the cash is received, Company A will
pay tax and record a Deferred Tax Asset (DTA). The DTA will be consumed and expensed as Deferred Tax Expense (DTE) in future periods as
the subscription revenue is recognized in book earnings.
c. Book income recognized before taxable income generally results in a Deferred Tax Liability: Company B records depreciation on a straight-
line method for book purposes but uses a statutorily required accelerated depreciation method for tax purposes. At the start of the
depreciation period, expenses for tax purposes will exceed book expenses because Company B records a higher depreciation expense for tax
purposes. Book income will exceed taxable income during this time. At the end of the depreciation period, book expenses will be greater than
expenses for tax purposes. Taxable income will exceed book income later in the life of the asset.
d. DTA Illustration: Company C receives a $1,200 payment in December 20X4 for a 20X5 subscription. The tax rate is 30%. For book purposes,
Company C will record $100 of revenue per month ($1,200 ÷ 12 months) beginning in January 20X5. For tax purposes, $1,200 is recognized as
taxable income when it is received in 20X4. This results in a tax payable of $360 ($1,200 × 30%) and a DTA of the same amount. Essentially,
Company C has prepaid its tax on revenue that will be recognized for GAAP purposes in the following year. The following entry will be
recorded in 20X4:
Deferred Tax Asset 360
Deferred Tax Benefit 360
 Current Tax Expense 360
Tax Payable 360
To recognize a deferred tax asset for subscription revenue received before it is earned.
In 20X5, Company C will recognize $1,200 of revenue for the subscription, but will have no tax payable because the income was already taxed
in 20X4. Because the revenue is included in 20X5 books, Company C will show book tax expense of $360 resulting from the utilization
(reduction) of the DTA with the following entry:
Deferred Tax Expense 360
Deferred Tax Asset 360
To record tax expense and the reduction of the DTA for subscription revenue recognized in the current year.
e. DTL Illustration: Company D has pretax income before depreciation expense of $200,000. An asset acquired during the year has book
depreciation of $50,000 and tax depreciation of $100,000 and Company D has no other book to tax differences. Company D has a 30% tax
rate. Pretax book income is $150,000 ($200,000 − $50,000) so book tax expense is $45,000 ($150,000 × 30%). However, taxable income is
$100,000 ($200,000 − $100,000), so Company D has a tax payable of only $30,000 ($100,000 × 30%) in tax for the year. Because this is the first
year of the asset's life, the difference between these two amounts results in the creation of a Deferred Tax Liability (DTL), which represents
tax that will be paid in a future year when the book depreciation exceeds the tax depreciation on the asset. The resulting entry for the first
year is noted below:
Current Tax Expense 30,000
Deferred Tax Expense 15,000

Tax Payable 30,000

Deferred Tax Liability 15,000
To record book tax expense for the year and recognize a deferred tax liability.
In a future year, Company D has pretax income before depreciation expense of $300,000. Company D records $50,000 in book depreciation
and $10,000 in tax depreciation and Company D still has a 30% tax rate and no other book to tax differences. Pretax book income is $250,000
($300,000 − $50,000) so book tax expense is $75,000 ($250,000 × 30%). However, taxable income is $290,000 ($300,000 − $10,000), so Company
D has a tax payable of $87,000 ($290,000 × 30%) in tax for the year. The $12,000 difference ($87,000 − $75,000) would be a reduction of the
existing DTL in the following entry:
Current Tax Expense 87,000

Deferred Tax Liability 12,000

Current Tax Payable 87,000

Deferred Tax Benefit 12,000

To record book tax expense for the year and recognize a reduction to the deferred tax liability.
f. DTAs and DTLs are calculated using enacted tax rates from the future periods in which the timing differences are expected to reverse.
g. Total Tax Expense is a combination of Current Tax Expense, the amount of tax liability on the organization's current-year tax return, and
Deferred Tax Expense, the change in the organization's DTAs and DTLs.
h. DTAs and DTLs are netted together and, depending upon the net value, the amount is presented in either the long-term assets or long-term
liabilities on the balance sheet.
i. If the realizable value of a DTA is questionable because there may not be future taxable income to offset the future reduction of taxable
income represented by the DTA, a valuation allowance will be recorded to reduce the value of the DTA. Recording a valuation allowance (a
credit) will increase tax expense for the period (a debit).

Practice Question
Autonomous Automobiles (Auto), a manufacturer of self-driving vehicles, had pretax financial income of $30 billion for the year 20X1, its
first year of operations. Auto has a current tax rate of 24% and a future enacted tax rate of 21%. The following differences between
financial and taxable income were reported by Auto for the current year (all numbers in millions):
Excess of tax depreciation over book depreciation……..……………………………$11,500
Interest revenue on municipal bonds..……………………………………………………1,600
Estimated warranty expense over actual expenditures…………………………………9,000
Fines paid.……………………………………………………………………………………6,400
Unrealized gains on marketable securities recognized for financial reporting.……….3,000

1. Calculate Auto's taxable income and current tax payable.

2. Calculate Auto's deferred tax asset or liability.
3. Prepare the journal entry needed to record Auto's total tax expense for the year. What is Auto's total tax expense for the year?
Answer
1. Auto's taxable income and current tax expense is calculated as follows (in millions):
Pretax Financial Income $30,000
Permanent Differences:

Interest Revenue Municipal Bonds (1,600)

Fines Paid 6,400

 Temporary Differences:
Depreciation (11,500)

Warranty Expense 9,000

Unrealized Gain (3,000)

Taxable Income $29,300

Tax ($29,300 × 24%) $7,032

2. Auto's net deferred tax liability is calculated as follows:
Temporary Differences Balance Tax Rate DTA/(DTL)
Depreciation $(11,500) 21% $(2,415)

Warranty Expense 9,000 21% 1,890

Unrealized Gain (3,000) 21% (630)

Deferred Tax Asset (Liability) $(1,155)

3. The journal entry to record the total tax expense and deferred tax liability is as follows:
Current Tax Expense 7,032

Deferred Tax Expense 1,155

Current Tax Payable 7,032

Deferred Tax Liability 1,155

To record book tax expense for the year and recognize a deferred tax liability.
Total Tax Expense on the income statement for the year is $8,187 ($7,032 + $1,155).

Summary
Tax accounting rules are often different than book accounting rules. As such, taxable income often differs from book income. These differences are defined as
either temporary or permanent depending on the underlying reasons for the difference. Permanent differences occur when GAAP revenues are not taxable or
GAAP expenses are not deductible under the tax law and these differences will never reconcile. Temporary differences occur when revenue or expenses are
recorded in different periods for book purposes compared to tax purposes. Temporary differences are recognized in the financial statements through deferred tax
assets (DTAs) or deferred tax liabilities (DTLs).