Financial Reporting of

Income tax
CHAPTER 19
Homework problems
E19-1 one rate, no beginning balance, 1 difference, 1 year
E19-2 one rate, no beginning balance, 2 differences, 2 years
E19-3 one rate, with beginning balance, 1 difference, 2 years
E19-5 one rate, with beginning balance, 2 difference (1 DTA, 1 DTL)
E19-10 NOL multiple rates (this problems is exactly like the NOL on my slides)
E19-11 Current vs non-current deferred tax presentation on balance sheet
E19-13 multiple rates, effect of beginning balance in DTL.
I expect to have questions about the following
on the quiz
1. Calculate tax expense 1 rate 1 temporary difference no beginning balance
2. Calculate tax expense 2 rates 1 temporary difference no beginning balance
3. Calculate EOY balance DTA, 2 rates
4. Calculate EOY balance DTL, 2 rates
5. Change in mandated tax rates
6. Current non/current balance sheet disclosure
7. NOL Tax benefit
8. NOL – DTA
9. 2 CPA questions on above topics
Deferred Taxes: Basics
Deferred taxes arise when income tax expense differs from income tax liability.

The tax expense is determined under GAAP.

The income tax liability is determined under the Internal Revenue Code.

Some of these differences are temporary and reverse over time.

Others are permanent and do not reverse.

Summary of Temporary Differences
When recorded When recorded Deferred
Transaction
in books on tax return tax effect

Rev or Gain Earlier Later Liability

Rev or Gain Later Earlier Asset

Exp or Loss Earlier Later Asset

Exp or Loss Later Earlier Liability

Permanent Differences: Examples
Items, recognized for financial accounting purposes, but not for income tax purposes:

o interest income received on tax exempt securities

o fines and expenses resulting from violations of law
o Premiums paid for life insurance on key officers/employees
o Wages in excess of $1,000,000 for executives
 Permanent Differences: Examples
Items, recognized for tax purposes, but not for financial accounting purposes:

o the dividends received deduction under the Code

o percentage depletion of natural resources in excess of their cost
Summary of Permanent Differences
Sources of Permanent Differences

Some items are recorded but NEVER

in Books on tax return

are NEVER but recorded

Other items recorded in books on tax return

No deferred tax effects

for permanent differences
Deferred Tax Asset Liability: Sources
Deferred tax liability arises due to temporary differences that lead to net
taxable amounts when they reverse in the future.

More tax paid in future  Deferred Tax Liability

Deferred tax asset arises due to temporary differences that lead to net
deductible amounts when they reverse in the future.

Less tax paid in future  Deferred Tax Asset

X has $200 revenue in 2016 and 2017. The firm has one asset that will last 2 years and will be deprecated $50 in 2016 and $50 in 2017.
No other expenses before tax. 30% tax rate. Tax law allows X to depreciate $100 in 2016 and $0 in 2017.

Net Income =$105

Same firm in 2017

Net Income =$105

Simple example continued
Over 2 years Depreciation Expense is $100 for both tax and GAAP
Any difference is temporary

In first year Deferred tax expense was

◦ Tax rate x Excess depreciation
◦ 30% x (50 – 100) = <15>

In second year Deferred tax benefit was

◦ Tax rate x reversal of temporary difference (excess depreciation)
◦ 30% x (50-0) = 15
Deferred Tax Liability
In general depreciation for taxes is faster than depreciation for GAAP.
◦ This allows firms to pay less tax in the early years
◦ But they will have to pay more tax in latter years

◦ This will create deferred tax expense and a deferred tax liability
 Simple example – 2: Deferred Tax Asset
2016 Y receives $100 cash for 2017 rent – unearned rent revenue. The firm’s only expense is tax of 30%. Tax law forces Y recognize the
rent as revenue in 2016. We should recognize $0 net income in 2016 and $70 in 2017.
2016
GAAP income before tax = 0 = $0
Without Deferred tax
2016 NI = <$30>
Net Income =$0 2017 NI = $100

2017 This adds up to the

GAAP income before tax = 100 = $100 right number but not
recognized in right
year
Net Income =$70
Deferred Taxes: Applying Tax Rates
Basic Rule: Apply the yearly tax rate to calculate deferred tax effects.

If future tax rates change: use the enacted tax rate expected to apply in the
future year.

If new rates are not yet enacted into law for future years, the current rate
should be used.
DTA and DTL: Two temporary differences
Two Temporary differences originating in 2017

Temporary difference #1)

◦ Excess of tax depreciation over book depreciation = 40,000 – will reverse equally over 4 years

Temporary difference #2)

◦ Deferral for book purposes of 20,000 of unearned rent revenue will be earned in 2018
Permanent difference
◦ $10,000 non-taxable income
Pretax Financial income = $310,000
Tax Rate = 40%
Temporary difference #1: Depreciation
Excess of tax depreciation over book depreciation = 40,000
◦ will reverse equally over 4 years

2017 2018 2019 2020 2021

Book
0 10,000 10,000 10,000 10,000
Depreciation

Tax Depreciation 40,000 0 0 0 0

Temporary difference #2: Unearned rent revenue
2017 2018
Book
0 20,000
Rent Revenue

Tax
Rent Revenue 20,000 0

Deferral for book purposes of 20,000 of unearned rent revenue will be

earned in 2018 for book purposes
What is taxable income for 2017?
◦ pretax financial income
◦
◦
◦ Temporary differences
Rent revenue recognized early for tax
Dep exp recognized early for tax

Total taxable income

Depreciation: How much more tax in the future?
2017 2018 2019 2020 2021
Book 10,000
0 10,000 10,000 10,000
Depreciation

Tax Depreciation 40,000 0 0 0 0

How much more tax?

2018 
2019 
2020 
2021 
Total 16,000
Unearned rent revenue how much less tax in future?
2017 2018
Book
0 20,000
Rent Revenue

Tax
Rent Revenue 20,000 0

How much less tax?

2018 

Total 8,000
Calculating DTA and DTL
◦ Cumulative Difference
◦ Tax rate
◦ Deferred Tax Asset

◦ Cumulative Difference
◦ Tax rate
◦ Deferred Tax Liability
Calculating Tax Expense
Tax Expense JE 2017

DTA DTL
2017
In 2018 differences start to reverse
2018
DTA
◦ EOY Cumulative Difference
◦ Tax rate
◦ Deferred Tax Asset

DTL
◦ EOY Cumulative Difference
◦ Tax rate
◦ Deferred Tax Liability
 Reversals in 2018
Taxable income = 325,000 (Given in problem)
Tax rate =
Tax Payable =
Journal Entry

DTA DTL
2017 8,000 16,000

2018 12,000
0
Multiple tax rates
What happens when future tax rates are not all the same?

Use the rate that is expected to be in effect when temporary

differences reverse
 Multiple tax rate example from book
Year = 2018; Tax rate 2018 = 45%; 40% thereafter

1) $96,000 revenue for GAAP in 2018; Recognized 2019-2021 for tax

2) recognize 30,000 depreciation exp for tax in 2018; 6,000 per year for GAAP
3) Receive $100,000 for 2 years rent. Recognized all at once for tax.

Future taxable (deductible) amounts

2019 2020 2021 2022 2023 Total
Installment Sales 32,000 32,000 32,000 96,000
Depreciation 6,000 6,000 6,000 6,000 6,000 30,000
Unearned Rent (50,000) (50,000) (100,000)
DTA and DTL based on future tax rates
Taxable amounts
◦ Cumulative Diff Installment sales 96,000
◦ Cumulative Diff Depreciation 30,000
◦ Total Cumulative Diff taxable amounts 126,000
◦ Tax Rate 40%
◦ Deferred tax liability 50,400
Deductible amounts
◦ Unearned Rent 100,000
◦ Cumulative Diff Deductible amounts 100,000
◦ Tax Rate 40%
◦ Deferred tax Asset 40,000
DTA and DTL are balance sheet accounts
DTA DTL
2018 0 0

40,000 50,400
2019
How much tax to pay this year
2018 Pretax financial income (given) = 250,000
◦ Temporary differences
◦ Excess Installment sales book (96,000)
◦ Excess Depreciation Tax (30,000)
◦ Excess Rental Income 100,000
Taxable income 224,000

◦ Current Tax Rate

◦ Tax Payable
Tax Expense Journal Entry
Example with permanent difference
Sylvanas’ Beauty shop begins business in 2017. In its first year of business the firm has 10,000 of
taxable income. There were two differences between taxable income and pretax financial
income. The first was 500 of excess deprecation for taxes and the second was $1,000 of non-
taxable municipal bond interest. The firm had a 30% tax rate in 2017 and 40% in all future years.
What is Sylvanas’ 2017 tax expense?
Revision of Future Tax Rates
When a change in tax rate is enacted, its effect should be recorded
immediately.
The effect is reported as an adjustment to tax expense in the period of
change.
Changes in tax rates are treated just like any other change in estimate,
prospectively.

In other words, what if we have deferred tax asset and deferred tax liability and congress
changes the tax rates?
 Revision of Future Tax Rates:
Example
End of 2015, corporate tax rate is changed from 40% to 35%.
The new rate is effective January 1, 2017.
The deferred tax account (1/1/2015) is as follows:
Excess tax depreciation: $3 million
Deferred tax liability: $1.2 million
Related taxable amounts are expected to occur equally over
2016, 2017, and 2018.
Provide the journal entry to reflect the change.
Revision of Future Tax Rates: Example
The deferred tax liability end of 2015 is as follows:
2016 2017 2018
Future tax inc $1,000,000 1,000,000 1,000,000
Tax rate 40% 35% 35%
Deferred tax liability $400,000 350,000 350,000
Entry:
Deferred Tax Liability $100,000
Income Tax Expense $100,000*
Balance Sheet Presentation
Balance Sheet Presentation:
o The deferred tax classification relates to its underlying asset or liability.
o Classify the deferred tax amounts as current or non-current.

o Sum the various deferred tax assets and liabilities classified as current.

o Sum the various deferred tax assets and liabilities classified as non-current.
Balance Sheet Presentation
Balance Sheet Presentation:
Sum the various deferred tax assets and liabilities classified as current:
o If net result is an asset, report as current asset
o If net result is a liability, report as current liability
Sum the various deferred tax assets and liabilities classified as non-current:
o If net result is an asset, report as long-term asset
o If net result is a liability, report as long-term liability
Balance sheet presentation example
In Year 1, The Consortium had three differences between its book and tax income. The first was
$5,000 excess tax deprecation on a building with a 10 year life, the second was $15,000 excess
taxable revenue that will reverse in the third year of business, the third difference is a $1,000
fine paid to local authorities that is not deductible for taxes. The firm’s tax rate is 40%. What is
the deferred tax asset that will be reported on the year 1 balance sheet?
Change in DTL when rates change
BOY 2017; Current Tax rate = 40%
Current temporary difference
◦ $3,000,000 installment receivable will be paid equally in 2018 and 2019
◦ DTL BOY 2017=$1,200,000
◦ Late in 2017 new tax rate enacted = 34% to be effective 2019
◦ Taxable income is 5,000,000
What will DTL be 12/31/2017?
Change in DTL when rates change
Taxable amounts
◦ Cumulative Diff Installment sales

◦ Year difference reverses 2018 2019

◦ Amount
◦ Tax rate in effect
◦ Deferred tax liability

◦
Change in DTL when rates change
DTA DTL

2016 0 1,200,000

2017
0 1,110,000
Change in DTL when rates change
What is net income for 2017?
Pretax Income = Taxable income
◦ No changes in temporary differences, No PD

◦ = 5,000,000
Tax Expense
◦ Current = 5,000,000 x 40% =
◦ Adjustment due to change in rates =
◦ Total

Pretax income
Tax Expense
Net Income
Current Non-Current
o classifying DTA/DTL as current or non-current is a function of the classification of
the underlying asset or liability.

o In this example, current and a long term portion of the installment sale
determines the classification of the DTL

o Since PPE is always non-current DTL associated with depreciation will

always be non-current
Income Statement Presentation
Income tax expense, is allocated to:
o Continuing operations
o Discontinued operations
o Extraordinary items

o Cumulative effect of an accounting change, and

o Prior period adjustments

Disclose other significant components, such as:

o current tax expense,
o deferred tax expense/benefit, etc.
Net Operating Losses, NOL
Net operating loss is a tax terminology.
A net operating loss occurs when tax deductions for a year exceed taxable revenues.
Net loss or operating loss is a financial accounting term.
NOL can be derived from net loss, but these two amounts must be kept separately.
NOLs: Rules of Application
o NOL for each tax year is computed.
o The NOL of one year can be applied to offset taxable income of other years,
possibly resulting in tax refunds
NOLs can be:
o carried back 2 years and carried forward 20 years (carryback option), or
carried forward 20 years (carryforward only)
Net Operating Loss: Carryback Rules
If NOLs are carried back 2 years and carried forward 20 years:
o NOL is applied to the earlier of the 2-year period, then to the immediately
preceding year, etc.
o Remaining NOLs are applied to the following 20-year period.
o Any tax refunds are reported in the year of the original net operating loss.
NOL Carryback Rules
Tax years
2017 2018 2019 2020 2021 2022 2023 2024
next
NOL
Apply first 2020 Loss carryforward
20 years forward

Expect Expect
tax
tax refund Record all shield
here tax effects here here
NOL example
o No temporary differences
o No permanent differences (no book tax differences)
o Tax rate 45% in 2016, 2017; 40% 2018-2022

Year Pretax income

2016 160,000
2017 250,000
2018 80,000
2019 (160,000)
2020 (380,000)
2021 120,000
2022 500,000
NOL example
Journal Entries for tax expense
2018

2019
 NOL example
2020 (second loss = 380,000)
Go back two years then forward.

2018 x 40%
2019 No tax paid
Future x 40% = shield future taxes
Total
2021

2022
Recording a Valuation Allowance for Doubtful
Deferred Tax Assets
If the deferred tax asset appears doubtful, a Valuation Allowance account is needed.

Journal entry :
Income Tax Expense $$
Valuation Allowance $$
The entry records a potential future tax benefit that is not expected to be
realized in the future.
New Tax Rates
Firm has excess tax depreciation of 300 which will reverse over 3 years 100 per year.
Year Old rates New rates
2016 35% 35%
2017 35% 40%
2018 35% 40%
Old DTL

New DTL
Tax Expense JE
o J corp has a Deferred Tax Asset of 150,000 at the end of 2016 due to a single
cumulative temporary difference of 375,000.
o By the end of 2017 this cumulative temporary difference had risen to
450,000
o Taxable income is $820,000, the tax rate is 40% for all years

o At the end of 2016 there was no valuation allowance account

1) Assuming that there is no valuation allowance needed, make the JE to record tax expense in
2017
Tax Expense JE: no valuation allowance
Tax payable
◦ DTA
150,000
Deferred Tax
◦
2) Same situation as above only it is more likely than not that 30,000 of the deferred tax
asset would not be realized. (0 beginning balance in valuation allowance) Make the
additional JE to record tax expense in 2017.
Income Tax footnote
In the tax footnote there will be a reconciliation between the
statutory rate and the effective tax rate.
◦ Statutory rate
◦ The rate written into law
◦ Effective tax rate
◦ Tax expense/pretax financial income
Uncertain tax positions
Tax laws are so complex that firms are never sure if their tax positions will be
accepted by the IRS.
◦ Large firms get audited every year and there will be adjustments to their taxable income.
◦ Final tax payable is often settled in court.

When a firm take tax positions that may be disallowed by the tax authorities or
the court, the firm has a contingent liability
Evaluation of a tax position
o Step 1: recognition
o The enterprise determines whether it is more likely than not that a tax position will be
sustained upon examination

o Step 2: measurement
o The tax position is measured as the largest amount of benefit that is greater than 50

percent likely of being realized.

Differences between tax positions taken in a tax
return and amounts recognized
o Increase liability for income taxes payable or a reduction of an income tax refund receivable

and/or

o Reduce deferred tax asset or increase deferred tax liability

Just two journal entries
Accounting for income tax is done in two journal entries

Tax expense (debit) xxx

DTA (debit or credit) yyy
DTL (debit or credit) zzz
Taxes payable (credit) qqq

Tax expense (debit or credit) a

Valuation allowance (debit or credit) a
Example 1 – the Consortium
In Year 1, The Consortium had three differences between its book and tax income. The first was
$5,000 excess tax deprecation on a building with a 10 year life, the second was $15,000 excess
taxable revenue that will reverse in the third year of business, the third difference is a $1,000
fine paid to local authorities that is not deductible for taxes. The firm’s tax rate is 40%. What is
the deferred tax asset that will be reported on the year 1 balance sheet?

How would this change if tax rate was 40% in year 1 and 2 but 30% thereafter?
Example 2 - Sylvanas
Sylvanas’ Beauty shop begins business in 2012. In its first year of business the firm has 10,000 of
taxable income. There were two differences between taxable income and pretax financial
income. The first was 500 of excess deprecation for taxes and the second was $1,000 of non-
taxable municipal bond interest. The firm had a 30% tax rate in 2012 and 40% in all future years.
What is Sylvanas’ 2012 tax expense?
Example 2 – Sylvanas modified
Sylvanas’ Beauty shop begins business in 2012. In its first year of business the firm has 10,000 of
taxable income. There were two differences between taxable income and pretax financial
income. The first was 500 of excess deprecation for taxes on assets with a 5 year life and the
second was $1,000 of non-taxable municipal bond interest. The firm had a 30% tax rate in 2012
and 2013 and 40% in all future years. What is Sylvanas’ 2012 tax expense?
Example 3 - Angor Mines
On 12/31/2011 Angor Mines Inc. calculated its deferred tax asset at 10,000 based on a single
temporary difference of 50,000 that will reverse in 2013 and a 20% tax rate. In 2012 congress
changed the tax law and the new tax rate will be 25% beginning 1/1/2013. In 2012 Angor has
$20,000 of taxable income and no change in the temporary difference. What is the tax expense
reported on Angor’s 2012 income statement?

DTA
10,000

12,500
Example 4 - Grom
Grom’s reported pretax income and taxable income are the same each year. The firm had a 20%
tax rate in 2010 and a 30% tax rate in 2011 onward. If the firm carry’s its NOL back, what is the
net loss Grom will report on its 2012 income statement?
Year Pretax income Tax Rate
2010 300,000 20%
2011 200,000 30%
2012 <400,000> 30%
Example 5 – Old Tristram
Old Tristram’s reported pretax income and taxable income are the same each year. The firm had a
20% tax rate in 2010 through 2012 and a 30% tax rate after 2012. If the firm carry’s its NOL back,
what is the net loss Tristram will report on its 2012 income statement?
Year Pretax income Tax Rate
2010 300,000 20%
2011 200,000 20%
2012 <600,000> 20%
2013+ ------------- 30%
Example 6 – Caldeum
For each year, Caldeum had no temporary differences, and its effective income tax rate was 30%
at all relevant times. In its Year 2 income tax return, Caldeum elected to carry back the
maximum amount of loss possible. In its Year 3 income statement, what amount should
Caldeum report as current portion of income tax expense?
Year Pretax income Tax Rate
2010 300,000 30%
2011 <700,000> 30%
2012 1,200,000 30%
Example 7 - Zeppelin Travel Service
In 2012, Zeppelin Travel Service had taxable income of $50,000. The firm had 2 differences
between taxable income and pretax financial income. The firm deferred 10,000 of gross margin
for tax purposes that was not deferred from book purposes. In addition the firm paid a 2,000
fine that was not deductible for tax purposes. The tax rate was 20%. What was the firms pretax
financial income for 2012?

What was net income?

 Problem 7 replacement from CPA exam
Kieso Corporation, in its first year of operations: The Company has pretax income of 400,000 and the fooling
items in its records. No estimated tax payments were made during year 1.

Depreciation on tax return in excess of book depreciation 10,000

Interest on municipal bonds 5,000
Bad debt expense 1,400
Beginning balance in allowance for bad debt 0
Ending balance in allowance for bad debt 800
Tax rate for all year’s 40%

Prepare the following schedule for deferred tax amounts for the year
Depreciation, Interest on municipal bond, bad debts
Kieso Corp example
Prepare the following schedule for deferred tax amounts for the year
Depreciation, Interest on municipal bond, bad debts
Item Difference tax DTA/DTL Current Deferred tax
and income Non-current amount
statement

Depreciation 10,000 DTL Non-Current 4,000

Interest 5,000 NONE N/A 0
Bad Debts 800 DTA Current 320
Kieso Corp Example
Complete the following table to calculate taxable income

Pretax financial income 400,000

Interest on municipal bonds <5,000>
Depreciation for tax in excess of book <10,000>
Adjustment for bad debt 800

Taxable income 385,800

Example 8 – Panda Farm/Syndicate
In 2012, Thrall’s panda farm has taxable income of 100. In that year the firms deferred tax
liability decreased by $10. The firm has a 40% tax rate. What is tax expense in 2012?

In 2012, The Syndicate has pretax financial income of 100. In that year, temporary differences
changed by 25 increasing DTA by $10. The firm has a 40% tax rate. What is the current portion
of tax expense for 2012?
Example 9 -
Among the items reported on Perez Company’s income statement for the year ended December
31 were the following:
Compensation expense for a stock option plan $50,000
Insurance premium on the life of an officer 25,000
Neither is deductible for tax purposes.
Temporary differences amount to?

On December 31st 2011 is Crystal Hall tailors reported a deferred tax asset of $100,000 due to a
net operating loss carry forward. The firm had a 25% tax rate in all years and there are no other
temporary or permanent book/tax differences. If the firm reports pretax income of 60,000, in
2012, what will be the balance in the deferred tax asset account on the 2012 balance sheet?
Example 10 -
Leslie Knope began business on 1/1/2013. Her first year’s taxable income is $30,000. She had
$5,000 of non-taxable investment revenue (a permanent difference) and 1 temporary difference
due to $10,000 of excess depreciation taken for tax purposes. The temporary difference will
reverse equally over 4 years beginning in 2014. The tax rate is 20% in 2013 and 2014 and 30%
thereafter. The balance in Leslie’s 2013 deferred tax liability is

The balance in Leslie’s 2014 deferred tax liability is