Module 7 - Income Tax

What is the starting point for all income tax problems?

Pretax Financial Income

This is the book income before taxes and is always the base for reconciliation.

What is taxable income?

Pretax Financial Income ± Adjustments for book-tax differences

What is the formula for income taxes payable?

Income Taxes Payable = Taxable Income × Tax Rate

What is income tax expense?

Current tax (payable) + Deferred tax (future effects)

What is the formula for income tax expense?

Income Tax Expense =

Income Taxes Payable

+ Increase in Deferred Tax Liability

− Increase in Deferred Tax Asset

What is a temporary difference?

A difference between book and tax income that Reverses in future periods.

→ Creates DTA or DTL

What is a permanent difference?

A difference that: Never reverses

→ Affects taxable income
→ Does NOT create deferred tax

Example of a permanent difference?

Fines and penalties (not tax deductible)

How do permanent differences affect accounting?

• ✅ Change taxable income

• ✅ Affect effective tax rate

• ❌ Do NOT create DTA/DTL

What is the key question to decide ADD vs SUBTRACT?

Is taxable income higher or lower than pretax income?

If taxable income is higher than pretax income, what do you do?

ADD the difference

If taxable income is lower than pretax income, what do you do?

SUBTRACT the difference

How do you treat “tax depreciation > book depreciation”?

Taxable income ↓

SUBTRACT

→ Creates DTL

How do you treat “tax revenue > book revenue”?

Taxable income ↑

ADD

→ Often creates DTA

How do you treat advance rent (taxed now, recognized later)?

ADD to taxable income

→ Creates DTA

How do you treat fines (not deductible)?

ADD to taxable income

→ Permanent difference (no deferred tax)

What is a Deferred Tax Liability (DTL)?

Future tax owed due to Taxable temporary differences

What is a Deferred Tax Asset (DTA)?

Future tax savings due to Deductible temporary differences

Formula for DTL?

DTL = Temporary Difference × Tax Rate

Formula for DTA?

DTA = Temporary Difference × Tax Rate

When do you get a DTL?

You pay LESS tax now → more later

When do you get a DTA?

You pay MORE tax now → less later

How do you compute change in DTL or DTA?

Change = Ending balance − Beginning balance

If no beginning balance, what is the change?

Change = Ending balance

What happens when DTL increases?

Tax expense increases

What happens when DTA increases?

Tax expense decreases

What happens when DTL decreases (reversal)?

Tax expense decreases

What happens when DTA decreases (reversal)?

Tax expense increases

What is the journal entry format when only DTL exists?

Dr Income Tax Expense

Cr Income Taxes Payable

Cr Deferred Tax Liability

What is the journal entry format when only DTA exists?

Dr Income Tax Expense

Dr Deferred Tax Asset

Cr Income Taxes Payable

What is the journal entry when BOTH DTA and DTL exist?

Dr Income Tax Expense

Dr Deferred Tax Asset

Cr Income Taxes Payable

Cr Deferred Tax Liability

What happens to DTL when it reverses?

Debit DTL

What happens to DTA when it reverses?

Credit DTA

Should you net DTA and DTL in journal entries?

NO — always show separately

What is the income tax section order?

Income before income taxes

Income tax expense:

Current

Deferred

Total income tax expense

Net income

What is “current tax”?

Income taxes payable

What is “deferred tax”?

Change in DTL − Change in DTA

Formula for effective tax rate?

Effective Tax Rate = Income Tax Expense ÷ Pretax Financial Income

Does effective tax rate use taxable income?

NO — uses pretax financial income

Does effective tax rate use payable or expense?

Income Tax Expense (NOT payable)

Why can ETR differ from statutory rate?

• Permanent differences

• Temporary differences

Wiley formatting trap: percentages

If % is already shown: Enter number only (e.g., 35.5)

Wiley trap: taxes payable

Always use:

Taxable income × rate

NOT pretax income

Wiley trap: permanent differences

Do NOT: Create DTA or DTL

Wiley trap: depreciation

If Tax depreciation > book

→ SUBTRACT

Wiley trap: advance rent

Wiley trap: advance rent

ADD → creates DTA

Wiley trap: reversal problems

Always:

Use CHANGE in DTL/DTA

NOT full amount again

What is the full 10-step process for income tax problems?

1. Start with pretax income

2. Adjust → taxable income

3. Compute taxes payable

4. Identify temporary differences

5. Compute DTL/DTA

6. Find changes

7. Compute tax expense

8. Journal entry

9. Income statement

10. Effective tax rate

What is the first thing you should do when reading a tax problem?

Identify the problem type immediately:

• Taxes payable → use taxable income

• Journal entry → full calculation

• Deferred tax → temp difference × rate

• Income statement → split current + deferred

• Effective tax rate → expense ÷ pretax

What is the fastest way to decide whether to ADD or SUBTRACT?

Is taxable income higher or lower than pretax income?

What is the instant rule for Deferred Tax Liability (DTL)?

DTL = Pay LESS tax now → more later

What is the instant rule for Deferred Tax Asset (DTA)?

DTA = Pay MORE tax now → less later

How does a Deferred Tax Liability reversal affect accounts?

DTL decreases → Debit DTL → lowers tax expense

How does a Deferred Tax Asset reversal affect accounts?

DTA decreases → Credit DTA → increases tax expense

What must you do in multi-year tax rate problems?

Split temporary differences by year

× each year’s tax rate

Add results

What is the rule when a tax rate changes?

Recompute DTL/DTA using new rate

Difference → income tax expense

When do you use beginning balances in deferred tax problems?

Change = Ending − Beginning

What is a valuation allowance trigger phrase?

“More likely than not not realized”

What is the journal entry for a valuation allowance?

Dr Income Tax Expense

Cr Valuation Allowance

What is the biggest conceptual mistake students make?

Confusing: Income Taxes Payable ≠ Income Tax Expense

What is the difference between taxes payable and tax expense?

• Payable → current tax owed

• Expense → total (current + deferred)

When do permanent differences matter most?

They affect: Effective tax rate

But NOT deferred taxes

What is the formula for effective tax rate?

Effective Tax Rate = Income Tax Expense ÷ Pretax Income

Why can effective tax rate differ from statutory rate?

Because of:

• Permanent differences

• Temporary differences

What does a negative deferred tax amount on the income statement mean?

Deferred tax benefit (reduces total tax expense)

What is the shortcut formula under exam pressure?

1. Pretax income

2. Adjust → taxable income

3. Payable = taxable × rate

4. Find DTL/DTA

5. Expense = payable + DTL − DTA

What must you NEVER do with DTA and DTL in journal entries?

Never net them — show separately

Wiley trap: common mistake with taxes payable

Students incorrectly use: Pretax income × rate

Correct is: Taxable income × rate

Wiley trap: common mistake with permanent differences

❌ Creating DTA/DTL
✅ They only affect taxable income and ETR

What is the final “master flow” for solving ANY problem?

Pretax income

→ Taxable income

→ Taxes payable

→ DTL/DTA

→ Change in deferred

→ Tax expense

→ Journal entry

→ Income statement

→ Effective tax rate

What tax rate do you use for deferred taxes?

The enacted tax rate at the time the temporary difference reverses

What do you do if there are different tax rates for different years?

Split the temporary difference by year

× each year’s tax rate

Add results

What tax rate do you use when calculating income taxes payable?

The current year’s tax rate

What happens if the tax rate changes?

Recalculate DTL/DTA using the new rate

Record the change in income tax expense

What is the difference between statutory tax rate and effective tax rate?

• Statutory rate → given in problem

• Effective rate → Income Tax Expense ÷ Pretax Income

Why is the effective tax rate often different from the given tax rate?

Permanent differences (like fines)

Does the tax rate change how you classify DTL vs DTA?

NO — classification depends on timing, not rate