Chapter 18 Accounting for Income Tax

Why are pretax financial income and and taxable income different?

Because GAAP and the IRS use different rules for recognizing revenues and expenses. some differences reverse later (temporary), while other never reverse (permanent)

Temporary vs. Permanent Difference

• Temporary: reverse in the future → creates a Deferred Tax Asset or Liability.

• Permanent: Never reverses → no deferred taxes

What does a Deferred Tax Liability mean?

You pay less tax today but more tax later.” I saved taxes now, but I’ll owe them later”

What does a Deferred Tax Asset mean?

You pay more tax today but less tax later. “ I’m building up future tax savings”

DTL

• Deduction sooner for tax

• Revenue later for tax

DTA

• Deduction later for tax

• Revenue sooner for tax

Summary of DTA and DTL

If deductions are taken sooner ( or revenue is recognized later) for tax, it’s a DTL; if deductions are taken later (or revenue is recognized sooner) for tax, it’s a DTA

Tax depreciation > Book depreciation

Deferred Tax Liability( you’re deducting more today, and paying less tax now)

Warranty expense accrued for books but deducted when paid

Deferred Tax Asset ( book expense happens first. Tax deduction happens later)

Cash received before earned and taxed immediately

Deferred Tax Asset( tax recognizes revenue before GAAP)

Book recognizes revenue immediately, tax recognizes later

Deferred Tax Liability

Lawsuit expense accrued for books

Deferred Tax Asset( tax waits until cash is actually paid)

Tax-exempt municipal bond interest

Permanent Difference (never taxable)

Government fines

Permanent difference (never deductible)

Company receives life insurance proceedds

Permanent Difference ( never taxable)

80% dividend deduction

Permanent difference

Income Tax Expense vs Income Taxes Payable

= Total tax cost on this year’s income

Income Tax Expense vs Income Taxes Payable

= amount owed to the IRS this year only

When do Expense and Payable differ? Why aren’t they always the same?

Because of:

• Deferred Tax Assets

• Deferred Tax Liabilities

Never because of permanent differences

Why is the effective tax rate different?

Permanent differences. Temporary differences don’t permanently change the effective tax rate.

What is an originating difference?

The FIRST year a temporary difference appears.

Creates a DTA or DTL

What is a reversing difference

Future year when the temporary difference disappears.

removes the DTA or DTL

Which tax rate do you use

Use the tax rate enacted for the year the temporary difference reverses

What does a Net Operating Loss create

Deferred Tax Asset

because future taxes will be reduced

What happens when the company finally earns income

• Income Taxes Payable goes down

• Deferred Tax Asset goes away

When do we need a valuation allowance

when it’s more likely than not(>50%) the company won’t realize part of the deferred tax asset

What determines DTL vs DTA

Ask:

Will this make me pay MORE taxes later

Yes→ DTL

No, it saves taxes later → DTA

Accelerate depreciation for tax

DTL

Warranty Expense

DTA

Municipal bond interest

Pernament

Fine expense

Permanent

Income Taxes Payable is based on ____, not book income

Taxable income