Deferred Income Taxes [Deferred Tax Liabilities] With Case Example

 

Income for financial statement purposes is determined under generally accepted accounting principles as set forth by the accounting profession. Income for tax purposes is determined according to the rules of the Internal Revenue Service which are passed into law by Congress (Thought the same rules applied with other contries). These rules often do not follow generally accepted accounting principles. Accordingly, differences will arise between accounting income and taxable income.
These differences may be either temporary or permanent in nature. Temporary differences are referred to as “timing differences” because, with time, they reverse or turn around. Permanent differences are forever they do not reverse. In this post we are going to discuss the temporary differences.
Temporary differences involve the recognition of revenue or expense items in one year for tax purposes but in a different year for accounting purposes. Overall the total income is the same for both tax and accounting purposes; it is just the timing that is different.

EXAMPLE: under GAAP, revenue is recognized when earned, not when received. Thus if in year 1 a company earns revenue but does not receive it until year 2, it would recognize it as income in year 1. However, for tax purposes, revenue is usually recognized when received. Thus this item would not be reported on the tax return until year 2. Accordingly, in year 1, the income statement reports this revenue while the tax return does not; in year 2, the tax return reports it as revenue while the income statement does not. For both years together, however, the total income is the same—the difference is only in timing. Year 1 is called the “year of origination of the difference”; year 2 is the “year of reversal.”

Other case examples of temporary differences would be as follows:

1. Unearned revenue received in 19A and recognized for tax purposes this year, but not recognized for accounting purposes until earned in 19B
2. Accrued expenses recognized in 19A for accounting purposes but not recognized for tax purposes until paid in 19B
3. Revenue from installment sales recognized totally in 19Afor accounting purposes, but recognized gradually over several years under the installment method for tax purposes
4. Straight-line depreciation used for accounting purposes while an accelerated method is used for tax purposes
5. Warranty costs recognized in 19A for accounting purposes before they actually occur (using estimates), but not recognized until paid for tax purposes
6. Percentage-of-completion method for construction contracts used for accounting purposes while the completed-contract method is used for tax purposes
7. Expenditures for prepaid items in 19A deducted completely this year for tax purposes, but amortized gradually for accounting purposes

We’ve known that the standard entry to record income taxes has been:
[Debit]. Income Tax Expense = $xxx
[Credit]. Income Tax Payable = $xxx
But now that we’ve become aware of temporary differences, this entry becomes more complex. The debit to Income Tax Expense is based upon what the tax should be according to GAAP. However, the credit to Income Tax Payable is based upon what is physically payable and that is determined according to tax rules.
The difference between the debit and credit goes to an account called “Deferred Tax Liability” or “Deferred Tax Asset“, depending upon the circumstances.

Deferred Income Tax Case Example-1
Company X has the following information regarding its income for 19A and 19B:

By “regular income” I mean income recognized both for accounting and tax purposes. The temporary difference is due to revenue earned in 19A but not collected until 19B. Thus in 19A it is recognized for accounting purposes but not for tax purposes. Notice, however, that it reverses in 19B at the time of collection. At that time, it is recognized for tax purposes but not for accounting purposes.

The entry for 19A is:
[Debit]. Income Tax Expense = $22
[Credit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability = $2

Income tax expense is 20% of the accounting income of $110, which equals $22. Income tax payable is the amount that the tax office demands we pay 20% of $100. The deferred tax liability of $2 is 20% of the $10 difference between accounting income and taxable income.

TIPS: A helpful tip in doing entries involving deferred taxes is to proceed via the following three steps:
Step-1: Record the payable using the actual tax due. In this case we credit income tax payable for $20.
Step-2: Record the deferred tax amount. In this case we credit deferred tax liability for $2.
Step-3: Plug the debit to income tax expense. The entire entry would thus appear as shown above:
[Debit]. Income Tax Expense = $22 (Plug)
[Credit]. Income Tax Payable = $20 (Step-1)
[Credit]. Deferred Tax Liability = $2 (Step-2)

The reason why income tax expense is based upon accounting income is the matching principle. Under this principle, expenses relating to revenue must be matched against that revenue, and recognized in the same period. Since for accounting purposes we recognize the $10 revenue item this period, we must recognize the related $2 tax expense as well (even though the tax office isn’t asking us for the money now!).
Thus income tax expense consists of two components; $20 payable now and $2 deferred until later. In this case, because the reversal takes place only 1 year from now, it is a current liability.

The entry for 19B is:
[Debit]. Income Tax Expense = $20
[Debit]. Deferred Tax Liability = $2
[Credit]. Income Tax Payable = $22

Once again, income tax expense is based on accounting income and income tax payable on taxable income. The tax liability of $2 from last year which was deferred has now appeared, and it is being paid.
Next….Let’s take a look at a situation where the reversal takes more than 1 year on the next case example.

Deferred Income Tax Case Example-2
Company Y has the following information regarding its income for 19A, 19B, and 19C:

The entry for 19A is:
[Debit]. Income Tax Expense = $24**)
[Credit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability = $4
**). Based upon accounting income

In 19B only one-half the deferred liability is paid. The entry is:
[Debit]. Income Tax Expense = $20
[Debit]. Deferred Tax Liability = $2
[Credit]. Income Tax Payable = $22

This entry would also be made in 19C. In 19A, only $2 of the $4 deferred liability is considered current. The other $2 is considered long-term since it requires more than 1 year to reverse.
In the situations discussed so far, the tax rates were the same for all years. If the tax rates are different, and they have already been passed by Parliament and are known in the first year, then they should be taken into account in the journal entry. Have a look at the next case example.

Deferred Income Tax Case Example-3
Company Z has the following information regarding years 19A and 19B:

The 19B tax rate has already been passed by Congress in 19A. The 19A entry is:
[Debit]. Income Tax Expense = $23
[Credit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability = $3

Income tax payable is what we must physically pay the tax office 20% of $100. The deferred tax liability of $3 is based upon the $10 temporary difference multiplied by the rate of 30%, which will be in effect in 19B when this difference reverses.

The entry for 19B is:
[Debit]. Income Tax Expense = $30
[Debit]. Deferred Tax Liability = $3
[Credit]. Income Tax Payable = $33

Deferred Income Tax Case Example-4
Assume the same information as in the previous example except that the $10 difference in 19A will reverse $5 in 19B and $5 in 19C, and the tax rates for the 3 years are 20%, 30%, and 40%, respectively.

The entry for 19A is:
[Debit]. Income Tax Expense = $23.50
[Credit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability = $3.50

The deferred tax liability consists of 0.30($5) + 0.40($5) = $3.50. If in 19A a change in the rate has not yet been passed by Congress, then the 19A entry should use the 19A rate and not assume that any future changes will be made. This is true even if Congress is discussing the possibility of a change.
Later on, if a rate change goes into effect, an adjusting entry should be made to account for the effect of this change. Let’s look at the next case example.

Deferred Income Tax Case Example-5
Let’s use the same information as in case example 1 but assume that the 30% rate for 19B has not yet been passed in 19A.

The entry for 19A uses the 19A rate, as follows:
[Debit]. Income Tax Expense = $22
[Debit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability (0.20 x $10) = $2

In 19B, when the new rate of 30% is passed and goes into effect, an adjusting entry must be made to recognize the additional $1 tax (10% of $10).

The entry is:
[Debit]. Income Tax Expense = $1
[Credit]. Deferred Tax Liability = $1

As a result, the Deferred Tax Liability now has a balance of $3 ($2 + $1).

The entry for 19B is:
[Debit]. Income Tax Expense = $30
[Debit]. Deferred Tax Liability = $3
[Credit]. Income Tax Payable = $33