Chapter 17: Accounting for Taxes

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Learning Objectives[edit]

Chapter Summary[edit]

Fundamental Theory of Accounting for Taxes[edit]

Governments fund their operations and services through the use of taxes. A tax is a required by law contribution of money to a government. Most governments levy taxes based on an individual's income or based on a company's profits. The calculations used to determine the tax rates is found in the government's tax code. The variation in tax methods can be quite extensive to go into detail for the scope of this course. Therefore, we will focus on the largest tax systems, which are generally, income taxes. Also note this course focuses on the income tax system found in the United States. The nature and type of tax systems in place varies from jurisdiction to jurisdiction but generally follow the same general principles. If you want to learn about the variations and methods used to calculate taxes, you will need to use the government's tax code or take a course in taxation.

As discussed in previous chapters, financial accounting reports are prepared using accrual accounting which allows businesses to calculate pretax income (income before any taxes are subtracted). Pretax income is calculated based on GAAP and accrual accounting principles. For income tax purposes, the amount of taxable income is calculated based on the tax code. The tax code uses a modified cash basis to determine how much tax is to be paid and when. To make the situation even more complex, most tax codes allow for deductions, credits and deferring of when tax is to be paid.

Deduction: A tax benefit which reduces taxable income. For example, a company with $5,000 taxable income and having a tax deduction of $500 will have taxable income of $4,500. The $4,500 taxable income would then be subject to the income tax rate. If the income tax rate was a flat 25% (hypothetical example) the income tax would be $1,125 paid to the government.

Credit: A tax benefit which reduces income tax dollar for dollar. Using the same facts as above, if the company had a tax credit for $500, the company would only pay $625 because the tax credit of $500 is reducing the tax dollar for dollar.

Income tax deferral: A tax benefit that allows a company to shift when the income is subject to tax. For example if a company has $5,000 of taxable income in year 2017 but obtains a tax deferral of all the income for one year then the $5,000 of 2017 income would be subject to the tax in 2018. The income tax that is to be paid is effectively deferred to a later period.

For financial accounting purposes, the company must calculate income tax expense to not violate accrual accounting principles. A company might report an income tax expense even though the actual tax dollars have not been officially levied by the government. When taxes are reported as income tax expense in the current period with the actual income tax due in a future period the difference is referred to as a deferred tax liability. As the name implies, a deferred tax liability is taxes that are due to the government in a future period. In other situations, the company might obtain beneficial tax benefits in the form of deductions or credits. When a company obtains deductions or credits that will reduce future income tax payable, it is referred to as a deferred tax asset. As the name implies, a deferred tax asset is an asset which will reduce income tax payable in the future. Recording deferred tax assets and liabilities is essential to making sure the financial statements always comply with accrual accounting.

So where do deferred tax liabilities and assets ultimately come from? The answer has to do with two key concepts:

Temporary differences: Are tax benefits or liabilities that will impact future taxable income. For example, a company might obtain a tax deduction which reduces taxable income by $5,000 after one year has passed.

Permanent differences: Are tax benefits that never reverse. For example, certain forms of income are never subject to the income tax and therefore, will never be used in taxable income. Other benefits are deductions which exceed the cost of the expense while other expenses are limited in terms of their deductibility or not deductible completely.

Determining Income Tax Expense and Income Tax Payable[edit]

As discussed previously, a company must determine income tax expense which is applicable to the correct period to ensure they are not violating accrual accounting principles. A company must calculate what their income tax expense will be for the current period based on their estimated tax liability will be. Due to the complexity with taxes and how taxes are subject to change due to political shifts, only a reasonable estimate is required. Most companies use a historical average tax rate to calculate the income tax expense. For the sake of our discussions, we will use a flat income tax rate of 30% based on net income (revenue - expenses). The example below shows the differences between calculating income tax expense and the unique issues that are created in terms of how much actual tax is paid.

Accrual Basis Year 1 Year 2 Year 3 Total
Revenue 75,000 75,000 75,000 225,000
Expenses 35,000 35,000 35,000 105,000
Pretax Net Income 40,000 40,000 40,000 120,000
Tax Rate 30% 30% 30% 30%
Income Tax Expense 12,000 12,000 12,000 36,000

As you can see from the above, we have a steady net income of $40,000 per year. The income tax expense is calculated as 30% of the net income or $12,000 per year.

When the company prepares their income tax return, they will use all the deductions and credits which are available to them in the tax code. Some forms of revenue will not be subject to income tax and thus their taxable revenue will be lower their accrual basis revenue. The opposite could also be true (taxable revenue exceeds accrual revenue). In other situations the expense reported will be higher than the amounts reported based on accrual basis or the opposite could be the case. While in other situations tax credits will permanently reduce the amount of tax paid. The company will use all of these benefits to report the following data on their income tax return:

Tax Basis (modified cash basis) Year 1 Year 2 Year 3 Total
Taxable Revenue 70,000 55,000 93,000 218,000
Deductible Expenses 45,000 37,000 16,000 98,000
Taxable Net Income 25,000 18,000 77,000 120,000
Tax Rate 30% 30% 30% 30%
Income Tax Payable 7,500 5,400 23,100 36,000

As you can see from the above, when the income tax return is filed under the modified cash basis rules (based on the tax code) the taxable income and deducible expenses fluctuates which in turn causes the taxable income and income tax payable to fluctuate as well. The variance created between income tax payable and income tax expense must be accounted for by using deferred tax liabilities and deferred tax assets.

Year 1 Year 2 Year 3 Total
Income Tax Expense 12,000 12,000 12,000 36,000
Income Tax Payable 7,500 5,400 23,100 36,000
Variance 4,500 6,600 (11,100) 0
DTL/DTA 4,500 DTL 6,600 DTL 11,100 DTA

As you can see from above, when our income tax expense (accrual basis) exceeds the income taxable payable, the variance is called a deferred tax liability since we will owe additional income tax in the future due to temporary tax differences. If the income tax expense is less than the amount of income tax payable then the variance is called a deferred tax asset since we will get a tax benefit in the future. In regard to permanent differences, they never create deferred tax liabilities or assets because they do not defer tax liabilities or tax benefits to future periods.

Accounting for Deferred Tax Liabilities[edit]

As previously discussed, a deferred tax liability is when the taxable temporary differences created in the current accounting period results in future tax payable in future accounting periods. To properly record our income tax expense, we must determine what the current tax payable is and then analyze the changes in the deferred tax liability from our current accounting period. The formula for calculating income tax expense is as follows:

Income tax expense = current income tax payable + increase in deferred tax liability for the current accounting period

To illustrate this concept, we will analyze the accounts receivable account for Titan & Associates Inc.

Based on accrual accounting principles, the revenue related to the accounts receivable is recorded when the revenue is substantially earned. For tax purposes, the accounts receivable is reported when the cash is received. This difference in reporting creates a temporary tax difference.

For example, let's say that Titan & Associates has $50,000 in AR that will be received $25,000 in year 2 and $25,000 in year 3. In year 1, Titan & Associates has a deferred tax liability of $15,000 as illustrated below:

Year 1 Year 2 Year 3 Total
AR When Cash is Received 0 25,000 25,000 50,000
Tax Rate 30% 30% 30% 30%
Deferred Tax Liability 0 7,500 7,500 15,000

As you can see, the company has a deferred tax liability of $7,500 for year 2 and year 3. If we assume that Titan has income tax payable of 10,000 for year 1 then the following journal entry would be used to record the transaction.

Debit Income tax expense $25,000

Credit deferred tax liability $15,000

Credit income tax payable $10,000

We record the entire deferred tax liability in year 1 because the transactions that created the accounts receivable occurred in year 1.

Accounting for Deferred Tax Assets[edit]

Debit income tax expense xxx

Debit deferred tax asset xxx

Credit income tax payable xxxx

Valuation Allowance[edit]

A company will have to periodically test their deferred tax assets to ensure that the tax benefits of the deferred tax asset is more likely than not to be realized. The threshold for the more likely than not test is more than a 50% chance that the tax benefit will be realized. If the tax benefit is less than a 50% chance to be realized then a valuation allowance must be created to account for the reduced tax benefit. All tests are based on reasonable estimates.

Change in Rates[edit]

Net Operating Losses (NOL)[edit]

Financial Statement Presentation[edit]