Accounting For Income Taxes

(IAS 12)
 Taxes on income include all domestic and foreign
taxes which are based on taxable income.
 Accounting income (loss) is the net profit or loss for a
period, as reported in the statement of profit and
loss, before deducting income tax expense or adding
income tax saving.
 Taxable income (tax loss) is the amount of the income
(loss) for a period, determined in accordance with the
tax laws, based upon which income tax payable
(recoverable) is determined.
 In some circumstances, the requirements of laws to
compute taxable income differ from the accounting
policies applied to determine accounting income. The
effect of this difference is that the taxable income
and accounting income may not be the same.
 Pretax financial income is a financial reporting term. It also
is often referred to as income before taxes, income for
financial reporting purposes, accounting income or book
income and are synonymous and may be used
interchangeably. It indicates the amount used to compute
income taxes expense. Companies determine pretax
financial income according to GAAP and IFRS. They measure
it with the objective of providing useful information to
investors and creditors.
 Taxable income. Taxable income (income for tax purposes)
is a tax accounting term. It is the excess of taxable revenues
over tax deductible expenses and exemptions for the year.
 It indicates the amount used to compute income taxes
payable (liability). Companies determine taxable income
according to the Internal Revenue Code (the tax code).
Income taxes provide money to support government
operations (to obtain funds, in an equitable manner, to
operate the federal government.)
 Income taxes are based on taxable income and not
accounting income. Thus, the objectives of financial
reporting and the Internal Revenue Code are different.
 Because the objectives of financial reporting differ from the
objectives of the Internal Revenue Code, a company’s pretax
financial income and income tax expense (computed under
IFRS) will differ from its taxable income and income tax
obligation (computed under IRC).
 The causes of differences between a
corporation’s pretax financial income and
taxable income (and potentially between its
income tax expense and its income tax
obligation) can be categorized into five groups:
1. Permanent Differences.
2. Temporary Differences.
3. Operating Loss Carry-backs and Carry-forwards.
4. Tax Credits.
5. Intra-period Tax Allocation.
1. Permanent Differences. A difference between pretax
financial income and taxable income in an accounting
period, that originate in one period and never reverse in a
later accounting period, which means are not subject to
inter-period tax allocation.
 Permanent differences affect either a corporation’s
reported pretax financial income or its taxable income,
but not both.
 Permanent differences arise from revenues or
expenses that are recognized for financial reporting
purposes (IFRS) but never affect taxable income, or
deductions that reduce taxable income (IRC) but do
not qualify as expenses for financial reporting.
 Permanent differences do not have deferred tax
consequences.
(1 and 2 are allowed under GAAP, whereas 3 allowed under IRC)
2. Temporary (Timing) Differences. A corporation reports some
items of revenue and expense in one period for financial accounting
purposes, but in an earlier or later period for income tax purposes.
These items cause temporary differences between the corporation’s
pretax financial income and taxable income.
 They can also be thought of the differences between accounting
income and taxable income that originated in one period and
eventually reversed (are eliminated) through inter-period tax
allocation.
 A temporary difference is the difference between the tax basis of
an asset or liability and its reported (carrying or book) amount in
the financial statements, which will result in taxable amounts or
deductible amounts in future years.
 A) Future deductible amount. Temporary difference that will
result in deductible amounts in future years when the related asset
or liability is recovered or settled, respectively (also called a
deductible temporary difference). It decrease taxable income in
future years.
 B) Future taxable amount. Temporary difference that will result
in taxable amounts in future years when the related asset or
liability is recovered or settled, respectively. (also called taxable
temporary difference). It increase taxable income in future years.
 Temporary differences are the differences between
the carrying amount of assets and liabilities for
accounting purposes and their respective tax bases.
Deferred tax liability. The deferred tax consequences of temporary future taxable
amounts.
 Briefly, they are: (1) it is a responsibility of the corporation to another entity that will
be settled in the future, (2) the responsibility obligates the corporation, so that it
cannot avoid the future sacrifice, and (3) the transaction or other event obligating the
corporation has already occurred. The deferred tax consequences of temporary
differences that will result in taxable amounts for a corporation in future years meet
these characteristics.
 The first characteristic is met by a deferred tax liability because (a) the deferred tax
consequences stem from the tax law and are a responsibility to the government, (b)
settlement will involve a future payment of taxes, and (c) settlement will result from
events specified by the tax law. The second characteristic is met because income taxes
will be payable when the temporary differences result in taxable amounts in future
years. The third characteristic is met because the past events that result in the
deferred tax liability have already occurred.
Deferred Tax Asset. The deferred tax consequences of temporary future deductible
amounts and operating loss carry-forwards.
 Briefly, the three characteristics of an asset are: (1) it will contribute to the
corporation’s future net cash inflows, (2) the corporation must be able to obtain the
benefit and control other entities’ access to it, and (3) the transaction or other event
resulting in the corporation’s right to or control of the benefit has already occurred.
The deferred tax consequences of temporary differences of a corporation that will
result in deductible amounts in future years meet these characteristics.
 The first characteristic is met because the deductible amounts in future years will
result in reduced taxable income, and contribute to the corporation’s future net cash
inflows through reduced taxes paid. The second characteristic is met because the
corporation will have an exclusive right to the reduced taxes paid. Finally, the third
characteristic is met because the past events that result in the deferred tax asset have
already occurred.
 Both a deferred tax liability and deferred tax asset are measured using the enacted
tax rate for the period of recovery or settlement and provisions of the tax law.
 A deferred tax liability is the increase in future taxes payable due
to currently existing temporary differences (future taxable
amounts).
 A deferred tax asset is the reduction in future taxes payable due to
currently existing temporary differences (future deductible
amounts).
 A deferred tax asset should be reduced by a valuation allowance if
it is more likely than not that the deferred tax asset will not be
realized (e.g., the future deductible amount will not be used
because of insufficient future taxable income).
 Whether the company will realize a deferred tax
asset depends on whether sufficient taxable
income exists or will exist within the carry-forward
period available under tax law.
 If there is sufficient uncertainty about a
corporation’s future taxable income, the IASB
decided that it must establish a valuation
allowance to reduce its deferred tax asset(s) to the
realizable amount. (This approach is similar to
reporting accounts receivable at a gross amount
and then reducing the amount by an allowance for
doubtful accounts.)
 A corporation will realize the tax benefits from a
deferred tax asset only if it will have enough future
taxable income from which to subtract the future
deductible amount.
 Current tax is determined amount of income tax paid or
to be payable (recoverable/refundable) in respect of the
taxable income (tax loss) for a period. Sometimes also
called income tax payable/obligation (or refund).
 Deferred tax expense (or benefit) is the change during
the year in deferred tax liabilities and assets, and arise
when income tax expense (IFRS) differs from income tax
liability or payable (IRC) and for this matter it is called the
tax effect of timing differences.
 Income tax expense is the aggregate (total) of current tax
and deferred tax charged or credited to the statement of
profit and loss for the period. Under both IFRS and US
GAAP, income tax expense includes both current and
deferred components.
 To illustrate how differences in IFRS and IRS rules affect financial
reporting and taxable income, assume that Chelsea Inc.
 Chelsea reported the same expenses to the IRS in each of the
years. But, Chelsea reported deferent taxable revenues of 2015,
2016, and in 2017.
Financial Reporting Income

Tax Reporting Income

 The below table shows how income taxes payable can
differ from income tax expense. This can happen when
there are temporary differences between the income
amounts reported for tax purposes and those reported for
book purposes. This basically arise for a simple reason.
For financial reporting, companies use the full accrual
method to report revenues. For tax purposes, they use a
modified cash basis (cash basis).

 Income tax expense and income taxes payable differed

over the three years, but were equal in total.
 As Illustrated on the previous slide, the $12,000
($28,000 - $16,000) difference between income tax
expense and income taxes payable in 2015 reflects
taxes that it will pay in future periods. This $12,000
difference is often referred to as a deferred tax
amount. In this case it is a deferred tax liability.
 In Chelsea’s situation, the only difference between the
book basis and tax basis of the assets and liabilities
relates to accounts receivable that arose from revenue
recognized for book purposes, and it is a consequence
of taxable temporary difference.
 Thus, illustration indicates that Chelsea reports
accounts receivable at $30,000 in the December 31,
2015, IFRS-basis balance sheet. However, the
receivables have a zero tax basis.
 A deferred tax liability is the deferred tax consequences attributable
to taxable temporary differences. In other words, a deferred tax
liability represents the increase in taxes payable in future years as a
result of taxable temporary differences existing at the end of the
current year.
 The book basis of accounts receivable is $30,000 (130,000- 100,000),
and the tax basis is zero. What will happen to the $30,000 temporary
difference that originated in 2015 for Chelsea. Assuming that Chelsea
expects to collect $20,000 of the receivables in 2016 and $10,000 in
2017, this collection results in future taxable amounts. Thus, the total
deferred tax liability at the end of 2015 is $12,000. (Two methods to
determine deferred tax liability of current year, 2015 )
1

2
 Because it is the first year of operations for Chelsea, there is no
deferred tax liability at the beginning of the year.

 This computation indicates that income tax expense has two

components—current tax expense (the amount of income
taxes payable for the period) and deferred tax expense.
 Deferred tax expense is the increase in the deferred tax
liability balance from the beginning to the end of the
accounting period.
 Chelsea reports income tax payable of $16,000 as current
liability in the balance sheet.
 For Chelsea, it makes the following entry at the end of 2015.
 At the end of 2016 (the second year), the difference
between the book basis and the tax basis of the accounts
receivable is $10,000 ($30,000 – $20,000). Chelsea multiplies
this difference by the applicable tax rate to arrive at the
deferred tax liability of $4,000 ($10,000 x 40%), which it
reports at the end of 2016. Remember, income taxes payable
for 2016 is $36,000.

 Chelsea records income tax expense, the change in the

deferred tax liability, and income taxes payable for 2016 as
follows.
 At the end of 2017 (the third year), the difference between the
book basis and the tax basis of the accounts receivable is $0
($30,000 – $30,000).

 Chelsea records income tax expense, the change in the deferred

tax liability, and income taxes payable for 2017 as follows.

 The Deferred Tax Liability account has a zero balance at the end of
2017 after reversal.
 In cases where taxes will be lower in the future,
Chelsea records a deferred tax asset.
 Assume that Chelsea has a deductible temporary
difference of $1,000,000 at the end of its first year of
operations (2015). Its tax rate is 40 percent, which
means it records a deferred tax asset of $400,000
($1,000,000 x 40%). Assuming $900,000 of income taxes
payable, Chelsea records income tax expense, the
deferred tax asset, and income taxes payable for 2015
as follows.
 Income Statement Presentation
 Tax expense (total) for the period, comprising current tax
expenses and deferred tax expenses, should be included in the
determination of the net profit or loss for the period.
Balance Sheet Presentation
 Deferred tax should be recognized for all the timing differences,
in respect of deferred tax assets and deferred tax liability
(DTAL).
 If the net amount of the current groups is a debit balance, the
corporation reports the amount as a current asset, whereas it
reports a net credit amount as a current liability.
 The corporation reports a net debit balance for the noncurrent
groups as a noncurrent asset, and reports a net credit balance as
a noncurrent liability. This procedure is one of the few situations
in which ―offsetting‖ of assets and liabilities is allowed in
financial reporting.
 The FASB requires this approach because of the close relationship
between deferred tax assets and liabilities, and to avoid the
detailed analyses necessary for more refined classification
methods.
 This computation indicates that income tax
expense has two components—current tax
expense (the amount of income taxes payable for
the period) and deferred tax expense (benefit).
 Deferred tax expense is the increase in the
deferred tax liability balance from the beginning
to the end of the accounting period.
 Every management hopes its company will be profitable. But
hopes and profits may not materialize. For a start-up
company, it is common to accumulate operating losses while
expanding its customer base but before realizing economies
of scale.
 A net operating loss (NOL) occurs for tax purposes in a year
when tax-deductible expenses exceed taxable revenues.
 An inequitable tax burden would result if companies were
taxed during profitable periods without receiving any tax
relief during periods of net operating losses.
 Under certain circumstances, the IRC allows (permit) a
corporation (taxpayers) reporting an operating loss for
income tax purposes in the current year to carry this loss
back or carry it forward to offset previous or future taxable
income.
 Simply losses carry-back and carry-forward is income
averaging provision to use the losses of one year to offset
the profits of other years.
 Under this provision, a company pays no income taxes for a
year in which it incurs a net operating loss.
 The previous section and examples dealt with the recognition
of a deferred tax liability or asset when a corporation had
taxable income in the current year.
 This section deals with the situation where a corporation has
a loss for income tax purposes (and a pretax financial loss) in
the current year, resulting in an operating loss carryback or
carry-forward for income tax purposes.
 When a corporation reports an operating loss in a given year,
the IRC allows the corporation to carry back or carry forward
the loss to offset previous or future reported taxable income
on its income tax return. The corporation reports its pretax
financial income or loss in the current year on its income
statement.
 The corporation may first carry a reported operating loss back
two years (in sequential order, starting with the earliest of
the two years). This procedure is called an operating loss
carryback.
 In this case, the corporation files amended income tax
returns showing lower taxable income for those years and
receives a refund of income taxes previously paid. Operating
loss carrybacks can provide significant refunds for companies.
 If a corporation’s taxable income for the past two
years is not enough to offset the amount of the
currently reported operating loss, it then sequentially
carries forward the loss for 20 years and offsets the
loss against future taxable income, if there is any. This
procedure is called an operating loss carry-forward
option.
 The corporation then pays lower income taxes in the
future based on lower future taxable income.
 Generally, Operating loss-carryback is an excess of
tax-deductible expenses over taxable revenues in a
year that may be carried back to reduce taxable
income in a prior year.
 Operating loss carry-forward is an excess of tax-
deductible expenses over taxable revenues in a year
that may be carried forward to reduce taxable income
in a future year, the tax effect of a loss carry-
forward represents future tax savings. Realization of
the future tax benefit depends on future earnings, an
uncertain prospect.
 Through use of a loss carryback, a company may carry the net
operating loss back two years and receive refunds for income
taxes paid in those years. The company must apply the loss to
the earlier year first and then to the second year. It may use
carry forward option for any loss remaining after the two-year
carryback up to 20 years to offset future taxable income.

 Through use of a Loss carry-forward, a company may forgo the

loss carryback and loss carry-forward option, and use only the
loss carry-forward , offsetting future taxable income for up to
20 years.
To illustrate the accounting procedures for a net
operating loss carryback, assume that Groh Inc. has no
temporary or permanent differences. Groh experiences
the following.

Accordingly, Groh files amended tax returns for 2010 and 2011,
receiving refunds for the $110,000 ($30,000 + $80,000) of taxes
paid in those years. For accounting as well as tax purposes, the
$110,000 represents the tax effect (tax benefit) of the loss
carryback. Groh should recognize this tax effect in 2012, the loss
year. Since the tax loss gives rise to a refund that is both
measurable and currently realizable, Groh should recognize the
associated tax benefit in this loss period.
 Groh reports the account debited, Income Tax Refund
Receivable, on the balance sheet as a current asset at
December 31, 2012 as shown below.

Groh makes the following journal entry for 2012.

 Since the $500,000 net operating loss for 2012 exceeds the $300,000 total
taxable income from the 2 preceding years, Groh carries forward the
remaining $200,000 loss.
 In 2012, the company records the tax effect of the $200,000 loss carry-forward
as a deferred tax asset at the end of 2012 for the deferred tax consequences
(future tax benefit) of the carry-forward of $80,000 ($200,000 x 40%),
assuming that the enacted future tax rate is 40 percent.
 The current tax benefit of $110,000 is the income tax refundable for the year.
Groh determines this amount by applying the carryback provisions of the tax
law to the taxable loss for 2012.
 The $80,000 is the deferred tax benefit for the year, which results from an
increase in the deferred tax asset.
 For 2013, assume that Groh returns to profitable operations
and has taxable income of $250,000 (prior to adjustment for
the NOL carry-forward), subject to a 40 percent tax rate.
Groh then realizes the benefits of the carry-forward for tax
purposes in 2013, which it recognized for accounting
purposes in 2012. Groh computes the income taxes payable
for 2013 as shown below.

The benefits of the NOL carry-forward, realized in 2013, reduce the

Deferred Tax Asset account to zero.
 The 2013 income statement that appears in
Illustration 19-34 does not report the tax effects
of either the loss carryback or the loss carry-
forward because Groh had reported both
previously.
 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.
 The appropriate enacted rate for a year is the
average tax rate [based on graduated tax
brackets].