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CHAPTER 19
Accounting for Income Taxes

1.

Pretax financial income is reported on the income statement and is often referred to as income
before income taxes. Taxable income is reported on the tax return and is the amount upon which
a company’s income tax payable is computed.

2.

One objective of accounting for income taxes is to recognize the amount of taxes payable or
refundable for the current year. A second is to recognize deferred tax liabilities and assets for the
future tax consequences of events that have already been recognized in the financial statements
or tax returns.

3.

A permanent difference is a difference between taxable income and pretax financial income that,
under existing applicable tax laws and regulations, will not be offset by corresponding differences
or ―turn around‖ in other periods. Therefore, a permanent difference is caused by an item that:
(1) is included in pretax financial income but never in taxable income, or (2) is included in taxable
income but never in pretax financial income.

Examples of permanent differences are: (1) interest received on certain types of government
obligations (such interest is included in pretax financial income but is not included in taxable
income), (2) charitable donations recognized as expense, but sometimes not deductible for tax
purposes and (3) fines and expenses resulting from a violation of law. Item (3) is an expense which
is not deductible for tax purposes.

4.
A temporary difference is a difference between the tax basis of an asset or liability and its
reported (carrying or book) amount in the financial statements that will result in taxable amounts
2

or deductible amounts in future years when the reported amount of the asset is recovered or
when the reported amount of the liability is settled. The temporary differences discussed in this
chapter all result from differences between taxable income and pretax financial income which will
reverse and result in taxable or deductible amounts in future periods.

Examples of temporary differences are: (1) Sales accounted for on the accrual basis for financial
reporting purposes and on the installment (cash) basis for tax purposes. (2) Depreciation for
financial reporting purposes is less than that deducted in tax returns in early years of assets’ lives
because of using an accelerated depreciation method for tax purposes. (3) Rent and royalties
taxed when collected, but deferred for financial reporting purposes and recognized as revenue
when earned in later periods. (4) Unrealized holding gains or losses recognized in income for
financial reporting purposes but deferred for tax purposes.

5. An originating temporary difference is the initial difference between the book basis and the tax basis of
an asset or liability. A reversing difference occurs when a temporary difference that originated in
prior periods is eliminated and the related tax effect is removed from the tax account.

6. Book basis of assets ...............................................................................

€900,000
Tax basis of assets....................................................................................... 700,000
Future taxable amounts................................................................................ 200,000
Tax rate ........................................................................................................ X 34%
Deferred tax liability (end of 2015) ............................................................... € 68,000
 7.

Book basis of asset $90,000 Deferred tax liability (end of 2015) $ 30,600
Tax basis of asset 0 Deferred tax liability (beginning of 2015) 68,000
Future taxable amounts 90,000 Deferred tax benefit for 2015 (37,400)
Tax rate X 34% Income tax payable for 2015 230,000
Deferred tax liability (end of 2015) $30,600 Total income tax expense for 2015 $192,600

8. future taxable amount will increase taxable income relative to pretax financial income in future
periods due to temporary differences existing at the statement of financial position date. A future
deductible amount will decrease taxable income relative to pretax financial income in future periods
due to existing temporary differences.

A deferred tax asset is recognized for all deductible temporary differences. However, a deferred
tax asset should be reduced if, based on all available evidence, it is probable that some portion
or all of the deferred tax asset will not be realized.

9. Taxable income $100,000

Tax rate X 40%
Income tax payable $ 40,000
Deferred tax liability (end of 2015) $ 28,000
Deferred tax liability (beginning of 2015) 0
Deferred tax expense for 2015 $ 28,000

10. Deferred tax accounts are reported on the statement of financial position as assets and liabilities. They
should be classified in a net non-current amount.

11. Deferred tax assets and deferred tax liabilities are separately recognized and measured but are
offset in the statement of financial position. The net deferred tax asset or net deferred tax liability is
reported in the non-current section of the statement of financial position.

12. Pretax financial income......... .......................................................................... $550,000

Interest income on governmental bonds............................................................... (70,000)
 Hazardous waste fine ........................................................................................... 25,000
Depreciation ($60,000 – $45,000) ........................................................................ 15,000
Taxable income .................................................................................................... 520,000
Tax rate................................................................................................................. 30%
Income tax payable............................................................................................... $156,000

13. £200,000 (2017 taxable amount)

X 10% (30% – 20%)
£ 20,000 Decrease in deferred tax liability at the end of 2014
Answer:
Deferred Tax Liability ................................................................................. 20,000
Income Tax Expense ......................................................................... 20,000
14. Some of the reasons for requiring income tax component disclosures are:
(a) Assessment of the quality of earnings. Many investors seeking to assess the quality of a
company’s earnings are interested in the relationship between pre-tax financial income and
taxable income. Earnings that are enhanced by a favorable tax effect should be examined
carefully, particularly if the tax effect is non-recurring.
(b) Better prediction of future cash flows. Examination of the deferred portion of income tax
expense provides information as to whether taxes payable is likely to be higher or lower in
the future.
 SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 19-1

2014 taxable income................................................................. $120,000

Tax rate...................................................................................... X 40%
12/31/14 income taxes payable ............................................... $ 48,000

BRIEF EXERCISE 19-2

Excess depreciation on tax return.......................................... €40,000

Tax rate...................................................................................... X 30%
Deferred tax liability ................................................................. €12,000

BRIEF EXERCISE 19-3

Income Tax Expense .................................................. 67,500***

Deferred Tax Liability .......................................... 12,000**
Income Tax Payable ............................................ 55,500*

*€185,000 x 30% = €55,500

***€55,500 + $12,000 = €67,500

The €12,000 deferred tax liability should be classified as a non-current

liability.

BRIEF EXERCISE 19-4

Answer: $42,000
Deferred tax liability, 12/31/14 ........................................................ (25,000)
Deferred tax expense for 2015 ....................................................... 17,000
Current
Deferredtax
taxexpense
liability, for 2015 .........................................................
12/31/15 ........................................................ 48,000
Total tax expense for 2015.............................................................. $65,000
**€40,000 x 30% = €12,000
 SOLUTIONS TO EXERCISES

EXERCISE 19-1 (15–20 minutes)

(a) Pretax financial income for 2014 .......................................... $400,000

Temporary difference resulting in future taxable
amounts in 2015 ................................................................. (55,000)
in 2016 ................................................................. (60,000)
in 2017 ................................................................. (75,000)
Taxable income for 2014 ....................................................... $210,000

Taxable income for 2014 ....................................................... $210,000

Enacted tax rate ..................................................................... X 30%
Income tax payable for 2014 ................................................. $ 63,000

(b) Future Years

2015 2016 2017 Total
Future taxable (deductible) amounts $55,000 $60,000 $75,000 $190,000
Tax rate X 30% X 30% X 30%
Deferred tax liability (asset) $16,500 $18,000 $22,500 $ 57,000

Deferred tax liability at the end of 2014.................. $ 57,000

Deferred tax liability at the beginning of 2014 ....... 0
Deferred tax expense for 2014 (increase in
deferred tax liability) ............................................ 57,000
Current tax expense for 2014
(Income tax payable)............................................. 63,000
Income tax expense for 2014 .................................. $120,000

Income Tax Expense................................................ 120,000

Income Tax Payable ......................................... 63,000
Deferred Tax Liability ....................................... 57,000

(c) Income before income taxes ................................... $400,000

Income tax expense
Current............................................................... $63,000
Deferred............................................................. 57,000 120,000
Net income ................................................................ $280,000
Note: The current/deferred tax expense detail can be presented in the
notes to the financial statements.
EXERCISE 19-2 (15–20 minutes)

(a) Pretax financial income for 2014 ........................... £350,000

Excess of tax depreciation over
book depreciation ................................................ (40,000)
Rent received in advance....................................... 25,000
Taxable income ............................................... £335,000

(b) Income Tax Expense .............................................. 140,000

Deferred Tax Asset ................................................. 10,000*
Income Tax Payable (£335,000 X .40) ............ 134,000
Deferred Tax Liability...................................... 16,000**

Temporary Future Taxable Tax Deferred Tax

Difference (Deductible) Amounts Rate (Asset) Liability

**Depreciation £40,000 40% £16,000
*Unearned rent (25,000) 40% £(10,000)
£(10,000) £16,000

(c) Income Tax Expense .............................................. 136,000*

Deferred Tax Liability (£10,000 X .40) ................... 4,000
Income Tax Payable (£325,000 X .40) ............ 130,000
Deferred Tax Asset (£25,000 X .40)................ 10,000

*(£130,000 – £4,000 + £10,000)

EXERCISE 19-3 (15–20 minutes)

(a) Taxable income for 2014 ........................................ $400,000

Enacted tax rate ...................................................... X 40%
Income tax payable for 2014 .................................. $160,000

(b) Future Years

2015 2016 Total
Future taxable (deductible) amounts $175,000 $175,000 $350,000
Tax rate X 40% X 40%
Deferred tax liability (asset) $ 70,000 $ 70,000 $140,000
EXERCISE 19-3 (Continued)
Deferred tax liability at the end of 2014................ $140,000
Deferred tax liability at the beginning of 2014 ..... 90,000
Deferred tax expense for 2014 (increase
required in deferred tax liability)....................... 50,000
Current tax expense for 2014 ................................ 160,000
Income tax expense for 2014 ................................ $210,000

Income Tax Expense.............................................. 210,000

Income Tax Payable .................................... 160,000
Deferred Tax Liability .................................. 50,000

(c) Income before income taxes ................................. $525,000

Income tax expense
Current ........................................................ $160,000
Deferred....................................................... 50,000 210,000
Net income ............................................................. $315,000

Note to instructor: Because of the flat tax rate for all years, the amount
of cumulative temporary difference existing at the beginning of the
year can be calculated by dividing $90,000 by 40%, which equals
$225,000. The difference between the $225,000 cumulative temporary
difference at the beginning of 2014 and the $350,000 cumulative tem-
porary difference at the end of 2014 represents the net amount of
temporary difference originating during 2014 (which is $125,000). With
this information, we can reconcile pretax financial income with taxable
income as follows:
Pretax financial income ......................................................... $525,000
Temporary difference originating giving rise
to net future taxable amounts ........................................... (125,000)
Taxable income ...................................................................... $400,000

EXERCISE 19-4 (15–20 minutes)

(a) Pretax financial income for 2014 .......................................... € 80,000
Excess depreciation per tax return ...................................... (16,000)
Excess rent collected over rent earned ............................... 27,000
Nondeductible fines ............................................................... 11,000
Taxable income ...................................................................... €102,000

Taxable income ...................................................................... €102,000

Enacted tax rate ..................................................................... X 30%
Income tax payable ................................................................ € 30,600
(a) 2014
Income Tax Expense ................................ 336,000,000
Deferred Tax Asset (W20,000,000 X 40%) 8,000,000
Deferred
EXERCISE 19-18Tax Liability
(10–15 minutes)
(W30,000,000 X 40%) ........................ 12,000,000
Income Tax Payable
(W830,000,000 X 40%) ...................... 332,000,000

2015
Income Tax Expense ................................ 364,000,000
Deferred Tax Asset (W10,000,000 X 40%) 4,000,000
Deferred Tax Liability
(W40,000,000 X 40%)........................ 16,000,000
Income Tax Payable
(W880,000,000 X 40%)...................... 352,000,000

2016
Income Tax Expense ............................... 378,000,000
Deferred Tax Asset
(W8,000,000 X 40%) .............................. 3,200,000
Deferred Tax Liability
(W20,000,000 X 40%) ........................ 8,000,000
Income Tax Payable
(W933,000,000 X 40%) ...................... 373,200,000

(b) Non-current liabilities

Deferred tax liability
(W36,000,000 – W15,200,000 ........... W 20,800,000

(c) Pretax financial income........................... W945,000,000

Income tax expense
Current ...................................................... W373,200,000
Deferred (W8,000,000 – W3,200,000) ...... 4,800,000 378,000,000
Net Income ............................................... W567,000,000

Note: The details on the current/deferred tax expense can be disclosed

in the notes to the financial statements.
 SOLUTIONS TO PROBLEMS

PROBLEM 19-1

(a) X(.40) = $320,000 taxes due for 2014

X = $320,000 ÷ .40
X = $800,000 taxable income for 2014

(b) Taxable income [from part (a)] ................................ $800,000

Excess depreciation ................................................. 120,000
Governmental interest.............................................. 10,000
Unearned rent ........................................................... (40,000)
Pretax financial income for 2014 ..................... $890,000

(c) 2014
Income Tax Expense
($320,000 + $42,000 – $14,000) ............................ 348,000
Deferred Tax Asset ($40,000 X .35) ......................... 14,000
Income Tax Payable ($800,000 X .40) .............. 320,000
Deferred Tax Liability ($120,000 X .35)............ 42,000

2015
Income Tax Expense
($343,000 + $7,000 – $10,500) .............................. 339,500
Deferred Tax Liability [($120,000 ÷ 4) X .35] ........... 10,500
Income Tax Payable ($980,000 X .35) .............. 343,000
Deferred Tax Asset [($40,000 ÷ 2) X .35] ......... 7,000

(d) Income before income taxes ................................... $890,000

Income tax expense
Current ............................................................... $320,000
Deferred ($42,000 – $14,000) ............................ 28,000 348,000
Net income ................................................................ $542,000
 PROBLEM 19-2

(a) Before deferred taxes can be computed, the amount of temporary dif-
ference originating (reversing) each period and the resulting cumulative
temporary difference at each year-end must be computed:
2014 2015 2016 2017
Pretax financial income €290,000 €320,000 €350,000 €420,000
Nondeductible expense 30,000 30,000 30,000 30,000
Subtotal 320,000 350,000 380,000 450,000
Taxable income 180,000 225,000 260,000 560,000
Temporary difference
originating (reversing) €140,000 €125,000 €120,000 €(110,000)

Cumulative Temporary
Difference At End of Year
2014 €140,000
2015 €265,000 (€140,000 + €125,000)
2016 €385,000 (€265,000 + €120,000)
2017 €275,000 (€385,000 – €110,000)

Because the temporary difference causes pretax financial income to

exceed taxable income in the period it originates, the temporary differ-
ence will cause future taxable amounts.

Taxable income for 2014 ..................................................... €180,000

Enacted tax rate for 2014..................................................... X 35%
Current tax expense for 2014 (Income tax payable) ......... € 63,000

2014

Income Tax Expense................................................ 112,000

Income Tax Payable ......................................... 63,000
Deferred Tax Liability ....................................... 49,000
The deferred taxes at the end of 2014 would be computed as follows:
Temporary Future Taxable Tax Deferred Tax
Difference (Deductible) Amounts Rate (Asset) Liability

Depreciation €140,000 35% €49,000

Deferred tax liability at the end of 2014 ............................... € 49,000

Deferred tax liability at the beginning of 2014 .................... 0
Deferred tax expense for 2014 (increase in
deferred tax liability).......................................................... € 49,000

Deferred tax expense for 2014.............................................. € 49,000

Current tax expense for 2014 (Income tax payable) ........... 63,000
Income tax expense for 2014 ................................................ €112,000

2015

Income Tax Expense ................................................ 7,000*

Deferred Tax Liability........................................ 7,000
(To record the adjustment for the
increase in the enacted tax rate)

Income Tax Expense ................................................ 140,000

Income Tax Payable.......................................... 90,000
Deferred Tax Liability........................................ 50,000
(To record income taxes for 2015)

*The adjustment due to the change in the tax rate is computed as

follows:

Cumulative temporary difference at the end

of 2014 ................................................................................ €140,000
Newly enacted tax rate for future years............................... X 40%
Adjusted balance of deferred tax liability
at the end of 2014 .............................................................. 56,000
Current balance of deferred tax liability .............................. (49,000)
Adjustment due to increase in enacted tax rate ................. € 7,000
PROBLEM 19-2 (Continued)

Taxable income for 2015 ....................................................... €225,000

Enacted tax rate ..................................................................... 40%
Current tax expense for 2015 (Income tax payable) ........... € 90,000

The deferred taxes at December 31, 2015, are computed as follows:

Temporary Future Taxable Tax Deferred Tax
Difference (Deductible) Amounts Rate (Asset) Liability

Depreciation €265,000 40% €106,000

Deferred tax liability at the end of 2015................................ €106,000

Deferred tax liability at the beginning of 2015
after adjustment ................................................................. (56,000)
Deferred tax expense for 2015 exclusive of
adjustment due to change in tax rate (increase
in deferred tax liability) ...................................................... € 50,000

Deferred tax expense for 2015 .............................................. € 50,000

Current tax expense for 2015 (Income tax payable) ........... 90,000
Income tax expense (total) for 2015, exclusive
of adjustment due to change in tax rate .......................... €140,000

2016

Income Tax Expense............................................... 152,000

Income Tax Payable ........................................ 104,000
Deferred Tax Liability ...................................... 48,000

Taxable income for 2016 ....................................................... €260,000

Enacted tax rate ..................................................................... X 40%
Current tax expense for 2016 (Income tax payable) ........... €104,000

The deferred taxes at December 31, 2016, are computed as follows:

Temporary Future Taxable Tax Deferred Tax
Difference (Deductible) Amounts Rate (Asset) Liability

Depreciation €385,000 40% €154,000

 Deferred tax liability at the end of 2016 ................................ €154,000
Deferred tax liability at the beginning of 2016 ..................... 106,000
Deferred tax expense for 2016 (increase in
deferred tax liability)........................................................... € 48,000
Deferred tax expense for 2016............................................... € 48,000
Current tax expense for 2016 (Income tax payable) ............ 104,000
Income tax expense for 2016 ................................................. €152,000
2017
Income Tax Expense ............................................. 180,000
Deferred Tax Liability ............................................ 44,000
Income Tax Payable....................................... 224,000
Taxable income for 2017 ........................................................ €560,000
Enacted tax rate ...................................................................... X 40%
Current tax expense for 2017 (Income tax payable) ............ €224,000
The deferred taxes at December 31, 2017, are computed as follows:
Temporary Future Taxable Tax Deferred Tax
Difference (Deductible) Amounts Rate (Asset) Liability

Depreciation €275,000 40% €110,000

Deferred tax liability at the end of 2017 ................................ € 110,000
Deferred tax liability at the beginning of 2017 ..................... (154,000)
Deferred tax benefit for 2017 (decrease in
deferred tax liability)............................................................ € (44,000)
Deferred tax benefit for 2017 ................................................. € (44,000)
Current tax expense for 2017 (Income tax payable) ............ 224,000
Income tax expense for 2017................................................. € 180,000
(b) 2015
Income before income taxes ................................ €320,000
Income tax expense
Current.............................................................. €90,000
Deferred............................................................ 50,000
Adjustment due to change in tax rate............ 7,000 147,000
Net income ............................................................. €173,000
 PROBLEM 19-3

Book Depreciation Tax Depreciation Difference

2014 $ 150,000 $ 120,000* $ 30,000
2015 150,000 240,000 (90,000)
2016 150,000 240,000 (90,000)
2017 150,000 240,000 (90,000)
2014 150,000 240,000 (90,000)
2015 150,000 120,000* 30,000
2016 150,000 0 150,000
2017 150,000 0 150,000
Totals $1,200,000 $1,200,000 $ 0

*($1,200,000 ÷ 5) X .5

(a) Pretax financial income for 2015 ........................................ $1,400,000

Nontaxable interest .............................................................. (60,000)
Excess depreciation ($240,000 – $150,000) ....................... (90,000)
Taxable income for 2015 ..................................................... $1,250,000
Tax rate ................................................................................. X 35%
Income tax payable for 2015 ............................................... $ 437,500

(b) Income Tax Expense............................................. 469,000

Income Tax Payable ...................................... 437,500
Deferred Tax Liability .................................... 21,000
Deferred Tax Asset........................................ 10,500
PROBLEM 19-3 (Continued)

Scheduling—End of 2015

Future Years
2016 2017 2014
Future taxable (deductible)
Amounts $(90,000) $(90,000) $(90,000)
Enacted tax rate X 35% X 35% X 35%
Deferred tax (asset) liability $(31,500) $(31,500) $(31,500)

Future Years
2015 2016 2017 Total
Future taxable (deductible)
Amounts $30,000 $150,000 $150,000 $60,000
Enacted tax rate X 35% X 35% X 35%
Deferred tax (asset) liability $10,500 $ 52,500 $ 52,500 $21,000

The net deferred tax liability at December 31, 2015, is $21,000.

Scheduling—End of 2014

Future Years
2015 2016 2017 2014
Future taxable (deductible)
Amounts $(90,000) $(90,000) $(90,000) $(90,000)
Enacted tax rate X 35% X 35% X 35% X 35%
Deferred tax (asset) liability $(31,500) $(31,500) $(31,500) $(31,500)

Future Years
2015 2016 2017 Total
Future taxable (deductible)
Amounts $30,000 $150,000 $150,000 $(30,000)
Enacted tax rate X 35% X 35% X 35%
Deferred tax (asset) liability $10,500 $ 52,500 $ 52,500 $(10,500)
The net deferred tax asset at December 31, 2014, is $10,500.
Deferred tax liability at the end of 2015................................. $ 21,000
Deferred tax liability at the beginning of 2015 ...................... 0
Deferred tax expense for 2015 (increase in
deferred tax liability) ........................................................... $ 21,000

Deferred tax asset at the end of 2015.................................... $ 0

Deferred tax asset at the beginning of 2015 ......................... 10,500
Deferred tax expense for 2015 (decrease in
deferred tax asset) .............................................................. $ 10,500

Deferred tax expense for 2015

(from deferred tax liability) ................................................. $ 21,000
Deferred tax expense for 2015
(from deferred tax asset) .................................................... 10,500
Net deferred tax expense for 2015......................................... $ 31,500

Current tax expense for 2015 (Income tax payable) ............ $437,500
Deferred tax expense for 2015 ............................................... 31,500
Income tax expense for 2015 ................................................. $469,000

(c) Income before income taxes .............................. $1,200,000a

Income tax expense
Current ($437,500 – $70,000b)..................... $367,500
Deferred........................................................ 31,500 399,000
Income from continuing operations .................. 801,000
Discontinued operations gain .................... 200,000
Less applicable income tax ........................ 70,000b 130,000
Net income ........................................................... $ 931,000
a
$1,400,000 pretax financial income – $200,000 discontinued operations gain =
$1,200,000.
b
($200,000 X 35%)

(d) Non-current liabilities

Deferred tax liability ............................................ $21,000
(a) Schedule of Pretax Financial Income
and Taxable Income for 2014

Pretax financial income ........................................................ $750,000

Permanent differences
Bond interest revenue .................................................... (4,000)
Pollution fines ................................................................. 4,200
750,200
Temporary differences
Depreciation expense ..................................................... (30,000)*
Installment sales ($100,000 – $75,000).......................... (25,000)
Warranty expense ($50,000 – $10,000).......................... 40,000
Taxable income .............................................................. $735,200

* Depreciation for books ($300,000/5) = $60,000

Depreciation tax return ($300,000 X 30%) = 90,000
Difference $30,000

The income tax payable for 2014 is as follows:

Taxable income ........................................ $735,200
Tax rate ..................................................... X 30%
Income tax payable .................................. $220,560

The computation of the deferred income taxes for 2014 is as follows:

Temporary differences
Depreciation expense $(30,000) X 30% = $(9,000) DTL
Installment sales ($100,000 – $75,000) (25,000) X 30% = (7,500) DTL
Warranty expense ($50,000 – $10,000) 40,000 X 30% = 12,000 DTA
(b) The journal entry to record income tax payable, income tax expense
and deferred income taxes is as follows:

Income Tax Expense .............................................. 225,060*

Deferred Tax Asset ................................................. 12,000
Deferred Tax Liability ($9,000 + $7,500) .......... 16,500
Income Tax Payable.......................................... 220,560

*Deferred tax expense for 2014

(from deferred tax liability) ($9,000 + $7,500)..... $ 16,500
Deferred tax benefit for 2014
(from deferred tax asset).................................. (12,000)
Net deferred tax expense for 2014 ........................ 4,500
Current tax expense for 2014
(income tax payable) ........................................ 220,560
Income tax expense for 2014................................. $225,060