CHAPTER ONE

ACCOUNTING FOR INCOME

TAX
Basic Concepts
Income tax: Income tax is a tax that is levied by a government
on the earnings or income of individuals, businesses, and other
entities.

Accounting profit: It is profit or loss for a period determined

in accordance with IFRS

Taxable profit: It is the profit (loss) for a period, determined in

accordance with income tax law
Fundamentals of Accounting for Income Tax
➢ Corporations use guidelines to report information to investors and
creditors (IFRS)
➢ Corporations also must file income tax returns following the guidelines
developed by the Internal Revenue Service (IRS).
➢ Because of IFRS and tax regulations differ in a number of ways, a
company reports as tax expense will differ from the amount of taxes
payable to the IRS
Financial Vs Tax reporting
Cont’d….
Temporary differences = differences between the carrying
amount of an asset or liability in the statement of financial
position and its tax base.
Impact of Temporary Difference
Current tax-tax consequences that are legal assets or liabilities
at the reporting date.
The other consequences, which are expected to become, or
(more strictly) form part of, legal assets or liabilities in a future
period, are referred to as a deferred tax.
Tax Base Concept
The tax base is the total value or measure used to calculate taxes.
It is used to determine how much tax individuals, businesses, or
other entities owe to the government.

It is a value attributed to asset for tax purpose and it is used as

base to calculate tax payable.
Cont’d….

Difference between
AP and TP

Permanent Temporary
Temporary Vs Permanent Differences

1. Temporary Difference: Temporary differences in accounting

occur when there are discrepancies between the values of assets
and liabilities on a company's financial statements and their
values as recognized by tax authorities.

These differences are considered "temporary" because they are

expected to be resolved or reversed in future periods.
Temporary Difference …………Cont;d

Temporary
Difference

Taxable Deductible
Temporary Temporary
Difference Difference
Temporary Difference …………Cont’d
• Taxable Temporary Differences: result in taxable amounts in
future years when the related assets are recovered.
• Taxable temporary differences give rise to deferred tax
liabilities.
• Deductible Temporary Differences: are differences that will
result in deductible amounts in future years when the related
book liabilities are settled.
• Deductible temporary differences give rise to recording deferred
tax assets.
Deferred Tax Liability Vs Deferred Tax Asset
• Deferred tax liabilities (DTL): reflect the expected future tax
obligations resulting from differences in the values of assets and
liabilities for financial reporting and tax purposes. These
differences create situations where the company will pay less in
taxes in the current period, but will owe more in taxes in future
periods.
Deferred Tax Liability Vs Deferred Tax Asset
• Deferred Tax Asset (DTA): refers to the expected future tax
advantages a company anticipates as a result of temporary
differences in the values of its assets and liabilities for financial
reporting compared to their values for tax purposes. These
differences can lead to higher taxable income in the present
period, but lower taxable income in the future.
Illustration IFRS Vs Tax Reporting
• ABC Company reported revenues of Br130,000 and
expenses of Br60,000 in each of its first three years of
operations. For tax purposes, the company reported
the same expenses to the IRS in each of the years. ABC
reported taxable revenues of Br100,000 in 2020,
Br150,000 in 2021, and Br140,000 in 2022. What is the
effect on the accounts of reporting different amounts
of revenue for IFRS versus tax reporting?
IFRS Reporting vs Tax Reporting

IFRS Reporting 2020 2021 2022 Total

Revenues Br130,000 Br130,000 Br130,000 Br390,000

Expenses 60,000 60,000 60,000 180,000
Pretax financial income Br70,000 Br70,000 Br70,000 Br210,000

Income tax expense (40%) Br28,000 Br28,000 Br28,000 Br84,000

Tax Reporting 2020 2021 2022 Total

Revenues Br100,000 Br150,000 Br140,000 Br390,000

Expenses 60,000 60,000 60,000 180,000
Taxable income Br40,000 Br90,000 Br80,000 Br210,000

Income tax payable (40%) Br16,000 Br36,000 Br32,000 Br84,000

IFRS Reporting vs Tax Reporting
Comparison 2020 2021 2022 Total

Income tax expense (IFRS) Br28,000 Br28,000 Br28,000 Br84,000

Income tax payable (IRS) 16,000 36,000 32,000 84,000
Difference Br12,000 Br(8,000) Br(4,000) Br0

Are the differences accounted for in the financial statements? Yes

Year Reporting Requirement

2020 Deferred tax liability account increased to Br12,000
2021 Deferred tax liability account reduced by Br8,000
2022 Deferred tax liability account reduced by Br4,000
Financial Reporting for 2020 ABC Company
Balance Sheet Income Statement
2020 2020
Assets:
Revenues:

Expenses:
Liabilities:
Deferred taxes 12,000
Income tax payable 16,000
Income tax expense 28,000
Equity:
Net income (loss)
Future Taxable Amounts and Deferred Taxes

Illustration: In ABC Company’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. ABC
Company reports accounts receivable at Br30,000 in the December 31, 2020,
IFRS-basis balance sheet. However, the receivables have a zero tax basis.

Per Books 12/31/2020 Per Tax Return 12/31/2020

Accounts receivable Br30,000 Accounts receivable Br–0–
Future Taxable Amounts and Deferred Taxes

Assuming that ABC Company expects to collect Br20,000 of the receivables in

2021 and Br10,000 in 2022, this collection results in future taxable amounts of
Br20,000 in 2021 and Br10,000 in 2022. These future taxable amounts will
cause taxable income to exceed pretax financial income in both 2021 and 2022.
Future Taxable Amounts and Deferred Taxes

Deferred Tax Liability – ABC Company

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.
Future Taxable Amounts and Deferred Taxes

Deferred Tax Liability – ABC Company

Illustration: Because it is the first year of operations for ABC, there is no deferred tax liability at the
beginning of the year. ABC Company computes the income tax expense for 2020 as follows:
Deferred tax liability at end of 2020 Br12,000

Deferred tax liability at beginning of 2020 –0–

Deferred tax expense for 2020 12,000

Current tax expense for 20120 (income taxes payable) 16,000

Income tax expense (total) for 2020 Br28,000

Future Taxable Amounts and Deferred Taxes

Journal Entry to Record Income Tax Expanse on December 31, 2020

Income Tax Expense 28,000

Income Tax Payable 16,000
Deferred Tax Liability 12,000
Future Taxable Amounts and Deferred Taxes

Computation of Income Tax Expense for 2021

Deferred tax liability at end of 2021 Br 4,000

Deferred tax liability at beginning of 2021 12,000

Deferred tax expense (benefit) for 2021 (8,000)

Current tax expense for 2021 (income taxes payable) 36,000

Income tax expense (total) for 2021 Br28,000
Future Taxable Amounts and Deferred Taxes

Journal Entry to Record Income Tax Expanse on December 31, 2021

Income Tax Expense 28,000

Deferred Tax Liability 8,000
Income Tax Payable 36,000
Future Taxable Amounts and Deferred Taxes

Computation of Income Tax Expense for 2022

Deferred tax liability at end of 2022 Br 0

Deferred tax liability at beginning of 2022 4,000

Deferred tax expense (benefit) for 2022 (4,000)

Current tax expense for 2022 (income taxes payable) 32,000

Income tax expense (total) for 2022 Br28,000
Future Taxable Amounts and Deferred Taxes

Journal Entry to Record Income Tax Expanse on December 31, 2022

Income Tax Expense 28,000

Deferred Tax Liability 4,000
Income Tax Payable 32,000
Financial Statement Effects
For the Balance Sheet
Income taxes payable will be reported as current liability, and
the deferred tax liability is reported as a non-current liability.
reports the information on its balance sheets for 2020–2022 as
follows:
Year-End Income Taxes Payable Deferred Tax
Liability
2020 Br16,000 Br12,000
2021 36,000 4,000
−0−
2022 32,000
For Income Statement, Income Tax Expense will be Presented
totally or separately as current tax and differed tax.

For the Year Ended 2020 2021 2022

Income before income taxes Br70,000 Br70,000 Br70,000
Income tax expense 28,000 28,000 28,000
Net income Br42,000 Br42,000 Br42,000
Exercise
XYZ Corporation has one temporary difference at the end of 2017 that will
reverse and cause taxable amounts of Br55,000 in 2018, Br60,000 in 2019, and
Br65,000 in 2020. The company reported pretax financial income of Br300,000
for 2017 and the tax rate is 30% for all years. There are no deferred taxes at the
beginning of 2017.

Instructions
a) Compute taxable income and income taxes payable for 2017.
b) Prepare the journal entry to record income tax expense, deferred income
taxes, and income taxes payable for 2017.
Future Deductible Amounts and Deferred Taxes
❖ Deductible amounts reduce taxable income in future
years.
Assume that during 2017, XYZ Company estimated its warranty costs related to
the sale of microwave ovens to be Br500,000, paid evenly over the next two years.
✓ For book purposes, the company reported warranty expense and a related estimated
liability for warranties of Br500,000.
✓ For tax purposes, the warranty tax deduction is not allowed until paid.
• XYZ Company’s temporary difference originates (arises) in
one period (2017) and reverses over the future two periods
(2018 and 2019).
Deferred Tax Asset
A deferred tax asset: the increase in taxes refundable (or saved) in future years
result of deductible temporary differences existing at the end of the current year.

To illustrate, assume that Tsehay Company has revenues of Br900,000 for both
2017 and 2018. It also has operating expenses of Br400,000 for each of these
years. In addition, Tsehay Company accrues a loss and related liability of Br50,000
for financial reporting purposes because of pending litigation.

Tsehay Company cannot deduct this amount for tax purposes until it pays the liability, expected
in 2018. As a result, a deductible amount will occur in 2018 when Tsehay Company settles the
liability, causing taxable income to be lower than pretax financial information.
IFRS Reporting
2017 2018
Revenues Br900,000 Br900,000
Expenses (operating) 400,000 400,000
Litigation loss 50,000 −0−
Pretax financial income Br450,000 Br500,000
Tax rate 40% 40%
Income tax expense Br180,000 Br200,000

Tax Reporting
2017 2018
Revenues
Expenses (operating) Br900,000 Br900,000
400,000 400,000
Litigation loss −0− 50,000
Taxable income Br500,000 Br450,000
Tax rate 40% 40%
Income taxes payable Br200,000 Br180,000
• Computation of the deferred tax asset at the end of 2017
(assuming a 40% tax rate) will be.

Book basis of litigation liability Br50,000

Tax basis of litigation liability –0–

Cumulative temporary difference at the end of 2017 50,000

Tax rate 40%

Deferred tax asset at the end of 2017 Br20,000

• Assuming that 2017 is Tsehay Company’s first year of operations
and income taxes payable is Br200,000, Tsehay Company
computes its income tax expense as follows.

Deferred tax asset at end of 2017 Br 20,000

Deferred tax asset at beginning of 2017 –0–
Deferred tax benefit (Save) for 2017 (20,000)
Current tax expense for 2017 (income taxes payable) 200,000
Income tax expense (total) for 2017 Br180,000
• The deferred tax benefit results from the increase in the
deferred tax asset from the beginning to the end of the
accounting period.
• The deferred tax benefit is a negative component of income
tax expense.
• Tsehay Company makes the following journal entry.

Income Tax Expense 180,000

Deferred Tax Asset 20,000
Income Taxes Payable 200,000
Income Tax Expense for 2018

Deferred tax asset at the end of 2018 Br –0–

Deferred tax asset at the beginning of 2018 20,000
Deferred tax benefit (Save) for 2018 20,000
Current tax expense for 2018 (income taxes payable) 180,000
Income tax expense (total) for 2018 Br200,000
The company records income taxes for 2018 as follows.
Income Tax Expense 200,000
Deferred Tax Asset 20,000
Income Taxes Payable 180,000
• The total income tax expense of Br200,000 on the
income statement for 2018 thus consists of two
elements.
• current tax expense of Br180,000 and
• deferred tax expense of Br20,000.
Financial Statement Effects
For Balance Sheet: Tsehay Company reports the following information
on its balance sheets for 2017 and 2018 as shown in Illustration.
• Income taxes payable is reported as a current liability, and the deferred tax
asset is reported as a noncurrent asset.
For Income statement
On its income statement, Tsehay Company reports the
information as follows.
Tsehay COMPANY
INCOME STATEMENT
FOR THE YEAR ENDING DECEMBER 31, 2017
Revenues Br900,000
Expenses (operating) 400,000
Litigation loss 50,000
Income before income taxes 450,000
Income tax expense
Current Br200,000
Deferred (20,000) 180,000
Net income Br270,000
Permanent Differences

Sources of Permanent Differences

Some items are recorded but NEVER

in Books on tax return

are NEVER but recorded

Other items
recorded in books on tax return

No deferred tax effects

for permanent differences
Permanent Differences: Examples
1. Interest received on state and municipal obligations.
2. Expenses incurred in obtaining tax-exempt income.
3. Proceeds from (Premiums paid for) life insurance carried by the
company on key officers or employees.
4. Fines and expenses resulting from a violation of law.
Since permanent differences affect only the period in which they
occur, they do not give rise to future taxable or deductible amounts.
As a result, companies recognize no deferred tax consequences.
Illustrations of Temporary and Permanent Differences

• Assume that XYZ Company reports pretax financial income of

Br200,000 in each of the years 2015, 16, and 17. The company is
subject to a 30% tax rate and has the following differences
between pretax financial income and taxable income.
1. It pays life insurance premiums for its key officers of Br5,000 in
2016 and 2017. Although not tax-deductible, XYZ expenses the
premiums for book purposes.
2. XYZ Company reports gross profit of Br18,000 from an
installment sale in 2015 for tax purposes over an 18-month
period at a constant amount per month beginning January 1,
2016. It recognizes the entire amount for book purposes in 2015.
• The installment sale is a temporary difference, whereas
the life insurance premium is a permanent difference.
2016 2017
2015
Pretax financial income Br200,000 Br200,000 Br200,000
Permanent Difference
(Non-deductible expense ) 5,000 5,000

Temporary difference
(Installment sale) (18,000) 12,000 6,000
Taxable income 182,000 217,000 211,000

Tax rate 30% 30% 30%

Income taxes payable Br 54,600 Br 65,100 Br 63,300

Interpretation
XYZ Company deducts the installment-sales gross profit from
pretax financial income to arrive at taxable income Because Pretax
financial income includes the installment-sales gross profit; taxable
income does not.
Conversely, it adds the Br5,000 insurance premium to pretax
financial income to arrive at taxable income Because Pretax financial
income records an expense for this premium, but not for tax
purposes.
Therefore, the life insurance premium must be added back to pretax
financial income to reconcile to taxable income.
December 31, 2015

Income Tax Expense (Br54,600 + Br5,400) 60,000

Deferred Tax Liability (Br18,000 × 30%) 5,400

Income Taxes Payable (Br182,000 × 30%) 54,600

December 31, 2016

Income Tax Expense (Br65,100 – Br3,600) 61,500

Deferred Tax Liability (Br12,000 × 30%) 3,600

Income Taxes Payable (Br217,000 × 30%) 65,100

December 31, 2017

Income Tax Expense (Br63,300 – Br1,800) 61,500

Deferred Tax Liability (Br6,000 × 30%) 1,800
63,300
Income Taxes Payable (Br211,000 × 30%)
❑ XYZ has one temporary difference, which originates in
2015 and reverses in 2016 and 2017.
❑ As the temporary difference reverses, XYZ reduces the
deferred tax liability.
❑ There is no deferred tax amount associated with the
difference caused by the nondeductible insurance expense
because it is a permanent difference.
❑ Although an enacted tax rate of 30% applies for all three
years, the effective rate differs from the enacted rate in 2016
and 2017.
❑ XYZ computes the effective tax rate by dividing total
income tax expense for the period by pretax financial
income.
❑ The effective rate is 30% for 2015 (Br60,000 ÷ Br200,000 =
30%) and 30.75% for 2016 and 2017 (Br61,500 ÷
Br200,000).
Revision of Future Tax Rates
❑ change in the tax rate is enacted, record effects immediately
on existing differed income tax account.

❑ A company reports the effect as an adjustment to income tax

expense in the period of the change.
Revision of Future Tax Rates

To illustrate, on December 10, 2017, a new income tax act is

signed into law that lowers the corporate tax rate from 40%to
35%, effective January 1, 2019. If Hostel Co. has one
temporary difference at the beginning of 2017 related to Br3
million of excess tax depreciation, then it has a Deferred Tax
Liability account with a balance of Br1,200,000 (Br3,000,000 ×
40%) at January 1, 2017. If taxable amounts related to this
difference are scheduled to occur equally in 2018, 2019, and
2020, the deferred tax liability at the end of 2017 is
Br1,100,000, computed as follows.
2018 2019 2020 Total
Future taxable amounts Br1,000,000 Br1,000,000 Br1,000,000 Br3,000,000
Tax rate 40% 35% 35%
Deferred tax liability Br 400,000 Br 350,000 Br 350,000 Br1,100,000

.
Hostel, therefore, recognizes the decrease of Br100,000 (Br1,200,000 – Br1,100,000) at the
end of 2017 in the deferred tax liability as follows.

Deferred Tax Liability 100,000

Income Tax Expense 100,000

• Corporate tax rates do not change often. Therefore, companies usually employ
the current rate.
• However, state and foreign tax rates change more frequently, and they require
adjustments in deferred income taxes accordingly.
ACCOUNTING FOR NET OPERATING LOSSES
• Net operating loss (NOL) occurs for tax purposes,
when tax-deductible expenses exceed taxable
revenues.
• For an established company, a major event such as
• a labor strike,
• rapidly changing regulatory and competitive forces,
• a disaster such as 9/11, or
• a general economic recession can cause expenses
exceed revenues—a net operating loss.
ACCOUNTING FOR NET OPERATING LOSSES
• Inequitable tax burden would result if
companies were taxed during profitable
periods without receiving any tax relief during
periods of net operating losses.
• Companies accomplish this income-averaging
provision (losses of one year to offset the
profits of other years) through the
• carryback and carryforward of net operating losses.
Loss Carryback
• 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.
Example
• To illustrate the accounting procedures for a net operating loss carryback, assume that
XYZ Co has no temporary or permanent differences.
Year Taxable Income or Loss Tax Rate Tax Paid
2014 Br 50,000 35% Br17,500
2015 100,000 30% 30,000
2016 200,000 40% 80,000
2017 (500,000) — –0–

• In 2017, XYZ Co incurs a net operating loss that it decides to carry back.
• XYZ Co Inc must carries the loss back first to 2015. Then, XYZ Co carries back any
unused loss to 2016.
• Accordingly, XYZ Co files amended tax returns for 2015 and 2016, receiving refunds
for the Br110,000 (Br30,000 + Br80,000) of taxes paid in those years.
For accounting as well as tax purposes, the Br110,000 represents the
tax effect
(tax benefit) of the loss carryback. XYZ Co should recognize this tax effect
in 2017,
the loss year.
Income Tax Refund Receivable 110,000
Benefit Due to Loss Carryback (Income Tax Expense) 110,000
• XYZ Co reports the account debited, Income Tax Refund
Receivable, on the balance sheet as a current asset at December 31,
2017. It reports the account credited on the income statement for
2017.
• Since the Br500,000 net operating loss for 2017 exceeds the Br300,000
total taxable income from the 2 preceding years, XYZ Co carries
forward the remaining Br200,000 loss.
Loss carryforwards
• CARRY FORWARDS. Deductions or credits that cannot be utilized on the tax
return during a year and that may be carried forward to reduce taxable income
or taxes payable in a future year.
• If a carryback fails to fully absorb a net operating loss or if the company decides
not to carry the loss back, then it can carry forward. Because companies use
carryforwards to offset future taxable income, the tax effect of a loss
carryforward represents future tax savings.
Example
Return to the XYZ Co example In 2017, the company records the
tax effect of the Br200,000 loss carryforward as a deferred tax asset
of Br80,000 (Br200,000 × 40%), assuming that the enacted future
tax rate is 40%. XYZ Co records the benefits of the carryback and
the carryforward in 2017 as follows.
• XYZ Co realizes the income tax refund receivable of Br110,000
immediately as a refund of taxes paid in the past.
• It establishes a Deferred Tax Asset account for the benefits of future tax
savings.
• The two accounts credited are contra income tax expense items, which
XYZ Co presents on the 2017 income statement .
• The current tax benefit of Br110,000 is the income tax refundable for
the year.
• The Br80,000 is the deferred tax benefit for the year, which results from
an increase in the deferred tax asset
Computation of Income Taxes Payable with Realized Loss Carryforward
• For 2018, assume that XYZ Co returns to profitable operations
and has taxable income of Br250,000 (prior to adjustment for
the NOL carryforward), subject to a 40% tax rate. XYZ Co then
realizes the benefits of the carryforward for tax purposes in
2018, which it recognized for accounting purposes in 2017.
XYZ Co computes the income taxes payable for 2018.

Taxable income prior to loss carryforward Br 250,000

Loss carryforward deduction (200,000)
Taxable income for 2018 50,000
Tax rate 40%
Income taxes payable for 2018 Br 20,000
• XYZ Co records income taxes in 2018 as follows.

Income Tax Expense 100,000

Deferred Tax Asset 80,000

Income Taxes Payable 20,000

• The benefits of the NOL carryforward, realized in 2018, reduce the

Deferred Tax Asset account to zero.
FINANCIAL STATEMENT PRESENTATION
1. Balance Sheet

• Income taxes payable and income tax refund receivable are

reported as a current liability and current asset, respectively, on
the balance sheet.
• Deferred tax assets and deferred tax liabilities are separately
recognized and measured and then offset on the balance sheet.
• The net deferred tax asset or net deferred tax liability is therefore
reported in the noncurrent section of the balance sheet.
Income Statement
• Companies are required to report income before taxes and
income tax expense on the income statement.
• Income tax expense generally equals the sum of income
taxes payable and the change in the deferred tax expense.
• Income tax benefit generally equals the sum of income
taxes refundable and the change in the deferred tax
benefit.
• For example, a company adds an increase in a deferred tax
liability to income taxes payable. On the other hand, it
subtracts an increase in a deferred tax asset from income
taxes payable.
Summary
Exercise
1. ABC Corporation has one temporary difference at the end of 2017 that
will reverse and cause taxable amounts of Br55,000 in 2008, Br60,000 in
2019, and Br65,000 in 2020. ABC’s pretax financial income for 2017 is
Br300,000, and the tax rate is 30% for all years. There are no deferred
taxes at the beginning of 2017.
Instructions
A. Compute taxable income and income taxes payable for 2017.
B. Prepare the journal entry to record income tax expense, deferred income
taxes, and income taxes payable for 2017.
Exercise
XYZ Inc. incurred a net operating loss of Br450,000 in
2017. Taxable income was Br150,000 for 2015 and
Br200,000 for 2016. The tax rate for all years is 40%. XYZ
elects the carryback option and remaining loss to be
carried forward:
Required: Prepare the journal entries to record the benefits
of the loss carryback and the loss carry forward.