Intermediate Accounting/Accounting for Income Taxes

Introduction to Tax Accounting
SAFA #109, 740-10-25-20

Although most of the information on a company’s income tax return comes from the income statement, there often is a difference between pretax income and taxable income. These differences are due to the recording requirements of GAAP for financial accounting (usually following matching principle and allowing accruals of revenue and expenses) and the requirements of the IRS’s tax regulations for tax accounting (which are more oriented to cash). Such timing differences between financial accounting and tax accounting create temporary differences. Also there are events, usually one-time, which create "permanent differences", such as GAAP recognizing as expense an item which the IRS will not allow to be deducted.

Temporary Differences
A temporary difference between pretax financial accounting income and taxable income often creates the amount to be included in taxable income one or two years before or after the revenue or expense was realized in financial accounting. Recording in this matter, in turn, creates a difference of the amount that is recorded of an asset or a liability on the financial statements. Items that create temporary differences include: •	Installment sales •	Unrealized gain on recorded investments •	Rent collected in advance •	Subscriptions collected in advance •	Revenue collected in advance •	Estimated expenses and loses •	Unrealized loss from recorded investments at fair value •	Differences in recording method for depreciation •	Prepaid tax deductable expenses These temporary differences create either a deferred tax liability or a deferred tax asset.

Deferred Tax Liability
A deferred tax liability is best described as “a liability that represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year” (Kieso, Weygandt, & Warfield, 2007, p. 967).

For example: The Cram Corporation sold property worth $100 million on January 1, 2009. Terms included $25 million installments each year starting on January 1, 2009 and the final payment to be made on January 1, 2012. Example of a sale creating a deferred tax liability that is a temporary difference ($ in millions)         Originates	     Reverses Year	                    2009     2010   2011  2012   Total Pretax Accounting Income   $200     $150   $125  $100   $575 Installment sale of land  ($100)     0      0      0   ($100) Installment income of sale  $25      $25    $25   $25   $100 Taxable income	     $125     $175   $150  $125   $575

In this example the pretax income vary from the taxable income for that given year due to differences in recognition of the sale of the land. Remember, according to GAAP, revenue is recognized when earned, but the IRS recognizes revenue when it is received for tax accounting.

Deferred Tax Asset
The opposite is true of a deferred tax asset. This is best described as a “deferred tax asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year” (Kieso, Weygandt, & Warfield, 2007, p. 970). For example: The Cram Corporation 2009 income statement included a warranty expense valued at $50 million that is deducted when paid in 2010 and 2011.

Example of a expense creating a deferred tax asset that is temporary in nature ($ in millions)   Originates   Reverses Year	                      2009	 2010  2011   Total Pretax accounting income    $200	 $150  $125    $475 Expense on income statement  $50		        $50 Expense on tax return	         0	 ($25) ($25)   (50) Taxable income 	      $250	  $125  $100   $475

In this example the expense on tax return is representative of a future tax benefit from reversing a temporary difference in warranty expense that is paid in the current year.

Permanent Differences
One permanent difference arises when a firm has engaged in illegal activity, and has incurred expenses that are real in GAAP terms but are disallowed by the IRS. For example the payment of fines to the government for illegal activities.

Self Study Questions
1. Below are 5 causes for temporary differences. For each temporary difference indicate if it will create a future deductable amount (D) or a future taxable amount (T).

A.___ Newspaper subscription B.___ Prepaid Rent C.___ Straight line depreciation of an asset D.___ Bad debt expense; Direct write off method E.___ Prepaid Insurance

2. For the following exercise, calculate the taxable income each year from the given information;

2009 Pretax accounting income of $500, Installment sale $100 of land first payments of $60 due on January 1, 2009, $20 received on 1/1/2010, $20 received on 1/1/2011; 2010 Pretax accounting income of $600; 2011 Pretax income of $450, additional subscription revenue of $50; 2012 Pretax income of $425, subscription revenue on income statement, $30.

Answers to self study questions;

1.   A.   D    B.   T   C.   T   D.   D   E.   T

2.	 Year 	                                    2009  2010	2011  2012 Pretax Accounting Income	           $500  $600	$450  $425 Installment sale of land	          ($100) Installment income of sale	            $60   $20	 $20 Subscription Revenue on income statement		     (30) Subscription Revenue on tax return			 50 Taxable income                             $460  $620   $520 $395