Accounting for Income Taxes PDF

**Accounting for Income Taxes** Companies compute GAAP (financial) income and income tax expense on an **accrual basis** in accordance with generally accepted accounting principles (GAAP). Companies compute taxable income/income tax income and income taxes payable on a **modified cash basis** in a...

**Accounting for Income Taxes** Companies compute GAAP (financial) income and income tax expense on an **accrual basis** in accordance with generally accepted accounting principles (GAAP). Companies compute taxable income/income tax income and income taxes payable on a **modified cash basis** in accordance with the Internal Revenue Code (IRC). +-----------------------------------+-----------------------------------+ | Why is taxable income different | Ans d | | from accounting income? | | | | | | a\. because the International | | | Financial Reporting Standards | | | Foundation requires the full | | | accrual method over modified | | | cash basis. | | | | | | b\. because the International | | | Financial Reporting Standards | | | Foundation requires the | | | modified cash basis over the | | | full accrual method. | | | | | | c\. because companies use full | | | accrual for tax reporting and | | | modified cash basis for | | | financial reporting. | | | | | | d\. because companies use full | | | accrual for financial reporting | | | and modified cash basis for tax | | | reporting. | | +-----------------------------------+-----------------------------------+ GAAP (financial) income is reported on the income statement and is often referred to as income before income taxes or pretax financial income or book income. Taxable income is reported on the tax return and is the amount upon which a company's income taxes payable is computed (the amount owed to the government). +-----------------------------------+-----------------------------------+ | Which income is used to compute a | Ans d | | company's income taxes payable? | | | | | | a\. financial income. | | | | | | b\. book income. | | | | | | c\. GAAP income. | | | | | | d\. taxable income. | | +-----------------------------------+-----------------------------------+ Differences normally exist between a company\'s (GAAP) GAAP (financial) income and taxable (IRS) income because generally accepted accounting principles (GAAP) are used to measure GAAP (financial) income while the Internal Revenue Code and state tax laws are used to determine taxable income for purposes of paying income taxes. These differences stem from the different objectives of generally accepted accounting principles (GAAP) and of tax laws. The objective of generally accepted accounting principles (GAAP) is to provide information useful to present and potential users in making rational investment, credit, or similar decisions. However, the objectives of the Internal Revenue Code are to raise revenue to operate the government and to assist the government in achieving social or economic goals. Differences between a company\'s GAAP (financial) income and taxable income are a result of permanent and/or temporary differences. Permanent differences do not have deferred tax consequences, and, therefore, affect either a company\'s reported GAAP (financial) income or its taxable income, but not both. Temporary differences, also referred to as timing differences, are a difference in a company's GAAP (financial) income and taxable income resulting from reporting revenues and expenses in one period for income tax purposes and in another period for GAAP (financial) reporting purposes. The temporary differences normally originate in one year and reverse in later years. Temporary differences in the year of origination may result in either future GAAP (financial) income exceeding future taxable income (deferred tax asset) or future taxable income exceeding future GAAP (financial) income (deferred tax liability) in the year of reversal. Temporary differences create the need for interperiod tax allocation because income tax expense is being allocated from one accounting period to others. Please understand and study the following illustration. GAAP Income Deferred Tax Asset Temporary Differences Deferred Tax Liability Permanent Taxable Income +-----------------------------------+-----------------------------------+ | Taxable income of a corporation | Ans c | | differs from pretax financial | | | income because of? | | | | | | Permanent Temporary | | | | | | Differences Differences | | | | | | a\. No No | | | | | | b\. No Yes | | | | | | c\. Yes Yes | | | | | | d\. Yes No | | +===================================+===================================+ | The sources of differences | Ans a | | between pretax financial income | | | and taxable income in the current | | | year are? | | | | | | a\. permanent differences and | | | temporary differences. | | | | | | b\. permanent differences only. | | | | | | c\. temporary differences only. | | | | | | d\. none of the answer choices | | | are correct. | | +-----------------------------------+-----------------------------------+ **\ ** **Temporary Differences -** temporary differences (also referred to as timing differences) arise because of timing differences in the recognition of revenue/gains or the deduction of expenses/losses between GAAP (financial) income and taxable income. The initial difference between GAAP (financial) income and taxable income is called an originating temporary difference. Originating differences reverse themselves in future years and the related tax effect is removed from the deferred tax asset or deferred tax liability account. Four major categories of temporary differences are: - revenues/gains are taxable after recognition in financial income =\> deferred tax liability e.g. sales on account, installment sales, equity method for investments, percentage-of-completion method, gain on involuntary conversion of nonmonetary assets, and unrealized holding gain on trading securities. - revenues/gains are taxable before recognition in financial income =\> deferred tax asset e.g. rent or subscriptions received in advance. - expenses/losses are tax deductible after recognition in financial income =\> deferred tax asset e.g. product warranty accrual, contingent liability, bad debt using allowance method, unrealized holding loss on trading securities, and stock based compensation. - expenses/losses are tax deductible before recognition in financial income =\> deferred tax liability e.g. tax accelerated depreciation, prepaid rent, and prepaid insurance. +-----------------------------------+-----------------------------------+ | Which of the following difference | Ans a | | would result in a deferred tax | | | liability? | | | | | | a\. accelerated depreciation. | | | | | | b\. subscriptions received in | | | advance. | | | | | | c\. proceeds from life insurance | | | on key officer or employees. | | | | | | d\. product warranty accrual. | | +===================================+===================================+ | Which circumstance causes a | Ans c | | temporary difference that results | | | in a deferred tax asset? | | | | | | a\. accounts receivable | | | increases over the course of | | | the year. | | | | | | b\. depreciable assets are | | | purchased in the current year | | | and depreciated more rapidly | | | for tax purposes. | | | | | | c\. the company begins offering | | | a five-year warranty on all | | | items sold. | | | | | | d\. the company prepays various | | | expenses that will be incurred | | | in the subsequent year. | | +-----------------------------------+-----------------------------------+ | Which circumstance causes a | Ans a | | temporary difference that results | | | in a deferred tax liability? | | | | | | a\. unrealized holding gains on | | | investments held as trading | | | securities. | | | | | | b\. accrued expenses associated | | | with defending a lawsuit that | | | will be settled in a subsequent | | | period. | | | | | | c\. recognition of bad debt by | | | the direct write-off method for | | | tax reporting and the allowance | | | method for financial reporting. | | | | | | d\. rental income or | | | subscriptions received in | | | advance. | | +-----------------------------------+-----------------------------------+ | Which of the following | Ans c & d | | differences would result in a | | | deferred tax liability? | | | | | | a\. expenses or losses that are | | | tax deductible after they are | | | recognized in financial income. | | | | | | b\. revenues or gains that are | | | taxable before they are | | | recognized in financial income. | | | | | | c\. revenues or gains that are | | | taxable after they are | | | recognized in financial | | | income.. | | | | | | d\. expenses or losses that are | | | tax deductible before they are | | | recognized in financial income. | | +-----------------------------------+-----------------------------------+ | Which of the following | Ans a & b | | differences would result in a | | | deferred tax asset? | | | | | | a\. expenses or losses that are | | | tax deductible after they are | | | recognized in financial income. | | | | | | b\. revenues or gains that are | | | taxable before they are | | | recognized in financial income. | | | | | | c\. revenues or gains that are | | | taxable after they are | | | recognized in financial | | | income.. | | | | | | d\. expenses or losses that are | | | tax deductible before they are | | | recognized in financial income. | | +-----------------------------------+-----------------------------------+ | What is one way that a temporary | Ans b | | difference between financial | | | income and taxable income can | | | become a deferred tax asset or | | | deferred tax liability? | | | | | | a\. expenses or losses are tax | | | deductible before they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | | | | | b\. expenses or losses are tax | | | deductible before they are | | | recognized in financial income, | | | resulting in deferred tax | | | liability. | | | | | | c\. revenues or gains are | | | taxable after they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | | | | | d\. revenues or gains are | | | taxable before they are | | | recognized in financial income, | | | resulting in deferred tax | | | liability. | | +-----------------------------------+-----------------------------------+ | What is one way that a temporary | Ans d | | difference between financial | | | income and taxable income can | | | become a deferred tax asset or | | | deferred tax liability? | | | | | | a\. expenses or losses are tax | | | deductible before they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | | | | | b\. expenses or losses are tax | | | deductible after they are | | | recognized in financial income, | | | resulting in deferred tax | | | liability. | | | | | | c\. revenues or gains are | | | taxable after they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | | | | | d\. revenues or gains are | | | taxable before they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | +-----------------------------------+-----------------------------------+ | Which temporary difference | Ans b is an example of a deferred | | increases net income in the | tax liability, choice a is an | | current financial statements but | example of a deferred tax asset, | | is potentially taxable in a | choices c and d are examples of | | future period? | permanent differences. | | | | | a\. advance rental receipts. | | | | | | b gain from involuntary | | | conversion of a nonmonetary | | | asset. | | | | | | c\. interest earned from | | | tax-exempt bonds. | | | | | | d\. proceeds from life insurance | | | carried by the company on key | | | officers. | | +-----------------------------------+-----------------------------------+ | Which temporary difference | Ans b is an example of a deferred | | increases net income in the | tax liability, choice a is an | | current financial statements but | example of a deferred tax asset, | | is potentially taxable in a | choices c and d are examples of | | future period? | permanent differences. | | | | | a\. advance rental receipts. | | | | | | b unrealized holding gain for | | | trading securities use fair | | | value. | | | | | | c\. interest earned from | | | tax-exempt bonds. | | | | | | d\. proceeds from life insurance | | | carried by the company on key | | | officers. | | +-----------------------------------+-----------------------------------+ | Which circumstance causes a | Ans d | | temporary difference that results | | | in a deferred tax liability? | | | | | | a\. accounts receivable | | | increases over the course of | | | the year. | | | | | | b\. depreciable assets are | | | purchased in the current year | | | and depreciated more rapidly | | | for tax purposes. | | | | | | c\. the company prepays various | | | expenses that will be incurred | | | in the subsequent year. | | | | | | d\. all of the answer choices | | | result in a deferred tax | | | liability. | | +-----------------------------------+-----------------------------------+ | Which circumstance causes a | Ans d | | temporary difference that results | | | in a deferred tax asset? | | | | | | a\. rental income or | | | subscriptions received in | | | advance. | | | | | | b\. accrued expenses associated | | | with defending a lawsuit that | | | will be settled in a subsequent | | | period. | | | | | | c\. recognition of bad debt by | | | the direct write-off method for | | | tax reporting and the allowance | | | method for financial reporting. | | | | | | d\. all of the answer choices | | | result in a deferred tax asset. | | +-----------------------------------+-----------------------------------+ **\ ** **Deferred Tax Assets (DTA) -** deferred tax assets result when GAAP (financial) income is less than taxable income or stated differently taxable income is greater than GAAP (financial) income in the current reporting period. This is due to more income being recognized in taxable income than in GAAP (financial) income, or less expenses being deducted for tax purposes than for GAAP (financial) purposes. This temporary difference of paying more taxes today eventually reverses to paying less taxes in the future. Deferred tax assets (DTA) show the amount of taxes that will be saved or refunded in the future from a **deductible** temporary difference. Deferred tax assets represent **future tax benefits or savings**. An example would be overpaying taxes (funds paid in advance) due to the taxing authority. Deductible temporary differences are temporary differences that will result in deductible amounts in future years, when the carrying amount of the asset or liability is recovered or settled. A deferred tax asset arises from the following - when the taxable income is higher than accounting income because of timing difference. - when the tax base of asset is higher than its carrying amount. - when the tax base of a liability is lower than its carrying amount. Deferred tax assets are shown as a noncurrent asset on the balance sheet. The journal entry to record a deferred tax asset is Debit income tax expense (plug) XXX Debit deferred tax asset (temporary difference x future enacted tax rate) XXX Credit income taxes payable (taxable income x current tax rate) XXX Anytime deferred income taxes exist, be it a deferred tax asset or deferred tax liability, income tax expense will be the plug figure to balance the debit and credit column balances. Income taxes payable and deferred income taxes can be computed; but what cannot always be computed is income tax expense. Income taxes payable is computed taking taxable income and multiplying it by the current tax rate. Deferred income taxes is computed by taking the temporary difference amount in the current reporting period and multiplying it by the future enacted tax rate that applies. Notice that income tax expense is made up of deferred income taxes (deferred tax asset/deferred tax liability) and income taxes payable. Income tax expense is also referred to as provisional income taxes. When there is a deferred tax asset (DTA) income tax expense is lower and income taxes payable is higher. Study and understand the previous journal entry to record a deferred tax asset. +-----------------------------------+-----------------------------------+ | What does a deferred tax asset | Ans a | | represent? | | | | | | a\. future tax benefit. | | | | | | b\. future tax expense. | | | | | | c\. future tax liability. | | | | | | d\. future deductible amount. | | +===================================+===================================+ | Which difference will cause a | Ans a | | deferred tax asset? | | | | | | a\. a difference between | | | modified cash basis and full | | | accrual accounting methods. | | | | | | b\. a difference between | | | financial income and taxable | | | income on the income statement. | | | | | | c\. a difference between when | | | the tax is accrued and when it | | | is paid. | | | | | | d\. a difference between | | | domestic and international | | | financial reporting standards. | | +-----------------------------------+-----------------------------------+ | Which description illustrates the | Ans c | | nature of a deferred tax asset? | | | | | | a\. decrease in tax savings in | | | future years as a result of | | | taxable temporary differences. | | | | | | b\. increase in tax savings in | | | future years as a result of | | | taxable temporary differences. | | | | | | c\. increase in tax savings in | | | future years as a result of | | | deductible temporary | | | differences. | | | | | | d\. decrease in tax savings in | | | future years as a result of | | | deductible temporary | | | differences. | | +-----------------------------------+-----------------------------------+ | Which situation causes a company | Ans a | | to have a deferred tax asset? | | | | | | a\. estimates of funds to be | | | paid for warranties offered. | | | | | | b\. prepaid rent. | | | | | | c\. equity method of investment. | | | | | | d\. a fine resulting from | | | violations of regulations. | | +-----------------------------------+-----------------------------------+ | Which partial entry should be | Ans b | | used to record the temporary | | | difference between income tax | | | expense of \$10,000 and income | | | taxes payable of \$12,000? | | | | | | a\. credit to a deferred tax | | | asset. | | | | | | b\. debit to a deferred tax | | | asset. | | | | | | c\. debit to a deferred tax | | | liability. | | | | | | d\. credit to a deferred tax | | | liability. | | +-----------------------------------+-----------------------------------+ | Which difference will cause a | Ans a | | deferred tax asset? | | | | | | a\. a difference between | | | modified cash basis and full | | | accrual accounting methods | | | | | | b\. a difference between | | | financial income and taxable | | | income on the income statement | | | | | | c\. a difference between when | | | the tax is accrued and when it | | | is paid | | | | | | d\. a difference between | | | domestic and international | | | financial reporting standards | | +-----------------------------------+-----------------------------------+ | Which description illustrates the | Ans c | | nature of a deferred tax asset? | | | | | | a\. decrease in refundable taxes | | | in future years as a result of | | | taxable temporary differences. | | | | | | b\. increase in refundable taxes | | | in future years as a result of | | | taxable temporary differences. | | | | | | c\. increase in refundable taxes | | | in future years as a result of | | | deductible temporary | | | differences. | | | | | | d\. decrease in refundable taxes | | | in future years as a result of | | | deductible temporary | | | differences. | | +-----------------------------------+-----------------------------------+ | Which description illustrates the | Ans d | | nature of a deferred tax asset? | | | | | | a\. decrease in taxes in future | | | years as a result of taxable | | | temporary differences. | | | | | | b\. increase in taxes in future | | | years as a result of taxable | | | temporary differences. | | | | | | c\. increase in taxes in future | | | years as a result of deductible | | | temporary differences. | | | | | | d\. decrease in taxes in future | | | years as a result of deductible | | | temporary differences. | | +-----------------------------------+-----------------------------------+ | Which presentation of deferred | Ans c | | taxes should be used on the | | | balance sheet? | | | | | | a\. as a reduction of | | | shareholders\' equity. | | | | | | b\. as a current liability. | | | | | | c\. as a noncurrent amount. | | | | | | d\. as a current asset | | +-----------------------------------+-----------------------------------+ | What effect does a deductible | Ans b | | temporary difference have on | | | future taxable income compare to | | | future pretax financial income? | | | | | | a\. greater than. | | | | | | b\. less than. | | | | | | c\. no effect. | | | | | | d\. none of the answer choices | | | are correct. | | +-----------------------------------+-----------------------------------+ | Which of the following is an | Ans b | | example of a deferred tax asset? | | | | | | a\. prepaid expenses that are | | | deducted on the tax return in | | | the period paid. | | | | | | b\. product warranty | | | liabilities. | | | | | | c\. tax depreciable property. | | | | | | d\. fines and expenses resulting | | | from a violation of law. | | +-----------------------------------+-----------------------------------+ | Which temporary difference | Ans b | | results in a deferred tax asset? | | | | | | a\. dividends received from a | | | joint venture. | | | | | | b\. accrual for product warranty | | | liability. | | | | | | c\. interest payments received | | | from municipal bonds. | | | | | | d\. prepaid insurance expense. | | +-----------------------------------+-----------------------------------+ | What is a deferred tax asset? | Ans d | | | | | a\. a payment to a company, | | | based on profitability, that is | | | paid in advance from the | | | government. | | | | | | b\. a payment to a company, | | | based on profitability, to be | | | paid from the government. | | | | | | c\. a company\'s balance sheet | | | account representing funds to | | | be paid to the government. | | | | | | d\. a company\'s balance sheet | | | account representing funds paid | | | in advance to the government | | +-----------------------------------+-----------------------------------+ | In Year 1, a company reported | Ans b | | \$30,000,000 in gross revenue, | | | \$22,000,000 in operating profit, | (\$15,000,000 - \$18,000,000) x | | \$15,000,000 in net income before | 28% | | taxes on the financial | | | statements, and \$18,000,000 in | | | taxable income. The difference | | | between reported and taxable | | | income is expected to be | | | temporary and to reverse in the | | | next year. The tax rate for Year | | | 1 is 25%, and the tax rate for | | | Year 2 is 28%. Which amount | | | should the company record as a | | | net deferred tax asset in Year 1? | | | | | | a\. \$750,000 | | | | | | b\. \$840,000 | | | | | | c\. \$1,000,000 | | | | | | d\. \$3,360,000 | | +-----------------------------------+-----------------------------------+ | Which temporary difference | Ans b. Choices a and c are | | results in a deferred tax asset? | permanent differences and choice | | | d is a deferred tax liability. | | a\. dividends received from a | | | joint venture. | | | | | | b\. accrual for product warranty | | | liability. | | | | | | c\. interest payments received | | | from municipal bonds. | | | | | | d\. prepaid insurance expense. | | +-----------------------------------+-----------------------------------+ | In 2020, a magazine publisher | Ans a | | collects one year in advance for | | | subscription revenue. The company | | | would record in its financial | | | statement for 2020? | | | | | | a\. an increase in a deferred | | | tax asset. | | | | | | b\. a decrease in a deferred tax | | | asset. | | | | | | c\. an increase in a deferred | | | tax liability. | | | | | | d\. a decrease in a deferred tax | | | liability. | | +-----------------------------------+-----------------------------------+ | In 2020, a company decides to add | Ans a | | a 36-month warranty on its new | | | product sales. Warranty costs are | | | tax deductible when claims are | | | settled. In its financial | | | statements for 2020, the company | | | incurs? | | | | | | a\. an increase in a deferred | | | tax asset. | | | | | | b\. a decrease in a deferred tax | | | asset. | | | | | | c\. an increase in a deferred | | | tax liability. | | | | | | d\. a decrease in a deferred tax | | | liability. | | +-----------------------------------+-----------------------------------+ | What are two ways that a | Ans b & d | | temporary difference between | | | taxable income and financial | | | income can become a deferred tax | | | asset? | | | | | | a\. revenues or gains are | | | taxable before they are | | | recognized in financial income, | | | resulting in deferred tax | | | liability. | | | | | | b\. revenues or gains are | | | taxable before they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | | | | | c\. expenses or losses are | | | deductible before they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | | | | | d\. expenses or losses are | | | deductible after they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | +-----------------------------------+-----------------------------------+ | What is the difference between a | Ans c | | company\'s calculated tax expense | | | and taxes payable based on tax | | | laws? | | | | | | a\. ordinary tax expense. | | | | | | b\. income tax expense. | | | | | | c\. deferred tax expense. | | | | | | d\. Excise tax expense. | | +-----------------------------------+-----------------------------------+ **\ ** **Deferred Tax Asset Valuation Allowance -** companies recognize a deferred tax asset for all deductible temporary differences. However, a company should reduce a deferred tax asset by a valuation allowance if, based on available evidence, it is more likely than not that it will not realize some portion or all of the deferred tax asset. "More likely than not" means a level of likelihood of at least slightly more than 50 percent. An example is provided in the following problem. On December 31, a company has a deductible temporary difference of \$200,000. The company's taxable income is \$750,000, and the tax rate is 40%, which means it records an income taxes payable of \$300,000 (\$750,000 x 40%). The company records income tax expense, the deferred tax asset, and income taxes payable as follows: Debit income tax expense 220,000 Debit deferred tax asset (\$200,000 x 40%) 80,000 Credit income taxes payable (\$750,000 x 40%) 300,000 After careful review of all available evidence, the company determines that it is more likely than not that it will not realize \$20,000 of this deferred tax asset. The company records this reduction in asset value as follows: Debit income tax expense 20,000 Credit allowance to reduce deferred tax asset to expected realizable value 20,000 The company increases income tax expense in the current period because it does not expect to realize a favorable tax benefit for a portion of the deductible temporary difference in the future. The allowance to reduce deferred tax asset to expected realizable value is a contra account to the deferred tax asset account on the balance sheet. +-----------------------------------+-----------------------------------+ | If a company\'s deferred tax | Ans c | | asset is not reduced by a | | | valuation allowance, the company | | | believes it is more likely than | | | not that | | | | | | a\. sufficient accounting income | | | will be generated in future | | | years to realize the full tax | | | benefit. | | | | | | b\. sufficient accounting and | | | taxable income will exist in | | | future years to realize the | | | full tax benefit. | | | | | | c\. sufficient taxable income | | | will be generated in future | | | years to realize the full tax | | | benefit. | | | | | | d\. tax rates will not change in | | | future years. | | +===================================+===================================+ | If a company\'s deferred tax | Ans c | | asset is not reduced by a | | | valuation allowance, the company | | | believes it is | | | | | | a\. probable that sufficient | | | taxable income will be | | | generated in future years to | | | realize the full tax benefit. | | | | | | b\. probable that sufficient | | | financial income will be | | | generated in future years to | | | realize the full tax benefit. | | | | | | c\. more likely than not that | | | sufficient taxable income will | | | be generated in future years to | | | realize the full tax benefit. | | | | | | d\. more likely than not that | | | sufficient financial income | | | will be generated in future | | | years to realize the full tax | | | benefit. | | +-----------------------------------+-----------------------------------+ | For classification purposes, a | Ans c | | valuation allowance | | | | | | a\. is allocated proportionately | | | between deferred tax assets and | | | deferred tax liabilities. | | | | | | b\. is allocated proportionately | | | between the current and | | | noncurrent portions of the | | | deferred tax asset. | | | | | | c\. is contra to the deferred | | | tax asset and classified as | | | noncurrent. | | | | | | d\. is added to the deferred tax | | | asset and classified as | | | current. | | +-----------------------------------+-----------------------------------+ | The valuation allowance account | Ans c | | that is used in conjunction with | | | deferred taxes relates | | | | | | a\. only to deferred tax | | | liabilities. | | | | | | b\. to both deferred tax assets | | | and liabilities. | | | | | | c\. only to deferred tax assets. | | | | | | d\. only to income taxes | | | receivable due to net operating | | | loss carrybacks. | | +-----------------------------------+-----------------------------------+ | The valuation allowance account | Ans d | | that is used in conjunction with | | | deferred tax assets is a(n) | | | | | | a\. liability. | | | | | | b\. component of shareholders' | | | equity. | | | | | | c\. asset. | | | | | | d\. contra asset. | | +-----------------------------------+-----------------------------------+ | Which account may be used to | Ans b | | reduce a deferred tax asset | | | | | | a\. accounts payable. | | | | | | b\. valuation account. | | | | | | c\. fixed asset. | | | | | | d\. trade accounts receivable. | | +-----------------------------------+-----------------------------------+ **\ ** **Deferred Tax Liabilities (DTL) -** deferred tax liabilities result when GAAP (financial) income is greater than taxable income. Or, stated differently, taxable income is less than GAAP income in the current reporting period. This is due to less income being recognized in taxable income than in GAAP (financial) income, or more expenses being deducted for tax purposes than for GAAP (financial) purposes. This temporary difference of paying less taxes today eventually reverses to paying more taxes in the future.  Deferred tax liabilities show the amount of taxes that will be due or owed in the future from a **taxable** temporary difference. Deferred tax liabilities represent an increase in **future taxes payable**. Taxable temporary differences are temporary differences that will result in taxable amount in future years, when the carrying amount of the asset or liability is recovered or settled. A deferred tax liability arises from the following - when the accounting income is higher than taxable income because of timing differences. - when the carrying amount of an asset is higher than its tax base. - when the carrying amount of a liability is lower than its tax base. Deferred tax liabilities are shown as a noncurrent liabilities on the balance sheet. The journal entry to record a deferred tax liability is Debit income tax expense (plug) XXX Credit deferred tax liability (temporary difference x future enacted tax rate) XXX Credit income taxes payable (taxable income x current tax rate) XXX Anytime deferred income taxes exist, be it a deferred tax asset or deferred tax liability, income tax expense will be the plug figure to balance the debit and credit column balances. Income taxes payable and deferred income taxes can be computed; but what cannot be computed is income tax expense. Income taxes payable is computed taking taxable income and multiplying it by the current tax rate. Deferred income taxes is computed by taking the temporary difference amount in the current reporting period and multiplying it by the future enacted tax rate that applies. Notice that income tax expense is made up of deferred income taxes (deferred tax asset/deferred tax liability) and income taxes payable. Income tax expense is also referred to as provisional income taxes. When there is a deferred tax liability (DTL), income tax expense is higher and income taxes payable is lower. Study and understand the previous journal entry to record a deferred tax liability. +-----------------------------------+-----------------------------------+ | What is the difference between a | Ans c | | company\'s calculated tax expense | | | and taxes payable based on tax | | | laws? | | | | | | a\. ordinary tax expense. | | | | | | b\. income tax expense. | | | | | | c\. deferred tax expense. | | | | | | d\. excise tax expense. | | +===================================+===================================+ | Which description illustrates the | Ans b | | nature of a deferred tax | | | liability? | | | | | | a\. decrease in taxes in future | | | years as a result of taxable | | | temporary differences. | | | | | | b\. increase in taxes in future | | | years as a result of taxable | | | temporary differences. | | | | | | c\. increase in taxes in future | | | years as a result of deductible | | | temporary differences. | | | | | | d\. decrease in taxes in future | | | years as a result of deductible | | | temporary differences. | | +-----------------------------------+-----------------------------------+ | What does a deferred tax | Ans c | | liability represent? | | | | | | a\. future tax benefit. | | | | | | b\. future tax expense. | | | | | | c\. future tax liability. | | | | | | d\. future taxable amount. | | +-----------------------------------+-----------------------------------+ | Which difference will cause a | Ans a | | deferred tax liability? | | | | Taxable income is not on the | | a\. a difference between | income statement; when income tax | | modified cash basis and full | is accrued, it is paid shortly | | accrual accounting methods. | thereafter and has nothing to do | | | with a timing difference. | | b\. a difference between | | | financial income and taxable | | | income on the income statement. | | | | | | c\. a difference between when | | | the tax is accrued and when it | | | is paid. | | | | | | d\. a difference between | | | domestic and international | | | financial reporting standards. | | +-----------------------------------+-----------------------------------+ | Which partial entry should be | Ans d | | used to record the temporary | | | difference between income tax | | | expense of \$12,000 and income | | | taxes payable of \$10,000? | | | | | | a\. credit to a deferred tax | | | asset. | | | | | | b\. debit to a deferred tax | | | asset. | | | | | | c\. debit to a deferred tax | | | liability. | | | | | | d\. credit to a deferred tax | | | liability. | | +-----------------------------------+-----------------------------------+ | Which presentation of deferred | Ans c | | liabilities should be used on the | | | balance sheet? | | | | | | a\. as a reduction of | | | shareholders\' equity. | | | | | | b\. as a current liability. | | | | | | c\. as a noncurrent amount. | | | | | | d\. as a current asset | | +-----------------------------------+-----------------------------------+ | Which description illustrates the | Ans b | | nature of a deferred tax | | | liability? | | | | | | a\. decrease in taxes payable in | | | future years as a result of | | | taxable temporary differences. | | | | | | b\. increase in taxes payable in | | | future years as a result of | | | taxable temporary differences. | | | | | | c\. increase in taxes payable in | | | future years as a result of | | | deductible temporary | | | differences. | | | | | | d\. decrease in taxes payable in | | | future years as a result of | | | deductible temporary | | | differences. | | +-----------------------------------+-----------------------------------+ | What effect does a taxable | Ans a | | temporary difference have on | | | future taxable income compared to | | | future pretax financial income? | | | | | | a\. greater than. | | | | | | b\. less than. | | | | | | c\. no effect. | | | | | | d\. none of the answer choices | | | are correct. | | +-----------------------------------+-----------------------------------+ | Which of the following gives rise | Ans c | | to a deferred tax liability? | | | | | | a\. subscriptions received in | | | advance. | | | | | | b\. prepaid royalty received in | | | advance. | | | | | | c\. an installment sale | | | accounted for on the accrual | | | basis for financial reporting | | | purposes and on the installment | | | (cash) basis for tax purposes. | | | | | | d\. interest received on a | | | municipal obligation. | | +-----------------------------------+-----------------------------------+ | Which type of temporary | Ans b | | difference is represented by the | | | collection of revenue recorded on | | | account? | | | | | | a\. deferred tax asset. | | | | | | b\. deferred tax liability. | | | | | | c\. none of the answer choices | | | are correct. | | +-----------------------------------+-----------------------------------+ | Which situation will result in a | Ans a | | temporary difference between | | | financial accounting and tax | | | accounting? | | | | | | a\. a company used straight line | | | depreciation for financial | | | accounting and an accelerated | | | method for tax. | | | | | | b\. a company received life | | | insurance proceeds reported as | | | financial income but not as | | | taxable income. | | | | | | c\. a company received dividends | | | from another company in which | | | it has ownership. | | | | | | d\. a company listed municipal | | | bond income as net income in | | | financial accounting but not in | | | tax accounting. | | +-----------------------------------+-----------------------------------+ | What does a deferred tax | Ans c | | liability represent? | | | | | | a\. future tax benefit. | | | | | | b\. future tax expense. | | | | | | c\. future tax liability. | | | | | | d\. future taxable amount. | | +-----------------------------------+-----------------------------------+ | Which difference will cause a | Ans a | | deferred tax liability? | | | | | | a\. a difference between | | | modified cash basis and full | | | accrual accounting methods | | | | | | b\. a difference between | | | financial income and taxable | | | income on the income statement | | | | | | c\. a difference between when | | | the tax is accrued and when it | | | is paid | | | | | | d\. a difference between | | | domestic and international | | | financial reporting standards | | +-----------------------------------+-----------------------------------+ | What is a deferred tax liability? | Ans c | | | | | a\. a payment to a company, | | | based on profitability, that is | | | paid in advance from the | | | government. | | | | | | b\. a payment to a company, | | | based on profitability, to be | | | paid from the government. | | | | | | c\. a company\'s balance sheet | | | account representing funds to | | | be paid to the government. | | | | | | d\. a company\'s balance sheet | | | account representing funds paid | | | in advance to the government | | +-----------------------------------+-----------------------------------+ | What are two ways that a | Ans a & c | | temporary difference between | | | taxable income and financial | | | income can become a deferred tax | | | liability? | | | | | | a\. revenues or gains are | | | taxable after they are | | | recognized in financial income, | | | resulting in deferred tax | | | liability. | | | | | | b\. revenues or gains are | | | taxable before they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | | | | | c\. expenses or losses are | | | deductible before they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | | | | | d\. expenses or losses are | | | deductible after they are | | | recognized in financial income, | | | resulting in deferred tax | | | asset. | | +-----------------------------------+-----------------------------------+ | Which situation causes a company | Ans c | | to have a deferred tax liability? | | | | | | a\. estimates of funds to be | | | paid for warranties offered. | | | | | | b\. advance collection of rent. | | | | | | c\. equity method of investment. | | | | | | d\. a fine resulting from | | | violations of regulations. | | +-----------------------------------+-----------------------------------+ | Which description illustrates the | Ans b | | nature of a deferred tax | | | liability? | | | | | | a\. decrease in taxes payable in | | | future years as a result of | | | taxable temporary differences. | | | | | | b\. increase in taxes payable in | | | future years as a result of | | | taxable temporary differences. | | | | | | c\. increase in taxes payable in | | | future years as a result of | | | deductible temporary | | | differences. | | | | | | d\. decrease in taxes payable in | | | future years as a result of | | | deductible temporary | | | differences. | | +-----------------------------------+-----------------------------------+ | Which of the following is an | Ans a | | example of a deferred tax | | | liability | | | | | | a\. prepaid expenses that are | | | deducted on the tax return in | | | the period paid. | | | | | | b\. product warranty | | | liabilities. | | | | | | c\. stock based compensation. | | | | | | d\. fines and expenses resulting | | | from a violation of law. | | +-----------------------------------+-----------------------------------+ | Which temporary difference | Ans a | | results in a deferred tax | | | liability | | | | | | a\. unrealized holding gain on | | | trading securities use fair | | | value. | | | | | | b\. accrual for product warranty | | | liability. | | | | | | c\. interest payments received | | | from municipal bonds. | | | | | | d\. advance collection of | | | subscriptions. | | +-----------------------------------+-----------------------------------+ | Which situation will result in a | Ans b is an example of a deferred | | temporary difference between | tax liability. The other answer | | financial accounting and tax | choices are examples of permanent | | accounting? | differences. | | | | | a\. a company received life | | | insurance proceeds reported as | | | financial income but not as | | | taxable income. | | | | | | b\. a company used straight line | | | depreciation for financial | | | accounting and an accelerated | | | method for tax. | | | | | | c\. a company listed municipal | | | bond income as net income in | | | financial accounting but not in | | | tax accounting. | | | | | | d\. a company received dividends | | | from another company in which | | | it has ownership. | | +-----------------------------------+-----------------------------------+ | In Year 1, a company reported | Ans b (\$18,000,000 - | | \$30,000,000 in gross revenue, | \$15,000,000) x 28% | | \$22,000,000 in operating profit, | | | \$18,000,000 in net income before | | | taxes on the financial | | | statements, and \$15,000,000 in | | | taxable income. The difference | | | between reported and taxable | | | income is expected to be | | | temporary and to reverse in the | | | next year. The tax rate for Year | | | 1 is 25%, and the tax rate for | | | Year 2 is 28%. Which amount | | | should the company record as a | | | net deferred tax liability in | | | Year 1? | | | | | | a\. \$750,000 | | | | | | b\. \$840,000 | | | | | | c\. \$1,000,000 | | | | | | d\. \$3,360,000 | | +-----------------------------------+-----------------------------------+ | Which temporary difference | Ans d choices a and c are | | results in a deferred tax | permanent differences and choice | | liability? | b is a deferred tax asset. | | | | | a\. dividends received from a | | | joint venture. | | | | | | b\. accrual for product warranty | | | liability. | | | | | | c\. interest payments received | | | from municipal bonds. | | | | | | d\. prepaid insurance expense. | | +-----------------------------------+-----------------------------------+ | Which differences are included in | Ans b | | both financial income and taxable | | | income but at different time | | | periods? | | | | | | a\. permanent differences only. | | | | | | b\. temporary differences only. | | | | | | c\. both permanent differences | | | and temporary differences. | | | | | | d\. none of the answer choice | | | are correct. | | +-----------------------------------+-----------------------------------+ **\ ** **Permanent differences-** result from items that (1) enter into GAAP (financial) income but never into taxable income, or (2) enter into taxable income but never into GAAP (financial) income. Permanent differences do not affect both incomes like temporary differences do, and it is because of this that permanent differences do not have a deferred tax consequence. Permanent differences are nontaxable income and/or nondeductible expenses. Please study and understand the information in the following illustration. +-----------------------------------+-----------------------------------+ | Which situation will create a | Ans d | | permanent difference between | | | accounting and taxable incomes | | | for a company? | | | | | | a\. accelerated depreciation. | | | | | | b\. subscriptions received in | | | advance. | | | | | | c\. prepaid expenses. | | | | | | d\. proceeds from life insurance | | | on key officers or employees. | | +===================================+===================================+ | Which difference does not give | Ans b | | rise to future taxable or | | | deductible amounts? | | | | | | a\. temporary. | | | | | | b\. permanent. | | +-----------------------------------+-----------------------------------+ | Which of the following is an | Ans c | | example of a permanent | | | difference? | | |