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Corporate Income Tax

Deferred Income Taxes [Deferred Tax Liabilities] With Case Example

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Income for financial statement purposes is determined under generally accepted accounting principles as set forth by the accounting profession. Income for tax purposes is determined according to the rules of the Internal Revenue Service which are passed into law by Congress (Thought the same rules applied with other contries). These rules often do not follow generally accepted accounting principles. Accordingly, differences will arise between accounting income and taxable income.

These differences may be either temporary or permanent in nature. Temporary differences are referred to astiming differences” because, with time, they reverse or turn around. Permanent differences are forever they do not reverse. In this post we are going to discuss the temporary differences.

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Temporary differences involve the recognition of revenue or expense items in one year for tax purposes but in a different year for accounting purposes. Overall the total income is the same for both tax and accounting purposes; it is just the timing that is different.

EXAMPLE: under GAAP, revenue is recognized when earned, not when received. Thus if in year 1 a company earns revenue but does not receive it until year 2, it would recognize it as income in year 1. However, for tax purposes, revenue is usually recognized when received. Thus this item would not be reported on the tax return until year 2. Accordingly, in year 1, the income statement reports this revenue while the tax return does not; in year 2, the tax return reports it as revenue while the income statement does not. For both years together, however, the total income is the same—the difference is only in timing. Year 1 is called the “year of origination of the difference”; year 2 is the “year of reversal.”

 

Other case examples of temporary differences would be as follows:

  1. Unearned revenue received in 19A and recognized for tax purposes this year, but not recognized for accounting purposes until earned in 19B
  2. Accrued expenses recognized in 19A for accounting purposes but not recognized for tax purposes until paid in 19B
  3. Revenue from installment sales recognized totally in 19Afor accounting purposes, but recognized gradually over several years under the installment method for tax purposes
  4. Straight-line depreciation used for accounting purposes while an accelerated method is used for tax purposes
  5. Warranty costs recognized in 19A for accounting purposes before they actually occur (using estimates), but not recognized until paid for tax purposes
  6. Percentage-of-completion method for construction contracts used for accounting purposes while the completed-contract method is used for tax purposes
  7. Expenditures for prepaid items in 19A deducted completely this year for tax purposes, but amortized gradually for accounting purposes

 

We’ve known that the standard entry to record income taxes has been:

[Debit]. Income Tax Expense = $xxx
[Credit]. Income Tax Payable = $xxx

But now that we’ve become aware of temporary differences, this entry becomes more complex. The debit to Income Tax Expense is based upon what the tax should be according to GAAP. However, the credit to Income Tax Payable is based upon what is physically payable and that is determined according to tax rules.

The difference between the debit and credit goes to an account called “Deferred Tax Liability” or “Deferred Tax Asset“, depending upon the circumstances.

 

Deferred Income Tax Case Example-1

Company X has the following information regarding its income for 19A and 19B:

By “regular income” I mean income recognized both for accounting and tax purposes. The temporary difference is due to revenue earned in 19A but not collected until 19B. Thus in 19A it is recognized for accounting purposes but not for tax purposes. Notice, however, that it reverses in 19B at the time of collection. At that time, it is recognized for tax purposes but not for accounting purposes.

The entry for 19A is:

[Debit]. Income Tax Expense = $22
[Credit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability = $2

 

Income tax expense is 20% of the accounting income of $110, which equals $22. Income tax payable is the amount that the tax office demands we pay 20% of $100. The deferred tax liability of $2 is 20% of the $10 difference between accounting income and taxable income.

TIPS: A helpful tip in doing entries involving deferred taxes is to proceed via the following three steps:

Step-1: Record the payable using the actual tax due. In this case we credit income tax payable for $20.

Step-2: Record the deferred tax amount. In this case we credit deferred tax liability for $2.

Step-3: Plug the debit to income tax expense. The entire entry would thus appear as shown above:

[Debit]. Income Tax Expense = $22 (Plug)
[Credit]. Income Tax Payable = $20 (Step-1)
[Credit]. Deferred Tax Liability = $2 (Step-2)

 

The reason why income tax expense is based upon accounting income is the matching principle. Under this principle, expenses relating to revenue must be matched against that revenue, and recognized in the same period. Since for accounting purposes we recognize the $10 revenue item this period, we must recognize the related $2 tax expense as well (even though the tax office isn’t asking us for the money now!).

Thus income tax expense consists of two components; $20 payable now and $2 deferred until later. In this case, because the reversal takes place only 1 year from now, it is a current liability.

The entry for 19B is:

[Debit]. Income Tax Expense = $20
[Debit]. Deferred Tax Liability = $2
[Credit]. Income Tax Payable = $22

 

Once again, income tax expense is based on accounting income and income tax payable on taxable income. The tax liability of $2 from last year which was deferred has now appeared, and it is being paid.

Next….Let’s take a look at a situation where the reversal takes more than 1 year on the next case example.

 

Deferred Income Tax Case Example-2

Company Y has the following information regarding its income for 19A, 19B, and 19C:

The entry for 19A is:

[Debit]. Income Tax Expense = $24**)
[Credit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability = $4
**). Based upon accounting income

 

In 19B only one-half the deferred liability is paid. The entry is:

[Debit]. Income Tax Expense = $20
[Debit]. Deferred Tax Liability = $2
[Credit]. Income Tax Payable = $22

 

This entry would also be made in 19C. In 19A, only $2 of the $4 deferred liability is considered current. The other $2 is considered long-term since it requires more than 1 year to reverse.

In the situations discussed so far, the tax rates were the same for all years. If the tax rates are different, and they have already been passed by Parliament and are known in the first year, then they should be taken into account in the journal entry. Have a look at the next case example.

 

Deferred Income Tax Case Example-3

Company Z has the following information regarding years 19A and 19B:

The 19B tax rate has already been passed by Congress in 19A. The 19A entry is:

[Debit]. Income Tax Expense = $23
[Credit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability = $3

 

Income tax payable is what we must physically pay the tax office 20% of $100. The deferred tax liability of $3 is based upon the $10 temporary difference multiplied by the rate of 30%, which will be in effect in 19B when this difference reverses.

The entry for 19B is:

[Debit]. Income Tax Expense = $30
[Debit]. Deferred Tax Liability = $3
[Credit]. Income Tax Payable = $33

 

Deferred Income Tax Case Example-4

Assume the same information as in the previous example except that the $10 difference in 19A will reverse $5 in 19B and $5 in 19C, and the tax rates for the 3 years are 20%, 30%, and 40%, respectively.

The entry for 19A is:

[Debit]. Income Tax Expense = $23.50
[Credit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability = $3.50

 

The deferred tax liability consists of 0.30($5) + 0.40($5) = $3.50. If in 19A a change in the rate has not yet been passed by Congress, then the 19A entry should use the 19A rate and not assume that any future changes will be made. This is true even if Congress is discussing the possibility of a change.

Later on, if a rate change goes into effect, an adjusting entry should be made to account for the effect of this change. Let’s look at the next case example.

 

Deferred Income Tax Case Example-5

Let’s use the same information as in case example 1 but assume that the 30% rate for 19B has not yet been passed in 19A.

The entry for 19A uses the 19A rate, as follows:

[Debit]. Income Tax Expense = $22
[Debit]. Income Tax Payable = $20
[Credit]. Deferred Tax Liability (0.20 x $10) = $2

 

In 19B, when the new rate of 30% is passed and goes into effect, an adjusting entry must be made to recognize the additional $1 tax (10% of $10).

The entry is:

[Debit]. Income Tax Expense = $1
[Credit]. Deferred Tax Liability = $1

 

As a result, the Deferred Tax Liability now has a balance of $3 ($2 + $1).

The entry for 19B is:

[Debit]. Income Tax Expense = $30
[Debit]. Deferred Tax Liability = $3
[Credit]. Income Tax Payable = $33

35 Comments

35 Comments

  1. Pedro

    Dec 18, 2008 at 9:33 pm

    Hey, I a decent understanding of how deferred tax liabilities and assets come to be. But what reverses the deferred tax liability? The most common cause for a DTL is depreciation timing difference. Assuming that there is no fixed assets additions. And an assets depreciate at 2yr tax 8 years book. When will the DTL reverse?
    Thank you.

  2. Putra

    Dec 19, 2008 at 11:57 am

    Hi,

    We are going to discuss about “deferred tax asset” (and probably “permanent differences” as well) on the next “tax day”. Meanwhile you may want to bookmark this page for easier re-visiting 🙂

  3. djl_daniel@yahoo.com

    Dec 23, 2008 at 5:09 am

    edisi bahasa indonesianya mana

    TQ

  4. Mohamed abdelkader

    Jan 27, 2009 at 10:54 am

    Thanks very much but please also make one like that on deferred tax assets

  5. meqy

    Jun 20, 2009 at 12:37 pm

    can you please give an example about deferred tax liability arising from a convertible bonds.. tnx a lot!

  6. mandy

    Aug 3, 2009 at 7:15 am

    hi,

    thanks for your explanation about the deferred tax, its excellent, better for me to understand than my text book.

    Mandy 🙂

  7. Putra

    Aug 3, 2009 at 9:58 am

    Mandy,

    Great!

  8. Mike

    Aug 23, 2009 at 8:02 am

    Does IRS allow installment sales income method on an auto dealership selling autos in installment basis?

  9. gopal saboo

    Sep 6, 2009 at 1:16 pm

    u have explained the entire concept of DTL in an excellent manner. It really helped me than any other text book.

    THANKS

  10. Robert Bikuru

    Nov 26, 2009 at 9:10 am

    Its indeed a beautiful explanation. Ditto for assets

  11. Farzan Raza

    Feb 13, 2010 at 11:52 pm

    Your explanation is really helpful or me to understand this concept of deferred taxation. I would like to thank you.

  12. chess_atif@yahoo.co.uk

    Mar 7, 2010 at 12:15 pm

    can you help me about this please?
    discusses the need for deferred tax. Should it be accounted for or should it be ignored?

    (Your answer should explain the main circumstances that that give rise to deferred tax and discuss the advantages and disadvantages of accounting for deferred tax. As this is an essay about the principle of having or not having deferred tax, you can refer to accounting standards from any country, as well as the international accounting standard together with any conceptual framework document.)
    Thnx

  13. FRED

    Mar 11, 2010 at 5:25 pm

    I am unable to locate an example of how the “provision to return true-up” impacts the deferred tax assets/liabilities. Can anyone provide calculation examples?

  14. mushtaq ahmad

    Apr 26, 2010 at 5:25 am

    please help me i dnt understand about deffered tax

  15. john onditi

    May 29, 2010 at 12:15 pm

    it is great to share accounting and knowledge

  16. Subra Arun

    Jul 28, 2010 at 2:54 pm

    How is unrealized foreign exchange (gain) / Losses dealt in Deferred tax, appreciate we can see some examples

  17. STEVE

    Aug 7, 2010 at 6:08 am

    How do you record a deferred tax benefit as the result of a net operating loss generated? Would you record a deferred tax benefit on the P & L and a deferred tax asset? If there is a deferred tax liability (from prior years) that is greater than the anticipated current year NOL would you just decrease the deferred tax liability? Or do you need to show a deferred tax asset and the deferred tax liability?

  18. Bimal

    Aug 19, 2010 at 3:48 am

    Putra, I must thank you for explaining the concept of DTL in such a way that probably I will never forget DTL in my life. Being a non-commerce guy, I used to find it difficult to remember the concept of DTL always, but its good in my mind now. I will appreciate if you take same kind of approach for DTA as well.

    Thanks again !

  19. Bhupinder Kaur

    Sep 16, 2010 at 5:10 pm

    Thank you very much for great explanation. I’m preparing for CPA exam (FAR part) and didn’t really understand this topic during the lectures. You are awesome!

  20. KIYINI ABUBAKAR

    Sep 29, 2010 at 6:11 am

    After getting the defferd tax liability or asset figure say $20,000 for the yr 2010 i am recorgnising this type of reporting for the fast time in my books what is the double entry and how does offsetting occur in the preceeding years

  21. kiyiniabubakar

    Sep 29, 2010 at 6:18 am

    Is it very essential for a small and medium organisation to recorgnise defferd tax in its books and how does it hermonise its tax budden at the end of the reporting period. direct your answer to the final tax paid

  22. Sarah

    Dec 17, 2010 at 10:04 pm

    It is excellent note for deferred tax treatment

  23. Jiten

    Dec 18, 2010 at 3:50 pm

    Thank You… It did help me understand this to some extent

  24. poonam

    Jan 19, 2011 at 6:31 am

    Really good stuff..and very helpful in understanding the basic concept.

  25. wardah

    Jan 21, 2011 at 6:31 pm

    helpful!

  26. rashid

    Jan 29, 2011 at 6:50 pm

    thanx alot so helpfuL

  27. Aladdin

    Feb 27, 2011 at 12:48 am

    great explanation, thanx very much for your effort
    in this way , you can make a book and sell it

  28. mimie

    Mar 14, 2011 at 4:16 pm

    how do you treat forex gain and forex loss – f/s presentation and tax

  29. shizuga wang

    May 19, 2011 at 10:51 am

    Thank you very much! Now, I understand how to calculate deferred tax liability. You’ve done an excellent teaching job for us. Thanks again!

  30. vikas

    Jun 30, 2011 at 1:47 pm

    I am glad to see your answers, Dear you have done very good job really helpful..
    thanks again

  31. Qamar

    May 31, 2012 at 11:37 am

    Dear Mr. Putra, I am really impressed and thankful for your post. You have made a difficult topic very easy to understand. I have read lots of books, but your way of explanation is marvelous. Thanks a lot. Pl keep it up.
    Regards

  32. Fabien

    Aug 5, 2012 at 8:59 am

    Thank you very much Putra, this explanation is very clear and definitely helps a lot!

    Thank you again!

    Fabien

  33. shakil

    Mar 4, 2013 at 4:55 am

    Thanks for a lot for your explanation.this is very much helpful for me to understand and apply

    shakil

  34. Munira

    Jul 19, 2017 at 12:59 pm

    hello,
    have one question regarding deferred tax, say in 2015 there was deferred tax liability of 700 and in 2016 became deferred tax assets of 800 and deference btwn them came to assets so what will be the double entry?

  35. Enoras

    Nov 3, 2017 at 6:45 am

    What is the journal entries for Deferred Tax Liability if the company incur a loss.

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