CHAPTER ONE

ACCOUNTING FOR INCOME TAXES

The accounting for income taxes is a method where an organization estimates its income tax liability payable to the
government for the current period.
Income tax is imposed by the government on incomes of individuals and business at the end of a financial year. Personal
income tax is imposed on the income of individuals. Business income tax is imposed on the earnings of various businesses.
Most states and local government also levy taxes on the individuals.
Income tax is type of direct tax levied by a government on businesses. Income tax due in a period is calculated by applying
the applicable tax percentage to the taxable income of the business.
Income tax is a type of tax that governments impose on income generated by businesses and individuals within their
jurisdiction. Income tax is used to fund public services, pay government obligations, and provide goods for citizens.
Income Tax vs. Accounting Tax

Tax as recorded in a company’s financial statement rarely ever matches the taxes filed in their tax returns. It is because each
item (company financials and tax return) has different purposes, users, and accounting treatment. The company’s financials
are intended for investors and lenders, and – as such – are made with application and dependability in mind. In contrast, the
tax return is intended for the government or corresponding tax body and is made with the purpose of adhering to public tax
policy.

The financial statements report a tax expense, but the true tax payable comes from the tax return. The dichotomy in reporting
these two items creates differences that need to be reconciled and accounted for. These differences are either permanent
differences, which never reverse, or temporary differences, which are timing differences that will reverse over time.

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

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

A future taxable amount will increase taxable income relative to pretax financial income in future periods due to temporary
differences existing at the balance sheet date. A future deductible amount will decrease taxable income relative to pretax
financial income in future periods due to existing temporary differences.

A deferred tax asset is recognized for all deductible temporary differences. However, a deferred tax asset should be reduced
by a valuation account if, based on all available evidence, it is more likely than not that some portion or all of the deferred tax
asset will not be realized. More likely than not means a level of likelihood that is slightly more than 50%.

The objectives of accounting for income taxes are to recognize

a. The amount of taxes payable or refundable for the current year and
b. Deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an
enterprise's financial statements or tax returns.

Interest on government bonds is often referred to as a permanent difference when determining the proper amount to report for
deferred taxes.

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A permanent difference is a difference between taxable income and pretax financial income that, under existing applicable
tax law and regulation, will not be offset by corresponding differences or "turn around" in other periods. Therefore, a
permanent difference is caused by an item that:

1. is included in pretax financial income but never in taxable income, or

2. is included in taxable income but never in pretax financial income.

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TAX BASE CONCEPTT
Tax base refers to the total income (including salary, income from investments, assets, etc.) that can be taxed by a
taxing authority and is thus used to calculate tax liabilities owed by the individual or the corporation. It serves as a
total base on which the tax can be charged. A tax base is the total amount of assets or revenue that a government
can tax.
Tax Base Formula = Tax Liability / Tax Rate
Example
Mrs. Lucia, a businesswoman, happened to earn $20000 last year. Out of this amount, $15000 was subject to tax.
Assuming a tax rate is 10%, Determine tax base
Solution
Tax Liability = Tax Base * Tax Rate
Total income 20,000
Taxable income 15,000
Tax rate 10%
Tax liability 15,000*0.1=1500
Tax base= Tax Liability / Tax Rate
Taxable income = 1500/0.1=15,000

Meaning of Deferred Tax

Deferred tax (DT) refers to the difference between tax amount arrived at from the book profits recorded by a
company and the taxable income. The effect arises when taxes are either not paid or overpaid. Companies calculate
book profits using a particular accounting method; tax authorities charge taxes based on tax laws, and the two
often differ.
Note: Book income is used by companies to report their income and expenses to shareholders. Taxable
income is used by businesses to report earnings and tax liability to tax authorities.
 Deferred tax is the gap between income tax determined by the company accounting methods and the tax
payable determined by tax authorities.
 Deferred tax arises when there is a difference in the treatment of income, expenses, assets, and a liability
under the company’s accounting procedure and the tax provision.
 It is the difference between income tax paid and income tax accrued. The difference results in a surplus or
deficit.
Types of Deferred Taxes
1. Deferred Tax Liabilities
 A deferred tax liability is a liability recognized when tax paid in current period is lower that tax that would
be payable if calculated under accrual basis. It arises when tax accounting rules defer recognition of income
or advance recognition of an expense resulting in a decrease in taxable income in current period that would

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 reverse in future. Financial statements are prepared in accordance with accounting standards but income tax
payable is worked out based on income tax rules of the tax authorities such as IRS.
 Deferred Tax Liabilities is the liability that arises to the company due to the timing difference between the
tax accrual and the date when the taxes are paid to the tax authorities, i.e., taxes get due in one accounting
period but are not paid in that period.
 In simple words, deferred tax liabilities are created when income tax expense (income statement item) is
higher than taxes payable (tax return), and the difference is expected to reverse. DTL is the amount of
income taxes payable in future periods due to temporary taxable differences.
 As opposed to deferred tax assets, the deferred tax liability is the underpaid amount that a company has recorded
in the filing of its taxes. This is the tax payment that the company is liable to pay in the future. The taxes are
applied to the income of the current year, while the tax record for the filing that occurs in the next calendar year
must happen now, which gives rise to deferred tax liabilities.
Where: Underpaid= pay too little to (someone). i.e., pay less than is due for (something).
 Corporations must file income tax returns following the guidelines developed by the appropriate tax
authority.
Because IFRS and tax regulations differ in a number of ways, frequently the amounts reported for the following
will differ:
 Income tax expense (IFRS)
 Income taxes payable (Tax Authority)

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2. Deferred Tax Asset (DTA)
 A deferred tax asset is an asset to the Company that usually arises when the Company has overpaid taxes or
paid advance tax. Such taxes are recorded as an asset on the balance sheet and are eventually paid back to the
Company or deducted from future taxes. These are created because of the timing difference between the book
and taxable profits.
 Deferred tax asset is an asset recognized when taxable income and tax paid in current period is higher than the
tax amount worked out based on accrual basis or where loss carry forward is available. A deferred tax
asset is often created when taxes are paid or carried forward but cannot yet be
recognized on the company's income statement.
For example, deferred tax assets can be created when the tax authorities recognize
revenue or expenses at different times than the periods that the company follows as
an accounting standard.
 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. A deferred tax asset
relates to an overpayment or advance payment of taxes. For example, deferred tax
assets can occur when there is a difference between when a tax authority recognizes
revenue and when a company does, based on the accounting standards that the latter
follows.

A deferred tax asset can reduce a company's taxable income in the future. Deferred tax
assets are financial assets (as opposed to tangible assets) that appear on a company's
balance sheet as non-current assets.

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 There can be the following scenario of deferred tax asset:
1. If book profit is lesser than taxable profit. Then deferred tax assets get created.
2. If, as per books, there is a loss in accounts, but as per income tax rules, the company shows a profit, and then the
tax has to be paid and will come under deferred tax assets that can be used for future year tax payment.
1.1. Recognition of deferred tax liabilities and assets
Recognition of deferred tax liabilities
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.
Deferred tax liabilities are recognized for taxable temporary differences, with some exceptions and Investments in
subsidiaries, branches and associates, and interests in joint ventures. Taxable temporary differences are temporary
differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the
carrying amount of the asset or liability is recovered or settled. Deferred tax liabilities are typically recognized
when:
 The carrying amount of an asset is higher than its tax base, or
 The carrying amount of a liability is lower than its tax base.
Taxable temporary differences arise, and deferred tax liabilities are recognized, when, for example:
 Reporting entity recognizes receivable and related revenue which will not be taxable until cash receipt.
 An item of property, plant and equipment (PP&E) is depreciated faster for tax purposes than for accounting
purposes.
 Expenditure is recognized as an item of PP&E or an intangible asset for accounting purposes, but treated as
revenue expenditure for tax purposes.
 The identifiable assets acquired in a business combination are recognized at their fair values in accordance
with IFRS 3 Business Combinations (IFRS 3), but no equivalent adjustment is made for tax purposes. What Is
an Identifiable Asset? An identifiable asset is an asset whose commercial or fair value can be measured at a given point
in time, and which is expected to provide a future benefit to the company. These assets are an important consideration
in the context of mergers and acquisitions.
 Assets are revalued upwards, but this revaluation does not affect taxable profit in the current period. N.B., An
upward revaluation of a fixed asset which has been previously subject to downward revaluation, an amount of the
upward revaluation equal to the amount previously expensed is credited back to the Profit and Loss Account.
To illustrate how differences in IFRS and tax rules affect financial reporting and taxable income, assume that ABC
Company reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations. For
tax purposes (following the tax rules), if ABC company reported the same expenses to the tax authority in each of
the years, but, assume ABC Company reported taxable revenues of $100,000 in 2015, $150,000 in 2016, and
$140,000 in 2017.

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Question 1: Assuming tax rate is 40% shows the income statement over these three years for Financial Reporting
purpose.
Solution
A B C C O M P A N Y .
IFRS REPORTING
2015 2016 2 0 1 7 T o t a l
Revenues 130,000 130,000 130,000
E x p e n s e s 60,000 60,000 60,000
Income Before tax 70,000 70,000 70,000 210,000
Income tax exp. 28,000 28,000 28,000 8 4 , 0 0 0
Income after tax 42,000 42,000 42,000 126,000
Question2 show income statement over these three years for Tax reporting purpose
Solution
A B C C O M P A N Y .
Tax REPORTING
2 0 1 5 2 0 1 6 2 0 1 7 Total
Revenues 100,000 150,000 140,000
Expenses 60,000 60,000 60,000
Taxable income 40,000 90,000 80,000 210,000
Income tax payable (40%) 16,000 36,000 32,000 84,000
Income after Tax 24,000 54,000 48,000 126,000
Question 3: Compare Income Tax Expense to Income Taxes Payable
Income tax expense and income taxes payable differed over the three years but were equal in total, as shows.
A B C C O M P A N Y
INCOME TAX EXPENSE AND INCOME TAXES PAYABLE
2 0 1 5 2016 2 0 1 7 Total
Income tax expense 28,000 28,000 28,000 84,000
Income tax payable (40%) 16,000 36,000 32,000 84,000
D i f f e r e n c e 12,000 (8,000) (4,000) -
The differences between income tax expense and income tax payable in this example arise due to the following
simple reason.
1. For financial reporting, companies use the full accrual method to report revenues.
2. For tax purposes, they generally use a modified cash basis.
Modified cash basis is an accounting method that combines elements of the two primary bookkeeping practices: cash and
accrual accounting. It seeks to get the best of worlds, recording sales and expenses for long-term assets on an accrual basis
and those of short-term assets on a cash basis.
Modified accrual accounting follows the cash-basis method to record short-term events. It follows the accrual method to
record long-term events. The modified accrual accounting method recognizes revenues when they are available and
measurable.
Year Reporting Requirement
2015  Deferred tax liability account increased to $12,000
2016 Deferred tax liability account reduced by $8,000

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2017  Deferred tax liability account reduced by $4,000
As indicates above, for ABC company the $12,000 ($28,000- $16,000) difference between income tax expense and
income taxes payable in 2015 reflects tax that will be paid in the future periods. This $12,000 difference is often
referred to as a deferred tax amount. In this case, it is a deferred tax liability. In cases where taxes will be lower
in the future, ABC Company records a deferred tax asset
1.2 Future Taxable and Deductible Amounts
A temporary difference is the difference between the tax basis of an asset or liability and its reported (carrying or
book) amount in the financial statements that will result in taxable amounts or deductible amounts in future
years.
 Taxable amounts increase taxable income in future years.
 Deductible amounts decrease taxable income in future years.
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.
Example: Assume that ABC Company reports accounts receivable at Br 30,000 in the December 31, 2014.
However, the receivables have a zero-tax basis
Per Book 12/31/2014 Per tax basis 12/31/2014
Account receivable Br 30,000 Account receivable 0
Assuming that ABC Company expects to collect Br. 20,000 of the receivables in 2015 and Br. 10,000 in 2016, this
collection results in future taxable amounts of Br. 20,000 in 2015 and Br. 10,000 in 2016.
1. Compute Deferred tax liability at the end of 2014
2. Compute Income tax expense for 2014
3. Make a necessary journal entry for 2014 end
4. Income tax expense for 2015
5. Make a necessary journal entry for 2015 end
6. Journal entry for 2016
Solution
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.
1. Computation of Deferred tax liability at the end of 2014
Book basis of A/R Br 30,000
Tax basis of A/R 0
Cumulative temporary difference 2014 30,000
Tax Rate 40%
Deferred tax liability at the end of 2014 Br. 12,000
Or
Companies may also compute the deferred tax liability by preparing a schedule that indicates the future taxable
amounts due to existing temporary differences:

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Future Years
2015 2016 Total
Future taxable amount Br. 20,000 10,000 30,000
Tate Rate 40% 40% 40%
Deferred tax liability at the end of 2014 8,000 4,000 12,000

2. Computation of Income tax expense for 2014

Income tax expense= current deferred tax expense + current tax expenses (income tax payable for the
period).
Because it is the first year of operations for ABC Company, there is no deferred tax liability at the beginning of
the year.
ABC Company computes the income tax expense for 2014 as shown below:
Deferred tax liability at the end of 2014 Br 12,000
Deferred tax liability at the beginning of 2014 –0–
Deferred tax expense for 2014 12,000
+ Current tax expense for 2014 (income taxes payable) 16,000
Income tax expense (total) for 2014 end ………… Br. 28,000
This computation indicates that income tax expense has two components: current deferred tax expense and
current tax expenses (income tax payable for the period).
Deferred tax expense is the increase in the deferred tax liability balance from the beginning to the end of the
accounting period.
3. Journal entry for 2014 end
Income Tax Expense 28,000
Income Taxes Payable 16,000
Deferred Tax Liability 12,000

4. Computation of Income tax expense for 2015

At the end of 2015 (the second year), the difference between the book basis and the
tax basis of the accounts receivable is Br10, 000. ABC company multiplies this difference by the
applicable tax rate to arrive at the deferred tax liability of Br. 4,000 (Br. 10,000 x 40%), which
it reports at the end of 2015. Income tax payable for 2015 is Br 36,000.
Deferred tax liability at end of 2015 Br. 4,000
Deferred tax liability at beginning of 2015 12,000
Deferred tax expense (benefit) for 2015 (8,000)
Current tax expense for 2015 (income taxes payable) 36,000
Income tax expense (total) for 2015 end Br. 28,000

5. Journal entry for 2015 end

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ABC Company records income tax expense, the change in the deferred tax liability, and income taxes payable for
2015 as follows.
Income Tax Expense 28,000
Deferred Tax Liability 8,000
Income Taxes Payable 36,000

The entry to record income tax at the end of 2016 reduces the Deferred Tax Liability by Br 4,000. The Deferred
Tax Liability account appeared as follows at the end of 2016.
6. Journal entry for 2016
Deferred tax liability for 2015 Br. 8,000
Deferred tax liability for 2016 Br. 4,000
Deferred tax liability for 2014 Br. 12,000
Deferred tax liability
2015 Br 8000 2014 Br 12000
2016 4000
- 0-
The Deferred Tax Liability account has a zero balance at the end of 2016.
Exercise
Problem 1. Starfleet Corporation has one temporary difference at the end of 2018 that will reverse and cause
taxable amounts of $55,000 in 2019, $60,000 in 2020, and $75,000 in 2021. Starfleet’s pretax financial income
(Pretax book income) for 2018 is $400,000, and the tax rate is 30% for all years. There are no deferred taxes at the
beginning of 2018.
Instructions
a) Compute taxable income and income taxes payable for 2018.
b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes
payable for 2018
Deferred tax:
Deferred taxes arise from temporary differences or the difference between the accounting income and the taxable
income excluding the permanent difference. Deferred taxes are recorded in the balance sheet as an asset or liability
depending on its impact. If the taxable income is less than the accounting income, then deferred tax liability arises as
you have already accrued the income tax expense in the books but paid lesser tax. If the taxable income is greater
than the accounting income, then deferred tax asset arises as you only recognized smaller income tax expense than
the tax that have been paid currently.

Answer and Explanation:

Taxable Income:

 Taxable income = Pretax financial income - Future taxable income

 Taxable income = $400,000 - $55,000 - $60,000 - $75,000
 Taxable income...

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  Tax payable is a type of current liability that is reported on the balance sheet of a company. The company
required to pay the tax payable amount to the tax authorities within one year.


Problem 2: Your Company’s EBITDA is $25 million, tax-exempt interest income is $1 million and depreciation
expense under straight-line method is $3 million. EBITDA worked out using tax laws is also $25 million.
However, it allows depreciation expense of $5 million as a deduction. Assume a tax rate of 40%.
a) Compute taxable income and income taxes payable .
b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes
payable.

Prepare Necessary journal entry

Your income before tax under financial accounting rules is $23 million (i.e. EBITDA of $25 million + tax-exempt
interest expense of $1 million – depreciation of $3 million). Your financial accounting income on which income
tax shall apply is $22 million i.e. after removal of exempt income. If you apply the 40% tax rate, your income tax
obligation under matching concept and accrual basis equal $8.8 million (i.e. $22 million multiplied by 40%). Your
taxable income i.e. the amount at which you have to pay the corporate tax is $20 million (i.e. EBITDA of $25
million - $5 million of MACRS depreciation). Your income tax payable worked out using tax rules amounts to $8
million (i.e. $20 million multiplied by 40%).
Journal entries
I n c o m e t a x e x p e n s e $8,800,000
I n c o m e t a x p a y a b l e $8,000,000
D e f e r r e d t a x l i a b i l i t y $800,000

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In future periods, when the deferred tax liability would be used up, the following journal entry needs to be posted:

D e f e r r e d t a x l i a b i l i t y $800,000
I n c o m e t a x e x p e n s e $800,000
Deferred tax liability would be recognized using the following journal entry:

RECOGNITION OF DEFERRED TAX ASSETS

Deferred tax assets are typically recognized when:
 The carrying amount of an asset is lower than its tax base, or
 The carrying amount of a liability is higher than its tax base.
Deductible temporary differences arise and deferred tax assets are recognized, when, for example:
 a provision is recognized under IAS 37 Provisions, Contingent Liabilities and Contingent Assets which
will be tax deductible in future periods when actual cash outflow takes place
 Liabilities for long-term employee benefits are recognized under IAS 19 Employee Benefits which will be
tax deductible in future periods when actual cash outflow takes place (.
 Research and development costs are recognized as an expense in determining accounting profit in the
period in which they are incurred but may not be permitted as a deduction in determining taxable profit
until a later period.
 The identifiable liabilities assumed in a business combination are recognized at their fair values in
accordance with IFRS 3, but no equivalent adjustment is made for tax purposes
 Assets are revalued downwards or impaired, but this does not affect taxable profit in the current period
Illustration:
Hunt Company has revenues of $900,000 for both 2019 and 2020. It also has operating expenses of $400,000 for
each of these years. In addition, Hunt accrues a loss and related liability of $50,000 for financial reporting
purposes because of pending litigation. Hunt cannot deduct this amount for tax purposes until it pays the liability,
expected in 2020. As a result, a deductible amount will occur in 2020 when Hunt settles the liability, causing
taxable income to be lower than pretax financial information. Assuming tax rate is 40%
Required:
a) Shows the IFRS reporting and tax reporting over the two years
b) Compute Deferred Tax Asset, End of 2019
c) Compute and Record income tax expense for 2019
d) Compute and Record income tax expense for 2020
e) Record entry at end of 2020
Solution a)

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b) Determine deferred tax asset

Or

c)

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Prepare the entry at the end of 2019 to record income taxes
Income Tax Expense 180,000
Deferred Tax Asset 20,000
Income Taxes Payable 200,000

D)

Prepare the entry at the end of 2020 to record income taxes.

Income Tax Expense 200,000

Deferred Tax Asset 20,000
Income Taxes Payable 180,000

E)

EXERCISE
Problem 1: Columbia Corporation has one temporary difference at the end of 2018 that will reverse and cause
deductible amounts of $50,000 in 2019, $65,000 in 2020, and $40,000 in 2021. Columbia’s pretax financial
income for 2018 is $200,000 and the tax rate is 34% for all years. There are no deferred taxes at the beginning of
2018. Columbia expects to be profitable in the future.
Instructions
a) Compute taxable income and income taxes payable for 2018.

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 b) Prepare the journal entry to record income tax expense, deferred income taxes, and income
taxes payable for 2018.
Problem 2:Let’s consider a company that has earnings before income taxes (EBT) of $30 million. During the
period, an amount of $4 million was received on a 2-year rental contract in advance half of which is included in
the EBT. For tax purpose, the whole $2 million is included in current period income, resulting in a taxable income
of $32 million. If the statutory tax rate is 40%, income tax payable works out to $12.8 million (=$32 million ×
40%). However, on accrual basis, tax ought to be $12 million (=$30 million × 40%). The excess tax paid in current
year of $0.8 million must be moved to future periods.
a) Compute and record taxable income and income taxes payable.
A c c o u n t D r C r
Current tax expense ($30 million × 0.4) 1 2 . 0 0
Deferred tax asset 0 . 8 0
Income tax payable ($32 million × 0.4) 12.80

FUTURE TAXABLE TEMPORARY DIFFERENCES

Temporary difference is Differences between the carrying amount of an asset or liability in the statement of
financial position and its tax bases. Taxable temporary is a temporary difference that will result in taxable amounts
in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is
recovered or settled. Taxable temporary differences are those on which tax will be charged in the future when
the asset (or liability) is recovered (or settled).
Deductable temporary difference is the temporary differences that will result in amounts that are deductible in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is
recovered or settled. Deductible temporary differences are those which will result in tax deductions or savings in
the future when the asset (or liability) is recovered (or settled).
Taxable temporary differences give rise to recording deferred tax liabilities. Deductible temporary differences give
rise to recording deferred tax assets.
ACCOUNTING FOR NET OPERATING LOSS (NOL)

Net operating loss is the operating loss i.e., the expenses in a period that are more than that of the revenues for
that company in a specific period, which goes into the accounting books in the period where the company has
allowable tax deductions which are greater than the current taxable income.
Net operating losses ("NOL") are a tax credit created when a company's expenses exceed its revenues, generating
negative taxable income as computed for tax purposes. NOL can be used to offset positive taxable income,
reducing cash taxes payable.
A net operating loss (NOL) for income tax purposes is when a company’s allowable deductions exceed the taxable
income in a tax period. When a company’s deductibles are greater than its actual income, the Internal Revenue
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 Service (IRS) allows the company to use the loss to reduce previous years’ taxes or to carry it forward to offset
future years’ profits. It is a benefit that helps reduce the tax liability of the business.
Common Reasons for Net Operating Loss
One of the most common periods for incurring net operating losses occurs when companies are in their start-up
phase. Such companies often are spending more money than they are taking in, in order to generate future sales or
income. An example is a mining business, where they may generate large profits in one period, incur an NOL in
the next, but make back the profit again in the following period. In this case, they can carry forward the second
year NOL to offset taxes in the third year.
When companies report an NOL, three common things can happen:
1. The company does not owe any taxes for the current period;
2. The company can get a refund for previously paid taxes; and
3. The company can carry forward its business losses to lower future taxable income.

CARRY BACKS & CARRY FORWARDS OF NET OPERATING LOSS

Rule of set-off of net operating losses in order to maximize the savings:

1. First, set off the NOL by carrying it back to the preceding 2 years to recover past taxes paid, . If any losses are still
available for set-off then,
2. Set off the NOL in next year and carry forward it for the next 20 years
3. Any remaining NOL expires after 20 years and has no value. After 20 years, any remaining NOL expire and are no
longer available for use and pending set off expires
4. NOL carried forward are recorded on the balance sheet as deferred tax assets ("DTA").

LOSS CARRY BACK EXAMPLE

To illustrate the accounting procedures for a net operating loss carry back, assume that Groh Inc. has no temporary
or permanent differences. Groh experiences the following.

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Year Taxable Income Tax Rate Tax paid
/Loss Tax Paid
2011 5 0 , 0 0 0 3 5 % 17,500
2012 1 0 0 , 0 0 0 3 0 % 30,000
2013 2 0 0 , 0 0 0 4 0 % 80,000
2014 (500,000) - 0

1. Compute and record Income-tax refund receivable

2. Compute and records the tax effect carry forward as a deferred tax asset assuming that the enacted future
tax rate is 40 percent.
3. How many Net losses would be forwarded?

SOLUTION
Under the law, Groh must apply the carry back first to the second year preceding the loss year. Therefore, it
carries the loss back first to 2012. Then, Groh carries back any unused loss to 2013. Accordingly, Groh files
amended tax returns for 2012 and 2013
2012 ………………….100,000*0.3=30,000
2013 ………………….200,000*0.4=80,000
Total tax refund ……………………..110,000
1. Income-tax refund receivable = $110,000 ($30,000 + $80,000) of taxes paid in those years.
Groh makes the following journal entry for 2014.

Income Tax Refund Receivable….110, 000

Benefit Due to Loss Carry back (Income Tax Expense) ……………….110, 000
Groh reports the account debited, Income Tax Refund Receivable, on the balance sheet as a current asset at
December 31, 2014
It reports the account credited on the income statement for 2014 as shown below
G R O H I N C .
I N C O M E S T A T E M E N T ( P A R T I A L ) F O R 2 0 1 4
Operating loss before income taxes $....................................................(500,000 )
I n c o m e t a x b e n e f i t
B e n e f i t d u e t o l os s c a r r yb a c k … … … … … … … … … … … … …… 1 1 0 , 0 0 0
Net loss ………………………………………………………………..$(390,000 )
Groh should recognize the associated tax benefit in this loss period.
Computation of tax effect

Tax effect accounting is the procedure to adjust the difference between profits/loss in business accounting
and taxable income.

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In above example Net loss is 500,000 and taxable income for 2012 and 2013 is 300,000, the adjustment amount is
200,000 at future that rate. Thus,

Groh Inc. records the tax effect of the $200,000 loss carry forward as a deferred tax asset of $80,000

Deferred Tax Asset (200,000*.4) 80,000

Benefit Due to Loss Carry forward (Income Tax Expense) 80,000

3. Since the $500,000 net operating loss for 2014 exceeds the $300,000 total taxable income from the 2 preceding
years, Groh carries forward the remaining $200,000 loss.
TAX CARRY BACK EXERCISE
Prblem1:Iron and Steel Company reports a pretax operating loss of $90,000 in 2007 for both financial reporting
and income tax purposes, Financial income and taxable income for the previous 2 years is as per below.
1. What is the Income-tax refund receivable?

Problem2:Let’s say XYX Company incurred a net operating loss of $40 million in 2017. XYZ company taxable
income for 2015 and 2016 were $10 million and $5 million. Assume a tax rate of 40% is applicable to 2015, 2016
and 2017.
1. What is the Income-tax refund receivable
SOLUTION
XYZ can use the $40 million NOL in 2017 to revise the tax return for 2015. This would result in a tax refundable
of $4 million (=$10 million × 40%). You are left with NOL of $30 million, $5 million of which you can set-off by
retrospectively adjusting tax return for 2016 and claiming a tax refund related to 2016 of $2 million (=$5 million ×
40%). After exhausting the 2-year carryback option, you are still left with NOL of $25 million which you must
carryforward to future period i.e. tax year 2018 onwards.
You will need to pass the following journal entry to recognize the tax carryback:

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A c c o u n t D r C r
Income tax refund receivable ($4 million +$2 million) $ 6 m i l l i o n
Income tax expense (benefit) $6 million
This would result in a negative income tax year for 2017 i.e. a tax benefit and your net income will be higher than
earnings before income taxes.
LOSS CARRY FORWARD EXAMPLE
If a carry back fails to fully absorb a net operating loss, or if the company decides not to carry the loss back, then it can carry
forward the loss for up to 20 years. Because companies use carry forwards to offset future taxable income, the tax effect of a
loss carry forward represents future tax savings. Realization of the future tax benefit depends on future earnings, an
uncertain prospect.
The key accounting issue is whether there should be different requirements for recognition of a deferred tax asset
for (a) deductible temporary differences, and (b) operating loss carry forwards. The FASB’s position is that in
substance these items are the same—both are tax-deductible amounts in future years. As a result, the Board
concluded that there should not be different requirements for recognition of a deferred tax asset from deductible
temporary differences and operating loss carryforwards.
Example
To illustrate the accounting for an operating loss carry forward, return to the Groh example from the preceding
section. In 2014, the company records the tax effect of the $200,000 loss carry forward as a deferred tax asset of
$80,000 ($200,000*40%), assuming that the enacted future tax rate is 40 percent. Groh records the benefits of the
carry back and the carry forward in 2014 as follows.
To recognize benefit of loss carry back
Income Tax Refund Receivable…………………………………………. 110,000
Benefit Due to Loss Carry back (Income Tax Expense)………………………. 110,000
To recognize benefit of loss carry forward
Deferred Tax Asset …………………………………………………………80,000
Benefit Due to Loss Carry forward (Income Tax Expense) ……………………………...80,000
Groh realizes the income tax refund receivable of $110,000 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 Groh presents on the 2014 income statement shown as shown below.
G R O H I N C .
I N C O M E S T A T E M E N T ( P A R T I A L ) F O R 2 0 1 4
Operating loss before income taxes $................................................................(500,000 )
Income tax Benefit due to loss carryback ……………………110,00 0
Benefit due to loss carryforward.……………… 80,000………………………..190,000
Net loss ………………………………………………………………………………..$(310,000

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The current tax benefit of $110,000 is the income tax refundable for the year. Groh determines this amount by
applying the carry back provisions of the tax law to the taxable loss for 2014. The $80,000 is the deferred tax
benefit for the year, which results from an increase in the deferred tax asset.
Required: computes the income taxes payable for 2015 assume that Groh returns to profitable operations and has
taxable income of $250,000 (prior to adjustment for the NOL carry forward), subject to a 40 percent tax rate.
Solution
Taxable income prior to loss carryforward………………… $ 250,00 0
Loss carryforward deduction………………………………. (200,000 )
Taxable income for 2015 ……………………………………..50,000
Tax rate 40% *0.4
In c o m e t a x e s p a ya b l e f o r 2 0 1 5 … … … … … … … … … … … … … … … … … … . $ 20 , 0 0 0
Groh records income taxes in 2015 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 2015, reduce the Deferred Tax Asset account to zero.
The 2015 income statement that appears in Illustration above does not report the tax effects of either the loss
carryback or the loss carryforward because Groh had reported both previously.
GROH INC.
INCOME STATEMENT (PARTIAL) FOR 2015
Income before income taxes …………………………..$250,000
Income tax expense
Current $20,000
Deferred 80,000 …………………………………………100,000
Net income……………………………………………… $150,000
EXERCISE
Problem 1:Forward Company reports a pretax operating loss of $60,000 in 2007 for both financial reporting and
income tax purposes. The income tax rate is 30%, and no change in the tax rate has been enacted for future years.
What is the deferred tax asset created?

Problem 2: Assume $25 million of net operating loss related to 2017 couldn’t be carried back because the
corporation ran out of available taxable income. The remainder of the NOL which can’t be carried back can be
carried back for 20 years. If we expect enough taxable income to be available in future periods, a deferred tax asset
must be recognized based on the statutory tax rates expected in future periods. Let’s assume expected taxable

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income is 2018, 2019 and 2020 is $8 million, $10 million and $20 million and the associated tax rates are 40%,
35% and 30%.
Compute and record deferred tax asset that can be recognized in 2017:
Solution
U S D i n m i l l i o n Calculation 2 0 1 8 2 0 1 9 2 0 2 0
Taxable income T I 8 1 0 2 0
NOL balance at the start of the year B N O L 2 5 1 7 7
NOL adjusted A 8 1 0 7
NOL balance at the end of the year ENOL = BNOL - A 1 7 7 -
T a x r a t e R 4 0 % 3 5 % 3 0 %
Deferred tax asset DTA = A × R 3 . 2 0 3 . 5 0 2 . 1 0
Total deferred tax asset is $8.8 million. Please note that this is lower than the product of NOL balance at the start
of the tax year 2018 and the 2017 tax rate because statutory tax rate has decreased in future periods thereby
reducing the value of the tax loss carryforward.
The following journal entry would recognize the deferred tax asset arising from the tax loss carryforward:
A c c o u n t D r C r

D e f e r r e d t a x a s s e t $8.8 million

Income tax expense (benefit) $8.8 million

Disclosure of Income tax related Financial Statement Presentations

a) Balance Sheet
Deferred tax accounts are reported on the balance sheet as assets and liabilities. Companies should classify these
accounts as a net current amount and a net noncurrent amount. An individual deferred tax liability or asset is
classified as current or noncurrent based on the classification of the related asset or liability for financial reporting
purposes. A company considers a deferred tax asset or liability to be related to an asset or liability if reduction of
the asset or liability causes the temporary difference to reverse or turn around. A company should classify a
deferred tax liability or asset that is unrelated to an asset or liability for financial reporting; including a deferred tax
asset related to a loss carryforward, according to the expected reversal date of the temporary difference.
b) Income Statement
Companies should allocate income tax expense (or benefit) to continuing operations, discontinued operations,
extraordinary items, and prior period adjustments. This approach is referred to as intraperiod tax allocation. In
addition, companies should disclose the significant components of income tax expense attributable to continuing
operations:
1. Current tax expense or benefit.
2. Deferred tax expense or benefit, exclusive of other components listed below.
3. Investment tax credits.
4. Government grants (if recognized as a reduction of income tax expense).
5. The benefits of operating loss carryforwards (resulting in a reduction of income tax expense).

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 6. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in
the tax status of a company.
7. Adjustments of the beginning-of-the-year balance of a valuation allowance because of a change in
circumstances that causes a change in judgment about the realizability of the related deferred tax asset
in future years.
Taxes Which Are Not Included Under Income Tax
The following are types of taxes that would not be accounted for as income tax because they are not based on
taxable profits:
 Sales taxes, because they are based on sales value (a gross amount) rather than on taxable profits (eg tax
based on total sales value from sale of alcohol or cigarettes).
 Consumption taxes such as value added tax (VAT), or goods and services tax (GST), which are taxes
levied on any value that is added to a product.
 Some production taxes may not meet the definition of income tax depending upon the specific terms (eg a
tax imposed on mining companies for each unit mined (based on an individual item)).
 Taxes payable on employee benefits paid (eg social security taxes payable based on a percentage of
employee’s wages).
 Stamp duty, a form of tax that is levied on documents.

Deferred Taxes Illustration:

@ Course Hero, Study.com, Quizlet.com, cheg

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Q1. In 2010 Amirante Co. had pretax financial income of $168,000 and taxable income of $120,000. The
difference is due to the use of different depreciation methods for tax and accounting purposes. The effective tax
rate is 40%. Compute the amount to be reported as income taxes payable at 12/31/2010.
Solution:
2010 taxable income $120,000
Tax rate X 40%
12/31/10 income taxes payable $ 48,000
Q2. At 12/31/2010 Percheron Inc. had a deferred tax asset of $30,000. At 12/31/2011 the deferred tax asset is
$59,000. The corporation's 2011 current tax expense is $61,000. What amount should Percheron report as total
2011 total tax expense?
Solution:
Deferred tax asset, 12/31/11 $59,000
Deferred tax asset, 12/31/10 30,000
Deferred tax benefit for 2011 (29,000)
Current tax expense for 2011 61,000
Total tax expense for 2011 $32,000
Q3. At 12/31/2010 Hillyard Co. has a deferred tax asset of $200,000. After a careful review of all available
evidence it is determined that it is more likely than not that $60,000 of this deferred tax asset will not be realized.
Prepare the JE.
Answer.
Income Tax Expense 60,000
....Allowance to Reduce Deferred Tax Asset
to Expected Realizable Value 60,000
Q4. Starfleet Co. has one temporary difference at the end of 2010 that will reverse and cause taxable amounts of
$55,000 in 2011, $60,000 in 2012, and $75,000 in 2013. Starfleet's pretax financial income for 2010 is $400,000,
and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2010. (a) Compute taxable
income and income taxes payable for 2010.
Answer:
Pretax financial income for 2010 $400,000
Temporary difference resulting in future taxable
amounts in 2011 (55,000)
in 2012 (60,000)
in 2013 (75,000)

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Taxable income for 2010 $210,000

Taxable income for 2010 $210,000

Enacted tax rate 30%
Income tax payable for 2010 $ 63,000
Q5. Starfleet Co. has one temporary difference at the end of 2010 that will reverse and cause taxable amounts of
$55,000 in 2011, $60,000 in 2012, and $75,000 in 2013. Starfleet's pretax financial income for 2010 is $400,000,
and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2010. (b) Prepare the JE to
record income tax expense, deferred income taxes, and income taxes payable for 2010..
Answer:
(b) Future Years
2011 2012 2013 Total
Future taxable (deductible) amounts $55,000 $60,000 $75,000 $190,000
Tax rate 30% 30% 30%
Deferred tax liability (asset) $16,500 $18,000 $22,500 $ 57,000

Deferred tax liability at the end of 2010 $ 57,000

Deferred tax liability at the beginning of 2010 0
Deferred tax expense for 2010 (increase in
deferred tax liability) 57,000
Current tax expense for 2010
(Income tax payable) 63,000
Income tax expense for 2010 $120,000

Income Tax Expense 120,000

....Income Tax Payable 63,000
....Deferred Tax Liability 57,000
Q6. Starfleet Co. has one temporary difference at the end of 2010 that will reverse and cause taxable amounts of
$55,000 in 2011, $60,000 in 2012, and $75,000 in 2013. Starfleet's pretax financial income for 2010 is $400,000,
and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2010. (c) Prepare the
income tax expense section of the IS for 2010, beginning with the line "Income before income taxes"
Answer:
Income before income taxes $400,000
Income tax expense
..Current $63,000

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..Deferred 57,000 120,000
Net income $280,000
Q7. At 12/31/2010 Appaloosa Co. had a deferred tax liability of $25,000. At 12/31/2011 the deferred tax liability is
$42,000. The corporation's 2011 current tax expense is $48,000. What amount should Appaloosa report as total
2011 tax expense
Answer:
Deferred tax liability, 12/31/11 $42,000
Deferred tax liability, 12/31/10 25,000
Deferred tax expense for 2011 17,000
Current tax expense for 2011 48,000
Total tax expense for 2011 $65,000
Q8. At 12/31/2010 Fell co. had a deferred tax liability of $680,000 resulting from future taxable amounts of
$2,000,000 and an enacted tax rate of 34%. In May 2011 a new income tax act is signed into law that raises the
tax rate to 40% for 2011 and future years. Prepare the JE for Fell to adjust the deferred tax liability.
Answer:
Income Tax Expense 120,000
....Deferred Tax Liability ($2,000,000 X 6%) 120,000
Q9. Youngman Co. has temporary differences at 12/31/2010 that result in the following deferred taxes:
Deferred tax liability-current $38,000
Deferred tax asset-current $(62,000)
Deferred tax liability-noncurrent $96,000
Deferred tax asset-noncurrent $(27,000)
Indicate how these balances would be presented in Youngman's 12/31/2010 BS
Answer:
Current assets
.... Deferred tax asset ($62,000 - $38,000) $24,000

Long-term liabilities
.... Deferred tax liability ($96,000 - $27,000) $69,000

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