TAX ASSETS, LIABILITIES AND REVENUE ACCOUNTS

       There are two situations in which usually some special accounts are used for recording the consequent tax effects.

1. Loss carry backs and loss carry forwards.

2. Temporary miss match in the calculation of taxable income between the methods acceptable under GAAP and tax department rules. Special accounts are not used for permanent differences.

The various special accounts used are

a. Tax refund Receivable.  (asset account)

b.  Tax benefit from carry back. (revenue account)

c.  Tax benefit from carry forward. (revenue account)

d.  Differed tax asset. (asset account)

e. Differed tax liability.(liability account)

  The first three accounts are used in situation 1 only. The differed tax asset account is used in both the situations. Differed liability account is used only in situation 2.

Situation 1. LOSS CARRY BACK AND CARRY FORWARD

   

LOSS CARRY BACK

   In some countries, a loss in an year is allowed to be carried back. The extent of the carry back depends upon the accounting rules. This means that the net loss can be absorbed into the net incomes of the previous years, which in turn reduces these net incomes. This makes the tax payed on these previous incomes, over paid. This over paid cash can be claimed back from the tax department in cash.

eg: Suppose the net incomes of the previous 2 years for a company totals $400000 and the net loss in the current year amounts to $600000. If the tax rule is the net loss can be carried back only for 2 previous years, and tax rate is 30%

tax reclaimable = $400000*30%=$120000. 

The entry is

Tax refund receivable                      120000

Tax benefit from carry back                                  120000

LOSS CARRY FORWARD

    If the previous example is examined, it can be seen that the net income total for the previous 2 years of $400000 is inadequate for completely absorbing the net loss of $600000. In order to get a tax relief on the balance of $200000 net loss, the tax rules of some countries allow this loss to be carried forward to as far as 20 years and only if some conditions are met.

The total tax relief that can be claimed in the future, which is calculated using an estimated future tax rate, is carried in the balance sheet as an intangible asset called the differed tax asset. This asset account is cumulative in nature.

Here the net loss carry forward = $200000

if the estimated future tax rate is 30%,

then the differed tax asset=           $60000

   suppose in the previous example, the net income for the next year is $300000, and if the tax rate is 30%, and if all conditions necessary are met, then

The total tax payable =$300000*30%=$90000

this tax payable can be offset with the differed tax asset of $60000

The entry is

Income tax expense             90000
Differed tax asset                                    60000
Income tax payable                                30000

Here, though the income tax expense is recorded completely, the tax payment is done only after subtracting the balance in the differed tax asset account.

Had the net income for the next year was $ 100000, the income tax expense would have been $30000, and the entry would have been

income tax expense             30000
differed tax asset                                   30000

Since the income tax expense is less than the accumulated differed tax asset, no cash had to be paid.

If we analyse the above examples the differed tax liability is never used in situation 1.

Situation 2. TEMPORARY MIS MATCH IN TAXABLE INCOME CALCULATION.

In most countries, the accounting for tax under GAAP rules, varies widely with the accounting rules of the tax department. This results in many type of temporary or permanent differences between the taxable incomes calculated under these two rules.

SITUATION 1.

This happens when income earned in a year but not received by the year end is added in the net income under GAAP but not added in the net taxable income under tax rules. This makes the net income taxable, calculated under the GAAP rules greater than that under the tax rules. So are the consequent taxes.

SITUATION 2.

This happens when income received in a year but not earned in the same year, is added in the net taxable income under tax rules, but is not added in the net taxable income under GAAP rules. This makes the former greater than the later. So are the consequent taxes.

SITUATION 3.

Thus happens due to different estimates used for future income and expenses.


SITUATION 4.

Due to tax departments not recognizing some income or expenses for tax purposes. These includes life insurance premiums, tax free bond interests etc which are admitted in calculating the taxable income under GAAP but not under the tax rules.

TEMPORARY DIFFERENCES

The first three situations are mostly temporary differences, because they will ultimately self correct.

An example for situation 1. 

An expense accrued in this year under GAAP may not be admitted for calculating the taxable income until payed for,under the tax rules. This causes net income calculated under GAAP, greater than that which is calculated according to tax rules. So will be the consequent taxes. But this decrease is compensated when the expense is finally payed in cash in a later year. This causes a liability called differed tax liability- a liability to pay the tax in cash in the future.

An example for situation 2.

An unearned revenue which is a payment in cash in advance, may be allowed to be added to the net taxable income under tax rules, but not admitted as an income under GAAP rules. This causes the taxable income under the tax rules to be more than that of which is calculated under GAAP rules. And so are the consequent taxes. And the tax is over paid in the current year though not required under the GAAP rules. This over payment creates a prepaid asset called a differed tax asset.

An example for situation 3.

If straight line method of depreciation is used under GAAP while accelerated method is used under tax purposes for the same life for an asset, then the net income for the initial years under GAAP (and subsequent tax payed) will be more than that calculated by tax rules. But in the later years the depreciation expense will be less under accelerated method and consequently, the net income (and the consequent tax) will be less under GAAP when compared to that under the tax rules, which causes the self correction.

DIFFERED TAX LIABILITY IN TEMPORARY DIFFERENCES (situation 1)

Suppose net taxable income under GAAP is $110000, and under tax department rules is $100000, if tax rate is 30% and we assume that the difference of $10000 is temporary.

for calculation purposes, we divide the figures into regular income and the temporary difference.

regular income=$100000;
temporary difference=$10000;

regular tax component=$30000
temporary tax component=$3000

This temporary tax component, which will have to be paid in the future(as shown in the entry given below) is carried in the balance sheet as a liability called the differed tax liability. This is because, this component is a payment which we have to make in the future, which we have not made now because we do not need to pay now according to the tax rules. This is an accrued liability.

The entry is

Income tax expense            33000
Differed tax liability                                  3000
Income tax payable                                 30000

Note that the differed tax liability account is also a cumulative account.

Suppose next year the net income under GAAP is $100000, and under dept rules is $110000

Income tax expense           30000
Differed tax liability             3000
Income tax payable                                 33000

Thus the tax difference which had to be paid in the next year, which was recorded as a differed tax liability, is paid in the next year from the same differed tax liability account set up for the same purpose.

DIFFERED TAX ASSET IN TEMPORARY DIFFERENCES (situation 2)


Suppose net taxable income under GAAP is $100000, and under tax department rules is $110000, if tax rate is 30% and we assume that the difference of $10000 is temporary.

for calculation purposes, we divide the figures into regular income and the temporary difference.

regular income=$100000;
temporary difference=$10000;

regular tax component=$30000
temporary tax component=$3000

This temporary tax component, which is pre paid (as shown in the entry given below) in the current year  is carried in the balance sheet as an asset called the differed tax asset. This is because, this component is a payment which we need not pay according to the GAAP rules, which we have already prepaid as required by the tax rules. This is a prepaid asset.

The entry is

 income tax expense            30000
differed tax liability              3000
income tax payable                                 33000

Note that the differed tax asset account is also a cumulative account.

Suppose next year the net income under GAAP is $110000, and under dept rules is $100000

income tax expense             33000
differed tax asst                                         3000
income tax payable                                  30000

COMPOUND ENTRY IN TEMPORARY ACCOUNTS

Consider the following situation

A company has a net taxable income under GAAP of $110000. The taxable income under tax rules is $108000. And we also find that $10000 in the GAAP income, is income earned but not received in cash and $8000 in the tax rules income is income received but not yet earned, then

Here before making the entries a preliminary calculation also has to be made

Regular income=$100000; tax =$30000
Income earned but not received in cash=$10000; tax payable=$3000
Income received in cash but not earned=$8000; tax prepaid=$2400
Tax payable according to tax rules= $32400 (30% of $108000)

The entry will be


Income tax expense     33000
Differed tax asset          2400
Differed tax liability                     3000
Income tax payable                      32400

There are many different rules for recording temporary differences for various situations other than those mentioned above. Some of these situations are mentioned below.

1. The tax rate gets changed for future years and is known in the current year.

2. The tax rate is expected to change for future years but has not yet changed.

3. Accrued tax liabilities are paid over a multiple number of years.

4. Prepaid tax assets are compensated over a multiple number of years.

5. Any combination of the above.

The accounting for these are beyond the scope of this post, and an be consulted in an intermediate accounting textbook.

Accrued liabilities/assets vs unearned revenue/prepaid assets

  For the definitions and accounting for these accounts, the articles posted before this date on these topics needs to be reviewed

COMPARISON

1. Accrued liability is an opposite counterpart of the accrued assets account. And the unearned revenue account is the opposite counterpart of the prepaid expenses account.

Accrued liability eg:

                     Expense     xxx
                     Accounts payable               xxx
(Cash payment is postponed, but expenses recorded)

When the cash is finally paid, the liability is reduced.

                     Accounts payable      xxx
                    Cash                                         xxx

Accrued Assets eg:

                      Accounts receivable   xxx
                      Revenue                                    xxx
(Cash is not received, but revenue is recognized)

When the cash is finally received, the asset is reduced.

                    Cash         xxx
                    Accounts receivable               xxx

Unearned revenue eg:

                      Cash       xxx
                      Extended Warranty Payable             xxx                                  
OR

                      Cash       xxx
                      Advance Received            xxx

Unearned revenue is a liability. Though cash is received, the revenue is not recognized until the task required to earn the revenue is not complete. Since  this cannot be brought as a part of income untill it is recognized, it is capitalized as a liability in the balance sheet, and is amortised as an when the task gets complete.

                      Advance Recieved       xxx
                       Sale                                             xxx

                     Extended Warranty Payable      xxx
                      Extended Warranty Revenue                   xxx

But unfortunately if we cannot complete the task or in case an extended warranty claim actually has to be paid back, then this revenue is reversed with an expense.

                     Advance Recieved    xxx
                     Cash                                             xxx

                     Extended Warranty Payable      xxx
                     Cash                                                           xxx


Prepaid expense     eg:

                       Rent for 3yrs paid        xxx
                       Cash                                               xxx

We cannot recognise the expense for future years in the current year. But we have already paid for future years. So this is an asset (because technically we can get back the money if the expected task is not completed) and is capitalised as such in the balance sheet. This is also amortised as and when the task for which we have paid in advance gets completed

                      Rent expense for current year    yyy
                      Rent for 3yrs paid                                        yyy

And if we do not want the task to get completed and gets  our money back,
                      Cash               xxx
                       Rent for 3yrs paid                                        xxx
                 

2. Accrued liability and unearned revenue are both liability accounts  whereas accrued assets and prepaid expenses are both asset accounts.

3. Accrued liability and accrued assets debits and credits an expense and a revenue account respectively, whereas unearned revenue and prepaid expenses debits and credits a cash account respectively.

4. Accrued liability and accrued asset account are reduced when the cash is paid and received respectively, whereas Unearned revenue and prepaid assets are reduced when the revenue and the expenses are finally recognised.

The unique thing about Contingent Liabilities

            A contingent liability an accrued liability. As with an accrued liability,which is a non cash liability,  no cash is taken from anybody to create a contingent liability. Instead we fear we may have to pay for something, soon, and thus create a liability by recording an expense.

Let us examine some examples.

         A typical example is the accounting of warranty. When we sell a product, we have to give warranty. Since we cannot charge warranty fees from the customers, we charge it indirectly while the product is sold. The entry is

  cash                                            1000000

  est warranty exp (3yrs)                200000

  est warranty liability                                          200000

  sales                                                                  1000000

Here the product is sold for 1200000, and the estimated warranty expense 200000 is recorded and a consequent liability is capitalized in the balance sheet. As we know, when an expense is made, the retained earning is reduced by the same amount. So 200000 is reduced from the capital to create a liability of the same amount. Now when the warranty is claimed by the customer for say 50000, that expense which is paid in cash, reduces the liability.

  est warranty liability                     50000

 cash                                                                     50000

If this is the only amount claimed during the entire warranty period of 3 years, we remove the unclaimed liability by adding it back to the retained earnings (capital) through a revenue entry

 est warranty liability                     150000

 warranty revenue                                                1500000         

Another example is that of a probable and estimable lawsuit settlement. We create a contigent liability called lawsuit settlement liability.

  lawsuit settlement exp               xxxxx

  lawsuit settlement liability                                xxxxx

When the settlement actually happens

  lawsuit liability                            xxxxx

  cash                                                                   xxxxx

for eg:

  cash                                  1000000

  est warranty exp                200000

  est warranty liability                              200000

  sales                                                       1000000

  est warranty liability         4000

  cash                                                            4000 (when claimed)

UNIQUENESS

The uniqueness of contingent liabilities is that they don't have an opposite called contingent asset. Yes, there are certain short lived asset additions made which goes into gain section in the income statement like the following entry

Investment-Securities.                             xxx
Gain on appreciation of securities.                             xxx
This is done  when an investment in security is declared as a dividend; the security in question is revalued to its fair market value. But the nature of Investment-Securities is short term. This account gets removed from the balance sheet once the said dividend is paid.

 We do not create a revenue by dreaming that we will gain/win an income, creating a contingent asset.

For example

 Lawsuit receivable        100000000
Lawsuit win revenue                             100000000    

As you can see this is as absurd as it seems.                                 

LOAN REPAYMENT METHODS

        When money is lent, is is done in two ways.

Equal Interest Method

1. The principal is expected to be repaid at the end of the loam term. Regular equal interest payments are done at a specified interest. This done in loans like some collateralised loans (eg: gold loan), company loans like bonds etc. Loans can be made with or without a discount/premium.

WITHOUT DISCOUNT/PREMIUM

for eg: suppose a loan is given for an amount of $50000, for 5 yrs with an interest of 10%

jan 1 19x1

notes receivable          50000

cash                                                        50000

dec 31

cash                                10000

interest receivable                             10000

dec 31 19x5

cash                                10000

interest receivable                             10000

cash                                50000

notes receivable                                 50000

WITH DISCOUNT

Consider a bond issued at a rated interest of 4%. Since the market rate prevailing is 5%, the 1% difference has to be compensated to the lender by issuing the bond at a discount in order to compensate the 1% difference. This is illustrated in the following example..

The bond of $100000 par is issued at a rated interest of 4%, with a maturity period of 8 periods and the market rate is 5%. The interest payment of $4000 has to be paid to the lender, because that is what is mentioned in the bond. But in order to compensate the 1%, the bond is issued at a discount

We find the present value of the principal by finding the present value of the principal and the payments at the actual interest rate which is the market rate ie at 5% for 8 periods..

Present value of $100000 @ 5% int for 8 years+ the present value of all the $4000 payments (8 payments)

= $93552.

This means that when we finally pay the $100000 and the 8 payments of $4000  after 8 years has only a real value for the lender of $93552. But he needs to get his $100000 at the end of the period. The interest payment of $4000 is only to maintain the value of his $10000 at the end of the period. In order to compensate for the deficit of $6448, the lender is allowed to lend only $93552 in the beginning and is assured to be paid with $100000 at the end of the term.

So at the date of receipt of cash, the entry is

cash                                93552

discount                            6448

bond payable                                        100000

At this point the amount liable to the lender is only $93552. (whatever he has paid if there is no prepayment charge)

Now when the first interest which has to be paid in cash according to the bond conditions, payed at 4% after 1 year, the entry is

interest expense              4000

cash                                                        4000

But we have to pay 5% ie at the market rate of $93552 ( this was the actual amount liable at the beginning of the year ). This will amount to $4678. But since $4000 has already been paid, the amount to be paid is only $678. This $678 is added to the amount to be paid ie $93552 instead of paying in cash and the actual amount to be paid at the end of the period is calculated as $ 94230.  The entry is

interest expense               $678

discount                                                  $678

Now the amount payable at the end of the year to the lender is increased to $100000-$5770=$94230. The balance of the various accounts at the end of the year is

Bond payable                                 $100000

minus discount                                ( $5770 )

Net liability in the balance sheet       $94230

At this point if the loan is closed, then the cash given is only $94230 ( if there is no loan pre payment charge)

Bond payable                   $100000

discount                                                  $5770

cash                                                       $94230

The complete table of payments is given below

Interest Period	Interest Paid (4% of Par)	Interest Expense (5% of Book Value)	Amortisation	Discount Balance	Book Value
Issue date	$4000	-------------------	-------------------	6448	93552
1	4000	4678	678	5770	94230
2	4000	4712	712	5058	94942
3	4000	4747	747	4311	95689
4	4000	4784	784	3527	96473
5	4000	4824	824	2703	97297
6	4000	4865	865	1838	98162
7	4000	4908	908	930	99070
8	4000	4930	930	0	100000

                  

Here the discount is also AMORTIZED over the period.

WITH PREMIUM

If bond of $100000 is issued @4% for 8 years and the market rate is only 3%, then we are over compensating the lender by 1%. In order to compensate for this extra interest payment to the lender, we issue the bonds at the premium.

By applying the same logic in a discount situation, the present value of $100000 and and $4000 interest at the actual rate of 5%= $106980. This additional $6980 is a premium we demand from the lender to compensate for the additional 1% interest we give him.

cash                             106980

premium                                              6980

bond payable                                   100000

At this point the amount liable to the lender is $106980 ( if there is no prepayment charge)

Now when the first interest which has to be paid in cash according to the bond conditions, payed at 4% after 1 year, the entry is

interest expense              4000

cash                                                        4000

But we have to pay only 3% ie at the market rate of $106980 ( this was the actual amount liable at the beginning of the year ). This will amount to $3209. But since $4000 has already been paid, the amount to be retrieved bakc is $791. This $791 is subtracted to the amount to be paid ie $106980, instead of paying in cash and the actual amount to be paid at the end of the period is calculated as $ 106189.  The entry is

premium               $791

interest expense                                                  $791

Now the amount payable at the end of the year to the lender is decreased to $100000+$6189=$106189. The balance of the various accounts at the end of the year is

Bond payable                                 $100000

plus premium                                    $6189

Net liability in the balance sheet       $106189

At this point if the loan is closed, then the cash given is only $106189 ( if there is no loan pre payment charge)

Bond payable                   $100000

premium                                $6189

cash                                                       $106189

The complete table of payments is given below

Interest Period	Interest Paid (4% of Par)	Interest Expense (5% of Book Value)	Amortisation	Discount Balance	Book Value
Issue date	$4000	-------------------	-------------------	6980	106980
1	4000	$3209	791	6189	106189
2	4000	3186	814	5375	105375
3	4000	3161	839	4536	104536
4	4000	3136	864	3672	103672
5	4000	3110	890	2782	102782
6	4000	3083	917	1865	101865
7	4000	3056	944	921	100921
8	4000	3079	921	0	100000

Here the premium is amortised over the period.

Equated Periodic Installments or Diminishing Interest Method.

WITHOUT DISCOUNT

2. The principal is expected to be received in installments along with the interest. This is normally done in loans like personal loans, vehicle and home loans etc

eg:  a loan is made for an amount of  $25000 for 3 years, the interest is 10% and the principal and the interest is expected to be paid in equated yearly installments with first installment to be paid initially.

This is an annuity due situation. To find the annuity payments, we divide the principal $25000 by the annuity due for $1.

25000/2.73554= 9139

for loan

notes receivable          25000

cash                                                          25000

for the first payment received at the beginning of the first year,

cash                                   9139

notes receivable                                          9139

by the end of the year, an interest is accrued on the remaining notes receivable, which is recorded as an interest revenue as

notes receivable                1586    

Interest revenue                                          1586

This process is repeated every year until the note is completely received. The interest revenue account gets accumulated with all the interest revenues of each year.

The full table of transactions in each accounts is given below

Date	Payment	Interest	Change in Receivable	Balance of Receivable
Yr 1 Beginning	-----------------------	----------------------	----------------------	$25000
Yr 1 Beginning	$9138.96	----------------------	$(9138.96)	15861.04
Yr 1 end	-----------------------	$1586.10	1586.1	17447.14
Yr 2 beginning	9138.96	------------------------	(9138.96)	8308.18
Yr 2 end	-----------------------	830.82	830.82	9139.00
Yr 3 beginning	9138.96	-----------------------	(9138.96)	-0-(rounded)

Here a few points may be noted

1. In the Equal Interest Method, the interest payments are all equal in amount and the principal outstanding always stands the same.

2. In the Equated Periodic Installment method, the payment amount always is the same every period.

3. The component which goes to the principal always increases when the payments progress, while the interest component always decreases. This is evident from the table of payments in the example.

WITH DISCOUNT

A bond like discount is never given in cases of equated periodic installments. This is because, only bonds are issued at a discount or premium to the par value, in order to compensate or get compensated for the difference in interest rate from the market rate.

There are situations where the loan incurred will be with a discount in a equated periodic installment situation.

For example

Suppose a machine is bought from a dealer for an amount of $10000, and the dealer agrees to get paid in 5 equal installments, then a discount situation arises. On the face of it, this is a transaction in which the dealer does not charge interest on the delayed payments in installment and we might be surprised why he forfeits a portion of his profits in the decaying value of his payment. But he should have more than made up for it in marking up the price of the machine at the time of sale.

In order to estimate how much he might have possibly marked up in order to make up for the apparently forfeited interest, we find the present value of the payments with the imputed rate.

If the rate we use is 10%, present value of $2000 for 5 periods is $7582

Now we can see that there is a $2418 loss for the dealer in interest had he not marked up the price of the machine by the same amount. So we make belief that has has done so and believe that he compensates the loss in the interest by amortizing the discount as seen below

The entry when the machine is delivered is

machine                   7582
discount                   2418
notes payable                           10000

At this point if the machine is returned the dealer will have to give only $7582 at the maximum

At the end of the year, for the installment payment

notes payable           2000
cash                                          2000

At the end of the year to compensate the dealer, we add the interest onto the amount we owe him ($7582) which is a non cash payment.

interest exp                 758
discount                                      758

Now the amount we owe him increases to   $8430. The amortization table is given below

Date	Payment	Change in net payable (payable-discount)	Balance of net payable	Interest on the net payable in one year	Change in net Payable (payable-discount)	Balance of net payable
Yr 1 Beginning	-------------	-------------	-------------	--------------	$(2418)	$7582
Yr 1 end	$2000	$(2000)	$5582	$758.2	$758.2	6340.2
Yr 2 end	2000	(2000)	4340.2	634.02	634.02	4974.2
Yr 3 end	2000	(2000)	2974.2	497.4	497.4	3471.6
Yr 4 end	2000	(2000)	1471.6	347.2	347.2	1818.8
Yr 5 end	2000	(2000)	(182)	182	182	-0-