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.
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.
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