It's important to understand that a temporary difference originates in one period and reverses, or turns around, in one or more subsequent periods. The temporary difference described above originates in the year the installment sales are made and are reported in the income statement and then reverses when the installments are collected and income is reported on the tax return. An example is provided in Illustration 16-1.
Revenue Reported on the Tax Return after the Income Statement
In 2011, taxable income is less than accounting income because income from installment sales is not reported on the tax return until 2012–2013.
Kent Land Management reported pretax accounting income in 2011, 2012, and 2013 of $100 million, plus additional 2011 income of $40 million from installment sales of property.5 However, the installment sales income is reported on the tax return when collected, in 2012 ($10 million) and 2013 ($30 million).* The enacted tax rate is 40% each year.†
*The installment method is not available to accrual method taxpayers. H.R. 1180, sec. 536, 1999.
†The enacted rate refers to the tax rate indicated by currently enacted tax legislation (as distinguished from anticipated legislation). This is discussed later in the chapter.
Notice that pretax accounting income and taxable income total the same amount over the three-year period but are different in each individual year. In 2011, taxable income is $40 million less than accounting income because it does not include income from installment sales. The difference is temporary, though. That situation reverses over the next two years. In 2012 and 2013 taxable income is more than accounting income because income from the installment sales, reported in the income statement in 2011, becomes taxable during the next two years as installments are collected.
Because tax laws permit the company to delay reporting this income as part of taxable income, the company is able to defer paying the tax on that income. The tax is not avoided, just deferred. In the meantime, the company has a liability for the income tax deferred. The liability originates in 2011 and is paid over the next two years as follows:
The 2011 tax liability is paid in the next two years.
At the end of 2011, financial and taxable income for 2012 and 2013 are, of course, not yet known. We assumed knowledge of that information above so we could compare the three-year effect of the temporary difference, but seeing the future is unnecessary to determine amounts needed to record income taxes in 2011. This is demonstrated in Illustration 16-1A.
Determining and Recording Income Taxes—2011
With future taxable amounts the future tax consequence of temporary difference will be to increase taxable income relative to accounting income. of $40 million, taxable at 40%, a $16 million deferred tax liability taxes to be paid in the future when future taxable amounts become taxable (when the temporary differences reverse). is indicated. Since no previous balance exists, we add this amount to the liability.
Each year, income tax expense comprises both the current and the deferred tax consequences of events and transactions already recognized. This means we:
Calculate the income tax that is payable currently.
Separately calculate the change in the deferred tax liability (or asset).
Combine the two to get the income tax expense.
Using the 2012 and 2013 income numbers, the journal entries to record income taxes for those years would be:
At the end of 2012, the deferred tax liability should have a balance of $12 million. Because the balance from 2011 is $16 million, we reduce it by $4 million.
At the end of 2013, the deferred tax liability should have a balance of zero. So, we eliminate the $12 million balance.
The FASB's Balance Sheet Approach
Our perspective in this example so far has centered around the income effects of the installment sales and thus on the changes in the deferred tax liability as the temporary difference reverses. Another perspective is to consider the balance sheet effect. From this viewpoint, we regard a deferred tax liability (or asset) to be the tax effect of the temporary difference between the financial statement carrying amount of an asset or liability and its tax basis. The tax basis of an asset or liability is its original value for tax purposes reduced by any amounts included to date on tax returns. In our example, a temporary book-tax difference exists for a receivable from installment sales that's recognized for financial reporting purposes but not for tax purposes. When a company sells something on an installment basis, it reports a receivable. From a tax perspective, though, there is no receivable because a “taxable sale” doesn't occur until installments are collected. This is shown in Illustration 16-1B.
Current GAAP focuses on the balance sheet and the recognition of
liabilities and assets.
An installment receivable has no tax basis.
Balance Sheet Perspective
The deferred tax liability each year is the tax rate times the temporary difference between the financial statement carrying amount of the receivable and its tax basis.
Of course, the income statement view and the balance sheet view are two different perspectives on the very same event. In this example, we derive the same deferred tax liability whether we view it as a result of a temporary difference (a) between accounting and taxable income or (b) between the financial statement carrying amount of an installment receivable and its tax basis. Conceptually, though, the balance sheet approach strives to establish deferred tax assets and liabilities that meet the definitions of assets and liabilities provided by the FASB's conceptual framework. As specified by SFAC 6, assets represent “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events,” and liabilities are “probable future sacrifices of economic benefits as a result of past transactions or events.”6 In our example, the probable future sacrifices of economic benefits are the payments of $4 million in 2012 and $12 million in 2013. The past transactions or events resulting in the future tax payments are the installment sales in 2011.
This balance sheet approach, sometimes called the “asset/liability approach,” is a perspective that extends beyond accounting for deferred taxes. In fact, the FASB and IASB increasingly appear to be moving to that perspective in their approach to accounting standards. The movement toward fair values we discussed in Chapters 12 (Investments) and 14 (Bonds and Long-term Notes) is consistent with that perspective. Measuring assets and liabilities at their fair values and then reporting changes in those fair values as holding gains and losses in the income statement is a fundamental departure from the “transactions approach,” by which we report in the income statement the effects of external transactions such as gains and losses from the sale of assets and liabilities.
Recent accounting standards provide evidence that U.S. and international standard setters are embracing a “balance sheet approach” to accounting.
Types of Temporary Differences
Examples of temporary differences are provided in Graphic 16-1.
Types of Temporary Differences
The temporary differences shown in the diagonal purple areas create deferred tax liabilities because they result in taxable amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse).
The temporary differences in the opposite diagonal blue areas create deferred tax assets because they result in deductible amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse).
Temporary differences between the reported amount of an asset or liability in the financial statements and its tax basis are primarily caused by revenues, expenses, gains, and losses being included in taxable income in a year other than the year in which they are recognized for financial reporting purposes as illustrated in Graphic 16-1. Other events also can cause temporary differences between the reported amount of an asset or liability in the financial statements and its tax basis. Three other such events that are beyond the scope of this textbook are briefly described in FASB ASC 740–10–25: Income Taxes–Overall–Recognition (previously “Accounting for Income Taxes,” Statement of Financial Accounting Standards No. 109 (Norwalk, Conn.: FASB, 1992), par. 11 e–h). Our discussions in this chapter focus on temporary differences caused by the timing of revenue and expense recognition, but it's important to realize that the concept of temporary differences embraces all differences that will result in taxable or deductible amounts in future years.
Be sure to notice that deferred tax liabilities can arise from either (a) a revenue being re-ported on the tax return after the income statement or (b) an expense being reported on the tax return before the income statement. Our previous illustration was of the first type. We look at the second type in Illustration 16-2.
Notice, too, that this temporary difference originates during more than a single year before it begins to reverse. This usually is true when depreciation is the cause of the temporary difference. Tax laws typically permit the cost of a depreciable asset to be deducted on the tax return sooner than it is reported as depreciation in the income statement.7 This means taxable income will be less than pretax accounting income in the income statement during the years the tax deduction is higher than income statement depreciation, but higher than pretax accounting income in later years when the situation reverses.
Expense Reported on the Tax Return before the Income Statement
To determine taxable income, we add back to accounting income the actual depreciation taken in the income statement and then subtract the depreciation deduction allowed on the tax return.
Courts Temporary Services reported pretax accounting income in 2011, 2012, 2013, and 2014 of $100 million. In 2011, an asset was acquired for $100 million. The asset is depreciated for financial reporting purposes over four years on a straight-line basis (no residual value). For tax purposes the asset's cost is deducted (by MACRS) over 2011–2014 as follows: $33 million, $44 million, $15 million, and $8 million. No other depreciable assets were acquired. The enacted tax rate is 40% each year.
2011 income taxes would be recorded as follows in Illustration 16-2A:
Determining and Recording Income Taxes—2011
Taxable income is $8 million less than accounting income because that much more depreciation is deducted on the 2011 tax return ($33 million) than is reported in the income statement ($25 million).
Income tax expense is comprised of two components: the amount payable currently and the amount deferred until later.
Let's follow the determination of income taxes for this illustration all the way through the complete reversal of the temporary difference. We assume accounting income is $100 million each year and that the only difference between pretax accounting income and taxable income is caused by depreciation. 2012 income taxes would be determined as shown in Illustration 16-2B on the next page.
Notice that each year the appropriate balance is determined for the deferred tax liability. That amount is compared with any existing balance to determine whether the account must be either increased or decreased.
Determining and Recording Income Taxes—2012
The cumulative temporary difference ($27 million) is both (a) the sum of the amounts originating in 2011 ($8 million) and in 2012 ($19 million) and (b) the sum of the amounts reversing in 2013 ($10 million) and in 2014 ($17 million).
Since a balance of $3.2 million already exists, $7.6 million must be added.
Income taxes for 2013 would be recorded as shown in Illustration 16-2C.
Determining and Recording Income Taxes—2013
A credit balance of $6.8 million is needed in the deferred tax liability account.
Since a credit balance of $10.8 million already exists, $4 million must be deducted (debited).
A portion of the tax deferred from 2011 and 2012 is now being paid in 2013.
Income taxes for 2014 would be recorded as shown in Illustration 16-2D:
Determining and Recording Income Taxes—2014
Because the entire temporary difference has now reversed, there is a zero cumulative temporary difference, and the balance in the deferred tax liability should be zero.
Since a credit balance of $6.8 million exists, that amount must be deducted (debited).
The final portion of the tax deferred from 2011 and 2012 is paid in 2014.
Notice there that the deferred tax liability is increased in 2011–2012 and decreased in 2013–2014.
The deferred tax liability increases the first two years and is paid over the next two years.
We can see this result from the alternate perspective of looking at the temporary book–tax difference that exists for the depreciable asset. Its carrying amount is its cost minus accumulated straight-line depreciation. Its tax basis is cost minus the accumulated cost recovery for tax purposes:
A balance sheet perspective focuses on the difference between the carrying amount and the tax basis.