Differences between taxable income and the pre-tax income or profit number reported for financial statements are either temporary or permanent in nature. Permanent differences result when deductibility rules differ in perpetuity between accounting and tax law. Temporary differences result when the recognition of deductions for tax and accounting standards differ in their timing. The result is a gap between tax expense computed using income before tax and current tax payable computed using taxable income.
While companies still debit income tax expense and credit income tax payable, the difference between the two accounts requires an additional debit entry to the so-called deferred tax asset to balance the total journal entries. All companies and individuals who have a taxable income are liable to pay taxes. For companies, this translates into an expense on their income statements and takes away a significant part of their profits.
However, that liability would not be recognized for tax purposes (i.e. a “zero tax basis”), because the expense related to the product warranty would not be deductible on the income tax return until it was paid. Therefore, the expense and associated liability are recognized for financial reporting purposes before they are recognized for tax purposes. Since GAAP is based on the accrual method of accounting, an asset or liability should be recognized for these differences that have future tax consequences.
What is Income Tax Expense on Income Statement?
It places the $2,000 difference on its balance sheet as an asset – a “deferred tax asset.” This is money the company has already paid, but that it can be used to satisfy a future income tax expense in its financial accounting. Companies record both income tax expense and income tax payable in journal entries. For companies that use the cash basis for both financial and tax reporting, income tax expense equals income tax payable, the actual amount of tax to be paid. However, a difference exists between income tax expense and income tax payable if companies use the accrual basis for financial reporting and the cash basis for tax filing.
This can be done with the help of accounting standards like Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standard (IFRS). In the asset-liability method, deferred income tax amount is based on the expected tax rates for the periods in which the temporary differences reverse. Further, this column offers extensions to show how valuation allowances, differences in tax rates across time, and tax credits affect the ETR and how each item is presented in the rate reconciliation. On the other hand, say your company calculates its income tax expense at $10,000, but its actual tax bill is $12,000. Your company reports the expense of $10,000 and denotes $12,000 as tax payable.
All entities are required to disclose the current and deferred income tax expense components of the total income tax provision from continuing operations. T and P will each calculate current tax liability and expense by multiplying taxable income by the 21% corporate tax rate enacted in the law known as the Tax Cuts and Jobs Act (TCJA), P.L. Income tax payable is a current tax liability and is reported on the balance sheet.
Since income tax is to be paid only if there is taxable income, companies try to further minimize their taxable income by under-reporting profits or showing exaggerated losses. Further, given the different accounting methods, income reported for tax purposes sometimes varies from income reported for financial purposes.
Deferred Tax Asset
For example, a company has to pay one kind of tax on the salaries it pays to employees – payroll tax, then another tax on the purchase of any assets – sales tax. Further, there are taxes levied at the state or the national level as well. Hence, the correct tax rate should be determined as this will ultimately affect the income tax expense to be borne by the company.
This is where the mismatch between the income tax expense and the tax bill. Deferred tax expense was based on differences in the timing of reporting income and expenses in financial statements and tax returns. In this method, the deferred income tax amount is based on tax rates in effect when the temporary differences originated.
- We discussed the idea of calculating deferred tax expense in the overview section above.
- Future taxable amounts increase taxable income and result in deferred tax liabilities for financial reporting purposes; future deductible amounts decrease taxable income and result in deferred tax assets for financial reporting purposes.
Under this method, which focuses on the balance sheet, the amount of deferred income tax expense is determined by changes to deferred tax assets and liabilities. Companies first need to calculate their current income taxes payable or receivable, then figure out their deferred tax assets and liabilities. The calculation of deferred tax assets and liabilities should be based on enacted tax law, not future expectations/assumptions. Finally, deferred tax assets (like any other asset) need to be assessed for recoverability. Any amounts not deemed to be recoverable should be written off through expense.
If the tax expense exceeds the current tax payable then there is a deferred tax payable; if the current tax payable exceeds the tax expense then there is a deferred tax receivable. After the “amount owed to the government” (current tax payable) is calculated we must then determine whether any other income taxes have to be recognized for financial reporting purposes.
Income tax payable can also be considered the current income tax expense and doesn’t equal the total income tax expense for financial reporting using the accrual method. Since tax reporting uses the cash method that reports only cash revenues and cash expenses, taxable income will be lower or higher than the accrual financial income that includes non-cash revenue or non-cash expense. As a result, income tax payable for tax reporting is also lower or higher than income tax expense for financial reporting.
This depends on whether there are any temporary differences between the amounts reported for tax purposes and those reported for book purposes. U.S. GAAP, specifically ASC Topic 740, Income Taxes, requires income taxes to be accounted for by the asset/liability method. The asset and liability method places emphasis on the valuation of current and deferred tax assets and liabilities. The amount of income tax expense recognized for a period is the amount of income taxes currently payable or refundable, plus or minus the change in aggregate deferred tax assets and liabilities.
T would file an amended 2017 tax return incorporating the $10,000 loss carryback to generate a $3,500 income tax refund in 2019 for the tax previously paid on the offsetting capital gain. It records the $3,500 refund receivable and a corresponding decrease to current income tax expense. Because the $10,000 capital loss in 2019’s financial income generates an incremental $1,400 tax savings over the $2,100 benefit assumed in the starting point of the rate reconciliation, T reduces its 2019 ETR by 0.74% ($1,400 ÷ $190,000 pretax financial income).
Do You Record Income Tax Expenses in Journal Entries?
We discussed the idea of calculating deferred tax expense in the overview section above. Generally speaking, temporary differences can be divided into future taxable amounts and future deductible amounts. Future taxable amounts increase taxable income and result in deferred tax liabilities for financial reporting purposes; future deductible amounts decrease taxable income and result in deferred tax assets for financial reporting purposes. Deferred tax expense or benefit generally represents the change in the sum of the deferred tax assets, net of any valuation allowance, and deferred tax liabilities during the year. Income tax expense is the amount of expense that a business recognizes in an accounting period for the government tax related to its taxable profit.
Depending on the accounting standards given by GAAP and IFRS, often the reported income by companies on their income statements differs from the taxable income as determined by the tax code. One reason this may occur is that on one hand, as per accounting standards companies employ the straight-line depreciation method to determine depreciation for that financial year. On the other hand, as per the tax code, they are allowed to employ the accelerated depreciation method to determine the taxable profit.
This difference will result in a taxable or deductible amount in the future. For book purposes, a company would record a liability related to a product warranty.
The current income tax payable or receivable is recorded with the offset to the P&L (current tax expense). Deferred tax assets and liabilities are normally recorded with the offsetting entry to the P&L (deferred tax expense). A temporary difference is the difference between the asset or liability provided on the tax return (tax basis) and its carrying (book) amount in the financial statements.
Some corporations put so much effort into delaying or avoiding taxes that their income tax expense is nearly zero, despite reporting large profits. and elsewhere, companies are permitted to report one pre-tax income number (also called income before tax, profit before tax or earnings before income tax) to shareholders, and another, called taxable income, to the tax authorities.
Historically, in many places, a revenue-expense method was used, in which the income statement was seen as primary, and the balance sheet as secondary. The approach in United States Generally Accepted Accounting Principles was codified in SFAS 96 published in December 1987, and updated in February 1992 with SFAS 109, accounting for income taxes from a balance-sheet approach. The accounting and financial reporting of a regular corporation’s income taxes is complicated because the accounting principles are likely to be different from the income tax laws and regulations. Generally, a profitable regular corporation’s financial statements will report both income tax expense and a current liability such as income taxes payable.