Question

What is the difference between an income tax expense and an income tax payable, demonstrating an understanding of the difference between GAAP and tax reporting. Identify are three temporary differences and discuss how the deferred tax asset or deferred tax liability is recorded and consumed.

Identify three permanent differences and examine the reporting of permanent differences.

Answer 1

Defference Between Income Tax Expense and Income Tax Payable

Income Tax Expense

Income tax expense is an income statement account that you use to record federal and state income tax costs. The accrual method of accounting requires you to show expenses in the period that the expense is incurred, rather than in the period that the expense is paid. Therefore, although you may pay taxes annually or quarterly, you should do an adjusting entry during each period for which you produce an income statement. The entry to income tax expense will be a debit because you are increasing the expense account. Typically, income tax expense is shown right after the total of income before tax and just before net income or loss.

Income Tax Payable

Income tax payable is a liability account that is shown on the balance sheet. You use it to record any income tax amount that you owe but have not yet paid to the appropriate taxing authority. When you do your adjusting entry each period and debit income tax expense, you will credit income tax payable. When you actually pay the income tax liability, you will debit income tax payable and credit cash. However, there are certain situations when net income reported according to generally accepted accounting principles does not equal taxable income as reported on your tax return. Generally, this is a temporary situation that evens out over time. Until then, you need to record those differences to an asset or liability account titled "Deferred Tax."

• Trial Balance

You must create a trial balance for the month. Do this by creating two columns. The column on the left should contain all of your debits for the month. The column on the right should contain all of your credits for the month. The two columns should have totals that match. The reason theymatch is that even if your income exceeds your expenses, you should show a debit that puts the excess income into an account.

• Adjusting Entries

At the end of the month, or sometimes during the following month, you may find debits and credits you did not record on your trial balance. Add the missing entries and balance the sheet so that debits match credits. This adjusted trial balance sheet is your opportunity to correct not only missing information that was left out of the trial balance, but also a chance to actually balance debits and credits. Your trial balance sheet may have been out of balance, and your adjusted balance sheet can create balanced columns because of the new information contained in the adjusting entries.

• Errors

You may have errors, even if your debit and credit columns have matching totals. For example, you may have placed an asset in the wrong category, or you may have used the wrong account to record an expense.

• Typical Adjustments

You will find that your adjusting entries come from some predictable areas. For example, payroll taxes usually have to be entered late in the month or during the following month because final figures for these taxes are not available until the month’s total wages have been figured.

Defference Between GAAP and Tax Reporting

GAAP

GAAP is the most common financial reporting standard in the United States. The Securities and Exchange Commission requires public companies to follow it. Many lenders expect private borrowers to follow suit, because GAAP is familiar and consistent.

In a nutshell, GAAP is based on the principle of conservatism, which generally ensures proper matching of revenue and expenses with a reporting period. The principle also aims to prevent businesses from overstating profits and asset values to mislead investors and lenders.

Tax-basis reporting

Compliance with GAAP can also be time-consuming and costly, depending on the level of assurance provided in the financial statements. So some smaller private companies opt to report financial statements using a special reporting framework. The most common type is the income-tax-basis format.

Tax-basis statements employ the same methods and principles that businesses use to file their federal income tax returns. Contrary to GAAP, tax law tends to favor accelerated gross income recognition and won’t allow taxpayers to deduct expenses until the amounts are known and other requirements have been met.

Key differences

When comparing GAAP and tax-basis statements, one difference relates to terminology used on the income statement: Under GAAP, businesses report revenues, expenses and net income. Tax-basis entities report gross income, deductions and taxable income. Their nontaxable items typically appear as separate line items or are disclosed in a footnote.

Capitalization and depreciation of fixed assets is another noteworthy difference. Under GAAP, the cost of a fixed asset (less its salvage value) is capitalized and systematically depreciated over its useful life. Businesses must assess whether useful lives and asset values remain meaningful over time and they may occasionally incur impairment losses if an asset’s market value falls below its book value.

For tax purposes, fixed assets typically are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which generally results in shorter lives than under GAAP. Salvage value isn’t subtracted for tax purposes, but Section 179 expensing and bonus depreciation are subtracted before computing MACRS deductions.

Other reporting differences exist for inventory, pensions, leases, and accounting for changes and errors. In addition, businesses record allowances for bad debts, sales returns, inventory obsolescence and asset impairment under GAAP. But these allowances generally aren’t permitted under tax law; instead, they’re deducted when transactions take place or conditions are met that make the amount fixed and determinable. Tax law also prohibits the deduction of penalties, fines, start-up costs and accrued vacations (unless they’re taken within 2½ months after the end of the taxable year).

Tax-basis reporting is a shortcut that makes sense for certain types of businesses. But for others, tax-basis financial statements may result in missing or even misleading information. Contact us to discuss which reporting model will work the best for your business.

Difference Between Deferred Tax Asset (DTA) and Deferred Tax Liability (DTL)

The basic difference between deferred tax asset and deferred tax liability is the difference in income that is computed as per the provisions of different laws. While computing income for the purpose of calculating tax liability, the provisions of Income Tax Act, 1961 are applicable whereas while computing income for disclosure in Financial Statements principles of financial accounting are applicable. Some differences that arise due to application of different provisions of law are temporary differences i.e. the differences that get eliminated over a period of time. These temporary differences are accounted for, recognized and carried forward in the books of accounts and accordingly Deferred tax asset A/C and Deferred tax liability A/C are created.

Basic Defference:

When profits as per tax laws is more than profits as per books of accounts,Deferred tax asset is required to be created.When profits as per tax laws is less than profits as per books of accounts,Deferred tax liability is required to be created.

Creation of deferred tax asset is subject to the principles of prudence.Creation of deferred tax liability is subject to payment of minimum Alternative Tax (MAT).

Deferred Tax Asset journal entry

Deferred Tax Asset A/C……. Dr

            To Profit & Loss A/C……….

Deferred Tax liability journal entry

Profit & Loss A/C ……. Dr
       To Deferred Tax Liability A/C…...

It is shown under the head of Non- Current Assets in the balance sheet.It is shown under the head of Non- Current Liability in the balance sheet.

Defered Tax Assets

It is shown under the head of Non- Current Liability in the balance sheet.Items on a company's balance sheet that may be used to reduce taxable income in the future are called deferred tax assets. The situation can happen when a business overpaid taxes or paid taxes in advance on its balance sheet. These taxes are eventually returned to the business in the form of tax relief. Therefore, overpayment is considered an asset to the company. A deferred tax asset is the opposite of a deferred tax liability, which can increase the amount of income tax owed by a company

Deferred tax assets are often created due to taxes paid or carried forward but not yet recognized on the income statement. For example, deferred tax assets can be created due to the tax authorities recognizing revenue or expenses at different times than that of an accounting standard. This asset helps in reducing the company’s future tax liability. It is important to note that a deferred tax asset is recognized only when the difference between the loss-value or depreciation of the asset is expected to offset future profit.

A deferred tax asset is an item on the balance sheet that results from overpayment or advance payment of taxes.It is the opposite of a deferred tax liability, which represents income taxes owed. A deferred tax asset can arise when there are differences in tax rules and accounting rules or when there is a carryover of tax losses. Beginning in 2018, most companies can carryover a deferred tax assets indefinitely.

A deferred tax asset can conceptually be compared to rent paid in advance or refundable insurance premiums; while the business no longer has cash on hand, it does have comparable value, and this must be reflected in its financial statements.

Deffered Tax Liability

Deferred tax liability is a tax that is assessed or is due for the current period but has not yet been paid. The deferral comes from the difference in timing between when the tax is accrued and when the tax is paid. A deferred tax liability records the fact the company will, in the future, pay more income tax because of a transaction that took place during the current period, such as an installment sale receivable.

Because U.S. tax laws and accounting rules differ, a company's earnings before taxes on the income statement can be greater than its taxable income on a tax return, giving rise to deferred tax liability on the company's balance sheet. The deferred tax liability represents a future tax payment a company is expected to make to appropriate tax authorities in the future, and it is calculated as the company's anticipated tax rate times the difference between its taxable income and accounting earnings before taxes.

A simple way to define the deferred tax liability is the amount of taxes a company has "underpaid"—which will (eventually) be made up in the future. By saying it has underpaid doesn't necessarily mean that it hasn't fulfilled its tax obligations, rather it is recognizing that the obligation is paid on a different timetable.

Reporting of Permanent Defferences

Permanent differences arise when there is a difference between the tax base and the carrying amount of assets and liabilities.

Financial Accounting

Examples of items recognized by financial accounting but not allowed by tax law are interest income received on tax-exempt securities, life insurance premiums paid for key officers or employees, fines and expenses for violating the law, and book depreciation in excess of the amount allowed by tax law. These items are recorded in a business's books but never on a tax return.

Tax Accounting

Examples of items allowed by tax law but not by financial accounting include the dividends-received deduction and the deduction for percentage depletion of natural resources in excess of their cost. These items are part of a tax return but never recorded in a business's books.

Another item that creates a permanent difference is expenses for meals and entertainment. The IRS generally allows only a 50 percent deduction for these expenses, while the financial statements record 100 percent of the expenses.

Permanent Defferences

• Permanent differences have no effect on the taxes or other aspects of a business
• Are easy to deal with from an accounting perspective.
• What is harder to deal with are temporary differences, because they require more tracking and understanding of the tax code.