Difficulty: Intermediate | Prerequisites: Introductory financial accounting, understanding of the difference between book income and taxable income, basic journal entries for expenses and liabilities.
Income tax accounting exists because the income a company reports on its financial statements (under GAAP) almost never matches the income it reports on its tax return. Chapter 16 explains how to account for those differences, which split into temporary differences (they reverse over time, creating deferred tax assets and liabilities) and permanent differences (they never reverse, so no deferred tax consequences). You need to be comfortable with the idea that book income and taxable income are computed under different rule sets before diving in. This chapter also covers net operating losses and the valuation allowance, both of which are reliable exam topics.
Temporary differences between book and tax income create deferred tax assets (future deductible amounts) or deferred tax liabilities (future taxable amounts). Permanent differences have no deferred tax effect. Income Tax Expense on the income statement equals Income Taxes Payable plus the net change in deferred tax accounts, and a valuation allowance reduces a DTA when realisation is not more likely than not.
Taxable income
Income reported on the tax return, computed in conformity with the tax code.
In simple terms, this is what the government says you earned.
Pretax financial income (book income)
Income reported on the financial statements, computed under GAAP.
In simple terms, this is what the company tells shareholders it earned.
Temporary difference
The difference between the tax basis of an asset or liability and its carrying amount on the financial statements. It will result in a taxable or deductible amount in future years when the asset is recovered or the liability is settled.
Think of it as: a timing gap. The total income recognised is the same under both systems; it just lands in different periods.
Permanent difference
An item that enters only into pretax financial income or only into taxable income, never both. There are no deferred tax consequences.
Examples: interest income on municipal bonds (book income only), expenses for fines (book expense only), life insurance premiums on executives (book expense only), dividends received deduction (tax only).
Deferred tax liability (DTL)
A credit balance representing future taxable amounts. Created when book income exceeds taxable income now, meaning additional tax will be owed later.
Think of it as: tax you have deferred paying.
Deferred tax asset (DTA)
A debit balance representing future deductible amounts. Created when taxable income exceeds book income now, meaning a tax benefit will come later.
Think of it as: tax you have prepaid, or a future tax break.
Income Tax Expense (on the income statement)
Equals Deferred Tax Expense (DTE) plus Income Taxes Payable (ITP). This is the total tax cost recognised on the financial statements for the period.
Income Taxes Payable (ITP)
Taxable Income multiplied by the tax rate. This is the actual amount owed to the government for the current year.
Deferred Tax Expense (DTE)
Equals the change in DTL minus the change in DTA (ΔDTL minus ΔDTA). If the liability goes up, so does the expense.
Valuation allowance
A contra account that reduces a DTA when it is more likely than not (greater than 50% probability) that some or all of the DTA will not be realised.
Net operating loss (NOL)
Occurs when taxable expenses exceed taxable revenue in a given year. Can be used to offset taxable income in other years through carryback or carryforward provisions.
The comprehensive allocation method provides deferred taxes for every item that enters taxable income in a period different from when it enters pretax financial income. It stresses matching revenues with expenses in the period they occur, consistent with accrual accounting. This method considers all timing differences, including amounts that may be unlikely to be paid in the foreseeable future.
Use this grid (rows = type of item, columns = when it is recognised for tax):
Recognised for tax NOW | Recognised for tax LATER | |
|---|---|---|
Revenue or gain | DTA | DTL |
Expense or loss | DTL | DTA |
DTA examples (revenue/gain taxed now, or expense/loss deducted later):
Unearned revenue: cash received is taxed now, but revenue is recognised for book purposes later.
Warranty or litigation expense: accrued for book purposes now, but the tax deduction comes later when cash is paid.
Accrued pension expense: recognised for book purposes now, deductible for tax when the employer contribution is paid.
Unrealised fair value loss: book loss now, tax benefit later when the sale occurs.
DTL examples (revenue/gain taxed later, or expense/loss deducted now):
Gross profit from instalment sales: recognised for book purposes now, but taxed later when cash is received.
Unrealised fair value gain: book gain now, taxed later when the sale occurs.
Depreciation differences: straight-line for book, accelerated for tax. The tax deduction is larger now, creating a DTL.
Prepaid advertising or subscription expense: tax benefit now when cash is paid, book expense later.
Permanent differences never reverse, so they produce no deferred tax consequences at all. You simply exclude them when computing deferred tax amounts.
Interest income on municipal bonds (in book income, never in taxable income)
Cash paid for life insurance premiums on an executive (book expense, never tax-deductible)
Expenses for fines (book expense, never tax-deductible)
Dividends received deduction (reduces taxable income, no effect on book income)
When taxable income exceeds pretax financial income (e.g. unearned revenue taxed now), the company has paid more tax than its book expense warrants. The excess is a DTA.
Year of origination:
Debit Income Tax Expense
Debit DTA
Credit Income Taxes Payable (or Cash)
Year(s) of reversal:
Debit Income Tax Expense
Credit DTA
Credit Income Taxes Payable
As the DTA reverses, Income Tax Expense rises and the DTA balance falls to zero.
When pretax financial income exceeds taxable income (e.g. instalment sale gross profit recognised for book now, taxed later), the company owes more tax in the future. The shortfall is a DTL.
Year of origination:
Debit Income Tax Expense
Credit DTL
Credit Income Taxes Payable (or Cash)
Year(s) of reversal:
Debit Income Tax Expense
Debit DTL
Credit Income Taxes Payable
As the DTL reverses, the DTL balance falls and Income Taxes Payable rises.
Income Tax Expense = Income Taxes Payable + Deferred Tax Expense
Income Taxes Payable = Taxable Income × Tax Rate
Deferred Tax Expense = ΔDTL minus ΔDTA
Net Income = Pretax Financial Income minus Income Tax Expense
Use enacted future tax rates to measure deferred tax amounts.
Do not use rates that are merely expected but not yet enacted.
When a new rate is enacted, adjust deferred tax balances immediately through Income Tax Expense in the period of enactment.
A DTA should be reduced by a valuation allowance if a portion or all of it is not expected to be realised. The threshold is "more likely than not" (slightly more than 50% probability) that the DTA will not produce a future tax benefit.
If evidence shows that $2,000 of a DTA will probably not be realised:
Debit Income Tax Expense $2,000
Credit Valuation Allowance, DTA $2,000
The valuation allowance is a contra asset. It reduces the net DTA on the balance sheet without eliminating the DTA account itself. If circumstances improve in a later year and realisation becomes more likely than not, the allowance is reversed (debit Valuation Allowance, credit Income Tax Expense).
An NOL occurs when taxable expenses exceed taxable revenue in a year. NOLs can offset taxable income in other years.
Loss carryback: NOLs could be carried back two years to recover taxes already paid. The NOL had to be applied to the earliest profitable year first.
Journal entry for carryback: Debit Receivable, Income Tax Refund (sum of the last two profitable years' income × rate), credit Income Tax Benefit.
Remaining loss after carryback: Carry forward the difference (total loss minus the income absorbed by the two carryback years).
Loss carryforward: If the NOL was not fully absorbed by carryback, it could be carried forward for up to 20 years. NOL carryforwards are treated as DTAs.
NOLs created after 2017 face an 80% limit on the deduction against taxable income in any future year. (You can only offset up to 80% of that year's taxable income, not 100%.)
NOLs can be carried forward indefinitely (no 20-year cap).
Loss carrybacks are not allowed for NOLs created after 2017.
You need to know both sets of rules for the exam, as problems may test either era.
Deferred tax amounts (including any valuation allowance) are classified as one net noncurrent amount.
Disclose the total of all DTLs, the total of all DTAs and the total valuation allowance.
Disclose any change in these amounts during the year.
Income tax expense (or benefit) should be allocated across: continuing operations, discontinued operations, cumulative effect of accounting changes and prior period adjustments.
This allocation is called intraperiod tax allocation: the tax effect follows the item that caused it.
Students often confuse temporary and permanent differences. A permanent difference (e.g. municipal bond interest) never creates a DTA or DTL. If you find yourself recording deferred tax on a permanent item, stop.
Students sometimes think Income Tax Expense equals Income Taxes Payable. It does not. Income Tax Expense also includes the deferred tax component (the change in DTL minus the change in DTA).
Students forget that the valuation allowance threshold is "more likely than not" (just over 50%), not "probable" or "virtually certain." It is a relatively low bar.
Students mix up the pre-2018 and post-2017 NOL rules. After 2017, there is no carryback and the carryforward deduction is capped at 80% of that year's taxable income.
⚠️ Valuation allowance problems are a near-certainty on the exam. Know the journal entry and the "more likely than not" threshold.
⚠️ DTA recognition problems typically involve unearned revenue, warranty expense or accrued pension expense. Be able to set up the origination entry and the reversal entries across multiple years.
⚠️ DTL problems on the exam focus heavily on excess tax depreciation (accelerated for tax, straight-line for book). Know how to schedule the origination and reversal.
⚠️ NOL carryback and carryforward problems test both the old rules (two-year carryback, 20-year carryforward, 100% offset) and the TCJA rules (no carryback, indefinite carryforward, 80% limit).
⚠️ Be prepared to compute Income Tax Expense as the sum of Income Taxes Payable and Deferred Tax Expense, working through the changes in DTL and DTA balances.
True or False: Interest income on municipal bonds creates a deferred tax asset.
Answer: False. It is a permanent difference with no deferred tax consequences.
Fill in the blank: Income Tax Expense = Income Taxes Payable + ______.
Answer: Deferred Tax Expense (ΔDTL minus ΔDTA).
True or False: Under the TCJA, NOLs created after 2017 can be carried back two years.
Answer: False. Post-2017 NOLs cannot be carried back at all.
Fill in the blank: A valuation allowance is created when the probability that a DTA will not be realised is ______.
Answer: more likely than not (slightly more than 50%).
True or False: Deferred tax amounts are classified as current assets or current liabilities on the balance sheet.
Answer: False. They are classified as one net noncurrent amount.
Q: A company has pretax financial income of $100,000 and taxable income of $80,000. The difference is entirely due to excess tax depreciation. The tax rate is 25%. What are Income Taxes Payable, Deferred Tax Expense and Income Tax Expense?
A: Income Taxes Payable = $80,000 × 25% = $20,000. The $20,000 temporary difference creates a DTL of $20,000 × 25% = $5,000. Deferred Tax Expense = ΔDTL = $5,000. Income Tax Expense = $20,000 + $5,000 = $25,000.
Q: A company records $3,000 of warranty expense for book purposes in 2024 but does not pay the warranty claims until 2025. The tax rate is 30%. What deferred tax account is created, and what is the journal entry in 2024?
A: A DTA of $3,000 × 30% = $900 is created. Entry: Debit Income Tax Expense, Debit DTA $900, Credit Income Taxes Payable (for the full tax on taxable income).
Q: In 2023, a company has an NOL of $50,000. Under pre-2018 rules, the two prior years had taxable income of $15,000 (2021) and $25,000 (2022). The tax rate is 25%. What is the journal entry for the carryback?
A: Total income absorbed = $15,000 + $25,000 = $40,000. Refund = $40,000 × 25% = $10,000. Debit Receivable, Income Tax Refund $10,000, Credit Income Tax Benefit $10,000. The remaining $10,000 loss is carried forward as a DTA.
Q: Under the TCJA, a company has an NOL carryforward of $100,000 and current-year taxable income (before the NOL deduction) of $60,000. How much of the NOL can be deducted this year?
A: 80% of $60,000 = $48,000. The remaining $52,000 carries forward indefinitely.
Q: A company has a DTA of $12,000. Management determines it is more likely than not that $4,000 will not be realised. What entry is recorded?
A: Debit Income Tax Expense $4,000, Credit Valuation Allowance, DTA $4,000.
Income tax accounting ties directly to leases (Chapter 15) because the book treatment of lease assets and liabilities often differs from the tax treatment, creating temporary differences. It also connects to revenue recognition, since differences in when revenue is recognised for book and tax purposes (e.g. instalment sales) are a classic source of DTLs. The depreciation differences that drive most DTL problems link back to long-lived asset accounting. Understanding accrual vs. cash-basis accounting is foundational to grasping why these differences arise at all.
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