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Deferred Income Tax
For several reasons, the amount of income tax owed based on accounting principals and the taxes owed based on governmental tax codes can differ.
Why is there a Difference?
- Accounting principles are designed using the accrual method of accounting to be relevant investors.
- Tax codes are designed by governments to generate tax revenues.
- Revenue and expense recognition can differ greatly.
Permanent Differences
Differences in net income and taxable income caused by revenues or expenses that are recognized by either financial reporting or tax purposes, but not both.
- Revenue and expense items are included on the financial statements.
- Income taxes related to these items are not included on financial statements.
Temporary Differences
Differences between net income and taxable income caused by revenue or expense items that are recognized for both financial reporting and tax purposes, but in different periods.
- Income tax expense is based on net income according to financial reporting principles (GAAP, IFRS)
- Income tax payable is based on taxable income according to local tax codes.
- Deferred income tax is the difference between the income tax expense and payable
- Deferred income tax asset: Occurs when taxes are paidbeforeincome tax is recorded on the income statement.
- Deferred income tax liability: Occurs when taxes are paidafterincome tax is recorded on the income statement.
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Example: Deferred Income Taxes - Permanent Differences
A company reported the following information on its 2025 income statement:
Total revenues include $85,000 of sales revenue and $4,000 of interest revenue earned on government bonds issued by the state of New York. The local tax code states that interest earned on state issued bonds is not taxable. If the company is subject to a 32% tax rate, what is the correct amount of net income that should be reported on the income statement?
Practice: Deferred Income Taxes - Permanent Differences
Alpha Corp. has hired you to correct a mistake made by its bookkeeper. The company reported the following information on its income statement for the year 2024 and submitted this information when filing its taxes for the year.
During 2024, the company received a fine totalling $2,000 due to one of the company's technicians accidentally trespassing on the wrong property while on a service call. The fine was included in operating expenses, but the company has been informed that local tax laws do not allow fines to be deducted for tax purposes.
What is the correct amount of net income that should be reported on the income statement?
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Example: Deferred Income Taxes - Temporary Differences
ABC Inc. reported the following on its financial statements for the two most recent years:
The company reported depreciation expense of $9,500 in both Years 1 and 2, however according to the tax code, depreciation expense for tax purposes is $11,000 and $6,000 in Years 1 and 2 respectively. The company records income tax expense on December 31st.
1. What is the taxable income under tax code for both years?
2. Prepare the journal entry to record the income tax expense in Year 1.
3. Prepare the journal entry to record the income tax expense in Year 2.
Practice: Deferred Income Taxes - Temporary Differences
Nexx Ltd., an auto repair shop, reported earnings before tax of $345,500 in 2023 and $433,400 in 2024. In 2023, the company began the year with $6,000 in supplies inventory, purchased and paid for $70,000 more and ended the year with $9,500 of supplies on hand. The local tax code considers only supplies paid for during the taxation period as tax deductible expenses, even if they have not been used.
The company is subject to a 25% income tax rate.
What is the amount of income taxes payable for 2023?
Practice: Deferred Income Taxes - Temporary Differences
In 2026, ABC Inc. reported total revenues of $600,000 on its income statement. Expenses (excluding income taxes) totalled $450,000 and the company is subject to a tax rate of 22%. During the year, the company collected $50,000 from a customer for services to be provided in 2027. The local tax code states that cash collected from customers is taxable in the year it is collected.
In 2027, the company reported total revenues of $644,000 and expenses (excluding income taxes) of $483,500.
What is the company's net income for financial reporting purposes and for tax purposes?