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C. Deferred Tax Assets and Liabilities

C. Deferred Tax Assets and Liabilities

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Module 14: Deferred Taxes



541



amount of expense stemming from this contingent liability must be added back to financial (book)

income to arrive at taxable income. Therefore, a deferred tax asset is created.









1] When the probable and measurable future event does actually occur, the contingent liability will

then represent a loss (deductible amount) on the tax return. Because the tax loss recognized will

reduce taxable income and income taxes payable, the amount of cash that will be needed to pay

the taxes due will be decreased.

2] Remember, an asset is defined in SFAC 6 as a “probable future economic benefit obtained or

controlled by a particular entity as a result of past transactions or events.” The reduction of

current tax expense and the resulting future decrease in cash paid out for taxes (an economic

benefit) will result from the contingent liability (a past transaction or event). Therefore, the

future tax impact of the current period difference between the financial statement value and tax

basis represents a deferred tax asset in the year the contingency is recognized.

NOTE: The deferred tax expense recorded in this situation is a credit because it represents a current

period benefit.



2.

Scheduling and Recording Deferred Tax Amounts











a. An entity’s total income statement provision for income taxes is the sum of that entity’s current and deferred

tax amounts.

(1)The current tax expense or benefit is defined by ASC Topic 740 (SFAS 109) as “the amount of

income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the

tax law to the taxable income or excess of deductions over revenues for that year.”

(2)The deferred tax expense or benefit is defined as “the change during the year in an enterprise’s

deferred tax liabilities or assets.”

(3) Current and deferred tax amounts are computed independently.







b. The deferred tax amount (the future tax consequences of temporary differences) should be recorded in the

current financial statements at the amounts that will be paid or recovered based upon tax laws and rates that

are already in place and due to be in effect at the date of payment or recovery.







(1) These are known as enacted tax laws and enacted tax rates. An entity must, therefore, determine when

the identified and measured temporary differences will become taxable or deductible.

(2)Future taxable amounts cause taxable income to be greater than financial (book) income in future

periods. They are a result of existing temporary differences and are reported as deferred tax liabilities in

the current year.

(3)Future deductible amounts cause taxable income to be less than financial (book) income in future

periods. They are a result of existing temporary differences and are reported as a deferred tax asset in

the current year.

(4) For illustrative purposes, the following examples show the scheduling of future temporary differences.











NOTE: In practice and on the CPA exam, extensive scheduling is generally not necessary unless (1) there is

a change in future enacted tax rates or (2) the problem requires the use of a valuation allowance account.



















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c. Deferred tax liabilities and assets are determined separately for each tax-paying component (an individual

entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction. That determination

includes the following procedures:

(1) Identify the types and amounts of existing temporary differences.

(2) Identify the nature and amount of each type of operating loss and tax credit carryforward and the

remaining length of the carryforward period.

(3) Measure the total deferred tax liability for taxable temporary differences using the applicable tax rate.

(4) Measure the total deferred tax asset for deductible temporary differences and operating loss

carryforwards using the applicable tax rate.

(5) Measure deferred tax assets for each type of tax credit carryforward.



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(6) Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is

more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets

will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the

amount that is more likely than not to be realized.

(7) Deferred tax assets and liabilities are not discounted to reflect their present value.







EXAMPLE 2

This example shows the deferred tax accounting in year 3, year 4, and year 5 for the temporary differences

included in Example 1 earlier in this module. Additional details are













a. On 1/1/Y1 the enterprise acquired a depreciable asset for $30,000 that had an estimated life of six years and

is depreciated on a straight-line basis for book purposes. For tax purposes, the asset is depreciated using the

straight-line election under MACRS and qualifies as a three-year asset.

b. The enterprise deducted warranty expense of $500 for book purposes in year 3 that is expected to be

deductible for tax purposes in year 4.

c. Taxable income was $110,500 in year 3, $112,000 in year 4, and $113,500 in year 5.

d. The applicable tax rate is 40% for all years affected.



The deferred component of income tax expense for year 3 is computed as follows. First, a schedule of the

­temporary depreciation differences for all affected years is prepared:



Book depreciation

Tax depreciation

Temporary difference:

No difference

Book deprec. < Tax deprec.

Book deprec. > Tax deprec.



Year 1



Year 2



Year 3



Year 4



Year 5



Year 6



$ 5,000

  5,000*



 $ 5,000

  10,000



 $ 5,000

  10,000



$5,000

  5,000*



$5,000





$5,000





$(5,000)



$(5,000)

$5,000



$5,000



   $ 0



   $ 0



* Due to MACRS half-year convention



Then, a schedule of future taxable (deductible) amounts is prepared.

Year 4

Taxable

(deductible)

Scheduled taxable

(deductible) amounts:

Depreciation differences:

taxable amounts

Warranty differences:

deductible amounts



$(500)



Year 5

Taxable

(deductible)



Year 6

Taxable

(deductible)



Tax

rate



Deferred tax

liability

(asset)



$5,000



$5000



40%



$4,000 Noncurrent



40%



$(200) Current



The above schedule shows that the future tax benefit (deductible amount) in year 4 of the $500 temporary

d­ ifference resulting from the Warranty Expense Liability must be recognized automatically as a deferred tax asset in

year 3. The deferred tax asset of $200 ($500 × 40%) should be reported as a current asset at 12/31/Y3 because the

classification of the temporary difference is based on the related asset or liability, in this case a warranty liability that

is expected to be satisfied in the next year. The amount of future taxes payable (deferred tax liability) associated with

the total temporary difference of $10,000 resulting from excess depreciation [$5,000 (year 3) + $5,000 (year 4)] is

$4,000 [($5,000 + 5,000) × 40%]. The $4,000 amount is reported as a noncurrent deferred tax liability at 12/31/Y3,

because classification as current or noncurrent is based on the classification of the related asset or liability, in this

case a depreciable asset that is noncurrent.

Once the deferred tax asset and deferred tax liability have been measured at year-end, a journal entry is necessary to adjust the deferred tax account balances to the current year-end amount. As stated earlier, income tax expense

for the year will consist of the taxes currently payable (based on taxable income) plus or minus any change in the

deferred tax accounts.

Equation for Determining Income Tax Expense

Income tax

Income tax

Change in

expense for financial = payable from ±

deferred

reporting

the tax return

taxes (net)*

* Ending balance of deferred tax liability/asset (net) less beginning balance of deferred tax liability/asset (net)



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Notes:

1.



Income Tax Expense is the sum of the two numbers on the right side of the equation.

Each of these two numbers is determined directly using independent calculations. It is

not possible to derive Income Tax Expense from pretax financial accounting income

adjusted for permanent differences, unless the tax rate is constant for all years affected.

2.The ± refers to whether the change is a credit or additional liability (+) or a debit or

additional asset (–).

3. Income Tax Payable is the amount of taxes calculated on the corporate tax return. It is

the amount legally owed the government (after credits).

4. One deferred tax (net) balance sheet account may be used in practice. If separate asset

and liability accounts are used, the changes in each account would all be netted to

determine the deferred tax component of income tax expense.



EXAMPLE

To illustrate, we will use the deferred tax liability computed in Example 2 above and the taxable income derived in

Example 1. Note that at the end of year 3, but prior to adjustment, the deferred tax asset account had a zero ­balance

and the deferred tax liability account had a balance of $2,000 ($5,000 × 40%) that was recognized as a result of

the accumulated depreciation temporary difference that originated in year 1. (Refer to the schedule following the

additional information given in Example 2 showing depreciation and the pattern of temporary differences and to

the T-account under (c) below.) To focus on the two components of income tax expense, two entries rather than the

­typical combined entry will be used.

Income tax expense—current

  Income tax payable (a)





44,200

44,200



(a) $110,500 taxable income (from Example 1) × 40% = $44,200

Income tax expense—deferred (d)

Deferred tax asset—current (b)

  Deferred tax liability—noncurrent (c)







1,800

200

2,000



(b) $500 × 40% = $200 needed Ending balance; $200 Ending balance – $0 Beginning balance = $200 increase

needed in the account

Deferred Tax Asset

Beg. bal.







0



Increase (b)



200



End. bal.



200



(c) $10,000 × 40% = $4,000 needed Ending balance; $4,000 Ending balance – $2,000 Beginning balance =

$2,000 increase needed in the account

Deferred Tax Liability

2,000



Beg. bal.



2,000



Increase (c)



4,000



End. bal.







(d) $2,000 increase in noncurrent deferred tax liability account – $200 increase in current deferred tax asset

account = $1,800

The bottom of the income statement for year 3 would appear as follows:

Income before income tax

Income tax expense

 Current

 Deferred

  Net income



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$146,000

$44,200

1,800



46,000

$100,000



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544



To determine the deferred component of income tax expense for year 3, a schedule of future taxable (deductible)

amounts is prepared.



Scheduled taxable

(deductible) amounts:

Depreciation differences:

taxable amounts



Year 4

Taxable

(deductible)



Year 5

Taxable

(deductible)



Year 6

Taxable

(deductible)



Tax

rate



Deferred tax

liability (asset)



-0-



$5,000



$5,000



40%



$4,000 Noncurrent



The temporary depreciation difference of $10,000 results in future taxes payable (a deferred tax liability) of

$4,000 [($5,000 + 5,000) × 40%]. Note that the amount of the deferred tax liability in this example does not change

from year 3 to year 4. The $4,000 amount would be reported as a noncurrent deferred tax liability at 12/31/11, based

upon the noncurrent classification of the related depreciable asset. The $500 warranty expense deducted in year 3 for

book purposes is deducted in year 4 for tax purposes. Therefore, the deferred tax asset related to warranty expense is

realized in year 4 and the temporary difference related to warranty expense no longer exists.

Once the deferred tax amounts have been measured at year-end, a journal entry is required to adjust the deferred

tax account balances to the current year-end amount. Income tax expense for the year consists of the taxes currently

payable plus or minus any change in the deferred tax accounts. The following journal entries are needed to record

income tax expense for year 4:

Income tax expense—current

  Income tax payable (a)





44,800

44,800



(a) $112,000 taxable income x 40% = $44,800

Income tax expense deferred (c)

  Deferred tax asset current (b)







200

200



(b) The credit to the deferred tax asset is the adjustment necessary to reduce the existing balance to the desired

ending balance.

Deferred Tax Asset

Beg. bal.



200

200



End. bal.





Decrease (b)



0



(c) Income tax expense—deferred results from the decrease in the deferred tax asset. There is no adjustment to

the deferred tax liability account.

Deferred Tax Liability

4,000



Beg. bal.



0

4,000



End. bal.



To determine the deferred component of income tax expense for year 5 the following journal entries are required:

Income tax expense—current

  Income tax payable (a)





45,400



(a) $113,500 taxable income × 40% = $45,400

Deferred tax liability—noncurrent (b)

  Income tax expense—deferred (c)







45,400



2,000

2,000



(b) The debit to the deferred tax liability is the adjustment necessary to reduce the existing balance to the

desired ending balance.

Deferred Tax Liability

4,000

2,000



Decrease (b)

2,000



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Beg. bal.

End. bal.



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545



(c) Income tax expense—deferred results from the decrease in the deferred tax liability. The deferred tax asset

account was closed in year 4 because all temporary differences have reversed.



The income tax liability per the tax return in year 5 is higher than total tax expense reported on the income

statement since depreciation is not deducted for tax purposes anymore. In effect, the income tax liability in year 5

includes a portion of the tax deferred from year 3- year 5 that was recorded as a liability; therefore, the deferred tax

liability is reduced in year 5. There is a corresponding decrease in income tax expense—deferred that will reconcile

the income tax liability per the tax return to income tax expense on the books.

Income tax expense—current

Income tax expense—deferred

Income tax expense per income statement



45,400

(2,000)

43,400 



d. Changing tax rates. The previous examples assumed a constant enacted tax rate of 40%.











(1) Under the liability method, future taxable or deductible amounts (deferred tax assets or liabilities) must

be measured using enacted tax rates expected to be in effect in the periods such amounts will impact

taxable income.

(2) However, when tax rates change, adjustments to reflect such changes are automatically included in

the journal entry amount to increase or decrease the deferred tax accounts to the balances needed to

properly reflect balance sheet amounts and to recognize the deferred component of income tax expense.

(a) The rate change effect would be included because the amount of the journal entry is determined by

comparing the needed balance in deferred taxes at the end of the period which would be based on

the newly enacted rates with the balance at the beginning of the period and taking the difference.



EXAMPLE 3

Assume that in June year 5 a new income tax law is passed which lowers the corporate tax rate to 35% effective

January 1, year 6. The entry debiting income tax expense—current and crediting income tax payable for year 5 is

identical to that above.

However, the debit to the deferred tax liability account is the adjustment necessary to reduce the existing balance

to the desired ending balance under the new tax rate.

Deferred tax liability—noncurrent

  Income tax expense—deferred



2,250

 2,250



Deferred Tax Liability

4,000

2,250



Beg. bal.

Decrease



1,750



End. bal.



The $1,750 is the necessary balance for the year 6 reversal of the remaining $5,000 at 35%.



EXAMPLE 4

Dart Corporation has the following temporary differences from its first year of operations:



1. Long-term contracts:

Year 1 (Current year):

Year 2:



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Treatment in the book to tax

reconciliation

Book contract income >

 tax contract income

Book contract income <

 tax contract income



$300 subtraction

$300 addition



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2. Accumulated depreciation:

Year 1 (Current year):

Year 2:

Year 3:

Year 4:

Year 7:

3. Estimated expense liability:

Year 1 (Current year):

Year 7:



Book deprec. < tax deprec.

Book deprec. < tax deprec.

Book deprec. > tax deprec.

Book deprec. > tax deprec.



$1,000 subtraction

$500 subtraction

$600 addition

$400 addition

$500 addition



Book est. exp./loss > tax deduction

Book exp./loss < tax deduction



$200 addition

$200 subtraction

Treatment in the book to tax

 reconciliation



4. Rent revenue:

Year 1 (Current year):

Year 4:

Year 7:

5.  Tax rates:



Book rev. < tax rev.

Book rev. > tax rev.

Book rev. > tax rev.

Current year:

Years 2–4:

Years 5–7:



$500 addition

$200 subtraction

$300 subtraction

40%

35%

30%



The schedule below combines (1) the pretax accounting income to taxable income reconciliation and (2) the

future taxable (deductible) amounts schedule. Remember that taxable amounts are added to financial (book) income

in the book to tax reconciliation schedule in the future years in which they increase taxable income. Deductible

amounts are subtracted from financial (book) income in the book to tax reconciliation schedule in the future years

in which they decrease taxable income. Taxable income and deferred tax liability (asset) balances for year 1 (the

­current year) would be determined as follows:

Future years

Current

Year 2

year

taxable

Year 1 (deductible)

Tax rate

Pretax accounting

income

Temporary differences:

LT contracts

Accumulated deprec.

Estimated expense

liability

Rent revenue

Taxable income

Income tax payable

($1,000 × 40%)



40%

$ 1,600



(300)

(1,000)

200



Year 3

taxable

(deductible)



Year 4

taxable

(deductible)



Year 7

taxable

(deductible)



35%



35%



35%



30%



300

(500)*



600



400



500

(200)



$ 105 Current

$ 325 Noncurrent

$ (60) Noncurrent



(200)



(300)



$(160) Noncurrent



500

$ 1,000



Deferred

tax liability

(asset)



$ 400



*  Note that in year 2 there is excess tax depreciation as there was in year 1.



Income tax expense would be computed as follows:

Income tax expense = Income taxes ± Change in deferred taxes (net)

Under ASC Topic 740, deferred tax assets and liabilities are classified as current or long-term based on the related

asset or liability, rather than on the expected timing of the future deductible or taxable amounts. However, if a

deferred tax asset or liability is not related to an asset or liability for financial reporting purposes, it is classified

based upon its expected reversal date. Presented below is a solution for Example 4.

Temporary difference



Deferred tax asset or liability



Related account



Classification*



LT contracts

Depreciation



$300 × 35% = $105 liability

[(500) + 600 + 400] × 35% + $500 ×

  30% = $325 liability

$200 × 30% = $60 asset

$200 × 35% + $300 × 30% = $160 asset



Const-in-Progress

Accumulated depr.



Current

Noncurrent



Estimated liability

Unearned rent



Noncurrent

Noncurrent



Est. expense

Rent revenue



*  Balance sheet disclosure is explained for this example in Section F.3.



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The journal entries required are as follows:

Income tax expense current

Income tax payable





400

400 (a)



(a) $1,000 taxable income × 40% = $400

Income tax expense deferred (e)

Deferred tax asset noncurrent (b)

Deferred tax liability current (c)

Deferred tax liability noncurrent (d)



210

220

105

325



(b) $200 × 30% + $200 × 35% + $300 × 30%= $220 needed Ending balance; $220 Ending balance – $0

Beginning balance = $220 increase needed in the account.

Deferred Tax Asset—Noncurrent

-0220

220





Beg. bal.

Increase (b)

End. bal.



(c) $300 × 35% = $105 Ending balance; $105 Ending balance – $0 Beginning balance = $105 increase needed

in the account

Deferred Tax Liability—Current

Beg. bal.

Increase (c)

End. bal.







-0105

105



(d) $1,000 × 35% + ($500) × 35% + $500 × 30% = $325 Ending balance; $325 Ending balance –$0 Beginning

balance = $325 increase needed in the account.

Deferred Tax Liability—Noncurrent

Beg. bal.

Increase (c)

End. bal.







-0325

325



(e) $105 increase in current deferred tax liability amount + $325 increase in noncurrent deferred tax liability

account – $220 increase in noncurrent deferred tax asset account = $210.

NOTE: Since this is the firm’s first year of operations, there are no beginning balances in

the deferred tax accounts. If there were any permanent differences, such differences would

affect only the current year as they did in Example 1. In addition, the need for a valuation

allowance to reduce the deferred tax asset to its net realizable value would need to be

considered.



e. Deferred tax asset valuation allowance. A deferred tax asset is reduced by a valuation allowance if, based

on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that some

portion or all of the deferred tax asset will not be realized.















c11.indd 547



(1) All available evidence, both positive and negative, should be considered to determine whether a

valuation allowance is needed. The need for a valuation allowance ultimately depends on the existence

of sufficient taxable income (necessary to receive the benefit of a future deductible amount) within the

carryback/carryforward period, as described in Section E of this module. If any one of the following

sources is sufficient to support a conclusion that a valuation allowance is not necessary, other sources

need not be considered.

(2) Possible sources of taxable income

(a) Future reversals of existing taxable temporary differences

(b) Future taxable income exclusive of reversing temporary differences and carryforwards

(c) Taxable income in prior carryback year(s) if carryback is permitted under the tax law



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(d) Tax-planning strategies that would, if necessary, be implemented to









1] Accelerate taxable amounts to utilize expiring carryforwards

2] Change the character of taxable or deductible amounts from ordinary income or loss to capital

gain or loss

3] Switch from tax-exempt to taxable investments.











(3) Examples of evidence to be considered when evaluating the need for a valuation allowance are

summarized as follows:

(a) Negative evidence—Indicates need for a valuation allowance













1]

2]

3]

4]



Cumulative losses in recent years

A history of operating loss or tax credit carryforwards expiring unused

Losses expected in early future years (by a presently profitable entity)

Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations

and profit levels on a continuing basis in future years

5] A carryback/carryforward period that is so brief that it would limit realization of tax benefits if

(1) a significant deductible temporary difference is expected to reverse in a single year or (2) the

enterprise operates in a traditionally cyclical business.











(b) Positive evidence—Can offset the impact of negative evidence







1] Existing contracts or firm sales backlog that will produce more than enough taxable income to

realize the deferred tax asset based on existing sales prices and cost structures

2] An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount

sufficient to realize the deferred tax asset

3] A strong earnings history exclusive of the loss that created the future deductible amount (tax

loss carryforward or deductible temporary difference) coupled with evidence indicating that the

loss (for example, an unusual, infrequent, or extraordinary item) is an aberration rather than a

continuing condition.









EXAMPLE

Valuation allowance

Assume Jeremiah Corporation has determined it has a noncurrent deferred tax asset of $800,000. Note that in the

current and prior periods when this asset was recognized, income tax expense was reduced. Based on the weight of

available evidence, Jeremiah feels it is more likely than not that $300,000 of this deferred tax asset will not be realized. Jeremiah would prepare the following journal entry:

Income tax expense

Allowance to reduce deferred tax asset to expected realizable value

The balance sheet presentation is



300,000

300,000



Other Assets (Noncurrent)

Deferred tax asset

Less Allowance to reduce deferred tax asset to expected realizable value



$ 800,000

(300,000)

$ 500,000 

At each year-end, the balance on the allowance account is adjusted upward or downward based on the evidence

available at that time, resulting in an increase or decrease of income tax expense. For example, if $600,000 was

deemed to be the net realizable value at the end of the next year, the following entry would be made:

Allowance to reduce deferred tax asset to expected realizable value

Deferred income tax expense







c11.indd 548



100,000

100,000



D. Deferred Tax Related to Business Investments

One additional issue concerns temporary differences from income on long-term investments that are accounted

for using the equity method. For these investments a corporation may assume that the temporary difference (the

undistributed income since date of acquisition) will ultimately become taxable in the form of a dividend or in

the form of a capital gain. Obviously, the tax expense and deferred tax liability recorded when the difference

originates will be a function of whichever of these assumptions is made.



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EXAMPLE

Assume Parent Company owns 70% of the outstanding common stock of Subsidiary Company and 30% of the ­outstanding

common stock of Investee Company. Additional data for Subsidiary and Investee Companies for the year year 1 are as follows:

Investee Co

Subsidiary Co

Net income

$50,000

$100,000

Dividends paid

20,000

60,000

Income Tax Effects from Investee Co.

The pretax accounting income of Parent Company will include equity in Investee income equal to $15,000 ($50,000 ×

30%). Parent’s taxable income, however, will include dividend income of $6,000 ($20,000 × 30%), and a ­dividends received

­deduction of 80% of the $6,000, or $4,800, will also be allowed for the dividends received. This 80% ­dividends received

deduction is a permanent difference between pretax accounting and taxable income and is allowed for dividends received from

domestic corporations in which the ownership percentage is less than 80% and equal to or greater than 20%. The ­originating

temporary difference results from Parent’s equity ($9,000 = $30,000 × 30%) in Investee’s undistributed income of $30,000

($50,000 – $20,000). The amount by which the deferred tax liability account would increase in year 1 depends upon the

expectations of Parent Co. as to the manner in which the $9,000 of undistributed income will be received. If the expectation

of receipt is via dividends, then the ­temporary difference is 20% of $9,000 because 80% of the expected dividend will be

excluded from taxable income when received. This temporary difference in year 1 of $1,800, multiplied by the tax rate, will

give the amount of the increase in the deferred tax liability. If the expectation of receipt, however, is through future sale of

the investment, then the temporary difference is $9,000, and the change in the deferred tax liability is the capital gains rate

(currently the same as ordinary rate) times the $9,000.

The entries below illustrate these alternatives. A tax rate of 34% is used for both ordinary income and capital gains. Note that

the amounts in the entries below relate only to Investee Company’s incremental impact upon Parent Company’s tax accounts.

Expectations for

undistributed income

Dividends

Income tax expense

Deferred taxes (net)

Income taxes payable

Computation of income taxes payable

Dividend income—30% ($20,000)

Less: 80% dividends received deduction



a



Capital gains



1,020



3,468

612b

408a



3,060c

408a

$ 6,000

(4,800)



Amount included in Parent’s taxable income



$ 1,200



Tax liability—34% ($1,200)



$



Computation of deferred tax liability (dividend assumption)

Temporary difference—Parent’s share of undistributed income—30% ($30,000)

Less: 80% dividends received deduction



408



b



$ 9,000

$(7,200)



Originating temporary difference



$ 1,800



Deferred tax liability—34% ($1,800)



$



Computation of deferred tax liability (capital gain assumption)

Temporary difference—Parent’s share of undistributed income—30% ($30,000)



612



c



Deferred tax liability—34% ($9,000)



$ 9,000

$ 3,060



Income Tax Effects from Subsidiary Co.

The pretax accounting income of Parent will also include equity in Subsidiary income of $70,000 (70% of $100,000). Note also

that this $70,000 will be included in pretax consolidated income if Parent and Subsidiary consolidate. For tax purposes, Parent

and Subsidiary cannot file a consolidated tax return because the minimum level of control (80%) is not present. Consequently,

the taxable income of Parent will include dividend income of $42,000 (70% of $60,000) and there will be an 80% dividends

received deduction of $33,600. The temporary difference results from Parent’s equity ($28,000 = $40,000 × 70%) in Subsidiary’s

undistributed earnings of $40,000 ($100,000 – $60,000). Remember that the undistributed income of Subsidiary has been

recognized for book purposes, but only distributed income (dividends) has been included in taxable income. The amount of

the deferred tax liability in year 1 depends upon the expectations of Parent Company as to the manner in which this $28,000 of

undistributed income will be received in the future. The same expectations can exist as previously discussed for Parent’s equity

in Investee’s undistributed earnings (i.e., through future dividend distributions or capital gains). Determination of the amounts

and the accounts affected for these two assumptions would be similar. The following diagram illustrates the accounting and

income tax treatment of the undistributed investee/subsidiary earnings by corporate investors under different levels of ownership.



c11.indd 549



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C. Deferred Tax Assets and Liabilities

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