Question

can someone please explain the illustration 16-1 and illustration 16-1A to me. I have to understand this before the exam tomorrow.
(I provided extra info if u need it)

TEMPORARY DIFFERENCES LO16-1 Describe the tybes of temporary differences that cause deferred tax liabilities and determine the amounts needed to record periodic income taxes. The differences in the rules for computing taxable income and those for financial reporting often cause amounts to be included in taxable income in a year later-or earlier-than the year in which they are recognized for financial reporting purposes. For example, you learned in Chapter 4 @ that income from selling properties on an installment basis is reported for financial reporting purposes This means taxable income might be less than accounting income in the year of an installment sale but higher than accounting income in later years when installment income is collected in the year of the sale. But tax laws permit installment income to be reported on the tax return as it actually is received. Temporary differences arise when tax rules and accounting rules recognize income in different periods. The situation just described creates what's referred to as a temporary differen ce between pretax accounting income and taxable income and, consequently between the amount of an asset or liability that is reported in the financial statements and the equivalent amount, called the tax basis of an asset or a liability. that is included in the company's tax records. In our example, the asset for which the temporary difference exists is the installment receivable that's recognized for financial reporting purposes, but not for tax purposes. DEFERRED TAX LIABILITIES It's important to understand that a temporary difference originates in one period and reverses, or turns around, in one or more subsequent periods. The temporary difference described above originates in the year the installment sales are made and are reported

  

Answer 1

Solution 16-1 & 16-1A :-

Before explaining the question we need to understand the basic concept related to accounting for taxes on income -

Tax liability, in general is calculated on the taxable income as per income tax law. In comparison to accounting principles adopted in the financial statements, the tax laws allow quicker write off of assets and disallowance of certain expenses. As per MATCHING PRINCIPLE expenses are recognized in the in the profit and loss account based upon corresponding revenue generated by asset thereby. In simple terms Tax expense (Current tax plus Deferred tax) should be accounted for in the period in which the revenue is accounted.      

A. Accounting income (loss) is the net profit or loss for a period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving.

B. Taxable income (tax loss) is the the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which tax payable (recoverable) is determined.

C. Tax expense (tax saving) is the aggregate of current tax and deferred tax charged or credited to the statement of profit and loss for the period. It is the amount expected to be paid using applicable tax rates.

D. Current Tax is the amount of income tax determined to be payable (recoverable) in respect of the taxable income (tax loss) for a period.

E. Deferred Tax is the tax effect of TIMING DIFFERENCES.

F. Timing Differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods.

G. Permanent Differences are the differences between taxable income and accounting income for a period that originate in one one period and do not reverse subsequently.

As explained above Tax expense is the aggregate of Current Tax and Deferred Tax.

Deferred Tax is the difference between tax expense and tax liability as per income tax law. It is measured as amount payable as per tax laws that have been force at the balance sheet date. Two differences (permanent differences and Temporary differences explained above) arises between accounting income and taxable income.

Deferred Tax liability is accounted in the books of accounts in following two situations where -

(i). Accounting income is greater than taxable income, and/or

(ii). Profit as per accounts but loss as per income tax law

Both the above stated situations leads to SAVE TAX NOW, PAY LATER. i.e. postponement of tax liability resulting in creation of deferred tax liability. In both the situations we will charge/Debit Profit & Loss Account thereby increasing income tax expense and credit Deferred Tax Liability.

In the year of reversing timing difference, Deferred tax liability is written back to Profit and Loss account. i.e. Debit deferred Tax liability and credit Profit and Loss account thereby reducing income tax expense.

$ in Millions Pretax Accounting Income Installment sale income on the income statement $-40 Installment sale income on the tax return Taxable Income (Tax return Income Tax @ 40% on taxable income 2018 2019 2020Total $140 $ 100 100 340 -40 $10 $ 30$ 40 s 100 S 110 S 130 s 340 S40 $ 44$ 52 136

In the light of the above statement it is very much clear that pretax accounting income of 2018 is $140 which is greater than taxable return income of $100. Postponement of tax liability (save now & pay later). Hence, we will Debit Profit and Loss account by $16 thereby increasing income tax expense and credit Deferred Tax Liability of $16 (40% income tax rate of $40 which is a temporary difference created in 2018 and reversed in 2019 and 2020).

Income Tax Expense (Profit and Loss account) Dr. 56 (Balancing Figure)

To Deferred Tax Liability 16     

To Income Tax Payable 40

Closing balance of Deferred tax Liability in 2018 - $16.

In the year 2019, where $10 is reversed on account of installment sale income on tax return. Hence, we will Debit Deferred Tax Liability of $4 (40% income tax rate of $10) and credit Profit and Loss account by $4 thereby reducing income tax expense by $4.

Income Tax Expense (Profit and Loss account) Dr. 40 (Balancing Figure)

Deferred Tax Liability Dr. 4   

To Income Tax Payable 44

Closing balance of Deferred tax Liability in 2019 - $12 ($16-$4).

In the year 2020, where $30 is reversed on account of installment sale income on tax return. Hence, we will Debit Deferred Tax Liability of $12 (40% income tax rate of $30) and credit Profit and Loss account by $12 thereby reducing income tax expense by $12.

Income Tax Expense (Profit and Loss account) Dr. 40 (Balancing Figure)

Deferred Tax Liability Dr. 12   

To Income Tax Payable 52

Closing balance of Deferred tax Liability in 2020 - $0 ($12-$12).