Accounting For Taxes

So far I wrote about accounting for long-term debt and leases. You can find them here and here. In this post I will be writing about accounting for taxes. In US, every company maintains two sets of books. One of them is prepared according to the GAAP rules which are read by investors, creditors, and suppliers. The other one is prepared according to the IRS rules which are submitted to the tax authorities. Because of the difference in rules, taxes that the company shows in its income statement will be different from the taxes it actually pays to the IRS. In this post I will explain how these differences are handled in accounting.

1. Permanent vs Temporary Differences

Given below is the income statement for Company A prepared according to GAAP rules. Take a look at the annotated item. According to the IRS rules, interest income from municipal bonds is exempt from taxes. But under GAAP they are not. This difference is permanent in nature. This means that until one of the authorities changes its rule to comply with the other, the income difference of $10,000 will be there forever. Since the authorities won’t comply we need to remove the effects of permanent differences. I did this by removing $10,000 from pre-tax income of $210,000 to come up with adjusted pre-tax income of $200,000. In the US, statutory tax rate is 35%. Applying this to adjusted per-tax income we get income tax expense of $70,000 ($200,000 * 0.35).

accounting-taxes-permanent-differences

On the pre-tax income of $210,000, the income tax expense comes to $70,000. This results in a tax rate of 33.33% ($70,000 / 210,000). This is known as effective tax rate which is lower than the statutory tax rate of 35%. The key takeaway is that permanent differences results in lower effective tax rate. Now take a look at the tax return the company filed with IRS.

accounting-taxes-temporary

Clearly the company had lower income tax payable of $52,500 compared to GAAP income tax expense of $70,000. Why is that? The reason for the difference is because of different depreciation methods the company used for GAAP and IRS. For this example let us assume that the company had fixed assets for $200,000. For GAAP it deprecated on a straight line basis in two years. Hence GAAP depreciation expense came to $100,000 ($200,000 / 2). For IRS it uses accelerated depreciation and takes a charge of $150,000 in 2013 and $50,000 in 2014.

Why would a company use two different methods of depreciation? There are few reasons I can think of (1) incentives; showing more profits in GAAP results in investors paying higher multiples. Many don’t think they just multiply one number with another (2) compound interest; money saved today is worth more than money saved tomorrow (3) differences in GAAP and IRS rules.

The income tax expense and payable is different in both 2013 and 2014. But if you add them up they will be the same; $140,000. Hence this difference is temporary in nature and with time they will converge. These temporary differences are handled through deferred taxes. Given below are some examples of permanent and temporary differences. Take sometime to think through them carefully.
accounting-taxes-temp-perm-examples

2. Deferred Tax Liabilities

On 31-Dec-2013, Company A will close its books with the following journal entry given below. In the world of accounting Dr. stands for a debit entry and Cr. stands for a credit entry. The company had an income tax expense of $70,000; refer to the GAAP income statement above. But its income tax payable is only $52,500; refer to the tax return above. To plug the difference it adds a deferred tax liability of $17,500. Why should the company do this entry? There are couple of reasons I can think of (1) golden rule of accounting states that sum of credits and debits should match and without deferred tax liability this rule would be broken (2) accounting is conservative in nature and the company knows that its future income tax payable will be higher and hence it shows this as a liability in the balance sheet.

31-Dec-2013 Dr. Income Tax Expense   $70,000
               Cr. Income Tax Payable     $52,500
               Cr. Deferred Tax Liability $17,500 (Kept as a balance sheet liability)

On 31-Dec-2014, Company A will close its books with the following journal entry given below. The company has more income tax payable compared to income tax expense. This difference is adjusted by reducing the deferred tax liability by $17,500. At this point there are no temporary differences and hence deferred tax liability goes to zero.

31-Dec-2014 Dr. Income Tax Expense     $70,000
            Dr. Deferred Tax Liability $17,500 (Removed from the balance sheet)
               Cr. Income Tax Payable    $87,500

Here is a simple rule to remember on deferred tax liabilities. If income tax expense (GAAP) is greater than income tax payable (IRS) then you will have an entry for deferred tax liability. This will be kept on the balance sheet on the liability side. This tells that in future the company will pay more in taxes to IRS. This concept is very important so make sure that you understand it deeply.

3. Deferred Tax Assets

Take a look at the GAAP income statement of Company B. The company received cash advance from its customers in 2013. But it actually delivered the service in 2014. According to GAAP, the company can’t book this as revenue in 2013 until the service is provided to the customers. Hence it keeps $100,000 as a liability in the balance sheet. In 2014, after delivering the service, the company booked $100,000 as revenue.

accounting-taxes-B-GAAP

Take a look at the tax return Company B filed with IRS. The cash advance received from customers was recognized as income in 2013 and this resulted in higher income tax payable. But if you add up the income tax expense and payable for 2013 and 2014, you will find that they will be the same; $245,000

accounting-taxes-CompanyB-IRS

On 31-Dec-2013, Company B will close its books and make the following journal entry. The income tax expense is lesser than income tax payable by $35,000. This difference is kept as a deferred tax asset in the balance sheet. This tells that in future the company will have lower income tax payable.

31-Dec-2013 Dr. Income Tax Expense    $105,000
            Dr. Deferred Tax Asset     $35,000 (Kept as balance sheet asset)
               Cr. Income Tax Payable      $140,000

On 31-Dec-2014, Company B will close its books and make the following journal entry. The income tax expense is more than income tax payable by $35,000. But since the company paid more taxes in 2013, it will adjust the difference by reducing the deferred tax asset.

31-Dec-2014 Dr. Income Tax Expense    $140,000
              Cr. Deferred Tax Asset     $35,000 (Removed from the balance sheet)
              Cr. Income Tax Payable    $105,000

Here is a simple rule to remember on deferred tax assets. If income tax expense (GAAP) is lesser than income tax payable (IRS) then you will have an entry for deferred tax asset. This will be kept on the balance sheet on the asset side. This tells that in future the company will pay less in taxes to IRS. This concept is very important so make sure that you understand it deeply.

4. Valuation Allowance and Net Operating Losses

Take a look at Company C which has a deferred tax asset of $50,000. This means that in future it can save on income taxes. But what if the company does not make any profit at all in future? This means that the company will not have any taxes to pay and it can’t use the deferred tax asset. In such situations management has to bring down the deferred tax asset by using valuation allowance. In order get this concept in your head think of deferred tax asset as accounts receivable and valuation allowance as doubtful accounts. If doubtful accounts goes up then your net accounts receivable goes down. Similarly if valuation allowance goes up then your net deferred tax asset goes down.

accounting-taxes-CompanyC

If we want to bring down the deferred tax asset by $20,000 then we need to do the following journal entries. So the net deferred asset will be $30,000 ($50,000 – $20,000). Keep an eye on valuation allowance while reading annual reports as management can increase or decrease it at their wish. If they decrease it then it will result in higher net income.

31-Dec-2013 Dr. Income Tax Expense    $20,000
              Cr. Valuation Allowance    $20,000 (Will bring down deferred tax asset)

Let us imagine another Company D which made an operating loss of $1,000,000 in 2013. In the US, companies can carry forward their loss up to 20 years or carry back their loss up to 2 years. This helps in reducing their taxable income. In this case let us suppose that Company D decided to carry forward its loss. It applies the statutory tax rate of 35% on the operating loss and arrives at $350,000 ($1,000,000 * 0.35). This amount will be kept in the deferred tax asset and it will be used to reduce future taxes.

5. Looking at deferred taxes for Walmart

You can download Walmart’s 2014 annual report from here. In 2014, income from continuing operations was $24,656 million and income tax expense came to $8,105 million. So it’s effective tax rate is 32.9% ($8,105 / 24,656). Why is the effective tax rate low? This is because of permanent differences that we discussed above. In the footnote Walmart itemized things that lead to lower effective tax rate.
accounting-taxes-walmart-perm-temp

For 2014, Walmart’s income tax expense was $8,105 million and income tax payable is $8,619 million. The difference of $514 million between income tax expense and payable is captured as deferred taxes. From this alone we cannot tell if the deferred taxes are assets or liabilities.

accounting-taxes-wmt-income-taxes

In 2014, Walmart’s deferred tax assets went up by $763 million. Around 55% of which is contributed by the reduction of valuation allowance. Remember when valuation allowance goes down then the deferred tax assets go up. Along with that net income gets inflated. Why did this happen? Given below is the explanation from the management. This is a standard template which is followed by every other company. So we cannot infer much. The company has more deferred tax liability than deferred tax asset. In 2014 the overall deferred tax liability went up by $101 million. But I am not able to reconcile $101 million with $514 million shown above. If you know why this is the case please comment about it.

accounting-taxes-wmt-deferred-taxes-split

The $0.4 billion net decrease in the valuation allowance during fiscal 2014 related to releases arising from the use of deferred tax assets, changes in judgment regarding the future realization of deferred tax assets, increases from certain net operating losses and deductible temporary differences arising in fiscal 2014, decreases due to operating and capital loss expirations and fluctuations in currency exchange rates. Management believes that it is more likely than not that the remaining net deferred tax assets will be fully realized. – Walmart 2014 annual report

Closing Thoughts

Finally I have come to the end of a very long post. I learned these concepts by reading the book shown below. Also I took the Financial Accounting course from coursera. I would highly recommend this course for anyone who wants to know how the financial statements are put together.

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