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Unit 6 – Accounting for Income Tax

Accounting income or financial income is the net income for the

period before deducting income tax expense.

Taxable income is the income for the period determined in accordance

with the rules established by the taxation authorities upon which income taxes
are payable or recoverable.

Learning Outcomes

At the end of this unit, you will be able to:

• Reconcile the tax expense identified based on Accounting Income and
Tax Base.

Pretest

Directions: Read and analyze each situation. Tick (✓) on the appropriate box of your
answer. Encode your answer in a separate word file and submit in the classwork section
of our google class on or before the date as reflected in your study schedule. Please follow
the format in naming the file for submission: Lastname_Unit6_Pretest

*AI – Accounting Income

TI – Taxable Income

AI > TI AI < TI Equal

1. The entity incurred cost of P6,000,000 in relation to
the development of a computer software product.

Considering the technical feasibility of the product,

this cost was capitalized and amortized over 3 years
for accounting purposes using straight line. However,
the total amount was expensed in 2021 for tax
purposes.

2. The equipment was acquired on January 1, 2021 for

P20,000,000. The useful life of the equipment is 4
years with no residual value.

The equipment is depreciated using the straight line

for accounting purposes and sum of year’s digits
method for tax purposes.

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3. In January 2021, the entity entered into an agreement

with the employees to provide health care benefits.
The cost of such plan for 2021 was P2,000,000. This
amount was accrued as expense in 2021 for
accounting purposes. However, health care benefits
are deductible for tax purposes only when actually
paid.

4. Litigation loss accrued for financial accounting

purposes but will be deducted for tax purposes in the
distant future.

5. Warranty cost expensed for financial accounting

purposes exceeded the amount currently deductible
for tax purposes by P300,000

6. The entity has made a provision for inventory

obsolescence of P2,000,000 which is not allowable
for tax purposes.

7. Impairment charge against trade receivables of

P1,000,000 has been made. This charge will not be
allowed in the current year for tax purposes.

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Content

Introduction

Deferred tax accounting is applicable to all entities, whether public or nonpublic entities.
A public entity is an entity:

a. Whose equity and debt securities are traded in a stock exchange or over-the-
counter market.

b. Whose equity or debt securities are registered with Securities and Exchange
Commission in preparation for sale of the securities.

Accounting Income

Accounting income or financial income is the net income for the period before
deducting income tax expense.

This is the income appearing on the traditional income statement and computed in
accordance with accounting standards.

Taxable Income

Taxable income is the income for the period determined in accordance with the rules
established by the taxation authorities upon which income taxes are payable or
recoverable. Taxable income is the income appearing on the income tax return and
computed in accordance with the income tax law.

Differences Between Accounting and Taxable Income

Differences between accounting income and taxable income may be classified into two,
namely:
a. Permanent differences
b. Temporary differences

Permanent Differences
• Items of revenue and expense which are included in either accounting income or
taxable income but will never be included in the other.

• Do not give rise to deferred tax asset and liability because they have no future tax
consequence.

• Example:
a. Interest income on deposits
b. Dividends received

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c. Life insurance premium

When the entity is the beneficiary of a life insurance policy on an officer or

employee, the premium paid by the entity is not deductible as expense for
tax purposes but said premium is an expense for financial reporting
purposes.

d. Tax penalties, surcharges and fines are nondeductible.

Temporary Differences
• Are differences between the carrying amount of an asset or liability and the tax
base.
• Includes timing differences

Timing Differences
Ø Differences between accounting income and taxable income that
originate in one period and reverse in one or more subsequent
periods.

Ø Items of income and expenses which are included in both

accounting income and taxable income but at different time periods.

• A temporary difference will give rise either to:

Ø Deferred tax liability
Ø Deferred tax asset

Kinds of Temporary Difference

a. Taxable temporary difference is the temporary difference that will result in future
taxable amount in determining taxable income of future periods when the carrying
amount of the asset or liability is recovered or settled.
b. Deductible temporary difference is the temporary difference that will result in future
deductible amount in determining taxable income of future periods when the
carrying amount of the asset or liability is recovered or settled.

Tax Base

The tax base of an asset or a liability is the amount attributable to the asset or
liability for tax purposes. Worded in another way, the tax base of an asset or a liability is
the amount of the asset or liability that is recognized or allowed for tax purposes.

Tax Base of an Asset

The tax base of an asset is the amount that will be deductible for tax purposes
against future income. For example, if an entity has appropriately capitalized P1,000,000

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as software development cost, the carrying amount is P1,000,000 for accounting

purposes.

However, if this amount is allowed as one-time deduction for tax purposes, the tax
base is zero because the entire amount is expensed in the current year.

Tax Base of a Liability

The tax base of a liability is normally the carrying amount less the amount that will
be deductible for tax purposes in the future. For example, if an entity has recognized an
estimated warranty liability of P500,000, the carrying amount is P500,000 for accounting
purposes.

However, an estimated warranty cost is deductible only when actually paid. Thus,
the tax base is zero because the estimated warranty cost is a future deductible amount.

Deferred Tax Liability

• Amount of tax payable in future periods with respect to a taxable temporary
difference
• Deferred tax consequence attributable to a taxable temporary difference or future
taxable amount

Deferred tax liability arises from the following:

a. When the accounting income is higher than taxable income because of timing
differences.
b. When the carrying amount of an asset is higher than the tax base.
c. When the carrying amount of a liability is lower than the tax base.

Accounting Income Higher than Taxable Income

Temporary differences that result in accounting income higher than taxable

income include the following:

1. Revenues and gains are included in accounting income of the current period but
are taxable in future periods.

For example, an installment sale is included in accounting income at the time of

sale and included in taxable income when cash is collected in future periods.

2. Expenses and losses are deductible for tax purposes in the current period but
deductible for accounting purposes in future periods.

a. Accelerated depreciation for tax purposes and straight line depreciation for
accounting purposes.
b. Development cost may be capitalized and amortized over future periods in
determining accounting income but deducted in determining taxable
income in the period in which it is paid.

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c. Prepaid expense has already been deducted on a cash basis in

determining taxable income of the current period.

Other Taxable Temporary Differences

Most taxable temporary differences arise because of differences in the timing of

the recognition of the transaction for accounting and tax purposes. However, there are
other temporary differences that technically are not timing differences but nevertheless
give rise to deferred tax liability.

Such other taxable temporary differences include:

a. Asset is revalued upward and no equivalent adjustment is made for tax purposes.
b. The carrying amount of investment in subsidiary, associate or joint venture is
higher than the tax base because the subsidiary, associate or joint venture has not
distributed its entire income to the parent or investor.
c. The cost of a business combination that is accounted for as an acquisition is
allocated to the identifiable assets and liabilities acquired at fair value.

Recognition of a Deferred Tax Liability

PAS 12 provides that a deferred tax liability shall be recognized for all taxable
temporary differences. However, a deferred tax liability is not recognized when the
taxable temporary differences arises from:

a. Goodwill resulting from a business combination and which is nondeductible for

tax purposes.
b. Initial recognition of an asset or liability in a transaction that is not a business
combination and affects neither accounting income nor taxable income.
c. Undistributed profit of subsidiary, associate or joint venture when the parent,
investor or venturer is able to control the timing of the reversal of the temporary
difference.

Deferred Tax Asset

A deferred tax asset is the amount of income tax recoverable in future periods
with respect to deductible temporary difference and operating loss carryforward. This
arises from the following:
a. When taxable income is higher than accounting income because of timing
differences.
b. When the tax base of asset is higher than the carrying amount.
c. When the tax base of a liability is lower than the carrying amount.

Taxable Income Higher than Accounting Income

Temporary differences that will result to taxable income higher than accounting
income because of timing differences include the following:

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1. Revenues and gains are included in taxable income of current period but are
included in accounting income of future periods.

For example, rent received in advance is taxable at the time of receipt but deferred
in future periods for accounting purposes.

2. Expenses and losses are deducted from accounting income of current period but
deductible for tax purposes in future periods.

Future Deductible Temporary Differences

Future deductible temporary differences include the following:

a. A probable and measurable litigation loss is recognized for accounting purposes

but deducted in determining taxable income when actually incurred or paid.
b. Estimated product warranty cost is recognized for accounting purposes in the
current period but deducted in determining taxable income when actually incurred
or paid.
c. Research cost is recognized as expense in determining accounting income but not
permitted as a deduction in determining taxable income until a later period.
d. An impairment loss is recognized for accounting purposes but ignored for tax
purposes until the asset is sold.
e. Doubtful accounts are recognized as expense for accounting purposes but
deductible for tax purposes only when written off as worthless.

Other Deductible Temporary Differences

Temporary differences that technically are not timing differences but nevertheless
give rise to deferred tax asset include the following:

a. Asset is revalued downward and no equivalent adjustment is made for tax

purposes.
b. The tax base of investment in subsidiary, associate or joint venture is higher than
the carrying amount because the subsidiary, associate or joint venture has
suffered continuing losses in current and prior years.

Recognition of Deferred Tax Asset

PAS 12 provides that a deferred tax asset shall be recognized for all deductible
temporary differences and operating loss carryforward when it is probable that taxable
income will be available against which the deferred tax asset can be used.

Operating Loss Carryforward

Operating loss carryforward is an excess of tax deductions over gross income in a

year that may be carried forward to reduce taxable income in a future year.

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Method of Accounting

a. Income statement approach

This method focuses on timing differences only in the computation of deferred

tax asset or deferred tax liability. As the method suggests, timing differences affect
the income statement of one period and will reverse in the income statement of
one or more subsequent periods.

b. Statement of financial position approach

This method considers all temporary differences including timing differences.

There are temporary differences that affect the statement of financial position only
and therefore technically are not timing differences but nonetheless are recognized
in computing deferred tax asset or liability.

Accounting Procedures

The recognition of a deferred tax asset or deferred tax liability is known as interperiod tax
allocation.

1. Determine the taxable income

The taxable income multiplies by the tax rate equals the current tax expense.

Income tax expense xx

Income tax payable xx

Current tax expense is the amount of income tax paid or payable for a year as
determined by applying the provisions of the enacted tax law to the taxable income.

2. Determine the taxable temporary differences

The amount of taxable temporary differences multiplied by the tax rate equals the
deferred tax liability.

Income tax expense xx

Deferred tax liability xx

3. Determine the deductible temporary differences

The amount of deductible temporary differences multiplied by the tax rate equals
the deferred tax asset.

Deferred tax asset xx

Income tax benefit xx

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The “income tax benefit account” reduces the current tax expense for the year and
is a deduction from current tax expense. The deferred tax asset may be credited
directly to “income tax expense”.

4. The total income tax expense for the year is the current tax expense plus the
deferred tax expense arising from taxable temporary differences minus the
income tax benefit arising from deductible temporary differences.

The total income tax expense for the year is equal to the accounting income subject
to tax multiplied by the tax rate, assuming there is no future enacted income tax
rate.

Illustration 1 – Deferred Tax Liability

In 2020, an entity reported in accounting income a gross profit on installment sale

of P1,000,000 but not in taxable income. This temporary difference is expected to be
reported in taxable income equally in 2021 and 2022. The income tax rate is 30%.

2020 2021 2022

Accounting income 4,000,000 5,000,000 7,000,000
Taxable income 3,000,000 5,500,000 7,500,000

Since the temporary difference results to a higher accounting income in 2020, there is a
deferred tax liability.

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Illustration 2 – Deferred Tax Asset

In 2020, an entity received an advance rental payment of P600,000 which was

subject to tax but not reported in accounting income until 2021. The income tax rate is
30%. The income statement and tax return showed the following:

2020 2021
Accounting income subject to tax 5,000,000 7,000,000
Taxable income 5,600,000 6,400,000

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Since the temporary difference results to a higher taxable income in 2020, there is a
deferred tax asset.

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Illustration 3 – Deferred Tax Asset and Liability

An entity reported the following for the year ended December 31, 2020.

Accounting income per book 6,000,000

Nondeductible expenses 500,000
Nontaxable revenue 300,000
Doubtful accounts 200,000
Estimated warranty cost that had been recognized as expense in
2020 when the product sales were made but is deductible for
tax purposes when paid 400,000
Accounting depreciation 600,000
Tax depreciation 800,000
Gross income on installment sale included in accounting income but
taxable only in 2021 100,000
Income tax rate 30%

Computation

Accounting income per book 6,000,000

Permanent differences:
Nondeductible expenses 500,000
Nontaxable revenue (300,000)
Accounting income subject to tax 6,200,000
Deductible temporary differences:
Doubtful accounts 200,000
Estimated warranty cost 400,000
Taxable temporary differences:
Excess tax depreciation (200,000)
Gross income on installment sale (100,000)
Taxable income 6,500,000

The permanent differences do not give rise to deferred tax asset or deferred tax liability
and thus eliminated from the reported accounting income. In other words, the accounting
income subject to tax must exclude permanent differences.

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Current Tax Liability and Current Tax Asset

Current tax liability

• The current tax expense or the amount of income tax actually payable
• Classified as current liability

Current tax asset

• Excess of the tax already paid for the current period and the amount
actually payable for the period
• A prepaid income tax and classified as current asset

A current tax liability or current tax asset shall be measured using the tax rate that
has been enacted and effective at the end of the reporting period.

Presentation of Deferred Tax Asset or Liability

PAS 12 provides that when an entity makes a distinction between current and
noncurrent assets and liabilities, it shall not classify deferred tax assets as current assets
and deferred tax liabilities as current liabilities.

Accordingly, a deferred tax asset shall be classified as noncurrent asset and

deferred tax liability shall be classified as noncurrent liability regardless of reversal period.
Moreover, a deferred tax asset or deferred tax liability shall not be discounted.

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Offset of Deferred Tax Asset and Liability

Under PAS 1, assets and liabilities shall not be offset unless required or permitted
by another standard. PAS 12 provides that an entity shall offset a deferred tax asset
against a deferred tax liability when:

a. The deferred tax asset ad deferred tax liability relate to income taxes levied by the
same tax authority.
b. The entity has a legal enforceable right to set off a current tax asset against a
current tax liability.

Measurement of Deferred Tax Asset or Liability

A deferred tax liability or deferred tax asset shall be measured using the tax rate
that has been enacted by the end of the reporting period and expected to apply to the
period when the asset is realized or the liability is settled.

For example, the tax rate of 30% is applicable to the taxable year 2020. By
December 31, 2020, a new tax law has been enacted imposing a 25% tax rate effective
taxable year 2021.

The current tax liability or current tax asset is measured at 30% but the deferred
tax liability or deferred tax asset is measured using the new enacted tax rate of 25%.

Intraperiod and Interperiod Tax Allocation

Intraperiod tax allocation is the allocation of income tax expense to the various
revenues that brought about the tax.

Thus, the total income tax expense is allocated to income from continuing
operations, income from discontinued operations and prior period errors or items directly
charged or credited to retained earnings.

Interperiod tax allocation is the recognition of a deferred tax asset or deferred tax
liability.

Statement of Financial Position Approach

To account for a deferred tax asset or liability, a statement of financial position that
shows all the assets and liabilities at their carrying amount is first prepared.

The following procedures are then followed:

1. Determine the tax base of the assets and liabilities in the statement of financial
position.
2. Compare the carrying amounts with the tax base.
3. The difference between the carrying amount and tax base normally will result to a
deferred tax asset or liability.

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4. Permanent differences do not give rise to deferred tax asset or liability.

5. Apply the tax rate to the temporary differences.
6. Determine the beginning and ending balance of deferred tax asset or liability.
7. Recognize the net change between the beginning and ending balance of deferred
tax asset or liability.

Comprehensive Illustration

On December 31, 2020, the accounts of Easy Company have the same basis for
accounting and tax purposes, except:

Carrying amount Tax base Difference

Computer software cost 4,000,000 0 4,000,000
Building 47,500,000 45,000,000 2,500,000

In January 2020, Easy Company incurred cost of P5,000,000 for the development of a
computer software product.

Considering the technical feasibility of the product, this cost was capitalized and amortized
over 5 years for accounting purposes using the straight line method.

Computer software cost 5,000,000

Amortization for 2020 (5,000,000/5) (1,000,000)
Carrying amount – December 31, 2020 4,000,000

The computer software cost has a zero tax base because the total amount was expensed
in 2020 for tax purposes.

The building was acquired on January 1, 2020 for P50,000,000 and depreciated using the
straight line at 5% for accounting purposes and 10% for tax purposes.

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Disclosures

The disclosure requirements for income tax are quite extensive. However, the key
elements are:

1. Components of the total income tax expense, for example, current tax expense,
deferred tax expense and deferred tax benefit.
2. An explanation of the relationship between total income tax expense and
accounting profit.
3. The applicable tax rate, the basis on which the tax rate has been applied, and the
explanation for any change in the applicable tax rate.
4. The aggregate amount of current and deferred tax relating to items recognized
directly in equity.
5. The aggregate amount of temporary differences associated with investments in
subsidiary, associate and joint venture for which no deferred tax liability has been
recognized.
6. Analysis of the beginning and ending balance of deferred tax asset and deferred
tax liability.

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Assessment

Directions: Read and analyze each item. For theory questions, provide the letter of your
answer. For problem solving, provide what is asked and show your solutions. No merit
shall be given if without solutions. Encode your answer in a separate word file and submit
in the classwork section of our google class on or before the date as reflected in your study
schedule. Please follow the format in naming the file for submission:
Lastname_Unit6_Assessment

I. Theory

1. Which entities are required to apply deferred tax accounting?

a. Public entities
b. Nonpublic entities
c. Both public and nonpublic entities
d. Neither public entities nor nonpublic entities

2. It is the profit for a period determined in accordance with the rules established by
tax authorities upon which income taxes are payable.
a. Accounting profit
b. Taxable profit
c. Net profit
d. Accounting profit subject to tax

3. It is the profit for a period before deducting tax expense.

a. Accounting profit
b. Taxable profit
c. Gross profit
d. Net profit

4. These are differences that will result in future taxable amount in determining
taxable profit of future periods.
a. Temporary differences
b. Taxable temporary differences
c. Deductible temporary differences
d. Permanent differences

5. These are differences that result in future deductible amount in determining taxable
profit in future periods.
a. Taxable temporary differences
b. Deductible temporary differences
c. Taxable temporary and permanent differences
d. Deductible temporary and permanent differences

6. It is the deferred tax consequence attributable to a taxable temporary difference.

a. Deferred tax liability
b. Deferred tax asset
c. Current tax liability

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d. Current tax asset

7. It is the deferred tax consequence attributable to a deductible temporary difference

and operating loss carryforward.
a. Deferred tax liability
b. Deferred tax asset
c. Current tax liability
d. Current tax asset

8. It is the amount of income tax payable in respect of taxable profit.

a. Current tax expense
b. Total income tax expense
c. Deferred tax expense
d. Deferred tax benefit

9. It is the aggregate amount included in the determination of net profit for the period
in respect of current tax and deferred tax.
a. Tax expense
b. Current tax expense
c. Deferred tax expense
d. Deferred tax benefit

10. The deferred tax expense is equal to

a. Increase in deferred tax asset less increase in deferred tax liability
b. Increase in deferred tax liability less increase in deferred tax asset
c. Increase in deferred tax asset
d. Increase in deferred tax liability

11. A deferred tax asset is recognized for deductible temporary differences and
operating loss carryforward when
a. It is probable that taxable income will be available against which the
deferred tax asset can be used.
b. It is probable that accounting income will be available against which the
deferred tax asset can be used.
c. It is possible that taxable income will be available against which the
deferred tax asset can be used.
d. It is possible that accounting income will be available against which the
deferred tax asset can be used.

12. An entity shall offset a deferred tax asset and deferred tax liability
a. When the income taxes are levied by different taxing authority.
b. When the entity has no legal enforceable right to offset.
c. When the income taxes are levied by the same taxing authority and the
entity has a legal enforceable right to offset a current tax asset against a
current tax liability
d. Under all circumstances

13. Which is correct about deferred tax assets and liabilities?

a. Current deferred tax assets are netted against current deferred tax
liabilities.

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b. All noncurrent deferred tax assets are netted against noncurrent deferred
tax liabilities.
c. Deferred tax assets are never netted against deferred tax liabilities
d. Deferred tax assets are netted against deferred tax liabilities if they relate
to the same tax authority.

14. Which statement is incorrect concerning tax assets and liabilities?

a. Deferred tax assets and liabilities shall be discounted.
b. Tax assets and liabilities shall be presented separately from other assets
and liabilities in the statement of financial position.
c. Deferred tax assets and liabilities shall be distinguished from current tax
asset and liabilities.
d. When an entity makes a distinction between current and noncurrent assets
and liabilities, it shall not classify deferred tax assets and liabilities as
current.

15. All of the following must be disclosed separately, except

a. The tax bases of major items on which deferred tax has been calculated.
b. The amount of deductible temporary differences for which no deferred tax
asset is recognized.
c. The amount of taxable temporary differences associated with investments
in subsidiaries and associates for which no deferred tax liability is
recognized.
d. The amount of income tax relating to each component of other
comprehensive income.

II. Problem Solving

Problem 1

Zeff Company prepared the following reconciliation for the first year of operations:

Pretax financial income 1,600,000

Nontaxable interest received (50,000)
Long-term loss accrual in excess of deductible amount 100,000
Depreciation in excess of financial depreciation (250,000)
Taxable income (Tax rate is 30%) 1,400,000

1. What amount should be reported as current tax expense?

2. What amount should be reported as total income tax expense?
3. What amount should be reported as deferred tax liability?
4. What amount should be reported as deferred tax asset?

Problem 2

Chamber Company revealed the following differences between the book and tax basis of
the assets and liabilities on December 31, 2022:
Book basis Tax basis
Installment accounts receivable 1,000,000 0
Litigation liability 200,000 0

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It is expected that the litigation liability will be settled in 2022. The differences in accounts
receivable will result in taxable amounts of P600,000 in 2023 and P400,000 in 2024.

The entity has a taxable income of P7,000,000 in 2022. The income tax rate is 30%. This
is the first year of operations of the entity.

1. What amount should be reported as current tax expense?

2. What amount should be reported as total tax expense?
3. What amount should be reported as deferred tax liability?
4. What amount should be reported as deferred tax asset?

Problem 3

Pecorino Company had a pretax financial income of P2,500,000 in the current year. The
entity made corporate estimated tax payment in the amount of P180,000 during the current
year. To compute the provision for income tax, the following information was provided:

Interest income received 360,000

Tax depreciation in excess of financial statement amount 160,000
Rent received in advance 280,000
Corporate tax rate 30%

1. What amount of permanent differences between book income and taxable income
existed at year-end?
2. What amount of current tax expense should be reported?
3. What amount of income tax payable should be reported?
4. What amount of total tax expense should be reported?

Problem 4

Lakeshore Company reported the following selected information for the current year:

Accounting income before tax 9,700,000

Interest income on tax-exempt municipal bonds 300,000
Depreciation claimed on the tax return in excess of financial depreciation 500,000
Carrying amount of depreciable asset in excess of tax basis 800,000
Warranty expense reported on the income statement 200,000
Actual warranty expenditures 50,000
Income tax rate 30%

At the beginning of current year, the entity reported deferred tax asset at zero and deferred
tax liability at P90,000.

1. What is the current tax expense for the current year?

2. What is the total tax expense for the current year?
3. What is the deferred tax liability at year-end?
4. What is the deferred tax asset at year-end?

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