Accounting principles | business valuation | topics | career center | dictionary | accounting Q & A | quizzes | about us

Browse Accounting Lessons Here

Accounting Terms & Definitions
Accounting for Merchandising Activities
Debits and Credits (Double Entry Accounting)
Business Valuation Formulas
Time Value of Money & Present/Future Values
Complex Debt & Equity Instruments
Common Stock & Shareholder's Equity
Accounting & Finance Ratios
Valuing Common Stock
Corporate Income Taxes
Lower of Cost or Market (LCM) & Inventory Valuation
Chart of Accounts & Bookkeeping
Bonds Payable & Long Term Liabilities
Capital Assets
GAAP, Accrual & Cash Accounting, Information Commodity, Internal Controls & Materiality

What category of browser are you on this website?

Chapter 5.5® - Changes in Income Tax Rate, Recording Future Tax Liability using Effective Tax Rates

Based on the above example, the tax rate was assumed to be unchanged throughout the three years. Now, the problem becomes more interesting, however, if tax rates change while a temporary difference exist.

- Net income before income taxes is $1,000,000 in each of 2006, 2007 and 2008.

- A gain of $600,000 is included in accounting income in 2006 but is not subject to tax until 2008.

- The income tax rate in 2006 is 40%; during 2007, the rate is reduced by act of Parliament to 30%, which remains in effect for both 2007 and 2008.

The calculation of income tax payable under this revised scenario is as follows:

2006 2007 2008
Income before Income taxes (Accounting basis) $1,000,000 $1,000,000 $1,000,000
2006 accounting gain that is taxable in 2008
($-600,000)   ($+600,000)
Taxable Income
$400,000 $1,000,000 $1,600,000
Tax rate
x 40% x 30% x 30%
Income Tax assessed for the Year $160,000 $300,000 $480,000

Using the liability method, the future liability is recorded in 2006 at then-enacted rate of 40%, which yields future income tax of $600,000 X 40% = $240,000. The entry to record income tax expense for 2006 is:

December 31st, 2006

Account Name

Dr. Income Tax Expense (IS)   $400,000  
  Cr. Income Tax Payable (B/S)   $160,000
Cr. Future Income Tax Liability (B/S)   $240,000
Entry to record income tax expense for 2006 & future income tax liability

When the rate changes to 30% in 2007, the future income tax liability balance is overstated. The temporary difference of $600,000 now will result in taxation of only $180,000 instead of $240,000. Therefore, we must reduce the balance of the future income tax liability by $60,000. The entry for income tax for 2007 will be as follows:

December 31st, 2007

Account Name

Dr. Future Income Tax Liability (B/S)   $60,000  
  Cr. Income Tax Expense (I/S) $240,000  
Cr. Income Tax Payable (B/S)   $300,000
Entry to record income tax expense for 2007 & future income tax liability

This is very important to observe that the debit to income tax expense of $240,000 is a built-up number. The 2007 tax expense is comprised of the current taxes at 30% reduced by the adjustment for the tax rate change:

Tax on 2007 earnings: $1,000,000 X 30%   $300,000
Minus impact of tax rate reduction on future    
Income tax balance:
  Old balance: $600,000 X 40% $240,000  
  New balance: $600,000 X 30% ($180,000) $60,000
Income Tax expense     $240,000

The effective tax rate for 2007 is 24%: $240,000 / $1,000,000, which is neither the old rate nor the new rate. Therefore, each year’s income tax expense must be treated as a residual – the amount needed to balance the entry after recording.


© Accounting Scholar | Privacy Policy & Disclaimer | Contact Us