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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 Debit Credit 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 Debit Credit 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.