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

• Part 5.1 - Accounting for Corporate Income Taxes & Intra-period Tax Allocations
• Part 5.2 - Income Tax Provision or Expense? Differences between Taxable & Accounting Income (Permanent & Temporary Differences)
• Part 5.3 - Conceptual Issues in Interperiod Tax Allocation - Comprehensive & Partial Tax Allocation Methods (theory only)
• Part 5.4 - Future Tax Calculations using the Deferral or Liability (Accrual) Methods, Basic Illustration of Interperiod tax Allocation
• Part 5.5 - Changes in Income Tax Rate, Recording Future Tax Liability
• Part 5.6 - Difference between Carrying Value and Tax Basis
• Part 5.7 - Reconciliation of Effective Tax Rates & Differential Reporting & Accounting Treatment of the Investment Tax Credit

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.

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

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:

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:

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:

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.