Accounting for income taxes
Accounting for income taxes CPA exam items are one sorting exercise followed by one multiplication. A difference between book and taxable income is either temporary — it reverses, so it creates deferred tax — or permanent, in which case it never does. Municipal bond interest is the classic permanent difference: it changes current tax and creates no deferred tax at all. Sorting the differences wrongly makes every number after it wrong.
| Blueprint group | FAR-III-D |
| Area weight | 25–35% |
| Approx. share of the exam | 4.3% |
What the Blueprint asks for here
At this group the Blueprint expects a candidate to reconcile pretax financial income to taxable income, to identify temporary and permanent differences, to calculate current and deferred income tax expense and the related deferred tax assets and liabilities, and to prepare the journal entries that record them.
This is our paraphrase, not the Blueprint’s wording. verbatim quote pending The authoritative representative-task text is in the AICPA Blueprints, which are published free — download them and read the group directly. We will not print a quotation we have not taken from the source document.
Accounting for income taxes CPA exam items: deferred tax in FAR
Why this group is worth its weight
Income taxes is one of the highest-weight groups in Area III and the one most often described as the hardest topic in FAR. The description is half right: the vocabulary is dense, but the mechanics reduce to a sorting step and a rate multiplication, and a candidate who can reliably sort differences has most of the group.
Temporary against permanent
A temporary difference is a timing difference between the book carrying amount of an asset or liability and its tax basis: it will reverse in a future period, and the tax effect of that future reversal is recognised now as a deferred tax liability or asset. Accelerated tax depreciation, an installment sale and warranty accruals are temporary. A permanent difference never reverses: municipal bond interest that is never taxable, fines that are never deductible, the excess of book over tax treatment of certain life insurance. Permanent differences change taxable income and the effective rate, and create no deferred tax.
The mechanics, in order
Start from pretax financial income. Remove permanent differences to get to the income the tax return recognises at all. Then adjust for temporary differences to reach taxable income. Current tax expense is taxable income times the enacted rate. Deferred tax is the change in the deferred balances, each measured at the enacted rate expected to apply when the difference reverses — enacted, not proposed. Total income tax expense is the sum of the two, and a useful check is that it equals pretax financial income times the rate, adjusted only for the permanent differences.
Valuation allowances and where judgement enters
A deferred tax asset is recognised in full and then reduced by a valuation allowance if it is more likely than not — a greater than 50% likelihood — that some portion will not be realised. That threshold is a number the exam expects you to state, and the allowance is the one place in the group where the answer depends on an assessment rather than on arithmetic. All deferred tax assets and liabilities are classified as noncurrent on a classified balance sheet.
The standard this group is examined on is published by the standard setter: FASB Accounting Standards Codification. The Blueprint coordinates and weight ranges above come from the AICPA Blueprints. What is ours, and labelled as ours, is the reading, the practice item and the misconception tags.
A practice item
our own practice item Written by us against the public Blueprint. It is not an AICPA question and it is not taken from any review course.
A company reports pretax financial income of $800,000 for the year. Included in it is $60,000 of interest on municipal bonds, which is never taxable. Tax depreciation for the year exceeds book depreciation by $100,000, a difference that will reverse in future periods. The enacted tax rate is 21% for the current and all future years, and there were no deferred balances at the beginning of the year.
What is the deferred tax liability at the end of the year?
| A | $21,000 | correct |
| B | $33,600 | |
| C | $12,600 | |
| D | $168,000 |
The rule
A deferred tax liability is recognised for the future tax consequences of taxable temporary differences: differences between the carrying amount of an asset or liability and its tax basis that will result in taxable amounts in future periods. It is measured at the enacted tax rate expected to apply when the difference reverses. Permanent differences do not reverse and give rise to no deferred tax.
The arithmetic
Only the depreciation difference is temporary, so the deferred tax liability is $100,000 × 21% = $21,000. The municipal interest is permanent. For the rest of the picture: taxable income is $800,000 − $60,000 − $100,000 = $640,000, current tax expense is $640,000 × 21% = $134,400, and total income tax expense is $134,400 + $21,000 = $155,400 — which equals ($800,000 − $60,000) × 21%, the check that the permanent difference is the only thing moving the effective rate.
What we would ask you first
This is the part of the product that is hard to show without an account, so here it is directly: for each wrong option above, the opening question our tutor asks — before any explanation — targeting the specific mistake that option represents. Choosing B ($33,600) and choosing D ($168,000) are different errors and deserve different first questions.
If you chose B — permanent_treated_as_temporary
“Your rate is right and your base is $160,000, which is both differences added together. One of those two will reverse in a future period and one never will. Which is which?”
If you chose C — permanent_difference_deferred
“You applied the rate to the municipal interest. Deferred tax exists because a difference will reverse and be taxed later — will the municipal interest ever be taxed?”
If you chose D — total_expense_reported
“Your figure is 21% of the whole pretax financial income. That is the neighbourhood of total tax expense, not the deferred piece. Which part of the year's tax has not been paid yet?”
To be precise about what happens next: the exchange is a rate limit, not a gate. Answering well gets you to the full worked explanation in three or four exchanges; answering badly still gets you there. And if you would rather skip it, asking three times gets you the walkthrough.
Common questions
What is the difference between a temporary and a permanent difference?
A temporary difference is a difference between the book carrying amount of an asset or liability and its tax basis that will reverse in a future period, so it creates a deferred tax asset or liability. A permanent difference — municipal bond interest, non-deductible fines — never reverses and creates no deferred tax, though it does change the effective tax rate.
Which tax rate is used to measure deferred tax?
The enacted rate expected to apply in the period the temporary difference reverses. Enacted, not proposed: a rate change that has been announced but not enacted does not change the measurement until it is.
Misconception tags in this group
These are the labels our diagnosis attaches when a wrong answer matches a known pattern. They are worth reading even if you never use the product — naming your own error is most of the work.
permanent_treated_as_temporary— Creating deferred tax on a permanent difference.permanent_difference_deferred— Applying the tax rate to the permanent difference and reporting the result as deferred tax.total_expense_reported— Answering with total income tax expense when the deferred balance was asked for.proposed_rate_used— Measuring deferred balances at a proposed rather than an enacted rate.valuation_allowance_threshold— Applying a threshold other than more likely than not to a deferred tax asset valuation allowance.