Chapter 14: Income Taxes & Financial Accounting

1. Chapter 14: Income Taxes & Financial Accounting • Income tax allocation • MACR system • SFAS no. 109 • Investment tax credit • Empirical research

2. Income Tax Law of 1913 • Established income as a basis for taxation • Since income for tax purposes was defined differently than income for accounting purposes • Resulted in many items being recognized in different time periods for tax and book purposes • Efforts to synchronize tax and book accounting go back to the 1930s

3. Income Tax Allocation • Made necessary by the timing differences between when a revenue or expense item reaches the published financial statements as opposed to when it appears on the tax return • tax expense is based on the published before-tax income figure

4. Income Tax Allocation • Comprehensive Allocation: as long as timing differences arise • tax allocation must take place, • despite the possibility of relevant circumstantial differences • Permanent differences between published statements and tax returns are not subject to the allocation process

5. Intrastatement  or Intraperiod Tax Allocation • items are shown net of the tax effect • prior period adjustments • extraordinary items • changes in accounting principle • operations of discontinued segments • balance of the total tax expense figure then appears below net income before income taxes and extraordinary items

6. Timing Differences • Referred to as temporary differences • Tax liability would be greater than tax expense where • revenues are recognized for tax purposes earlier than for published re­porting purposes • expenses are recognized more rapidly on the financial statements than on the tax return • Tax expense is greater than tax liability when either revenues are recognized more slowly or expenses more rapidly for tax purposes than for book purposes

7. Depreciation • Using straight line for book and accelerated for tax purposes creates • timing differences for a non-growth company • a potentially permanent deferral for a growth-type company • Federal government uses accelerated depreciation to stimulate economic growth

8. Orientations to Income Tax Allocations • No allocations...tax is a distribution of income • New form of equities...tax allocation is in effect an investment in the firm by government • Net-of-tax method...adjust book depreciation; tax expense = tax liability • Partial allocation...only those credits expected to be paid in foreseeable future are recorded • Discount deferred tax liabilities

9. Modified Accelerated Cost Recovery System • Came about in 1986 tax act • Eliminates concept of useful depreciable life • Uses six classes of capital assets with prescribed lives • Salvage values not considered • Eliminated IRS-corporation controversies over useful lives

10. 3 5 7 10 15 20 Short-lived special mfg tools & handling devices Cars, light trucks & certain mfg equipment Most heavy mfg equipment Includes RR track, electrical generating... Includes gas pipelines and nuclear plants Includes sewer pipes and phone cables Class (Years) Type of Asset

11. SFAS No. 96 (December 1987) • Kept comprehensive income tax orientation of APB Opinion No. 11, but substituted a liability (asset-liability) approach in place of the deferred approach of APB Opinion 11 • Dissatisfaction with the conservative recognition of deferred tax assets in SFAS No. 96 led to its replacement by SFAS 109

12. SFAS No. 109 • Carryback of deferred tax assets and the allowed carryforward against deferred tax liabilities of future years • Allows recognition of deferred tax assets if realization is “more likely than not” • Restores a consistency between deferred tax assets and liabilities • Current or noncurrent designation is derived from the classification of the related asset or liability

13. Net Operating Losses • SFAS No. 96 also took a negative view of treating tax-loss carryforwards as assets like its predecessor, APB Opinion No. 11 • SFAS No. 109 took a complete turnaround on booking tax-loss carryforwards from its two predecessors. Tax-loss carryforwards will now be booked subject to the same valuation allowance for deferred tax assets.

14. Empirical Research • Beaver and Dukes • Ayers • Espahbodi, Espahbodi, and Tehranian • Cheung, Krishnan, and Min • Givoly and Hayn • Chaney and Jeter

15. Investment Tax Credit (ITC) • First enacted in 1962. • Provisions of the law have changed several times. • As a tool of macroeconomic policy, the ITC is seen as a means of stimulating investment and, thus, fighting recession in the short run and combating inflation over the long run. • Tax Reform Act of 1986 eliminated ITC

16. Interpretations of the ITC Transaction • Reduction of the cost of the asset. • Allocation by means of a deferred investment credit account. • Capital donated by the government. • Flow through (immediate recognition of all benefits taken in the year of acquisition).

17. Improving Accounting Standards • Deferred tax assets and liabilities should be discounted to their present value. • Discount rate for deferred tax liabilities should be for a loan of similar duration, repayment schedule, and risk undertaken by the lender. • Deferred tax assets, a single rate might be prescribed since the government is the payer. • since the firm’s risk is low, the rate should be determined based on a very high quality investment having a very low rate of risk.

18. Chapter 14: Income Taxes & Financial Accounting • Income tax allocation • MACR system • SFAS no. 109 • Investment tax credit • Empirical research