Accounting for Income Taxes

1. Accounting for Income Taxes ACCTG 5120 David Plumlee

2. Accounting for Income Taxes Why do accountants record Deferred Taxes? Income is measured in two different ways, taxable income and GAAP income. Deferred taxes result from timing differences between these two.

3. Accounting Income = Taxable Income Why are GAAP and tax income computed differently? • Tax income is intended to • raise sufficient tax revenues • stimulate or depress certain sectors of the economy • GAAP is intended to provide relevant, reliable and representationally faithful • GAAP is full accrual, while tax is accrual with some cash basis adjustments.

4. Inter-period Tax Allocation From an income statement perspective what is the justification for inter-period tax allocation? It improves matching of tax expense to related accounting income. From a balance sheet perspective what is the justification for inter-period tax allocation? It allows recognition of deferred tax assets and liabilities associated with future deductible and future taxable amounts.

5. A Simple Example Assume that $9,000 is received on day 1, year 1 in payment of year 1 and year 2 rent ($4,500/year). What is the taxable and accounting income for each of these years?

6. “Cash” Basis Assume a tax rate of 30%, then the $2,700 of income tax would be paid in 2003. What is wrong with this approach? No matching of Tax Expense to related accounting income.

7. “Accrual” Basis Using Interperiod Tax Allocation: Total tax expense is still $2,750, but: • net income better reflects “effort” • effective tax rate reflects statutory rate • less volatility in earnings

8. Is a deferred tax really a liability? • Some say yes • eventually the timing difference will be reversed and the tax recorded in the deferred tax liability account will become payable • future cash outflow in the amount of the deferred tax liability (asset) will occur • Some say no • many reversing temporary differences continually replaced with new originating temporary differences • in reality deferred income tax liabilities continually grow • net temporary differences do not require future cash outflows • not a legal obligation of the firm until tax return filed

9. Permanent Differences A difference arising from an item that enters into accounting income but never taxable income (interest on state issued bonds) or enters into taxable income but never accounting income (excess depletion on wasting assets)

10. Examples of Permanent Differences • Interest on state/municipal bonds • Proceeds from executive life insurance • Premiums paid on executive life insurance • Fines due to violations of the law • Dividend received deduction - 70% - 80% of dividends received from U. S. corporations • Excess depletion on wasting assets

11. Example: Interest Income on State Bonds A company receives $1,000 in interest income on state bonds and tax rate is 45%. The company NEVER pays tax on this income. What if we did this? tax expense 450 deferred tax liability 450 Deferred tax would stay on the books forever!

12. Temporary Differences A difference between an asset or liability’s tax basis and its amount for accounting purposes that will result in taxable or deductible amounts in future years Or, a difference between in the financial and tax amounts for income (or expense) in a given year (or years)

13. How do we get taxable income? • Start with GAAP/financial ‘books’ • Make tax-related adjustments • permanent items that are in accounting income but not taxable or vice versa • temporary/timing items that are included in financial income at a different time than taxable income • Complete tax return and pay required taxes (taxes payable)

14. A company purchases an asset for $100,000. Depreciation expense: accounting - straight-line over 4 years tax - straight-line over 2 years Temporary Difference - Example

15. Reconciliation - Year 1

16. AJE to Record Tax Expense What is adjusting entry at the end of year 1? tax expense $80,000 tax payable $70,000 deferred tax liability $10,000

17. Reconciliation - Year 2

18. AJE to Record Tax Expense What is the balance in Deferred Tax Liability at the end of year 2? ($25,000+25,000) x 40% = $20,000 What is adjusting entry at the end of year 2? tax expense $40,000 tax payable $30,000 deferred tax liability $10,000

19. Reconciliation - Year 3

20. Tax Expense $72,000 Deferred Tax Liability $10,000 Tax Payable $82,000 AJE to Record Tax Expense What is the balance in Deferred Tax Liability at the end of year 3? ($25,000+25,000-25,000) x 40% = $10,000 What is the entry to record tax expense for year 3?

21. Changes in tax rates across time?

22. AJE to Record Tax Expense What is the balance in Deferred Tax Liability at the end of year 4? Should be $0, but ($25,000+25000-25000) x 40% +(-25,000)x 30% = 2500 What is the entry to record tax expense for year 4? Tax Expense $21,000 Deferred Tax Liability $ 7,500 Tax Payable $28,500

23. Find cumulative temp. basis differences = book - tax * Compute ending deferred tax balance. Prepare a schedule of anticipated reversals and applying appropriate enacted tax rates Tax Expense = tax payable +/- change in Deferred Tax balance Computing Tax Expense *differences that will reverse in the future. If differences are permanent, ignore! Compute taxes payable Compute change in Deferred Tax balance

24. Example • Year 2000 pretax accounting income = $500,000 • Current tax rate = 40% • Deferred Tax liability (Jan 1, 2000) = $320,000 • Year 2000 depreciation • accounting = $200,000 • tax = $400,000 • Municipal Bond Interest $10,000

25. Example (continued) As at the end of year 2000: Book basis of depreciable assets $1,000,000 Tax basis of depreciable assets 0 Cumulative temporary difference $1,000,000 Additional information: • enacted tax rates as shown in schedule • temporary differences expected to reverse as shown in schedule

26. Change in Deferred Tax Balance Closing deferred tax liability $350,000 Opening deferred tax liability 320,000 Net increase in deferred tax liability $ 30,000

27. Compute Taxes Payable Pre-tax accounting income $500,000 add accounting depr. 200,000 subtract tax depr. (400,000) subtract non-taxable interest ( 10,000) Taxable income $290,000 tax rate x 40% Tax Payable (per tax return) $ 116,000

28. Journal Entry tax expense (plug)146,000 tax payable 116,000 deferred tax liability* 30,000 *since we have a starting balance in DTL account, need to adjust to correct balance

29. Carry Forward Carry Back 2 years 20 years • If a carryback then • receive a refund of previous tax paid • record tax receivable based on prior year rate • If a carryforward then • future deductible item • record deferred tax asset based on future enacted rate NOL Year Net Operating Losses (NOL)

30. Deferred Tax Asset Valuation Allowance • Based on all available evidence it is more likely than not that some portion will not be realized • Intended to adjust Deferred Tax asset to expected net realizable value tax expense xx valuation allowance xx • Adjust to required ending balance each period

31. Deferred Tax Asset Valuation Allowance In year of expected reversal future deductible amounts > future taxable amounts • Will there be sufficient future taxable income to absorb the excess? • Could the excess be carried back to prior years? if answer is NO - valuation allowance required

32. Balance Sheet Presentation • Classify deferred tax balances based on • classification of related asset/liability • expected reversal date if not related • For reporting purposes • net current deferred tax balance • net non-current deferred tax balance • show deferred tax assets net of valuation allowance

33. Intraperiod Tax Allocation Allocation of tax across different sources of income/loss within a given period including: • income from continuing operations • discontinued operations • extraordinary items • cumulative changes in accounting policy • items charged directly to retained earnings, for example • prior period adjustments • mark-to-market adjustments under FAS 115

34. Intraperiod Tax Allocation A company has ordinary income of $50,000 and extraordinary income of $100,000 • tax rate is 45% • no permanent or temporary differences • tax payable • on ordinary income = $22,500 • on extraordinary income = $45,000

35. Intraperiod Tax Allocation