Accounting for Income Taxes

Accounting for Income Taxes Chapter 19 Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Prepared by Coby Harmon, University of California, Santa Barbara

Background • Deferral approach to tax allocation (APB Opinion 11) • Income tax expense = amount of taxes that would be paid if income statement numbers appeared on the current year's tax return. • Deferred taxes was the plug figure (difference between taxes payable and tax expense). • The effect of subsequent changes in tax rates on deferred tax account were essentially ignored. Matching Approach

Background • A method that was proposed theoretically (but has never been GAAP in US) • Assets and liabilities would be recorded NET of any deferred tax related to the item Net-of-Tax Approach

Background • Liability approach to tax allocation (FASB 96, 109) • Income tax expense = taxes currently payable plus change in deferred taxes. • If tax rates change, the effect on deferred tax amounts affect income tax expense in the year the change is enacted. • If there are no changes in tax rates, income tax expense should be approximately the same as under APB Opinion 11. Asset/Liability Measurement Approach

Fundamentals of Accounting for Income Taxes Financial Statements Tax Return IRS vs. Exchanges Investors and Creditors  Pretax Financial Income Taxable Income GAAP Tax Code  Income Tax Expense Income Tax Payable

Temporary Differences A Temporary Difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years. Future Taxable Amounts Future Deductible Amounts Deferred Tax Liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year. Deferred Tax Asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year. Illustration 19-22Examples of Temporary Differences

Temporary Differences (1) • Revenues and gains, recognized in financial income, are later taxed for income tax purposes. • Installment sales • Expenses and losses are deducted for income tax purposes before they are recognized in financial income. • MACRS depreciation • Goodwill deduction on tax return Called “taxable temporary differences”

Temporary Differences (2) • Revenues and gains are taxed for income tax purposes beforethey are recognized in financial income. • Subscription revenue • Prepaid rent • Expenses and losses, recognized in financial income, are later deducted for income tax purposes. • Warranty expense Called “deductible temporary differences”

Transaction When recorded in books When recorded on tax return Deferred tax effect Rev or Gain Earlier Later Liability Rev or Gain Later Earlier Asset Exp or Loss Earlier Later Asset Exp or Loss Later Earlier Liability Summary of Temporary Differences

Some items are recorded in Books but NEVER on tax return Other items are NEVER recorded in books but recorded on tax return Permanent Differences Sources of Permanent Differences No deferred tax effects for permanent differences

Permanent Differences: Examples • Items, recognized for financial accounting purposes, but not for income tax purposes: • Interest revenue on Municipal Bonds • Life insurance premiums and proceeds when corporation is beneficiary • Fines and penalties • Items, recognized for tax purposes, but not for financial accounting purposes: • Dividend exclusion • Statutory depletion

Deferred Tax Asset & Deferred Tax Liability: Sources • Deferred taxes may be a: • Deferred tax liability, or • Deferred tax asset • Deferred tax liability arises due to net taxable amounts in the future. • Deferred tax asset arises due to net deductible amounts in the future.

Valuation Allowance for Deferred Tax Assets If the deferred tax asset appears doubtful, a Valuation Allowance account is needed. Journal entry: Income Tax Expense $$ Allowance to Reduce Deferred Tax Asset to Expected Realizable Value$$ The entry records a potential future taxbenefit that is notexpected to be realized in the future. New GAAP = FIN 48 (not on a 2006 FARS)

What Tax Rate to Apply • Basic Rule: Apply the yearly tax rate to calculate deferred tax effects. • If future tax rates change: use the enacted tax rate expected to apply in the future year. • If new rates are not yet enacted into law for future years, the current rate should be used. • The appropriate enacted rate for a year is the average tax rate [based on graduated tax brackets].

Balance Sheet Presentation • The deferred tax classification relates to its underlying asset or liability. • Classify the deferred tax amounts as currentor non-current. • Presentation is • NET amount related to current items • If DR>CR, current deferred tax asset • If DR<CR, current deferred tax liability • NET amount related to noncurrent items • If DR>CR, noncurrent deferred tax asset • If DR<CR, noncurrent deferred tax liability

Net Operating Loss (NOL) Net operating loss is tax terminology. A net operating loss occurs when tax deductions for a year exceed taxable revenues. Net loss or operating loss is a financial accounting term.

NOL Rule (subject to change) • NOL for each tax year is computed. • The NOL of one year can be applied to offset taxable income of other years, possibly resulting in tax refunds • Current rule: NOLs can be: • carried back 2 years and carried forward 20 years (carryback option), • or carried forward 20 years (carryforward only)

next Apply first Loss carryforward 20 years forward Expect tax refund here Expect tax shield here Record all tax effects here NOL Carryback Tax years 2001 2002 2003 2004 2005 2006 2007 NOL 2004

Loss carryforward 20 years forward Forgo 2 year rule Expect tax shield here Record all tax effects here NOL Carryforward Tax years 2001 2002 2003 2004 2053 2006 2007 2024 NOL 2004

Intraperiod Tax Allocation Income tax expense, is allocated to: • Continuing operations • Discontinued operations • Extraordinary items • Cumulative effect of an accounting change,– we won’t see this one any more after FAS154 • Prior period adjustments Disclose other significant components, such as: • current tax expense, • deferred tax expense/benefit, etc.

Other Items Affected • Comprehensive income items • Holding gain/loss on AFS securities • Certain gains/losses related to foreign currency and derivatives • Pension & post-retirement benefit amounts not yet recognized on income statement • Correction of error/change in accounting principle that affects beginning retained earnings • Expenses for employee stock-based compensation • Existing deferred amounts in quasi-reorganization

FIN 48 –Uncertain Tax Positions • The key points in the Interpretation are: • A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits • A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50-percent likely to be realized

Examples of tax positions (1) • A deduction taken on the tax return for a current expenditure that the taxing authority may assert should be capitalized and amortized over future periods. • A decision that certain income is nontaxable under the tax law. • The determination of the amount of taxable income to report on intercompany transfers between subsidiaries in different tax jurisdictions.

Examples of tax positions (2) • The determination as to whether an entity qualifies as a real estate investment trust or regulated investment company. • The determination as to whether an entity is subject to tax in a particular jurisdiction. • The determination as to whether a spin-off transaction is taxable or nontaxable. • The calculation of the amount of a research and experimentation credit.

FIN 48 • First, identify uncertain tax positions • Determine the appropriate “unit of account” • Example – consider all R&D together or consider each R&D project separately • FASB did not specify • Next, apply FIN 48 step process to determine how much to recognize

FIN 48 – Step 1, Does it meet recognition threshold? • “More likely or not” of being accepted by IRS on its technical merits • Assumes taxing authority has full knowledge of all relevant facts • If not, entire amount must be “reserved” (e.g., offset by the allowance account)

FIN 48 – Step 2 Measure the tax benefit • Measurement • The benefit recognized for a tax position meeting the more-likely-than-not criterion is measured based on the largest benefit that is more than 50 percent likely to be realized. • A new methodology is introduced based on “cumulative probability” • Example needed to explain (next slide)

FIN 48 – PWC example • Assume that a position to claim a tax credit of $1,000 is “more likely than not,” based on its technical merits. The company seeking to claim this credit has developed the probability table [next slide] of all possible material outcomes.

FIN 48 – PWC example • Assume that a position to claim a tax credit of $1,000 is “more likely than not,” based on its technical merits. The company seeking to claim this credit has developed the probability table [next slide] of all possible material outcomes. • Under the Interpretation, $600 denotes the amount of tax benefit that would be recognized in the financial statements; it represents the maximum amount of benefit that is more than 50-percent likely to be the end result. How much to disclose? A big deal??

FIN 48 Disclosures • Must continuously monitor uncertain tax positions • Should have processes and controls to identify material changes • Will require much closer coordination between tax dept and financial accounting (public reporting) department!

From Para. A33 Example

FIN 48 – accruing interest • Interest and penalties must be paid if underpayment of tax liabilities exists • A position that does not qualify as “more likely than not” under GAAP is effectively a LOAN from government • Therefore, interest should be accrued on the full balance on the liability for unrecognized uncertain tax benefits

FIN 48 – Balance Sheet • Uncertain tax positions result in recognition of a tax liability or a decrease in recognized tax assets on the balance sheet • The tax liability for “uncertain positions” is NOT a component of deferred taxes and must be classified SEPARATELY from other tax balances • Current or noncurrent depending on expected timing of cash flows to/from IRS

Deferred Taxes IAS 12 vs FAS 109 versus

US GAAP Which Tax Rate to Use IFRS Enacted tax rates Enacted or substantively enacted tax rat

US GAAP Deferred Tax Assets IFRS Use an allowance account to reduce to net realizable value Uses same “more likely than not” criteria Don’t recognize at all unless it is “more likely than not” to be usable in the future

US GAAP Balance Sheet Presentation IFRS Current items netted Noncurrent items netted Always classified as noncurrent Plans to revise to do it the FASB way

Accounting for Income Taxes