Tax Discrepancies: Understanding Differences in Financial Reporting

1. Chapter 3 Taxes on the Financial Statements

2. Book-Tax Differences • Significant differences may exist between a corp.'s Federal income tax liability reported on Form 1120 (tax) and the corp.’s income tax expense on financial statements (book) • Differences are caused by any or all of the following: • Differences in reporting entities included in the calculation • Different definition of taxes included in the income tax expense amount • Different accounting methods

3. Different Reporting Entities (slide 1 of 2) • For book purposes: • For > 50% ownership, corporate group must consolidate all U.S. and foreign subs • For 20% to 50% ownership, parent uses the equity method to account for earnings of sub • For < 20% ownership, use the cost method to account for income from these investments

4. Different Reporting Entities (slide 2 of 2) • For tax purposes: • U.S. corporation may elect to include any domestic subsidiaries that are 80% or more owned in its consolidated U.S. tax return • The income of foreign subsidiaries and < 80% owned domestic subsidiaries is not included in consolidated tax return

5. Different Taxes • For book purposes, income tax expense includes: • Federal, state, local, and foreign income taxes • Both current and deferred tax expense amounts • For tax purposes: • Amount is based on the U.S. corporation’s taxable income • State income taxes are reported on the Federal tax return, but as deductions in arriving at taxable income

6. Different Methods (slide 1 of 4) • Many differences exist between book and tax accounting methods • Some are temporary differences • Income and expenses appear in both the financial statement and tax return, but in different periods • Others are permanent differences • Items appear in financial statement or tax return, but not both

7. Different Methods (slide 2 of 4) • Examples of temporary differences include: • Depreciation on fixed assets when MACRS is used for tax, straight-line for book • Compensation-related expenses where, under GAAP, corporations must accrue future expenses related to certain postretirement benefits, which are only deductible for tax purposes when paid • Accrued income and expenses such as warranty expenses which are accrued for book purposes, but are not deductible for tax purposes until incurred

8. Different Methods (slide 3 of 4) • Examples of temporary differences include (cont’d): • Net operating losses incurred in one year for book purposes may be used as a deduction for tax purposes in a different year • Certain intangible assets such as goodwill are not amortizable for book purposes, but for tax purposes, post-1993 intangibles are amortized over 15 years

9. Different Methods (slide 4 of 4) • Examples of permanent differences include: • Nontaxable income such as municipal bond interest, which is income for book purposes but is not taxable • Nondeductible expenses such as the disallowed portion of meals and entertainment expense and certain penalties that are not deductible for tax purposes but are expensed in arriving at book income • Tax credits such as the research activities credit which reduce the Federal income tax liability but have no corresponding book treatment

10. Schedule M–1 (slide 1 of 2) • Used to reconcile book income to the taxable income reported on the tax return • Contains positive and negative adjustments for both temporary and permanent differences • For tax years after 2004, Schedule M–3 is required for a consolidated tax group with total year-end assets ≥ $10 million • Income tax note of the financial statements also contains a tax reconciliation, but the purpose and content of this reconciliation are quite different • Typically the starting point for IRS audits of corporations • Identifies large differences between book and taxable income which may offer the IRS auditor insights into tax saving strategies

11. Schedule M–1 (slide 2 of 2)

12. FAS 109 Principles (slide 1 of 5) • Income tax expense under FAS 109 is made up of both current and deferred components • Current tax expense theoretically represents the taxes actually payable to (or refund receivable from) the government • Deferred tax expense or deferred tax benefit represents the future tax cost (or savings) connected with income reported in the current-period financial statement • Created as a result of temporary differences

13. FAS 109 Principles (slide 2 of 5) • FAS 109 adopts a balance sheet approach to measuring deferred taxes • Under this approach, the deferred tax expense or benefit is the change from one year to the next in the net deferred tax liability or deferred tax asset • A deferred tax liability is the expected future tax liability related to current income (measured using enacted tax rates and rules)

14. FAS 109 Principles (slide 3 of 5) • A deferred tax liability is created in the following situations: • An expense is deductible for tax in the current period but is not deductible for book until some future period • Income is includible currently for book purposes but is not includible in taxable income until a future period

15. FAS 109 Principles (slide 4 of 5) • A deferred tax asset is the expected future tax benefit related to current book income (measured using enacted tax rates and rules) • A deferred tax asset is created in the following situations: • An expense is deductible for book in the current period but is not deductible for tax until some future period • Income is includible in taxable income currently but is not includible in book income until a future period

16. FAS 109 Principles (slide 5 of 5) • Deferred tax assets and liabilities are reported on the balance sheet • Deferred tax liabilities represent an amount that may be paid to the government in the future • In essence, an interest-free loan from the govt. with a due date perhaps many years in the future • Deferred tax assets are future tax benefits • Similar to a receivable from the government that may not be received until many years in the future

17. Valuation Allowance (slide 1 of 2) • Under FAS 109, deferred tax assets are recognized only when it is more likely than not that the future tax benefits will be realized • When the more likely than not threshold is not met, a valuation allowance (a contra-asset account) must be created to offset all or a portion of the deferred tax asset

18. Valuation Allowance (slide 2 of 2) • To determine if a valuation allowance is needed, both positive and negative evidence must be evaluated • Examples of negative evidence include: • History of losses • Expected future losses • Short carryback/carryforward periods • History of tax credits expiring unused • Examples of positive evidence include: • Strong earnings history • Existing contracts • Unrealized appreciation in assets • Sales backlog of profitable orders

19. Earnings Of Foreign Subsidiaries (slide 1 of 2) • Corporate group’s financial statements include both domestic and foreign controlled subsidiaries • Foreign corps. controlled by U.S. shareholders, are not part of a U.S. consolidated tax return • May achieve deferral of current U.S. taxes on foreign income if earned through foreign subsidiary corporations in jurisdictions with lower tax rates than the United States • Effective tax rate for financial statement purposes may not reflect this deferral because FAS 109 requires that a corporate group report both current and deferred income tax expense

20. Earnings Of Foreign Subsidiaries (slide 2 of 2) • APB 23 provides a special exception to FAS 109 for income from foreign subs • If a corporation documents it is permanently reinvesting earnings of its foreign subs outside the U.S., the corporation does not record as an expense any future U.S. income tax that the corporation may pay on such earnings • APB 23 can be adopted in some years and not others • Even within a year it may be used for only a portion of foreign subsidiary earnings

21. Tax Disclosures (slide 1 of 4) • Deferred tax liabilities or assets appear in the corporation’s balance sheet • Classified as either current or noncurrent, based on the assets or liabilities that created the temporary difference • If not related to any asset, then the classification is based on the expected reversal period

22. Tax Disclosures (slide 2 of 4) • Income statement reports corp.'s total income tax expense • Consists of both the current tax expense (or benefit) and the deferred tax expense (or benefit) • Tax expense must be allocated to income from continuing ops, discontinued ops, extraordinary items, prior-period adjustments, and the cumulative effect of accounting changes • Additional disclosures are required for these items

23. Tax Disclosures (slide 3 of 4) • Income tax note contains the following info: • Breakdown of income between domestic and foreign • Detailed analysis of provision for income tax expense • Detailed analysis of deferred tax assets and liabilities • Effective tax rate reconciliation (dollar amount or percentage) • Information on use of APB 23 for the earnings of foreign subsidiaries • Discussion of significant tax matters

24. Tax Disclosures (slide 4 of 4) • Effective tax rate reconciliation • Demonstrates how a corporation’s actual book effective tax rate relates to its “hypothetical tax rate” as if the book income were taxed at a rate of 35% • Similar to Schedule M–1 or M–3, but only reports differences triggered by permanent differences • Can provide substantial clues as to tax planning strategies adopted (or not adopted) by a company

25. Calculating Corporate Income Tax Expense

26. Benchmarking • Reported income tax expense is a valuable source of information • Provides clues about a company’s operational and tax planning strategies • Companies may benchmark their tax situation to other years’ results or to other companies within the same industry • The starting point is data from the income tax note rate reconciliation

27. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: • Dr. Donald R. Trippeer, CPA • trippedr@oneonta.edu • SUNY Oneonta