Income Tax Accounting SFAS 109 (ASC 740-10)

1. Income Tax Accounting SFAS 109 (ASC 740-10)

2. Course Objectives Understand and apply basic concepts and procedures of SFAS 109 Understand the how to identify temporary differences Understand how to calculate the current and deferred tax provisions Understand the basics of the valuation allowance Understand how the tax provision affects financial statements and its role in the audit Ensure client compliance with financial statement disclosure requirements

3. Recognize: The amount of taxes payable or refundable for the current year 2. Deferred tax liabilities and assets for the future tax consequences of events that have been recognized in a company’s financial statements or tax returns Objectives of ASC 740-10

4. A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year A deferred tax liability or asset is recognized for estimated future taxes created by temporary differences The measurement of current and deferred taxes is based on the provisions of the enacted tax law Measurement of deferred tax assets is reduced if they will not be recognized. Basic Principles

5. Current income tax expense (benefit) + Deferred income tax expense (benefit) Total income tax expense (benefit) Components of Income Tax Expense

6. Balance Sheet Approach SFAS 109 requires the balance sheet approach to compute deferred taxes To compute the expense you must compare the beginning balance to the ending balance Balance Sheet Approach

7. Balance Sheet Approach

8. Domestic federal income taxes Foreign, state and local taxes based on income Domestic and foreign operations that are consolidated, combined or accounted for by the equity method Foreign enterprises in preparing financial statements under US GAAP ASC 740-10 Applicability

9. Hi Course Objectives story APB 11 Issued in 1967 Used the Deferred Method Calculation was a “with” and without” method History of Accounting for Income Taxes

10. The basic formula under APB 11 was: Pretax income +/- Permanent Differences Taxable Income X Tax Rate Tax Provision History of Accounting for Income Taxes

11. FASB 96 Issued in 1996 Used the Liability Method Required extensive scheduling Assumed co. would have not future income History of Accounting for Income Taxes

12. FASB 109 Issued in 1992 Maintained liability method Simplified the scheduling requirement Required all deferred assets to be recorded Introduced the concept of a valuation allowance History of Accounting for Income Taxes

13. Temporary Differences The difference between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled, respectively. 13

14. Types of Temporary Differences Taxable Temporary Differences Differences that will result in taxable amounts in future years when the related asset or liability is recovered or settled. Deductible Temporary Differences Differences that will result in deductible amounts in future years when the related asset or liability is recovered or settled 14

15. Types of Temporary Differences

16. Types of Temporary Differences

17. Types of Taxable Temporary Differences Revenue or gain that are taxable after they are recognized in book income. Ex. Installment Sales Expenses or losses that are deductible before they are recognized in book income. Ex. Depreciation

18. Types of Deductible Temporary Differences Revenue or gains that are taxable before they are recognized in book income. Ex. Prepaid Income Expenses or losses that are deductible after they are recognized in book income. Ex. Reserves NOLs and credit carryforwards

19. Calculation of the Balance of a Temporary Difference Calculation of Temporary Difference: Calculated Book Basis - Calculated Tax Basis Total Temporary Difference

20. Deferred Tax Provision – “Five Step Process” • Estimate the applicable tax rate • Determine the gross deferred tax liability • Determine the gross deferred tax asset • Determine the gross deferred tax asset for credit carryforwards • Record a valuation allowance, if necessary

21. Tax Rates Used • U.S. Federal Income Tax Rate • Regular • AMT • State Income Taxes • Blended Tax Rate • Foreign Income Taxes

22. Deferred Tax Liability DTL = Taxable temporary differences X applicable tax rate

23. Deferred Tax Asset DTA = [(Deductible temporary differences + loss and deduction carryforwards) X applicable federal rate] + tax credit carryforwards.

24. Deferred Tax Expense/Benefit Net DTA or DTL at end of year Less: Net DTA or DTL at beginning of year Deferred income tax expense (benefit)

25. Effect of Change in Net DTA or DTL

26. Exception to the General Rule APB 23 – Permanently reinvested earnings in a foreign subsidiary

27. Valuation Allowance Impairment Approach A valuation allowance is required if the deferred tax asset is “impaired” Realization Test A probability level of more than 50% A single criterion “more likely than not” Future Taxable Income is Required

28. Future Taxable Income • Future reversals of existing taxable temporary differences • Taxable income in carryback years • Tax-planning strategies • Future taxable income (exclusive of reversing temporary differences and carryforwards)

29. Tax Planning Strategies Tax-planning strategies will accelerate income so that the company can take advantage of future deductible differences. Tax-planning strategies must be prudent and feasible. The company does not have to actually implement the strategy.

30. Tax Planning Strategies Sale of operating assets Change of inventory method Elect out of the installment method Elect the alternative depreciation system

31. Positive and Negative Evidence • Positive Evidence • Existing contracts or sales backlog • Appreciated asset value over tax basis • Strong earnings history Negative Evidence • Cumulative losses • History of expiring tax benefits • Expectation of future losses • Unsettled circumstances • Brief carryback or carryforward period

32. Valuation Allowance RECOGNITION OF AN OPERATING LOSS OR ADJUSTMENTS TO BEGINNING-OF-YEAR VALUATION ALLOWANCE • When incurred - source of loss • Subsequently • Operations if based on future income • Source of income if based solely on current year income

33. Valuation Allowance - Change EFFECT OF A CHANGE IN THE VALUATION ALLOWANCE THAT RESULTS FROM A CHANGE IN CIRCUMSTANCES MUST BE INCLUDED IN INCOME FROM CONTINUING OPERATIONS.

34. Valuation Allowance - Change CHANGE IN JUDGMENT ABOUT REALIZABILITY • Affects Current Quarter If For Future Years • Affects Remaining Interim Periods If For Future Interim Periods

35. Valuation Allowance – Change at Interim Date DECREASE IN VALUATION ALLOWANCE IS SEGREGATED INTO TWO COMPONENTS • Portion related to a change in estimate regarding the current year's income • Taken into income by prospectively adjusting effective tax rate for current year • Portion related to a change in estimate about future years' income • Taken into income as a discrete event in the quarter of the change in estimate

36. Tax Effect of a Change in Tax Law MEASURED AND RECORDED ON THE ENACTMENT DATE • May be necessary to estimate temporary difference at interim dates RETROACTIVE APPLICATION - EITF ISSUE 93-13 • Impact on disc. operations, extraordinary and cumulative effect items REQUIRED DISCLOSURES

37. Change in Tax Law or Tax Rate • CURRENT TAX EXPENSE • Calculate New ETR • Apply New ETR To Year-To-Date Income • Cumulative Catch-Up Adjustment • DEFERRED TAX EXPENSE • Apply New Tax Rate to Deferred Tax Accounts • Impact of Change in Deferred Taxes Affects Quarter of Enactment

38. Current Tax liability The amount of income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year.

39. Expected Current Tax Provision Pretax Income +/- Schedule M-1 adjustments Taxable Income Before NOL Carryforward - NOL Carryforward Taxable Income x Applicable Tax Rate Current Tax Provision before Credits - Applicable Tax Credits Expected Current Tax Provision

40. Permanent Differences Permanent Differences arise from income that is permanently nontaxable and expense items are permanently nondeductible. Another way of saying it: Permanent differences are items that impact either the financial statements or the tax return but not the other

41. Examples of Permanent Differences 50% of Meal and Entertainment Fines and Penalties Officers’ Life Insurance Premiums and Proceeds Municipal Bond Interest Dividends Received Deduction

42. Cases

43. Cases – Deferred Tax Calculation Net Deferred Tax (Liability) Asset: 2008 2009 Net taxable temporary differences- state (294,000) (163,000) State Rate 8% 8% Net state deferred tax liability (23,520) (13,040) Net taxable temporary differences - federal (294,000) (163,000) Less state deferred tax 23,52013,040 (270,480) (149,960) Federal Rate 28% 26% Net Federal deferred tax (liability) asset (75,734)(38,990)

44. Cases – Current Provision State Federal Pretax Income 3,200,000 3,200,000 Less State Taxes (134,480) Schedule M-1 adjustments: Key-Man Life Insurance (1,500,000) (1,500,000) Tax-Exempt Interest (150,000) (150,000) Dividends Received Deduction (40,000) Change in Temporary Differences 131,000 131,000 Taxable Income 1,681,000 1,506,520 Tax Rate 8% 26% Current Tax Expense 134,480 391,695

45. Cases - Provision Summary of Total Tax Provision (Benefit) Current Tax Provision Federal 391,695 State 134,480 Total 526,175 Deferred Tax Provision Federal (36,744) State (10,480) Total (47,224) Total Tax Provision 478,951

46. Cases – Rate Reconciliation The reasons for the difference between income taxes computed by applying the statutory federal income tax rate and income tax expense in the financial statements are: Statutory Rate 832,000 26.00% State taxes, net of federal tax benefit 91,760 2.87% Key-man life insurance (390,000) (12.19)% Tax-exempt interest ( 39,000) (1.22)% Dividends Received Deduction ( 10,400) ( .32)% Change in of tax rate ( 5,409) ( .17)% Effective tax rate 478,95114.97%

47. Cases – Balance Sheet Presentation Deferred income tax assets and liabilities consist of the following: Deferred income tax assets: Inventories 17,000 Bad Debts 73,100 Pension Costs 35,700 Restructuring Reserve 39,100 Deferred Compensation 17,000 Provincial Taxes 3,390 Gross Deferred Tax Asset 185,290 Deferred income tax liabilities: Depreciation 237,320 Deferred Tax Liability 52,030

48. True-Ups During the provision work, a comparison is performed to identify any differences between the numbers used in last year’s tax provision and the amounts used on the tax return. The differences are “trued up” as part of the tax provision preparation process for the succeeding year.

49. True Up Process

50. True Up Process