Accounting for Income Taxes

1. Accounting for Income Taxes Chapter 17

2. Chapter 17--Learning Objectives 1. Contrast the objectives of income tax determination with the objectives of financial reporting

3. Income Taxes Result from the earnings process Are not incurred to provide a product or service Are paid to many jurisdictions, including the U.S. government, state governments, and other national governments Often require separate accounting records for each jurisdiction

4. U.S. corporationsare subject to federal income taxes

5. They may also be subject to a number of state income taxes

6. And increasingly to foreign income taxes as well

7. Our focus is primarily on U.S.federal income taxes

8. U.S. federal income taxes Rules on taxes to be paid encompass: 1. Revenue items to be included in taxable income 2. Expense items permitted to be deducted 3. The rates applied to taxable income 4. Tax credits permitted as direct reductions to income tax liability

9. Financial reporting and income tax assessment have different goals Hence, the rules are different for financial reporting and for income tax calculation Therefore, income for financial reporting purposes frequently differs from taxable income

10. Chapter 17--Learning Objectives 2. Apply the liability approach to determine (a) temporary differences and carryforwards, (b) deferred income tax assets and liabilities, and (c) income tax expense

11. Nature of Income Tax Expense? Distribution of profits to the government? ARB 43 Income tax is an expense

12. Accrual Basis Accounting Matching principle Allocates expenses to accounting periods Income tax = An expense Therefore, it too should be allocated among accounting periods

13. Income Tax Allocation Interperiod income tax allocation Allocating income tax among accounting periods Intraperiod income tax allocation Allocating income tax among items reported within a given accounting period Income from continuing operations Discontinued operations Extraordinary items Prior period adjustments Cumulative effect of accounting change

14. Asset/Liability Method Future tax consequences of temporary differences between pretax accounting income (AI) & taxable income (TI) are deferred tax assets & deferred tax liabilities Tax rates used: Future tax rates Based on currently enacted tax law Tax expense = Current provision +/- changes in deferred tax assets & liabilities

15. Differences between AI & TI Temporary differences Permanent differences

16. Permanent Differences Item in TI, never in AI Item in AI, never in TI

17. Items in TI, never in AI Tax deductions that are not expenses under GAAP Percentage depletion > Cost depletion Dividend exclusion

18. Items in AI, never in TI Tax exempt revenues Municipal bond interest Life insurance proceeds paid to corporation on death of employee Non-deductible expenses Life insurance premiums on officers where corporation is beneficiary Tax penalties

19. Temporary Differences Differences between AI and TI caused by differences in when amounts are recognized Timing differences Assets & Liabilities have different bases

20. Exercise Indicate whether each of the following is a temporary difference or a permanent difference between TI and AI

21. Municipal bond interest

22. Double declining balance depreciation for tax Straight-line depreciation for books

23. Depreciable life for tax < Depreciable life for books

24. Recognize sales when made for books Use installment sales method for tax

25. Warranty expense is probable and can be reasonably estimated. Deduct when paid for tax

26. Defer rent received in advance for books Rent is taxed upon receipt

27. Use percentage of completion for books Use completed contract method for tax

28. Tax penalties are incurred

29. Prepaid rent for 2 years in advance. The rent deductible when paid for tax

30. Statutory depletion exceeds full cost depletion recognized for books

31. Current Period Effect of Temporary Differences Temporary difference � Current TI > AI Temporary difference � Current TI < AI

32. Current TI > AI Tax Consequence: Future TI < AI Called deductible amounts Benefit = future tax reduction Asset today

33. Current TI > AI - Examples Revenues & Gains in TI before AI Rent received in advance Expenses & Losses in AI before TI Contingent liabilities

34. Current TI < AI Tax consequence: Future TI > AI Called taxable amounts Obligation to pay more tax in the future Liability today

35. Current TI < AI - Examples Revenues & Gains in AI before TI Installment sales method for tax Point of sale revenue recognition for books Expenses & Losses in TI before AI Accelerated depreciation for tax Straight line depreciation for books

36. Exercise For each temporary difference, determine: The originating effect The reversing effect Whether there will be future taxable or deductible amounts Whether there is a deferred tax asset or deferred tax liability

37. Depreciation DDB depreciation for tax Straight-line depreciation for books

38. Depreciation Life for tax < Life for books

39. Sales Record when made for books Installment sales method for tax

40. Warranty Expense Accrued for books Deductible when paid for tax

41. Rent Received in Advance Deferred for books Taxable upon receipt for tax

42. Long-Term Contract Percentage of completion for books Completed contract method for tax

43. Prepaid Rent Defer for books Deduct when paid for tax

44. Steps: Accounting for Deferred Tax Liabilities Identify temporary differences Identify future taxable amounts Identify future taxable amounts from prior temporary differences Calculate DTL Calculate income tax payable Income tax expense = Income taxes payable + D in DTL

45. ExampleDeferred Income Tax Liability Jan�s Cookies sells franchises Price of franchise = $20,000 Franchisee pays equal installments over 4 years Ignore time value of money Recognize sale for books contract is signed Cash basis for tax

46. Year 1 Sales $240,000 Pretax accounting income 200,000 Includes municipal bond interest of 10,000 Tax rate for 19x1 40% Tax rate for all future years 30%

47. Permanent Difference? Municipal bond interest $10,000

48. The Temporary Difference? Revenue in accounting income Revenue in taxable income Temporary difference $ 240,000 60,000 $ 180,000

49. Reversals Will future TI be greater than or less than AI? TI > AI Future Taxable or Deductible Amounts? Taxable Amounts Future Taxable Amounts will total? $180,000

50. The Balance Sheet will report

51. Amount of DTL 180,000 x 30% = 54,000

52. Taxable Income Pretax accounting income Municipal bond interest Temporary difference Taxable income $ 200,000 ( 10,000) (180,000) $ 10,000

53. Change in Deferred Tax Liability

54. Income Tax Expense Income tax payable Increase in DTL Income tax expense $ 4,000 54,000 $ 58,000

55. Balance Sheet Classification Classify as short term or long term Based on related asset or liability balance Report 1 long-term net asset or liability Report 1 current net asset or liability

56. Related Asset or Liability? Accounts Receivable $180,000 Current asset? If so, the DTL is a current liability

57. Year 2 Sales $360,000 Pretax accounting income 235,000 Includes municipal bond interest of $10,000 Includes $1,000 for tax penalties Tax law change: For all years subsequent to 2003 Tax rate = 35%

58. Permanent Differences? Municipal bond interest $10,000 Tax penalty $ 1,000

59. The amount of the Temporary Difference? Revenue in accounting income Revenue in taxable income Temporary difference $ 360,000 90,000 $ 270,000

60. Reversal in 2002? From 2001 Sales Revenue in taxable income Revenue in accounting income Taxable amount $ 60,000 none $ 60,000

61. Taxable Income Pretax accounting income Municipal bond interest Tax penalty Temporary difference Reversal (taxable amount) Taxable income $ 235,000 ( 10,000) 1,000 (270,000) 60,000 $ 16,000

62. Year 2002

63. Year 2003

64. Year 2004

65. Year 2005

66. Amount of DTL

67. Change in DTL

68. Income Tax Expense Income tax payable Increase in DTL Income tax expense $ 4,800 75,000 $ 79,800

69. Interperiod Tax Allocation Deferred Tax Asset

70. Deferred Tax Assets Future tax consequences = benefit Result from temporary differences associated with future deductible amounts Result from net operating loss carryovers

71. Net Operating Losses (NOL) When deductions and losses on a tax return exceed taxable revenues and gains Can carry back 3 years Can carry over 15 years

72. Accounting for DTAsAdditional Steps Identify future deductible amounts Including NOL carryovers Calculate DTA If more likely than not that NRV<DTA Calculate allowance to reduce net DTA to NRV Income Tax Expense = Income Taxes Payable + D in DTL D in DTA D in allowance

73. DTL & DTA Example 7/1/x1 - Purchased depreciable asset Cost $30,000 Ignore salvage value Useful life 6 years Tax life 4 years Straight-line depreciation - book & tax Pretax accounting income $10,000 Tax rate 40% 2001 35% after 2003

74. DTL & DTA Example Let TD = temporary difference Let TA = taxable amount Let DA = deductible amount

76. Taxable Income for 2001? Accounting income Temporary difference Taxable income $ 10,000 ( 1,250) $ 8,750

77. For 2001 Depreciation in TI Depreciation in AI Temporary difference $ 3,750 2,500 $ 1,250

78. Reversal will be a

79. Schedule Tax Consequences

80. Change in Deferred Tax Liability

81. 2001 Income Tax Expense Income tax payable Increase in DTL Income tax expense $ 3,500.00 437.50 $ 3,937.50

82. Assumption: 2001 AI = (8,000) Taxable income? Accounting income Temporary difference NOL (8,000) (2,500) (10,500)

83. Amount of Tax Refund? $ 3,500 Income Tax Refund Receivable Classified as a? Current asset

84. 2002- Cumulative TD?

85. Schedule Tax Consequences

86. NOL Carryover 2002 NOL 10,500 Carried back to 2001 8,750 NOL carryover 1,750

87. Future Tax Consequence - NOL? What tax rate to choose? We will use 35% Tax consequence 1,750 x 35% = 612.50

88. T Account DTL

89. T Account DTL

90. T Account DTA

91. T Account DTA

92. Journal Entry - 2002 Income Tax Refund Receivable 3,500.00 DTA 612.50 DTL 875.00 Income Tax Benefit 3,237.50

93. 2003 Accounting income = (10,000) Tax law change: Tax rate for current & future years Changed to 30%

94. Calculate Loss Carryover

95. 2003 Temporary Difference? $ 2,500

96. Schedule Tax Consequences

97. Future Tax ConsequencesNOL Carryover Amount of NOL Carryover Tax rate Future tax consequence What is it? $ 14,250 30% $ 4,275 DTA

98. Assumption More likely than not No future taxable income How much of the DTA is realizeable? The amount of the DTL $ 1,875

99. The Valuation Allowance? DTA Realizeable Valuation allowance 4,275 1,875 2,400

100. Balance Sheet? DTA $ 4,275 Allowance ( 2,400) Net Asset $ 1,875 DTL ( 1,875) Net amount none

101. T Account DTL

102. T Account DTL

103. T Account DTA

104. T Account DTA

105. T Account DTA-Valuation Allowance

106. T Account DTA-Valuation Allowance

107. Journal Entry - 2003 DTA 3,662.50 Valuation Allow 2,400.00 DTL 562.50 Income Tax Benefit 700.00

108. Assumptions - 2004 Accounting income = $4,000 Includes accrual of $8,000 Expected loss on lawsuit Expected to be settled in 2006

109. Calculate Loss Carryover

110. Cumulative TD for Depr? 2001 $ 1,250 2002 2,500 2003 2,500 2004 2,500 Cumulative TD $ 8,750

111. TD from Lawsuit? $ 8,000

112. Schedule Current Tax Consequences

113. Schedule Future Tax Consequences

114. Deferred Tax Asset? 3,825 NOL 4,750 Deductible Amount 8,000 Total 12,750 Tax Rate 30% DTA 3,825

115. Valuation Allowance? ZERO No Evidence to indicate that it is more likely than not that the DTA will not be realized

116. T Account DTL

117. T Account DTL

118. T Account DTA

119. T Account DTA

120. T Account DTA-Valuation Allowance

121. T Account DTA-Valuation Allowance

122. Journal Entry - 2004 Valuation Allowance 2,400 DTA 450 DTL 750 Income Tax Benefit 1,200

123. Chapter 17--Learning Objectives 3. Interpret the major issues central to the historical development of accounting for income taxes

124. Interperiod Income Tax Allocation Theories No income tax allocation Partial income tax allocation Comprehensive income tax allocation

125. No Income Tax Allocation Income tax expense = Income tax paid Rationale No income tax liability until a tax return is filed No future tax consequences yet Deferred income tax liabilities are never paid Continuous replacement Never write the check

126. Comprehensive Allocation Report all future tax consequences associated with items reported in the income statement APB & FASB take this position

127. Arguments in Favor of Interperiod Income Tax Allocation Matches Items reported in earnings with their future tax consequences Reports the anticipated future tax consequences as Assets & Liabilities

128. Methods of IncomeTax Allocation Deferred method Was required under APB 11 Asset/Liability method Is required under SFAS 109

129. Criticism of Deferred Method Measurement based on current tax rate Does not measure future tax consequence Because the tax is deferred, the tax consequence occurs in the future. Measurement should be based on expected future rates Tax expense should be based on the change in asset & liability measures

130. Net-of-tax presentation Refers to offsetting a deferred tax amount against a related asset or liability Was used briefly in certain business combination situations Is no longer acceptable under GAAP

131. Discounting to Present Value Is a subject under continuing debate Is not used for deferred tax items under current GAAP Yet, anticipated future cash flows for other assets and liabilities are discounted

132. Chapter 17--Learning Objectives 4. Analyze the financial reporting of income tax information disclosed in notes to financial statements

133. Income Statement Items are classified in four categories 1. Continuing operations 2. Discontinued operations 3. Extraordinary items 4. Changes in accounting principles Income tax expense is allocated among these categories

134. Required disclosure notesfor balance sheet items include Changes in deferred tax valuation allowances Types of temporary differences and carry-forwards that involve significant deferred tax assets or liabilities with amounts and uncertainties Exceptions involving deferred taxes

135. Required disclosure notesfor income statement items Significant components of income tax expense for continuing operations Amounts of tax expense allocated to other than continuing operations Nature of differences due to state taxes, nondeductible items, tax credits, etc. Nature of items affecting comparability between periods Amounts and dates for any carryforwards

136. Chapter 17--Learning Objectives 5. Interpret the impact income tax accounting principles can have on analyzing a company�s financial position, results of operations, and growth potential

137. Tax items which can cause special concern in financial analysis Effects of tax-exempt income Effects of tax credits and depreciation Contrast of tax rates and tax credits Valuation allowances Actual examples of the above situations are presented in the text.