Feb 10, 2016
C H A P T E R C H A P T E R 1919
ACCOUNTING FOR INCOME TAXESACCOUNTING FOR INCOME TAXES
Intermediate Accounting13th EditionKieso, Weygandt, and Warfield
Fundamental Differences between Financial and Tax
Reporting
4
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
5
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
6
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
7
Tax Code
Exchanges
Investors and Creditors
Financial Statements
Pretax Financial Income
GAAPIncome Tax Expense
Taxable Income
Income Tax Payable
Tax Return
vs.
Fundamentals of Accounting for Income Taxes
LO 1 Identify differences between pretax financial income and taxable income.
Illustration: KRC, Inc. reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations. For tax purposes, KRC reported the same expenses to the IRS in each of the years. KRC reported taxable revenues of $100,000 in 2010, $150,000 in 2011, and $140,000 in 2012. What is the effect on the accounts of reporting different amounts of revenue for GAAP versus tax?
LO 1 Identify differences between pretax financial income and taxable income.
Fundamentals of Accounting for Income Fundamentals of Accounting for Income TaxesTaxes
RevenuesExpensesPretax financial income
Income tax expense (40%)
$130,00060,000
$70,000
$28,000
$130,000
2011
60,000$70,000
$28,000
$130,000
2012
60,000$70,000
$28,000
$390,000
Total
180,000$210,000
$84,000
GAAP ReportingGAAP Reporting
RevenuesExpensesPretax financial income
Income tax payable (40%)
$100,0002010
60,000$40,000
$16,000
$150,0002011
60,000$90,000
$36,000
$140,0002012
60,000$80,000
$32,000
$390,000Total
180,000$210,000
$84,000
Tax Reporting
2010
LO 1 Identify differences between pretax financial income and taxable income.
Book vs. Tax DifferenceBook vs. Tax DifferenceIllustration 19-2
Illustration 19-3
Income tax expense (GAAP)Income tax payable (IRS)Difference
$28,00016,000
$12,000
$28,000
2011
36,000$(8,000)
$28,000
2012
32,000$(4,000)
$84,000
Total
84,000$0
ComparisonComparison 2010
Are the differences accounted for in the financial statements?Year Reporting Requirement201020112012
Deferred tax liability account increased to $12,000Deferred tax liability account reduced by $8,000Deferred tax liability account reduced by $4,000
YesYes
LO 1 Identify differences between pretax financial income and taxable income.
Book vs. Tax DifferenceBook vs. Tax DifferenceIllustration 19-4
Balance Sheet
Assets:
Liabilities:
Equity:Income tax expense Income tax expense 28,00028,000
Income Statement
Revenues:
Expenses:
Net income (loss)
2010 2010
DeferredDeferred taxes taxes 12,00012,000
Where does the “deferred tax liability” get reported in the financial statements?
Income tax payable Income tax payable 16,00016,000
LO 1 Identify differences between pretax financial income and taxable income.
Financial Reporting for 2010 – Chelsea Financial Reporting for 2010 – Chelsea Inc.Inc.
12
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 AmountsDeferred 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 19-22 Examples of Temporary Differences
LO 2 Describe a temporary difference that results in future taxable amounts.
Temporary Differences
LO 2 Describe a temporary difference that results in future taxable amounts.
Future Taxable Amounts and Deferred Future Taxable Amounts and Deferred TaxesTaxes
Illustration: In Chelsea’s situation, the only difference between the book basis and tax basis of the assets and liabilities relates to accounts receivable that arose from revenue recognized for book purposes. Chelsea reports accounts receivable at $30,000 in the December 31, 2010, GAAP-basis balance sheet. However, the receivables have a zero tax basis.
Illustration 19-5
LO 2 Describe a temporary difference that results in future taxable amounts.
Future Taxable Amounts and Deferred Future Taxable Amounts and Deferred TaxesTaxes
KRC assumes that it will collect the accounts receivable and report the $30,000 collection as taxable revenues in future tax returns. KRC does this by recording a deferred tax liability.
Illustration 19-6
Illustration: Reversal of Temporary Difference, Chelsea Inc.
LO 2 Describe a temporary difference that results in future taxable amounts.
Future Taxable Amounts and Deferred Future Taxable Amounts and Deferred TaxesTaxes
A 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 Liability – Chelsea Inc.
Income tax expense (GAAP)Income tax payable (IRS)Difference
$28,00016,000
$12,000
$28,000
2011
36,000$(8,000)
$28,000
2012
32,000$(4,000)
$84,000
Total
84,000$0
2010Illustration 19-4
LO 2 Describe a temporary difference that results in future taxable amounts.
Future Taxable Amounts and Deferred Future Taxable Amounts and Deferred TaxesTaxes
Illustration: Because it is the first year of operations for KRC, there is no deferred tax liability at the beginning of the year. KRC computes the income tax expense for 2010 as follows:
Deferred Tax Liability – Chelsea Inc.
Illustration 19-9
LO 2 Describe a temporary difference that results in future taxable amounts.
Future Taxable Amounts and Deferred Future Taxable Amounts and Deferred TaxesTaxes
Illustration: Chelsea Inc. makes the following entry at the end of 2010 to record income taxes.
Deferred Tax Liability
Income Tax Expense 28,000Income Tax Payable
16,000Deferred Tax Liability
12,000
LO 2 Describe a temporary difference that results in future taxable amounts.
Future Taxable Amounts and Deferred Future Taxable Amounts and Deferred TaxesTaxes
Illustration: Computation of Income Tax Expense for 2011.
Deferred Tax Liability – Chelsea Inc.
Illustration 19-10
LO 2 Describe a temporary difference that results in future taxable amounts.
Future Taxable Amounts and Deferred Future Taxable Amounts and Deferred TaxesTaxes
Illustration: Chelsea Inc. makes the following entry at the end of 2011 to record income taxes.
Deferred Tax Liability
Income Tax Expense 28,000Deferred Tax Liability 8,000
Income Tax Payable 36,000
20
E19-1 South Carolina Corporation has one temporary difference at the end of 2007 that will reverse and cause taxable amounts of $55,000 in 2008, $60,000 in 2009, and $65,000 in 2010. South Carolina’s pretax financial income for 2007 is $300,000, and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2007.
Instructionsa) Compute taxable income and income taxes payable for
2007.b) Prepare the journal entry to record income tax expense,
deferred income taxes, and income taxes payable for 2007.
South Carolina Corporation
21
South Carolina CorporationEx. 19- 1 Current Yr.INCOME: 2007 2008 2009 2010Financial income (GAAP)Temporary Diff .Taxable income (IRS)
Tax rateIncome tax
b. Income tax expense (plug)Income tax payableDeferred tax liability
a.a.
a.a.
22LO 2 Describe a temporary difference that results in future taxable amounts.
South Carolina Corp. (Solution)Ex. 19- 1 Current Yr.I NCOME: 2007 2008 2009 2010Financial income (GAAP) 300,000 Temporary Diff . (180,000) 55,000 60,000 65,000 Taxable income (I RS) 120,000 55,000 60,000 65,000
Tax rate 30% 30% 30% 30%I ncome tax 36,000 16,500 18,000 19,500
b. I ncome tax expense (plug) 90,000 I ncome tax payable 36,000 Deferred tax liability 54,000
a.a.
a.a.
23
Columbia Corporation has one temporary difference at the end of 2007 that will reverse and cause deductible amounts of $50,000 in 2008, $65,000 in 2009, and $40,000 in 2010. Columbia’s pretax financial income for 2007 is $200,000 and the tax rate is 34% for all years. There are no deferred taxes at the beginning of 2007. Columbia expects to be profitable in the future. Instructions
a) Compute taxable income and income taxes payable for 2007.
b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
Columbia Corporation
24
Columbia Corp. Current Yr.INCOME: 2007 2008 2009 2010Financial income (GAAP)Temporary Diff .Taxable income (IRS)
Tax rateIncome tax
b. Income tax expenseIncome tax payableDeferred tax asset
Columbia Corporation
a.a.
a.a.
Income tax payable or refundable
LO 5 Describe the presentation of income tax expense in the income statement.
Income Statement PresentationIncome Statement Presentation
Change in deferred income tax
Income tax expense or benefit
++-- ==
In the income statement or in the notes to the financial statements, a company should disclose the significant components of income tax expense (current and deferred).
Formula to Compute Income Tax Expense Illustration 19-20
LO 5 Describe the presentation of income tax expense in the income statement.
Income Statement PresentationIncome Statement Presentation
Given the previous information related to KRC Inc., KRC reports its income statement as follows.
Illustration 19-21
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”
• Revenues and gains are taxed for income tax purposes before they 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”
Temporary Differences (2)
TransactionWhen recordedin books
When recordedon tax return
Deferredtax 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
30
Sources of Permanent Differences
No deferred tax effectsfor permanent differences
Some items are recordedin Books
but NEVERon tax return
Other items are NEVERrecorded in books
but recordedon tax return
Permanent DifferencesPermanent Differences
31
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.
If the deferred tax asset appears doubtful, a Valuation Allowance account is needed.
Journal entry: Income Tax Expense $$
Allowance to ReduceDeferred Tax Asset toExpected Realizable Value $$
The entry records a potential future tax benefit that is not expected to be realized in the future.
Valuation Allowance for Deferred Tax Assets
• 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].
What Tax Rate to Apply
Let’s do an example• Second Best Company
– Working paper style – working paper blank will be provided on Exam 2
35
36
• The deferred tax classification relates to its underlying asset or liability.– Classify the deferred tax amounts as current or
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
Balance Sheet Presentation
38
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.
Net Operating Loss (NOL)
39
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)
40
2001 2002 2003 2004 2005 2006 2007
NOL2004
Tax years
Apply first
next
Loss carryforward20 years forward
Expect tax refund
hereRecord all
tax effects here
Expecttax
shieldhere
NOL Carryback
41
2001 2002 2003 2004 2053 2006 2007
NOL2004
Tax years
Loss carryforward20 years forward
Record alltax effects here
Expecttax
shieldhere
Forgo 2year rule
NOL Carryforward
42
Zoop Inc. incurred a net operating loss of $500,000 in 2007. Taxable income was $200,000 for 2005 and $200,000 for 2006. The tax rate for all years is 40%. Zoop elects the carryback option. Prepare the journal entries to record the benefits of the loss carryback and the loss carryforward.
Zoop Inc. (NOL)
LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
43
Zoop Inc. (NOL)Zoop Inc. 2005 2006 2007 2008Financial incomeDiff erenceTaxable income (loss)RateIncome tax
NOL ScheduleTaxable incomeCarryback from 2007Taxable income RateIncome tax (revised)
Refund
44
Zoop Inc. (NOL) - SolutionZoop Inc. 2005 2006 2007 2008Financial income 200,000$ 200,000$ Diff erenceTaxable income (loss) 200,000 200,000 (500,000) Rate 40% 40% 40%Income tax 80,000$ 80,000$
NOL ScheduleTaxable income 200,000$ 200,000$ (500,000) Carryback from 2007 (200,000) (200,000) 400,000 Taxable income - - (100,000) Rate 40% 40% 40%Income tax (revised) -$ -$ (40,000)
Refund 80,000$ 80,000$
$160,000$160,000 Deferred Tax AssetDeferred Tax Asset
45
Zoop’s Journal Entries for 2007I ncome tax refund receivable 160,000
Benefit due to loss carryback 160,000
Deferred tax asset 40,000 Benefit due to loss carryforward 40,000
Zoop Inc. (NOL) - Solution
LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
46
Now assume that it is more likely than not that the entire net operating loss carryforward will not be realized by Zoop Inc. in future years. Prepare all the journal entries necessary at the end of 2007.
Zoop Inc. (Variation)
LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
47
Zoop Inc. - Journal Entries for 2007I ncome tax refund receivable 160,000
Benefit due to loss carryback 160,000
Deferred tax asset 40,000 Benefit due to loss carryforward 40,000
Benefit due to loss carryforward 40,000 Allowance for deferred tax asset 40,000
Zoop Inc. (Variation) - Solution
48
Whether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period.
Valuation Allowance Revisited
Text Illustration 19-37 Possible Sources of Taxable Income
If any one of these sources is sufficient to support a conclusion that a valuation allowance is unnecessary, a company need not consider other sources.Text Illustration 19-38 Evidence to Consider in Evaluating the need for a Valuation Account
49
Valis Corporation had the following tax information.
Valis Corporation (NOL)
LO 8 Apply procedures for a loss carryback and a loss carryforward.
Taxable Tax TaxesYear I ncome Rate Paid2004 300,000$ 35% 105,000$ 2005 325,000 30% 97,500 2006 400,000 30% 120,000
In 2007 Valis suffered a net operating loss of $450,000, which it elected to carry back. The 2007 enacted tax rate is 29%. Prepare Valis’s entry to record the effect of the loss carryback.
50
Valis Corporation – Solution (NOL)
Valis Corp. 2004 2005 2006 2007Financial incomeDiff erenceTaxable income (loss)RateIncome tax
NOL ScheduleTaxable incomeCarryback from 2007Taxable income RateIncome tax (revised)
Refund
51
Valis Corp - Journal Entry for 2007I ncome tax refund receivable 135,000
Benefit due to loss carryback 135,000
Valis Corporation – Solution (NOL)
At the end of 2002, the corporate tax rate is changed from 40% to 35%. The new rate is effective January 1, 2004.The deferred tax account (1/1/2002) is as follows:
Excess tax depreciation: $3 million Deferred tax liability: $1.2 million
Related taxable amounts are expected to occur equally over 2003, 2004, and 2005.
Provide the journal entry to reflect the change.
Example: Revision of Future Tax Rate
The deferred tax liability end of 2005 is as follows: 2003 2004 2005Future tax inc $1,000,000 1,000,000 1,000,000Tax rate 40% 35% 35%Deferred tax $400,000 350,000 350,000liability Entry:
Deferred Tax Liability $100,000 Income Tax Expense $100,000*
*$1,200,000 – $1,100,000
Example: Revision of Future Tax Rate
Income tax expense, is allocated to:• Continuing operations• Discontinued operations• Extraordinary items• Prior period adjustments• Other comprehensive income
Disclose other significant components, such as:
• current tax expense, • deferred tax expense/benefit, etc.
Intraperiod Tax Allocation
} Income Statement
55
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
Special Reporting Issues
LO LO 66
EPS
Divide by weighted-average shares outstanding
ReviewReview of the Asset-Liability of the Asset-Liability MethodMethodCompanies apply the following basic principles:
(1) Recognize a current tax liability or asset for the estimated taxes payable or refundable.
(2) Recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards using enacted tax rate.
(3) Base the measurement of current and deferred taxes on provisions of the enacted tax law. Do not anticipate future changes in tax laws.
(4) Reduce the measurement of deferred tax assets (create allowance account), if necessary, by the amount of any tax benefits that, companies do not expect to realize.
Deferred Taxes
IAS 12 vs FAS 109
versus
US GAAP
• Enacted tax rates
Which Tax Rate to Use
• Enacted or substantively enacted tax rat
IFRS
US GAAP
• Use an allowance account to reduce to net realizable value
• Uses same “more likely than not” criteria
Deferred Tax Assets
• Don’t recognize at all unless it is “more likely than not” to be usable in the future
IFRS
US GAAP
• Current items netted
• Noncurrent items netted
Balance Sheet Presentation
• Always is noncurrent
• Plans to revise to do it the FASB way
IFRS
The classification of deferred taxes under iGAAP is always noncurrent.
Under iGAAP, an affirmative judgment approach is used, by which a deferred tax asset is recognized up to the amount that is probable to be realized. U.S. GAAP uses an impairment approach.
iGAAP uses the enacted tax rate or substantially enacted tax rate. (“Substantially enacted” means virtually certain.) For U.S. GAAP, the enacted tax rate must be used.
The tax effects related to certain items are reported in equity under iGAAP. That is not the case under U.S. GAAP, which charges or credits the tax effects to income.
U.S. GAAP requires companies to assess the likelihood of uncertain tax positions being sustainable upon audit. Potential liabilities must be accrued and disclosed if the position is “more likely than not” to be disallowed. Under iGAAP, all potential liabilities must be recognized. With respect to measurement, iGAAP uses an expected-value approach to measure the tax liability, which differs from U.S. GAAP.
Essential Knowledge• Be able to tell a permanent difference from
a temporary difference• Know the impact of temporary differences:
– Is it a future deductible item?– Is it a future taxable item?
• Textbook Illustrations 19-22 & 19-24:– If all else fails, memorize!– I’ll also provide a “study guide” for Exam 2
64
65
Do the following generate: • Future Deductible Amount = Deferred Tax Asset• Future Taxable Amount = Deferred Tax Liability• A Permanent Difference
1. The MACRS depreciation system is used for tax purposes, and the straight-line depreciation method is used for financial reporting purposes.2. A landlord collects some rents in advance. Rents received are taxable in the period when they are received.
3. Expenses are incurred in obtaining tax-exempt income.
4. Costs of guarantees and warranties are estimated and accrued for financial reporting purposes.
Specific Differences
LO 6 Describe various temporary and permanent differences.
66
Do the following generate: • Future Deductible Amount = Deferred Tax Asset• Future Taxable Amount = Deferred Tax Liability• A Permanent Difference
5. Sales of investments are accounted for by the accrual method for financial reporting purposes and the installment method for tax purposes.6. Proceeds are received from a life insurance company because of the death of a key officer (the company carries a policy on key officers).
7. Estimated losses on pending lawsuits and claims are accrued for books. These losses are tax deductible in the period(s) when the related liabilities are settled..
Specific Differences
LO 6 Describe various temporary and permanent differences.
67
First Place Example• Go to Excel and work the problem
– Identify temporary and permanent differences
– Compute tax payable (or refund)– Compute change in deferred taxes and
income tax expense– Show where deferred tax will be reported
on the balance sheet
68
69
Zurich Company reports pretax financial income of $70,000 for 2007. The following items cause taxable income to be different than pretax financial income. (1) Depreciation on the tax return is greater than depreciation on the income statement by $16,000. (2) Rent collected on the tax return is greater than rent earned on the income statement by $22,000. (3) Fines for pollution appear as an expense of $11,000 on the income statement.
Zurich’s tax rate is 30% for all years, and the company expects to report taxable income in all future years. There are no deferred taxes at the beginning of 2007.
Instructions Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
Review Problem
70
Review Problem – Abbreviated Working Paper
Current Yr. Deferred DeferredINCOME: 2007 Asset LiabilityFinancial income (GAAP)Permanent diffBook TITemp diffTemp diffTaxable income (IRS)
Tax rateIncome tax
Income tax expenseDeferred tax asset
Deferred tax liabilityIncome tax payable