ACCOUNTING FOR INCOME TAXES CHAPTER 12 ACCOUNTING FOR INCOME TAXES

Introduction Income taxes are an expense Consistent with the proprietary theory definition of comprehensive income Accounting for income taxes is a controversial issue

Historical Perspective Income taxes first became a significant issue because of the emerging facilities exception during World War II ARB No. 23 required the allocation of some deferred income taxes did not provide clear measurement guidelines The allocation of income taxes to the periods impacted is termed interperiod tax allocation APB Opinion No. 11 extended interperiod tax allocation to all timing differences criticism because resulting balance sheet items did not reflect future tax consequences result FASB Statement No. 96 later FASB Statement No. 109

The Income Tax Allocation Issue The objective of financial accounting provide information about the amount and timing of future cash flows Most economic events have tax cash flow consequences These cash consequences are reported on tax returns in accordance with the Internal Revenue Code (IRC)

The Income Tax Allocation Issue The goal of the IRC is to raise revenue to run the government and in some cases to regulate the economy These same economic events are reported for financial accounting purposes under GAAP

The Income Tax Allocation Issue The goals of the IRC and GAAP sometimes result in reporting revenues and expenses in different accounting periods creating an originating difference In subsequent years these differences will reverse creating a reversing difference This issue is termed the income tax allocation issue Revenue Expense 2005 2004

Permanent and Temporary Differences Permanent differences are differences between taxable income and financial accounting that will never reverse federal economic policy or to alleviate a provision of the IRC that falls too heavily on one segment of the economy Financial income Taxable income

Permanent and Temporary Differences will reverse in a subsequent period some temporary differences are timing differences others occur because of different measurement bases

Permanent Differences Occur because provisions of the IRC exempt certain types of revenue from taxation or prohibit the deduction of certain expenses Financial income Taxable income

Types of Permanent Differences Financial income Taxable income Revenue recognized for financial accounting purposes that is never taxable interest on municipal bonds Expenses recognized for financial accounting purposes that are never deductible for tax purposes life insurance premiums Income tax deductions that do not qualify as expenses under GAAP life insurance proceeds

Temporary Differences Create timing differences Result in assets and liabilities having differing bases for financial accounting and taxation purposes Originating differences when they reverse create Taxable amounts Deductible amounts

Temporary Differences Categories of timing differences Current financial accounting income exceeds current taxable income Current financial accounting income is less than current taxable income

Additional Temporary Differences Reduction in the tax basis of depreciable assets because of tax credits The ITC accounted for by the deferred method Foreign operations for which the reporting currency is the functional currency An increase in the tax basis of assets because of indexing for inflation Business combinations accounted for by the purchase method

Net Operating Losses Occurs when tax deductions are greater than taxable income in a period IRC allows for these losses to be carried back two years and forward twenty years Should the benefits of NOL’s be recognized?

Conceptual Issues Allocation versus Nonallocation Comprehensive versus Partial allocation Discounting deferred taxes

Alternative Interperiod Tax Allocation Methods Deferred method uses rates in effect when difference originates Asset/liability method uses rates expected to be in effect when the difference reverses Net of tax method use one of the above methods to adjust balance sheet items that caused the temporary difference e. g. depreciable assets

FASB Dissatisfaction With the Deferred Method APB Opinion No. 11 required the use of the deferred method Did not meet SFAS No. 6 definition of assets and liabilities

Measurement and Reporting Under SFAS No. 96 Required the asset/liability approach to allocation Deferred tax liability Deferred tax asset SFAS No. 96 limited the recognition of deferred tax assets created by NOLs zero future income assumption

Business Dissatisfaction With SFAS No. 96 The cost of scheduling necessary under its provision Loss of deferred tax assets under zero future income assumption

SFAS No. 109 Board remained committed to the asset/liability method Allowed for the separate recognition and measurement of deferred tax assets and liabilities without regard to future income considerations More likely than not criteria for deferred tax assets rather than zero future income assumption

Determining Deferred Asset and Liability Balances Identify temporary differences, NOL carryforwards, and unused tax credits Measure the total deferred tax liability by applying the expected tax rate to the future taxable amount Measure the total deferred tax asset by applying the expected future rate to future deductible amounts and NOL carryforwards Measure deferred tax assets for each type of unused tax credit Measure the valuation allowance based on the more likely than not criterion

The Valuation Allowance There may be insufficient future taxable income to derive the benefit from a deferred tax asset Use allowance to reduce the deferred tax asset to amount expected to be realized under the more likely than not criterion

Do Assets and Liabilities Created by SFAS No Do Assets and Liabilities Created by SFAS No. 109 Meet the Definitions in SFAC No. 6? Deferred tax liability - meets the three characteristics of liabilities Deferred tax asset - meets the three characteristics of assets

Financial Statement Disclosures Income statement Balance sheet SEC disclosure requirements

FIN No. 48: Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Stmt No. 109 Tax contingencies too flexible Used to manipulate earnings Reporting & disclosure of tax positions lacked transparency FIN 48 establishes proper accounting treatment for uncertain tax positions.

FIN No. 48: Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Stmt No. 109 Evaluation of tax position is a 2-step process Recognition Measurement

Financial Analysis of Income Taxes Disclosure requirements allow financial statement users to make better decisions including: Assessing the quality of earnings Assessing future cash flows Calculation of actual tax rates

Financial Analysis of Income Taxes The footnotes provide information on: Information on the amount of taxes that would be paid at the federal statutory rate and the amount actually paid Changes in the deferred tax asset and liability accounts Information concerning income tax carrybacks and carryforwards

Financial Analysis of Income Taxes The earnings conservatism ratio Pretax accounting incomea Taxable income aIn the event a company reports material permanent income tax differences, the amount of these differences adjusts the numerator.

Financial Analysis of Income Taxes Earnings conservatism ratios for Hershey and Tootsie

IAS No. 12: Accounting for Taxes on Income Recently amended to require the liability (asset/liability) method Considering other issues: Do tax consequences of recovery amounts of assets and liabilities depend on the manner of recovery? Disclosure of reconciliation between income tax expense and accounting profit

Prepared by Kathryn Yarbrough, MBA End of Chapter 12 Prepared by Kathryn Yarbrough, MBA Copyright © 2009 John Wiley & Sons, Inc.  All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.