Chapter 20: Accounting for Income Taxes Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield Chapter 20: Accounting for Income Taxes Prepared by Krishnan Ranganathan, Angelo State University, San Angelo, Texas

Deferred Taxes: Basics Deferred taxes arise when income tax expense differs from income tax liability The tax expense is determined under GAAP The income tax liability is determined under the Internal Revenue Code Some of these differences are temporary and reverse over time Others are permanent and do not reverse 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Temporary and Permanent Differences Temporary Differences Example: tax and book depreciation deductions may be different These are differences in revenue and expense amounts reported on tax returns and for financial purposes Over a given period, they reverse Permanent Differences Example: Interest on municipal obligations is not taxed but is income for accounting purposes Items, included on the financials but either excluded or not deducted on tax return These differences do not reverse 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Temporary Differences: Examples Revenues and Gains, recognized in financial income, are later taxed for income tax purposes Expenses and losses, recognized in financial income, are later deducted for income tax purposes Revenues and gains are taxed for income tax purposes before they are recognized in financial income Expenses and losses are deducted for income tax purposes before they are recognized in financial income 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Summary of Temporary Differences Transaction When recorded in books on tax return Deferred tax 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 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Permanent Differences: Examples Items, recognized for financial accounting purposes, but not for income tax purposes: interest income received on tax exempt securities fines and expenses resulting from violations of law Items, recognized for tax purposes, but not for financial accounting purposes: the dividends received deduction under the Code percentage depletion of natural resources in excess of their cost 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Summary of Permanent Differences Sources of PERMANENT DIFFERENCES Some items are recorded in Books but NEVER on tax return Other items are NEVER recorded in books but recorded on tax return No deferred tax effects for permanent differences 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

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. 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Recording Deferred Tax Liability: Example Book tax expense = $20,000 Tax liability = $18,000 Journal Entry: Income Tax Expense 20,000 Def.Tax Liability 2,000 Tax Payable 18,000 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Recording Deferred Tax Asset: Example Book tax expense = $5,000 Tax payable = $6,000 Journal Entry: Income tax expense 5,000 Def. Tax Asset 1,000 Tax payable 6,000 Deferred tax asset is recognized for all deductible differences 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Temporary Differences: Originating & Reversing Year Tax Expense Tax Liability Difference Nature (per GAAP) (per IRC) DTA / DTL 1 $17,600 $16,000 $1,600 D.Tax Liab 2 $17,600 $16,800 $ 800 D.Tax Liab 3 $17,600 $18,400 $ 800 D.Tax Asset 4 $17,600 $19,200 $1,600 D.Tax Asset Net Deferred Tax Effect $ -0- 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Recording a Valuation Allowance for Doubtful Deferred Tax Assets If Deferred tax asset appears doubtful, A Valuation Allowance account is needed. Journal entry: Income Tax Expense $$ Allowance to Reduce Deferred Tax Asset to Expected Realizable Value $$ The entry records a potential future tax benefit that is not expected to be realized in the future. 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Deferred Taxes: Applying Tax Rates 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]. 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Procedures for Computing and Reporting Deferred Taxes Identify types and amounts of existing temporary differences and carryforwards Measure deferred tax asset using enacted tax rate. Measure deferred tax liability using enacted tax rate. On the balance sheet, classify deferred taxes as current or noncurrent based on asset or liability to which they relate. Establish Valuation Allowance for doubtful asset 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Revision of Future Tax Rates When a change in tax rate is enacted, its effect should be recorded immediately The effect is reported as an adjustment to tax expense in the period of change See example following slide 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Revision of Future Tax Rates: Example End of 1999, corporate tax rate is changed from 40% to 35% The new rate is effective January 1, 2001 The deferred tax account (1.1.1999) is as follows: Excess tax depreciation: $3 million Deferred tax liability: $1.2 million. Related taxable amounts are expected to occur equally over 2000, 2001, and 2002. Provide the journal entry to reflect the change. 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Revision of Future Tax Rates: Example The deferred tax liability end of 2002 is as follows: 2000 2001 2002 Future tax inc $1,000,000 1,000,000 1,000,000 Tax rate 40% 35% 35% Deferred tax liability $400,000 350,000 350,000 Entry: Deferred Tax Liability $100,000 Income Tax Expense $100,000 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Financial Statement Presentation Balance Sheet Presentation: The deferred tax classification relates to its underlying asset or liability Classify the deferred tax amounts as current or noncurrent Sum the various deferred tax assets and liabilities classified as current Sum the various deferred tax assets and liabilities classified as noncurrent 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Financial Statement Presentation Balance Sheet Presentation: Sum the various deferred tax assets and liabilities classified as current: If net result is an asset, report as current asset If net result is a liability, report as current liability Sum the various deferred tax assets and liabilities classified as noncurrent If net result is an asset, report as long-term asset If net result is a liability, report as long-term liability 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Income Statement Presentation Income tax expense, as allocated to: Continuing operations Discontinued operations Extraordinary items Cumulative effect of an accounting change, and Prior period adjustments Other significant components, such as: current tax expense, deferred tax expense/benefit 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Net Operating Losses [NOLs]: Basic Terminology Net operating loss is a 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 NOL can be derived from net loss: but these two amounts must be kept separately 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

NOLs: Rules of Application NOL for each tax year is computed The NOL of one year can be applied to offset taxable income of other years, possibly resulting tax refunds NOLs can be: carried back 2 years and carried forward 20 years (carryback option), or carried forward 20 years (carryforward only) 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

NOL Carryback: Example Gross Income: $ 200,000 Less: Business deductions: ($ 300,000) Dividend Received deduction ($ 70,000) -------------- NOL [tax loss] $ 170,000 Year 2002 Net Loss: loss 100,000 Tax income: 40,000 NOL c/back: 170,000 Tax loss: 130,000 Year 2001 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

Net Operating Loss: Carryback rules. If NOLs are carried back 2 years and carried forward 20 years: NOL is applied to the earlier of the 2 year period, then to the immediately preceding year etc Remaining NOLs are applied to the following 20 year period Any tax refunds are reported in the year of the original net operating loss 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

NOL Carryback Rules: continued Tax years 1999 2000 2001 2002 2003 2004 2005 2022 next NOL 2002 Apply first Loss carryforward 20 years forward Expect tax refund here Record all tax effects here Expect tax shield here 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

NOL Carryforward Rules Tax years 1999 2000 2001 2002 2003 2004 2005 2022 NOL 2002 Forgo 2 year rule Loss carryforward 20 years forward Record all tax effects here Expect tax shield here 11/27/2018 Intermediate Accounting, 10th Edition, Ch. 20 (Kieso et al.)

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