Accounting for Income Taxes Chapter 16 Accounting for Income Taxes Chapter 16: Accounting for Income Taxes.

Deferred Tax Assets and Deferred Tax Liabilities The Internal Revenue Code is the set of rules for preparing tax returns. GAAP is the set of rules for preparing financial statements. Results in . . . Results in . . . Usually. . . Financial statement income tax expense. IRS income taxes payable. Part I Generally accepted accounting principles is a set of rules for preparing financial statements. Following these principles result in financial statement income tax expense. Part II The Internal Revenue Code is the set of rules for preparing tax returns. Following this code results in the income tax payable to the Internal Revenue Service. Usually, the income tax expense determined using generally accepted accounting principles and the income tax payable determined using the Internal Revenue Code do not equal. The rules used to determine taxable income and those for financial reporting purposes often cause amounts to be included in taxable income in a year later—or earlier—than the year in which they are recognized for financial reporting purposes, or not to be included in taxable income at all. For example, income from selling properties on an installment basis is reported on the tax return as it actually is received. This means taxable income might be less than accounting income in the year of an installment sale but higher than accounting income in later years when installment income is collected. The situation just described creates what’s referred to as a temporary difference between pretax accounting income and taxable income. The objective of accounting for income taxes is to recognize a deferred tax liability or deferred tax asset for the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions or events that already have occurred. The objective of accounting for income taxes is to recognize a deferred tax liability or deferred tax asset for the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions or events that already have occurred.

Temporary Differences Often, the difference between pre-tax accounting income and taxable income results from items entering the income computations at different times. Often, the difference between pre-tax accounting income and taxable income results from items entering the income computations at different times. These are called temporary differences. These are called temporary differences.

Temporary Differences Temporary differences will reverse out in one or more future periods. Accounting Income>Taxable Income Future Taxable Amounts Deferred Tax Liability Accounting Income<Taxable Income Future Deductible Amounts Deferred Tax Asset Temporary differences will reverse out in one or more future periods. When temporary differences cause accounting income to be greater than taxable income, the result is future taxable amounts and a deferred tax liability. When temporary differences cause accounting income to be less than taxable income, the result is future deductible amounts and a deferred tax asset. Let’s look at some examples of items that cause deferred tax liabilities and assets.

Deferred tax assets result in deductible amounts in the future. Part I The temporary differences in the gray boxes create deferred tax liabilities because they result in taxable amounts in the future. Items reported on the tax return after the income statement that result in deferred tax liabilities include installment sales of property when the installment method is used for taxes and unrealized gain from recording investments at fair value which is taxable when asset is sold. Items reported on the tax return before the income statement that result in deferred tax liabilities include accelerated depreciation on the tax return when straight-line is used on the income statement and prepaid expenses that are tax deductible when paid. Part II The temporary differences in the yellow boxes create deferred tax assets because they result in deductible amounts in the future. Items reported on the tax return after the income statement that result in deferred tax assets include estimated expenses and losses that are not tax deductible until paid and unrealized loss from recording investments at fair value or inventory at Lower-of-Cost-or-Market which is tax deductible when the asset is sold. Items reported on the tax return before the income statement that result in deferred tax assets include rent or subscriptions collected in advance and other revenue collected in advance. Deferred tax assets result in deductible amounts in the future. Deferred tax liabilities result in taxable amounts in the future.

Deferred Tax Liabilities In 2009, Baxter reports $300,000 of pretax income. Included in this amount is $100,000 resulting from revenue earned from an installment sale for which no cash was collected. The revenue will be taxed as the cash is collected in 2010 and 2011. Baxter expects to collect $70,000 in 2010 and the remaining $30,000 in 2011. In 2010 and 2011, Baxter reports $200,000 of pretax income. The company is subject to a 32% tax rate. There are no other temporary differences. In 2009, Baxter reports $300,000 of pretax income. Included in this amount is $100,000 resulting from revenue earned from an installment sale for which no cash was collected. The revenue will be taxed as the cash is collected in 2010 and 2011. Baxter expects to collect $70,000 in 2010 and the remaining $30,000 in 2011. In 2010 and 2011, Baxter reports $200,000 of pretax income. The company is subject to a 32% tax rate. There are no other temporary differences. Review the information provided in the table relating to Baxter.

Deferred Tax Liabilities 2009 Income tax payable = $200,000 × 32% = $64,000 2009 Deferred tax liability change = ($100,000 × 32%) - $0 = $32,000 Each year, Income Tax Expense comprises both the current and deferred tax consequences of events and transactions already recognized. This means we: Calculate the income tax that is payable currently. Separately calculate the change in the deferred tax liability or asset. Combine the two to get the income tax expense. For Baxter, the currently payable income tax is $64,000—which is a credit in the journal entry. Because the tax laws permit Baxter to delay reporting the $100,000 installment sale income as part of taxable income, Baxter is able to defer paying the tax on that income. The tax is not avoided, just deferred. In the meantime, Baxter has a liability for the income tax deferred. The liability originates in 2006 and is paid over the next two years as portions of the installment sale income are included in taxable income. This deferral of $100,000 of income results in an increase of $32,000 in the Deferred Tax Liability account, which is recorded as a credit in the journal entry. The Deferred Tax Liability balance represents the future taxes Baxter will pay in 2010 and 2011. The change in the Deferred Tax Liability account is calculated as the total of the future taxable amounts times the enacted tax rate minus the existing balance in the account. The debit to Income Tax Expense is the combination of the income tax payable and the deferred tax liability. Now, let’s look more closely at the Deferred Tax Liability account.

Deferred Tax Liabilities The Deferred Tax Liability represents the future taxes Baxter will pay in 2010 and 2011. The change in the Deferred Tax Liability account is calculated as the total of the future taxable amounts of $100,000 times the 32% enacted tax rate minus the existing balance in the account of $0. For Baxter, since 2009 is the originating year of the difference, the existing balance is zero. The ending balance in the Deferred Tax Liability represents the future taxes Baxter will pay in 2010 & 2011 when the temporary differences reverse. After posting the entry, the Deferred Tax Liability account will have the desired ending balance of $32,000. Let’s see what happens in the next year when a portion of the deferred tax liability reverses.

Deferred Tax Liabilities Recall this information for Baxter. 2010 Income tax payable = $270,000 × 32% = $86,400 2010 Deferred tax liability change = ($30,000 × 32%) - $32,000 = $22,400 In 2010, the currently payable income tax is $86,400—which is a credit in the journal entry. The deferred tax liability change is $22,400—which is a debit in the journal entry because it is a reversal of the original deferred tax liability. The change in the Deferred Tax Liability account is calculated as the total of the future taxable amounts times the enacted tax rate minus the existing balance in the account. We will look more closely at the calculation of this change in the Deferred Tax Liability account on the next slide. The debit to Income Tax Expense is the combination of the income tax payable and the deferred tax liability. Now, let’s look more closely at the Deferred Tax Liability account.

Deferred Tax Liabilities The Deferred Tax Liability represents the future taxes Baxter will pay in 2011. Future Taxable Amount Schedule The Deferred Tax Liability balance represents the future taxes Baxter will pay in 2011. The change in the Deferred Tax Liability account of $22,400 is calculated as the total of the future taxable amounts of $30,000 times the 32% enacted tax rate minus the existing balance in the account of $32,000. The ending balance in the Deferred Tax Liability represents the future taxes Baxter will pay in 2011 when the last part of the temporary difference reverses. Let’s see what happens in the next year when the last portion of the deferred tax liability reverses.

Deferred Tax Liabilities Recall this information for Baxter. 2011 Income tax payable = $230,000 × 32% = $73,600 2011 Deferred tax liability change = ($0 × 32%) - $9,600 = $9,600 In 2011, the currently payable income tax is $73,600—which is a credit in the journal entry. The deferred tax liability change is $9,600—which is a debit in the journal entry because it is a reversal of the original deferred tax liability. The change in the Deferred Tax Liability account is calculated as the total of the future taxable amounts times the enacted tax rate minus the existing balance in the account. We will look more closely at the calculation of this change in the Deferred Tax Liability account on the next slide. The debit to Income Tax Expense is the combination of the income tax payable and the deferred tax liability. Now, let’s look more closely at the Deferred Tax Liability account.

Deferred Tax Liabilities The Deferred Tax Liability represents the future taxes Baxter will pay. Future Taxable Amount Schedule The Deferred Tax Liability balance of $0 represents that there are no more future taxes related to this temporary difference. The change in the Deferred Tax Liability account of $9,600 is calculated as the total of the future taxable amounts of $0 times the 32% enacted tax rate minus the existing balance in the account of $9,600. The balance in the Deferred Tax Liability is zero because there are no more future taxes Baxter will pay related to this temporary difference.

The entire $150,000 will be taxed in 2009. Deferred Tax Assets Health Magazine received $150,000 of subscriptions in advance during 2009. Subscription revenue will be earned equally in 2010, 2011 and 2012 for financial accounting purposes. The entire $150,000 will be taxed in 2009. There is additional income of $500,000 in each year. The company is subject to a 30% tax rate in each year. Health Magazine received $150,000 of subscriptions in advance during 2009. Subscription revenue will be earned equally in 2010, 2011 and 2012 for financial accounting purposes. The entire $150,000 will be taxed in 2009. There is additional income of $500,000 in each year. The company is subject to a 30% tax rate in each year. Review the information provided in the table relating to Health Magazine.

Deferred Tax Assets This is the computation for the Deferred Tax Asset. The computation of the Deferred Tax Asset year-end balance is based on the future deductible amount times the tax rate. Now, let’s record the income tax entry for 2009. Now, let’s record the income tax entry for 2009.

Deferred Tax Assets 2009 Income tax payable = $650,000 × 30% = $195,000 2009 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000 Remember these steps we mentioned earlier: Calculate the income tax that is payable currently. Separately calculate the change in the deferred tax liability or asset. Combine the two to get the income tax expense. In 2009, the currently payable income tax is $195,000—which is a credit in the journal entry. The change in the Deferred Tax Asset is $45,000—which is a debit in the journal entry. The change in the Deferred Tax Asset account is calculated as the total of the future deductible amounts times the enacted tax rate minus the existing balance in the account. We will look more closely at the calculation of this change in the Deferred Tax Asset account on the next slide. The debit to Income Tax Expense is the combination of the credit to income tax payable and the debit to deferred tax asset. Let’s look more closely at the Deferred Tax Asset account.

Deferred Tax Assets After posting the entry, the Deferred Tax Asset account will have the desired ending balance of $45,000. The change in the Deferred Tax Asset account of $45,000 is calculated as the total of the future deductible amounts of $150,000 times the 30% enacted tax rate minus the existing balance in the account of $0. For Baxter, since 2009 is the originating year of the difference, the existing balance is zero. The ending balance in the Deferred Tax Asset account represents the future tax benefits Baxter will receive in 2010, 2011 and 2012 when the temporary differences reverse. After posting the entry, the Deferred Tax Asset account will have the desired ending balance of $45,000.

Deferred Tax Assets 2010 Income tax payable = $500,000 × 30% = $150,000 2010 Deferred tax asset change = [($100,000) × 30%] - $45,000 = ($15,000) In 2010, the currently payable income tax is $150,000—which is a credit in the journal entry. The deferred tax asset change is $15,000—which is a credit in the journal entry because it is a reversal of the original deferred tax asset. The change in the Deferred Tax Asset account is calculated as the total of the future deductible amounts times the enacted tax rate minus the existing balance in the account. We will look more closely at the calculation of this change in the Deferred Tax Asset account on the next slide. The debit to Income Tax Expense is the combination of the income tax payable and the deferred tax asset. Now, let’s look more closely at the Deferred Tax Asset account.

Can you prepare the entries for 2011 and 2012? Deferred Tax Assets In 2010, the balance in the Deferred Tax Asset should decrease to $30,000. The change in the Deferred Tax Asset account of $15,000 is calculated as the total of the future deductible amounts of $100,000 times the 30% enacted tax rate minus the existing balance in the account of $45,000. In 2010, the balance in the Deferred Tax Asset should decrease to $30,000. The ending balance in the Deferred Tax Asset account represents the future tax benefits Baxter will receive in 2011 and 2012 when the remaining temporary differences reverse. Can you prepare the entries for 2011 and 2012? Can you prepare the entries for 2011 and 2012?

This would be the entry for 2011 and 2012. Deferred Tax Assets This would be the entry for 2011 and 2012. At the end of 2012, the balance in the Deferred Tax Asset would be zero. The entries for 2011 and 2012 would be the same because the same amount reverses in each year and the tax rate is the same. At the end of 2012, the balance in the Deferred Tax Asset would be zero because there are no more future deductible amounts related to this temporary difference.

Valuation Allowance A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized. The deferred tax asset is then reported at its estimated net realizable value. A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized. The deferred tax asset is then reported at its estimated net realizable value.

Nontemporary Differences Created when an income item is included in taxable income or accounting income but will never be included in the computation of the other. Example: Interest on tax-free municipal bonds is included in accounting income but is never included in taxable income. Nontemporary differences are created when an income item is included in taxable income or accounting income but will never be included in the computation of the other. An example is interest on tax-free municipal bonds that is included in accounting income but is never included in taxable income. Nontemporary, or permanent, differences are disregarded when determining both the tax payable currently and the deferred tax asset or liability. Also called permanent differences.

Tax Rate Considerations Deferred tax assets and liabilities should be determined using the future tax rates, if known. The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs. Internal Revenue Code Deferred tax assets and liabilities should be determined using the future tax rates, if known. The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs.

Multiple Temporary Differences It would be unusual for any but a very small company to have only a single temporary difference in any given year. Categorize all temporary differences according to whether they create … Future taxable amounts Future deductible amounts It would be unusual for any but a very small company to have only a single temporary difference in any given year. Having multiple temporary differences doesn’t change any of the principles you have learned so far in connection with single differences. All that’s necessary is to categorize all temporary differences according to whether they create future taxable amounts or future deductible amounts. The total of the future taxable amounts is multiplied by the future tax rate to determine the appropriate balance for the deferred tax liability, and the total of the future deductible amounts is multiplied by the future tax rate to determine the appropriate balance for the deferred tax asset.

Net Operating Losses (NOL) Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or subsequent periods. When used to offset earlier taxable income: Called: operating loss carryback. Result: tax refund. When used to offset future taxable income: Called: operating loss carryforward. Result: reduced tax payable. Tax laws often allow a company to use tax net operating losses to offset taxable income in earlier or subsequent periods. When a net operating loss is used to offset earlier taxable income it is called an operating loss carryback and results in a tax refund. When a net operating loss is used to offset future taxable income it is called an operating loss carryforward and results reduced tax payable.

Net Operating Losses (NOL) Carryback Period +3 +2 +1 . . . +20 +4 +5 Carryforward Period -1 -2 Current Year The NOL may first be applied against taxable income from two previous years. Unused NOL may be carried forward for 20 years. The net operating loss may first be applied against taxable income from two previous years. Unused net operating losses may be carried forward for 20 years. Let’s look at an example.

Net Operating Losses (NOL) In 2009 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a 30% tax rate. In 2007, Garson reported taxable income of $20,000, and in 2008, taxable income was $10,000. The company elects to carryback the NOL. In 2009 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a 30% tax rate. In 2007, Garson reported taxable income of $20,000, and in 2008, taxable income was $10,000. The company elects to carryback the net operating loss. Review the information provided in the table for the carryback years, 2007 and 2008. Let’s look at the tax benefits of the operating loss carryback and carryforward. Let’s look at the tax benefits of the operating loss carryback and carryforward.

Net Operating Losses (NOL) In 2007, the net operating loss offsets the net income of $20,000 in that year. In 2008, the net operating loss offsets the net income of $10,000. The related tax refund from the net operating loss carryback to these two years is $9,000. This results in a debit to Receivable—Income Tax Refund in the journal entry. The remaining $55,000 of the net operating loss is available to reduce future net income and results in a deferred tax asset, after tax, of $16,500—which is a debit in the journal entry. The credit to Income Tax Benefit—Operating Loss is for the amount needed to balance the entry and is recognized in the year the operating loss occurs.

Net Operating Losses (NOL) Here is a portion of Garson’s Income Statement at the end of 2009. The deferred tax asset account created by the benefit of the carryforward will be used to lower income taxes payable in future years. The deferred tax asset account created by the benefit of the carryforward will be used to lower income taxes payable in future years.

Balance Sheet Classification Disclose the following: Total of all deferred tax liabilities. Total of all deferred tax assets. Total valuation allowance recognized. Net change in valuation account. Approximate tax effect of each type of temporary difference (and carryforward). Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability. Part I Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability. Part II Disclose the following: Total of all deferred tax liabilities. Total of all deferred tax assets. Total valuation allowance recognized. Net change in valuation account and Approximate tax effect of each type of temporary difference (and carryforward).

Additional Disclosures Current portion of tax expense (benefit) Deferred portion of tax expense (benefit), with separate disclosure for Portion that does not include the effect of the following separately disclosed amounts. Operating loss carryforwards. Adjustments due to changes in tax laws or rates. Adjustments to the beginning-of-the-year valuation allowance due to revised estimates. Investment tax credits. Additional disclosures include the current portion of tax expense (or benefit) and the deferred portion of tax expense, with separate disclosure for The portion that does not include the effect of the following separately disclosed amounts, Operating loss carryforwards, Adjustments due to changes in tax laws or rates, Adjustments to the beginning-of-the-year valuation allowance due to revised estimates and Investment tax credits.

Coping with Uncertainty in Income Taxes FASB Interpretation No. 48 Step 1. A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits. Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50-percent likely to be realized. Part I Most companies’ tax returns will include many tax positions inherent to normal business activities that are subject to multiple interpretations. Despite good faith positions taken in preparing tax returns, those judgments may not ultimately prevail if challenged by the IRS. Judgments frequently are subjected to legal scrutiny before the uncertainty ultimately is resolved. FASB Interpretation No. 48 indicates how companies should deal with this type of uncertainty in income taxes. This guidance allows companies to recognize in the financial statements the tax benefit of a position it takes only if it is “more likely than not” (greater than 50% chance) to be sustained if challenged. Guidance also prescribes how to measure the amount to be recognized. The decision is a two-step process. Step 1. A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits. Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50-percent likely to be realized. Part II If in step one it is determined that the more-likely-than-not criterion is not met, this means that none of the tax benefit is allowed to be recorded. Not “more likely than not” = none of the tax benefit is allowed to be recorded

Intraperiod Tax Allocation SFAS No. 109 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items. Statement of Financial Accounting Standards Number109 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations and Extraordinary items.

Conceptual Concerns Some accountants disagree with the FASB’s approach to accounting for income taxes. Should deferred taxes be recognized? Should deferred taxes be recognized for only some items? Should deferred taxes be discounted? Should classification be based on the timing of temporary difference reversals? Some accountants disagree with the FASB’s approach to accounting for income taxes. Some of the most persistent objections include the following questions. Should deferred taxes be recognized? Some feel the income tax expense for a reporting period should be the income tax actually payable currently. Should deferred taxes be recognized for only some items? Critics sometimes argue that the tax liability for certain recurring events will never be paid and therefore do not represent a liability. An example often cited is the temporary difference due to depreciation. Should deferred taxes be discounted? Some accountants contend that deferred tax assets and liabilities should reflect the time value of money by determining those amounts on a discounted (present value) basis. Should classification be based on the timing of temporary difference reversals? Some feel that deferred tax assets and liabilities should be classified in a balance sheet as current or noncurrent according to the timing of the reversal of the temporary differences that gave rise to them.

End of Chapter 16. End of Chapter 16