FA3 Lesson 6: Accounting for income tax 1.Intraperiod tax allocation 2.Permanent and temporary differences 3.Deferral method vs. liability method 4.Tax allocation – Canadian practice 5.Future income taxes on the balance sheet 6.Tax losses

1. Intraperiod tax allocation Total income tax for the year must be reported in accordance with the nature of the item that gave rise to the taxes. Key elements are: Continuing operations (“regular” income tax) Discontinued operations Extraordinary items Capital transactions Prior period restatements OBJECT: Enhance predictive ability of income statement... A16-1

2. Permanent and temporary differences Differences between income tax expense and income tax payable arise from two sources: 1.Permanent differences: Revenues/expenses that figure in accounting income or taxable income, but not both 2.Temporary differences: Items that figure in both accounting income and taxable income, but not in the same period; –Temporary differences originate and later reverse EXAMPLE: A16-9

3. Deferral method vs. liability method Deferral method Records future tax impact of temporary differences by using the corporation’s effective average tax rate in the year the temporary difference originates Liability method Records future tax impact of temporary differences by using the tax rate that will be in effect in the year the temporary difference reverses; updated if tax rates change

4. Canadian practice – the liability method Income statement approach: Temporary difference identified by its impact on taxable income vs. accounting income Balance sheet approach: Temporary difference occurs when an asset or liability has a tax basis that differs from its carrying value (book value) e. g., Capital asset net book value (NBV) vs. tax basis undepreciated capital cost (UCC) Future income tax = difference between tax basis and carrying value, multiplied by future tax rate

Liability method: Carrying value vs. tax basis Carrying value: book value of assets (cost less acccumulated amortization) and liabilities Tax basis: carrying value of asset or liability on an “income tax” balance sheet -For most assets and liabilities, the tax basis is zero since income tax is based principally on cash flows, e. g., the tax basis of warranty liability = 0 because only warranty costs incurred are tax deductible -Exception: capital assets, where tax basis is UCC

Tax basis and permanent differences Tax bases are only interesting for balance sheet assets and liabilities that are affected by temporary differences. Assets and liabilities that result from permanent differences (e. g., dividends receivable, golf dues payable) are considered to have tax bases that equal their carrying values. This is equivalent to saying that there are no future income taxes associated with assets and liabilities that result from permanent differences.

Liability method: Balance sheet approach 1.Calculate income taxes payable = (Accounting income before tax + non-deductible accounting expenses - tax-deductible expenses not on I/S - non-taxable revenues + taxable revenues not on income statement) x income tax rate 2.Calculate change in balance sheet future tax assets and liabilities 3.Plug income tax expense EXAMPLE: A16-18

Liability method: Income stmt approach 1.Calculate income taxes payable = (Accounting income before tax + non-deductible accounting expenses - tax-deductible expenses not on I/S - non-taxable revenues + taxable revenues not on income statement) x income tax rate 2.Calculate change in balance sheet future tax assets and liabilities by comparing rev/exp that give rise to temporary differences 3.Plug income tax expense

Liability method: Income statement vs Balance sheet approach Both approaches work Income statement approach is easier to understand Balance sheet approach is more difficult, but is better able to handle changes in income tax rates EXAMPLE: A16-19

5. Future income taxes on the balance sheet Future income taxes can be current or non- current, assets or liabilities. Current future income taxes: result from temporary differences that are related to current assets or current liabilities Non-current future income taxes: result from temporary differences that are related to non- current assets or non-current liabilities Note that the classification is unrelated to when the temporary differences are expected to reverse.

5. Future income taxes on the balance sheet Firms keep separate track of future income tax assets and liabilities related to each temporary difference. For balance sheet presentation purposes, current future income taxes are combined so that there is either a net current future income tax asset OR a net current future income tax liability (or neither one). The same treatment is applied to long-term future income taxes. EXAMPLE: A16-26

6. Tax losses The tax benefit of a loss in a given year (= tax loss multiplied by tax rate) can be carried back up to three years for a refund of taxes paid, and/or carried forward up to seven years to avoid taxes that would otherwise be payable. Tax loss carrybacks are realized and recognized in the year in which the loss occurs.

6. Tax losses (continued) Tax loss carryforwards are realized (if at all) in future years, and are recognized as assets if it is “more likely than not” that the company will be able to use the carryforward. EXAMPLE: A17-12