COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Income Taxes Chapter 16 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives 1.Understand the concept of deferred taxes and the distinction between permanent and temporary differences. 2.Compute the amount of deferred tax liabilities and assets. 3.Explain the provisions of tax loss carrybacks and carryforwards, and be able to account for these provisions.

Learning Objectives 4.Schedule future tax rates, and determine the effect on tax assets and liabilities. 5.Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities. 6.Comply with income tax disclosure requirements associated with the statement of cash flows. 7.Describe how, with respect to deferred income taxes, International Accounting Standards have converged toward the U.S. Treatment.

Overview The primary goal of financial accounting is to provide useful information to management, stockholders, creditors, and other properly interested. The primary goal of the income tax system is the equitable collection of revenue.

Deferred Income Tax Overview Two basic considerations in U.S. corporations computed net income. 1.How to account for revenues and expenses that have already been recognized and reported to shareholders in a company’s financial statements but will not affect taxable income until subsequent years.

Deferred Income Tax Overview Two basic considerations in U.S. corporations computed net income. 2.How to account for revenues and expenses that have already been reported to the IRS but will not be recognized in the financial statements until subsequent years.

Simple Deferred Income Tax Liability Examples: –Revenues (or gains) taxable after they are recognized for financial reporting, such as receivables from installment sales. –Expenses (or losses) deductible for tax purposes before they are recognized for financial reporting purposes, such as accelerated tax depreciation.

Simple Deferred Tax Liability In 2007, Hernandez Company earned revenues of $30,000. Hernandez has no expenses other than income taxes. In this case, Hernandez is taxed on cash received. The company received $10,000 in 2007 and $20,000 in The income tax rate is 40% and it is expected to remain the same into the foreseeable future.

Simple Deferred Tax Liability Income Tax Expense12,000 Income Taxes Payable4,000 Deferred Tax Liability8,000 $30,000 x.40 $10,000 x.40$20,000 x.40 Hernandez Company Income Statement For the Year Ended December 31, 2007 Revenues$30,000 Income tax expense: Current$4,000 Deferred 8,000 Net income$18,000

Simple Deferred Income Tax Asset Examples: –Expenses (or losses) that are deductible for tax purposes after they are recognized for financial reporting purposes, such as warranty expenses. –Revenues (or gains) that are taxable before they are recognized for financial reporting purposes, such as subscriptions received in advance.

Simple Deferred Tax Asset In 2007, Shah Corporation generated service revenues totaling $60,000, all taxable in No warranty claims were made in 2007, but Gupta estimates that in 2008 warranty costs of $10,000 will incurred for claims related to 2007 service revenues. Assume a 40% tax rate.

Simple Deferred Tax Asset Income Tax Expense20,000 Deferred Tax Asset4,000 Income Taxes Payable24,000 $30,000 x.40 $10,000 x.40$20,000 x.40 Shah Company Income Statement For the Year Ended December 31, 2007 Revenues$60,000 Less: Warranty Expense 10,000 Income before taxes 50,000 Income tax expense: Current$24,000 Deferred benefit (4,000)20,000 Net income$30,000

Temporary Differences Permanent Differences- Nondeductible expenses or nontaxable revenues that are recognized for financial reporting purposes but are never part of taxable income. Temporary Differences- Differences between pretax financial income and taxable income arising from business events that are recognized for both financial and tax purposes, but in different time periods.

Example of Permanent and Temporary Differences For the year ended December 31, 2007, Monroe Corporation reported net income before taxes of $420,000. This amount includes $20,000 of nontaxable revenues and $5,000 of nondeductible expenses. The depreciation method used for tax purposes allowed a deduction that exceeded the book approach by $30,000.

Example of Permanent and Temporary Differences Pretax income from income statement$420,000 Add (deduct) permanent differences: Nontaxable revenues$(20,000) Nondeductible expenses 5,000 (15,000) Financial income subject to tax$405,000 Add (deduct) temporary differences: Excess of tax depreciation over book depreciation (30,000) Taxable income$375,000 Tax on taxable income (income taxes payable): $375,000 x.35 $131,250

Annual Computation of Deferred Tax Liabilities & Assets Advantages of the asset and liability method: 1.Assets and liabilities are recorded in agreement with FASB definitions of financial statement elements. 2.Method is flexible and recognizes changes in circumstances and adjusts the reported amounts accordingly. 3.Has better predictive value.

Valuation Allowance for Deferred Tax Asset Statement No. 109 stipulates that both positive and negative evidence be considered when determining whether deferred tax assets will be fully realized.

Carryback and Carryforward of Operating Losses Loss Year -2 Year +20 Carryback Election Carryforward Election

Net Operating Loss (NOL) Carryback YearTax Rate Income Tax Income (Loss) 2007$10,00035%$3, ,000304, (19,000)300 Journal Entry in 2009: Income Tax Refund Receivable 6,200 Income Tax Benefit From NOL Carryback 6,200 [ $3,500 + (30% x $9,000) ]

Accounting for NOL Carryforward Continuing with the Prairie Company illustration, assume that in 2010 the firm incurred an operating loss of $35,000. Year Income (Loss) Tax Rate Income Tax 2009$(19,000) 30%$ (35,000) 30%0 The only loss remaining against which operating income can be applied is $5,000 from 2008 ($14,000 – $9,000). This leaves $30,000 to be carried forward from 2009 as a future tax benefit of $9,000 ($30,000 x.30).

Accounting for NOL Carryforward Income Tax Refund Receivable1,500 Deferred Tax Asset—NOL Carryforward9,000 Income Tax Benefit from NOL Carryback1,500 Income Tax Benefit from NOL Carryforward9,000 The journal entry for 2010 to record the tax benefits :

Accounting for NOL Carryforward Journal Entry: Income Tax Expense15,000 Income Taxes Payable6,000 Deferred Tax Asset—NOL Carryforward 9,000 The firm reports a taxable income of $50,000 in The tax carryforward allows management to deduct the carryforward from the $15,000 tax ($50,000 x.30) that would be due without the carryforward.

Accounting for NOL Carryforward If management believes that losses will continue in the future and the tax benefit will not be realized: Journal Entry: Income Tax Refund Receivable1,500 Deferred Tax Asset—NOL Carryforward9,000 Income Tax Benefit from NOL Carryback1,500 Allowance to Reduce Deferred Tax Assets to Realizable Value— NOL Carryforward9,000 As a result of this entry, the deferred tax asset is zero—the expected realizable value.

Scheduling for Enacted Future Tax Rates Proper recognition of deferred tax assets and liabilities is required when future tax rates are expected to differ from current tax rates. The firm must determine the temporary differences that will reverse. Statement No. 109 eliminates much of the need for scheduling through the “more- likely-than-not” criterion for future income.

Financial Statement Presentation and Disclosure The following items must appear in the income statement or an accompanying note: Current tax expense or benefit Deferred tax expense or benefit Investment tax credits Government grants recognized as tax reductions

Financial Statement Presentation and Disclosure The following items must appear in the income statement or an accompanying note: Benefits of NOL carryforwards Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of an enterprise Adjustments in beginning-of-the-year valuation allowance because of a change in circumstances

Deferred Taxes and the Statement of Cash Flows Callazo Company had the following information for 2007: Revenue (all cash) $30,000 Income tax expense: Current $10,300 Deferred 1,700(12,000) Net income $18,000 Cash paid for income taxes during 2007 totaled $13,300.

Deferred Taxes and the Statement of Cash Flows 12/31/07 Income tax refund receivable$2,000$ 0 Income taxes payable01,000 Deferred tax liability9,7008,000 Analysis Income Statement Adjustment SCF Revenue (all cash), $30,000No adjustment$30,000 cash collected from customers

Deferred Taxes and the Statement of Cash Flows Analysis Income Statement Adjustment SCF Income tax expense—current–$2,000—$(13,300) Cash $(10,300)Increase inpaid for taxes tax receivable –$1,000— Decrease in taxes payable

Deferred Taxes and the Statement of Cash Flows Analysis Income Statement Adjustment SCF Income tax expense—deferred+$2,000— No effect $(1,700)Increase in deferred tax liability

Deferred Taxes and the Statement of Cash Flows Analysis Income Statement Adjustment SCF Net income, $18,000–$1,300$16,700 Cash flow from operations Collazo Company Statement of Cash Flows (Direct Approach) Cash collected from customers$30,000 Income taxes paid(13,300) Cash provided by operating activities$16,700

Deferred Taxes and the Statement of Cash Flows Collazo Company Statement of Cash Flows (Indirect Approach) Net income$18,000 Decrease in income tax refund receivable(2,000) Decrease in income taxes payable(1,000) Increase in deferred tax liability 1,700 Cash provided by operating activities$16,700

International Accounting for Deferred Taxes No-Deferral Approach- Ignore the differences and report income tax expense equal to the amount of tax payable for the year. Comprehensive Recognition Approach- Deferred taxes are included in the computation of income tax expense and reported on the balance sheet. Partial Recognition Approach- A deferred tax liability is recorded only to the extent that the deferred taxes are actually expected to be paid in the future.