Chapter 14 Income Taxes Chapter 14 Income Taxes Mark Higgins

Transparency 14-2 Nature Of Income Taxes GAAP– The purpose of generally accepted accounting principles (GAAP) is to produce financial statements that show the underlying economic activity of the entity. TAP – The purpose of tax accounting principles (TAP) is to raise revenue for the government.

Transparency 14-3 Comparing GAAP with TAP Gain on Sale of Marketable Securities – Under GAAP, income (loss) is recognized for securities classified as trading securities. For TAP, gain (loss) is not recognized until the securities are sold. Post-Retirement Benefits Other Than Pensions – For GAAP, expense is recorded in the year the benefits are earned. For TAP, deduction is not until the year the benefit is paid.

Transparency 14-4 Comparing GAAP with TAP Asset Impairment – Under GAAP, the value of the asset is reduced and reflected in net income at the time the impairment occurs. For TAP, the deduction for the impaired asset does not occur until the asset is sold. Warranties – For GAAP, an expense is recorded in the year of the sale to reflect estimated future warranty obligations. For TAP, a deduction for warranties is not allowed until the year the warranty benefit is paid.

Transparency 14-5 Net Operating Loss (NOL) Carryforwards/Carrybacks To provide equity for a company who has a loss in one year and income in another year, TAP allows a company to carry back its loss in one year to offset the income it earned in a prior year. Alternatively, it can carry forward a loss from one year to offset its income in a future year. A company can carry back losses for 2 years and forward for 20 years.

Transparency 14-6 Net Operating Loss (NOL) Example Assume Rhody has $10 million of income in year 1 and has a loss of $2 million dollars in year 2. Alternatively, Huskie Corporation has $3 million of net income in year 1 and $5 million in year 2. The marginal tax rate for both companies is 34%. What amount does each company pay in taxes each year?

Transparency 14-7 Net Operating Loss (NOL) Example Huskie would pay $1,020,000 ($3,000,000 x 34%) in year 1 and $1,700,000 ($5,000,000 x 34%) in year 2. A total of $2,720,000 in taxes over the two years. Rhody would pay $3,4000,000 ($10,000,000 x 34%) in year 1 and no taxes in year 2. However, Rhody can carry back the $2,000,000 of loss to year 1 and receive an tax refund of $680,000 ($2,000,000 x 34%). Note that without the carryback provision, Rhody’s income tax on the same total income would have been higher than Huskies’ by $680,000 ($3,400,000 - $2,720,000).

Transparency 14-8 Comparing GAAP with TAP Inventory – After considering the LIFO conformity rule, inventory is the same under under GAAP and TAP. The only exception is if a company deducts obsolete inventory for GAAP. This is not permitted for TAP unless the inventory is actually disposed. Warranties – For GAAP, an expense is recorded in the year of the sale to reflect estimated future warranty obligations. For TAP, a deduction for warranties is not allowed until the year the warranty benefit is paid.

Transparency 14-9 Permanent Differences Permanent differences – Differences between taxable income and book income that will never reverse. For example, interest on municipal bonds is income for book purposes but not income for tax purposes. As a result, no asset/liability deferral is required.

Transparency Temporary Differences Temporary differences– The differences between taxable income and book income that will reverse in later years. For example, initially depreciation expense is higher for tax purposes than for book purposes. However, (on an asset by asset basis) this will eventually reverse and the book expense will be higher than tax expense.

Transparency Deferred Taxes Deferred taxes - Represent the difference between the tax liability based on book income and the tax liability based on taxable income (i.e., the tax return).

Transparency Deferred Tax Liability Deferred tax liabilities – These represent an obligation to pay more tax in later years. For example, for tax purposes an entity will depreciate tangible personal property using the Modified Accelerated Cost Recovery System (MACRS). In essence, this system depreciates the asset using a shorter asset life and the double declining-balance method discussed previously.

Transparency Deferred Tax Assets Deferred tax assets– These represent taxes paid due to taxable income being higher than book income. Expenses like warranties are not deductible for tax purposes until paid. Financial accounting accrues and “matches” them to the current period. The result is that taxable income is higher now. In later years, when the warranty expense is actually paid, the taxable income will be lower. As the authors suggest, deferred tax assets should be thought of as “prepaid” items!

Transparency Deferred Tax Liability The effect is that in the early years of an asset, more depreciation is taken for tax purposes than for book purposes. Thus book income is greater than taxable income As a result, a higher liability will be incurred. In the later years, the opposite occurs.

Transparency Calculation of Deferred Taxes 1. Find the temporary items that are treated differently for tax and book. Multiply the total difference by the current tax rate. 2. Compute tax liability (i.e., taxable income x tax rate) 3. Difference between the two numbers is Income tax expense (i.e., a plug)

Transparency Example of Deferred Taxes For the current year Rhody’s has $300,000 more deductions (i.e., temporary differences for tax purposes than for book purposes). Its tax rate is 34% and its taxable income is $3,500,000. Prepare the journal entry to record the income tax expense for the financial statements.

Transparency Example of Deferred Taxes Deferred tax - $ 300,000 x 34% = $102,000 Tax Liability - $3,500,000 x 34% = $1,190,000 Income Tax Expense 1,292,000 Deferred Taxes 102,000 Income Tax Payable1,190,000