Accounting for Income Taxes C hapter 19 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2 1.Understand permanent and temporary differences. 2.Explain the conceptual issues regarding interperiod tax allocation. 3.Record and report deferred tax liabilities. 4.Record and report deferred tax assets. 5.Explain an operating loss carryback and carryforward. Objectives

3 6.Account for an operating loss carryback. 7.Account for an operating loss carryforward. 8.Apply intraperiod tax allocation. 9.Classify deferred tax liabilities and assets. Objectives

4 1.Because there are differences between when an event is recognized for tax purposes and when it is recognized for financial purposes, there will be differences between tax expense on the income statement and taxes actually paid. 2.The objective of accounting for income taxes on the accrual basis is to recognize the amount of current and deferred taxes payable or refundable at the date of the financial statements. 1.Because there are differences between when an event is recognized for tax purposes and when it is recognized for financial purposes, there will be differences between tax expense on the income statement and taxes actually paid. 2.The objective of accounting for income taxes on the accrual basis is to recognize the amount of current and deferred taxes payable or refundable at the date of the financial statements. ContinuedContinued Differences Between Taxable and Financial Income

5 3.These differences require the use of Deferred Income Tax accounts to reflect the tax consequences of events recognized in different periods for financial and tax reporting. 4.Recognition of deferred tax liabilities and deferred tax assets is required for domestic federal income taxes, and foreign, state, and local (including franchise) taxes based on income. 3.These differences require the use of Deferred Income Tax accounts to reflect the tax consequences of events recognized in different periods for financial and tax reporting. 4.Recognition of deferred tax liabilities and deferred tax assets is required for domestic federal income taxes, and foreign, state, and local (including franchise) taxes based on income. Differences Between Taxable and Financial Income

6 The objective of financial reporting is to provide useful information about companies to decision makers. Income State- ment Income Tax Return Overview and Definitions

7 Income State- ment Income Tax Return Frees Corporation Income Statement For Year Ended 12/31/07 Revenues$180,000 Cost of goods sold(78,000) Gross profit$105,000 Other expenses(60,000) Pretax income from continuing operations$ 45,000 Income taxes(11,000) Net income$ 34,000 Overview and Definitions

8 Income State- ment Income Tax Return Frees Corporation Income Tax Return For Year Ended 12/31/07 Revenues$170,000 Cost of goods sold(70,000) Gross profit$100,000 Other expenses(60,000) Pretax income from continuing operations$ 40,000 Income taxes( 9,200) Net income$ 30,800 Overview and Definitions

9  Permanent differences.  Temporary differences.  Operating loss carrybacks and carryforwards.  Tax credits.  Intraperiod tax allocations. Causes of Differences

10 1.Should corporations be required to make interperiod income tax allocations for temporary differences, or should there be no interperiod tax allocation? 2.If interperiod tax allocation is required, should it be based on a comprehensive approach for all temporary differences or on a partial approach for certain temporary differences? 3.Should interperiod tax allocation be applied using the asset/liability method or the deferred method? Conceptual Issues

11 The FASB concluded that--  Interperiod income tax allocation of temporary differences is appropriate.  The comprehensive allocation approach is to be applied.  The asset/liability method of income tax allocation is to be used. Conceptual Issues

12 Some items of revenue and expense that a corporation reports for financial accounting purposes are never reported for income tax purposes. These permanent differences never reverse in a later accounting period. Permanent Differences

13 Permanent Differences

14 Revenues that are recognized for financial reporting purposes but are never taxable 1.Interest on state and local government bonds 2.Life insurance proceeds payable to a corporation upon death of insured Revenues that are recognized for financial reporting purposes but are never taxable 1.Interest on state and local government bonds 2.Life insurance proceeds payable to a corporation upon death of insured ContinuedContinued Permanent Differences

15 Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes 1.Life insurance premiums on officers 2.Fines resulting from a violation of the law 3.Expenses incurred in obtaining tax- exempt income Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes 1.Life insurance premiums on officers 2.Fines resulting from a violation of the law 3.Expenses incurred in obtaining tax- exempt income ContinuedContinued Permanent Differences

16 Deductions that are allowed for income tax purposes but do not qualify as expenses under generally accepted accounting principles 1.Percentage depletion in excess of cost depletion 2.Dividend received deduction Deductions that are allowed for income tax purposes but do not qualify as expenses under generally accepted accounting principles 1.Percentage depletion in excess of cost depletion 2.Dividend received deduction Permanent differences affect either a corporation’s reported pretax financial income or its taxable income, but not both. Permanent Differences

17 Corporations receive a 70% deduction for dividends received if less than 20% of a U.S. corporation is owned, an 80% deduction for dividends received if 80% or less of a U.S. corporation is owned, and a 100% deduction for dividends received if more than 80% of a U.S. corporation is owned. Dividend Received Deduction

18 A temporary difference causes a difference between a corporation’s pretax financial income and taxable income that “originates” in one or more years and “reverses” in later years. Temporary Differences

19 1.For example, a depreciable asset may be depreciated using MACRS over the prescribed tax life for income purposes, but using straight-line depreciation over a longer life for financial reporting purposes. Future Taxable Income Will Be Higher Than Future Pretax Financial Income ContinuedContinued Temporary Differences- Future Taxable AmountsT Over F T = Taxable

20 2.Gross profit on installment sales normally is recognized at the point of sale for financial reporting purposes, but for income tax purposes, in certain situations it is recognized as cash is collected. Future Taxable Income Will Be Higher Than Future Pretax Financial Income ContinuedContinued Temporary Differences- Future Taxable AmountsT Over F T = Taxable

21 3.It is assumed that investment income reported under the equity method for financial purposes, but not received as a dividend, will eventually be received as dividends or as a gain when the stock is sold. Future Taxable Income Will Be Higher Than Future Pretax Financial Income ContinuedContinued Temporary Differences- Future Taxable AmountsT Over F T = Taxable

22 4.Prepaid expenses are deductible when paid for tax purposes, but are not recorded as expenses under used for financial purposes. 5.Unrealized gains on trading securities are not taxable until realized. 4.Prepaid expenses are deductible when paid for tax purposes, but are not recorded as expenses under used for financial purposes. 5.Unrealized gains on trading securities are not taxable until realized. Future Taxable Income Will Be Higher Than Future Pretax Financial Income ContinuedContinued Temporary Differences- Future Taxable AmountsT Over F T = Taxable

23 6.Profit recognized, but not realized, under the percentage of completion method for financial reporting that will not be taxable until a later year. Future Taxable Income Will Be Higher Than Future Pretax Financial Income ContinuedContinued Temporary Differences- Future Taxable AmountsT Over F T = Taxable

24 1.For example, items such as rent, interest, and royalties received in advance are taxable when received but are not reported for financial reporting purposes until the service actually has been provided. Future Pretax Financial Income Higher Than Future Taxable Income ContinuedContinued Temporary Differences- Future Deductible AmountsF Over T F = Deductible

25 2.Product warranty costs may be estimated and recorded as expenses in the current year for financial reporting purposes but deducted, as actually incurred, for the determination of taxable income. Future Pretax Financial Income Higher Than Future Taxable Income ContinuedContinued Temporary Differences- Future Deductible AmountsF Over T F = Deductible

26 3.Bad debts expense estimated for financial reporting, but not deductible until the receivable is written off for tax purposes. 4.Portion of depreciation capitalized for tax purposes into inventory. 3.Bad debts expense estimated for financial reporting, but not deductible until the receivable is written off for tax purposes. 4.Portion of depreciation capitalized for tax purposes into inventory. Future Pretax Financial Income Higher Than Future Taxable Income ContinuedContinued Temporary Differences- Future Deductible AmountsF Over T F = Deductible

27 5.Accrued litigation losses for financial reporting, but not deducted until paid for tax purposes. 6.Losses on investments classified as trading securities. 7.Unrealized profit on sale and leaseback for financial reporting and a profit on the sale for tax purposes. 5.Accrued litigation losses for financial reporting, but not deducted until paid for tax purposes. 6.Losses on investments classified as trading securities. 7.Unrealized profit on sale and leaseback for financial reporting and a profit on the sale for tax purposes. Future Pretax Financial Income Higher Than Future Taxable Income Temporary Differences- Future Deductible AmountsF Over T F = Deductible

28 The FASB established four basic principles that a corporation is to apply in accounting for its income taxes at the date of its financial statements. Conceptual Issues

29 1.A current tax liability or asset is recognized for the estimated income tax obligation or refund on its income tax return for the current year. 2.A deferred tax liability or asset is recognized for the estimated future tax effects of each temporary difference. ContinuedContinued Conceptual Issues

30 3.The measurement of deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax law or rates are not anticipated. 4.The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized. Conceptual Issues

31 1.The applicable income tax rates. 2.Whether a valuation allowance should be established for deferred tax assets. The FASB addressed two issues regarding the measurement of deferred tax liabilities or deferred tax asset in its financial statements. Measurement

32 Step 1.Measure the income tax obligation by applying the applicable tax rate to the current taxable income. Step 2.Identify the existing temporary differences and classify each as either“taxable” or “deductible.” Step 3.Measure the deferred tax liability for each taxable temporary difference using the applicable tax rate. ContinuedContinued Steps in Recording and Reporting of Current and Deferred Taxes

33 Step 4.Measure the deferred tax asset for each deductible temporary difference using the applicable tax rate. Step 5.Reduce deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Step 6.Record the income tax obligation, change in deferred tax liabilities and/or deferred tax assets, change in valuation allowance (if any), and plug income tax expense. Steps in Recording and Reporting of Current and Deferred Taxes

34 In 2007, Track Company purchased an asset at a cost of $6,000. For financial reporting purposes, the asset has a 4-year life, no residual value, and is depreciated by the units-of-output method over 6,000 units (2007: 1,600 units). For income tax purposes the asset is depreciated under MACRS using the 3-year life (33.33% for 2007). The taxable income is $7,500 and the income tax rate for 2007 is 30%. Basic Entries This button will be used later

35 In the future taxable income will be higher than financial income, so the taxable amount times the tax rate is the deferred tax liability. Financial Income Tax Year Depreciation Depreciation Difference 2007$1,600$2, Deferred Tax Liability

36 Step 1.$7,500 (taxable income) x 30% Step 2.The depreciation difference is identified as the only taxable temporary difference. Step 3.The $120 total deferred tax liability is calculated by multiplying the total taxable temporary difference ($400) times the future tax rate (30%). Steps 4 and 5. No deferred tax asset, so not required. Step 6.A journal entry is made. ContinuedContinued Basic Entries

37 Income Tax Expense (plug)2,370 Income Taxes Payable2,250 Deferred Tax Liability120 $2,250 + $120 Basic Entries

38 When future enacted tax rates change, reversals are calculated at the future tax rates. Future Tax Rates Differ

39 Assume the same facts as in Slide 34, except that the income tax rate for 2007 for 40%, but Congress has enacted tax rates of 35% for 2008, 33% for 2009, and 30% for 2010 and beyond. Financial Income Tax Year Depreciation Depreciation 2007$2,800$2, , Click here to review Slide 34, then click the button on Slide 34 to return. Example 2-Multiple Rates

Deferred Tax Liability Financial depreciation$2,800 $1,100 $500 Income tax depreciation(2,667) (889)(444) Taxable amount$ 133 $ 211 $ 56 = $400 Income tax rate Deferred tax liability$ 47 $ 70 $ 17 = $134 Income Tax Expense (plug)3,134 Deferred Tax Liability134 Income Taxes Payable3,000 Example 2-Multiple Rates

41 Klemper Company sells a product on which it provides a 3-year warranty. For financial reporting purposes, the company estimates its future warranty costs and records a warranty expense/liability at year-end. For income tax purposes, the company deducts its warranty costs when paid. Deferred Tax Asset

42 At the beginning of 2007, the company had a deferred tax asset of $330 related to its warranty plan. At the end of 2007, the company estimates that its ending warranty liability is $1,400. In 2007, the company has taxable income of $5,000 and a tax rate of 30%. The ending Deferred Asset should be $1,400 X 30%, or $420. Income Tax Expense (plug)$1,410 Deferred Tax Asset ($420 - $330)90 Income Taxes Payable ($5,000 x 30%)1,500 Deferred Tax Asset

43 Deferred Tax Asset and Valuation Allowance If it is “more likely than not” that a deferred tax asset will not be realized, a valuation allowance must be established.

44 Negative Evidence Negative evidence indicating the need for a valuation allowance include: 1.A history of operating loss or tax credit carryforwards expiring unused. 2.Losses expected in early future years (by a presently profitable entity). 3.Unrecognized loss contingencies that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years. 4.A carryback, carryforward period that is so brief that it would limit realization of tax benefits.

45 Positive Evidence Positive evidence as to whether existing net deductible temporary differences and loss carryforwards will be realized include: 1.Existing contracts or firm sales backlog will produce more than enough future taxable income to realize the deferred tax asset based on existing sales prices and cost structures. 2.Income in carryback years prior to the present year. 3.Feasible and presently available tax strategies would result in more than enough taxable income to realize the deferred tax asset. 4.Appreciation of assets is sufficient to realize the deferred tax asset. 5.A strong earnings history exclusive of the charge to income that created the future deductible amount coupled with evidence indicating the transaction or event that created the charge to income (i.e. extraordinary item) is an aberration rather than a continuing condition.

46 Deferred Tax Assets and Valuation Allowance At the end of 2007, Klemper Corporation decides that it is “more likely than not” that $600 of the ending temporary difference will not be realized. (30% tax rate) Income Tax Expense180 Allowance to Reduce Deferred Tax Asset to Realizable Value180

47 PPretax financial incomeXX Add: Deductible temporary itemsXX FinesXX Excess charitable contributionsXX Expenses to earn tax exempt incomeXX Excess of bad debts expense over write-offs (deductible item)XXXX XX Less: Taxable temporary itemsXX Tax exempt interestXX Proceeds of life insuranceXX Excess of percentage depletion over cost depletionXX Equity income not received as dividends (taxable item)XX Dividends received deductionXXXX Taxable incomeXX Determining Taxable Income Both permanent and temporary differences are considered when determining taxable income.

48 Example 5-Pages 959 & 960 Assume the following for Sand Company for 2007: Interest on municipal bonds$1,500 Gross profit on installment sales-financial10,000 Gross profit on installment sales-taxable2,000 Rent revenue-financial3,000 Rent revenue-taxable9,000 Pre-tax financial income75,500 Deferred tax liability-Jan. 1, Deferred gross profit-installment sales-20061,000 Make the journal entry for 2007.

49 PPretax financial income$75,500 Add: Rent revenue collected in advance6,000 $81,500 Less: Tax exempt interest$1,500 Difference in gross profit on installment sales8,0009,500 Taxable income$72,000 Determining Taxable Income Both permanent and temporary differences are considered when determining taxable income.

50 Deferred Tax Assets and Liabilities Income Tax Expense (plug)22,200 Deferred Tax Asset1,800 Deferred Tax Liability2,400 Taxes Payable21,600 $8,000 (2007) + $1,000 (2006)

51 FASB concluded in FASB Statement No. 109 that GAAP for operating carrybacks and carryforwards are... Conceptual Issues

52 1.A corporation must recognize the tax benefit of an operating loss carryback in the period of the loss as an asset on its balance sheet and as a reduction of the operating loss on its income statement. 2.A corporation must recognize the tax benefit of an operating loss carryforward in the period of the loss as a deferred tax asset. However, it must reduce the deferred tax asset by a valuation allowance if it is more likely than not that the corporation will not realize some or all of the deferred tax asset. Conceptual Issues

53 Operating Loss Carrybacks and Carryforwards

54 Monk Company reports a pretax operating loss of $90,000 in 2007 for both financial reporting and income tax purposes, and that reported pretax financial income and taxable income for the previous 2 years had been: $40,000 (tax rate 25%); and $70,000 (tax rate 30%). Income Tax Refund Receivable25,000 Income Tax Benefit From Operating Loss Carryback25, $40,000 x 0.25 =$10, $50,000 x 0.30 =15,000 $25,000 Operating Loss Carryback ContinuedContinued

55 Income Statement An operating loss is reduced by the benefit, not by the total carryback. Pretax operating loss$(90,000) Less: Income tax benefit from operating loss carryback $40,000 x 25% + $50,000 x 30%25,000 Net loss$(65,000)

56 Lake Company reports a pretax operating loss of $60,000 in 2007 for both financial reporting and income tax purposes. The income tax rate is 30% and no change in the tax rate has been enacted for future years. The deferred tax asset is calculated to be $18,000 ($60,000 x 0.30). Deferred Tax Asset18,000 Income Tax Benefit From Operating Loss Carryforward18,000 ContinuedContinued Operating Loss Carryforward

57 If the company establishes a valuation allowance for the entire amount of the deferred tax asset, it also makes the following journal entry at the end of Income Tax Benefit From Operating Loss Carryforward18,000 Allowance to Reduce Deferred Tax Asset to Realizable Value18,000 Operating Loss Carryforward ContinuedContinued

58 In 2008, Lake Company operates successfully and earns pretax operating income of $100,000 for both financial reporting and tax purposes. Income Tax Expense12,000 Allowance to Reduce Deferred Tax Asset to Realizable Value18,000 Income Taxes Payable12,000 Deferred Tax Asset18,000 Operating Loss Carryforward $40,000 x 0.30

59 Income tax allocation within a period is mandatory under GAAP. Intraperiod Tax Allocation

60 Intraperiod Tax Allocation Income tax may appear in five different places in the financial statements for a period. 1.Income from continuing operations 2.Discontinued operations 3.Extraordinary items 4.Prior period and retrospective adjustments 5.Other comprehensive income

61 Income from continuing operations [$270,000 (revenues) – $190,000 (expenses)]$80,000 Gain on disposal of discontinued Segment X18,000 Loss from operations of discontinued Segment X(5,000) Extraordinary loss on bond redemption(10,000) Cumulative effect of change in accounting principle (accelerated depreciation to S/L)15,000 Prior period adjustment (error) (8,000) Amount subject to income taxes$90,000 ContinuedContinued Intraperiod Tax Allocation Kalloway Company reports the following items of pretax financial and taxable income for 2007:

62 Kalloway Company is subject to income tax rates of 20% on the first $50,000 of income and 30% on all income in excess of $50,000. Let’s take a look at Kalloway Company’s income statement for ContinuedContinued Intraperiod Tax Allocation

63 Pretax Amount Income Tax Rate Income Tax Expense (Cr.) Component (Pretax) Income from continuing operations$50, $10,000 30, ,000 Gain on disposal of discontinued Division X18, ,400 Extraordinary loss from tornado(5,000)0.30(1,500) x = ContinuedContinued Intraperiod Tax Allocation

64 Pretax Amount Income Tax Rate Income Tax Expense (Cr.) Component (Pretax) Cumulative effect of change in accounting principle on prior year’s income$15, $ 4,300 Prior period adjustment (8,000) 0.30 (2,400) Total income tax expense$22,000 x = Intraperiod Tax Allocation

65 Now, let’s examine Kalloway Company’s income statement for Intraperiod Tax Allcoation

66 (0.20 x $50,000) + (0.30 x $30,000) Kalloway Company Income Statement for Year Ended December 31, 2007 Revenues (listed separately)$270,000 Expenses (listed separately)(190,000) Pretax income from continuing operations$ 80,000 Income tax expense (19,000) Intraperiod Tax Allocation

67 Kalloway Company Income Statement for Year Ended December 31, 2007 Revenues (listed separately)$270,000 Expenses (listed separately)(190,000) Pretax income from continuing operations$ 80,000 Income tax expense (19,000) Income from continuing operations$ 61,000 Results of discontinued operations: Gain on disposal of discontinued Segment X (net of $5,400 tax)$12,600 Loss from operations of discontinued Segment X (net of $1,500 tax credit) (3,500) 9,100 Income before extraordinary item$ 70,100 Statement Continued $18,000 x 0.30 ($5,000) X.30

68 Income before extraordinary item$70,100 Extraordinary loss from tornado (net of $3,000 income tax credit)(7,000) Net Income$63,100 Prior period adjustments on the statement of retained earnings also would be shown net of tax. ($10,000) x 0.30

69 A corporation must report its deferred tax liabilities and assets in two classifications... …a net current amount and a net noncurrent amount. Balance Sheet Presentation

70 Deferred tax liabilities and assets are classified as current or noncurrent based upon their related assets or liabilities for financial reporting. Balance Sheet Presentation

71 Any deferred tax liability or asset not related to an asset or liability is classified according to the expected reversal date of the temporary difference. Balance Sheet Presentation

72 Current and Noncurrent Related Asset or Liability Classification Installment salesAccounts ReceivableCurrent Inventory differencesInventoryCurrent Allowance for DoubtfulAccounts ReceivableCurrent Depreciation differencesPlant AssetsNoncurrent Estimated Reversals Accrued Pension Expense Probably noncurrent Warranty Liability Probably current Unearned Revenue NOL

73 Account Related Balance Deferred Tax Accounts Balance Sheet Account Deferred Tax Liabilities Installment sales$ 6,000 creditAccounts receivable Depreciation$12,000 creditProperty, plant, and equipment Deferred Tax Assets Warranty costs$ 3,400 debitWarranty liability Rent revenue $ 2,500 debitUnearned revenue Balance Sheet Presentation Current Current Noncurrent Noncurrent

74 The next slide presents an illustration that includes several temporary differences. Assume taxable income of $700,000 at a 30% tax rate.

75 Comprehensive Illustration Balance sheet amounts Deferred Tax Asset25,500 Income Tax Expense (plug)194,500 Deferred Tax Liability10,000 Taxes Payable210,000 ContinuedContinued

76 Current and Deferred Amounts on INCOME STATEMENT Taxes Payable (current)$210,000 Deferred Tax Asset (net) ($25,500 asset - $10,000 liability)15,500 Income Tax Expense$194,500

77 C hapter 19 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.