MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell

Chapter 11 Accounting for

Topics –Sales taxes –Property taxes –Income taxes TAXES I just want my taxes to be BELOW ZERO!

SALES TAXES (Non-federal) Sales taxes collected are held (as a trustee), then remitted to taxing authorities. Sales taxes paid become part of the cost of acquiring the purchase (asset) being taxed. Sales taxes on items treated as a period expense are, therefore, also treated as a period expense.

PROPERTY TAXES In general, property taxes paid are treated as a period expense and matched against period revenues. Property taxes incurred on factory items are treated as factory overhead items (to be allocated to inventory produced).

INCOME TAXES Differences in GAAP and the tax code lead to book/tax differences. The text cases are based on the premise that difference in cash-basis and accrual- basis accounting are immaterial; differences in GAAP and TAX LAW become the emphasis.

Book/tax differences are classified as –Temporary (creates accounting problems) Example: Straight-line depreciation for book purposes; MACRS for tax purposes Example: Warranty expenses accrued for book purposes; not tax deductible until paid. –Permanent (no unusual accounting) Temporary differences create the need to calculate “Deferred income tax” related items.

Temporary Differences and Deferred Income Taxes Temporary differences originate in a single year (or over a series of years) and reverse in a single year (or over a series of years). Any related deferred income tax amounts are initiated in a single year (or over a series of years) and reverse in a single year (or over a series of years).

“Temporary” Book versus Tax Cases Incomes: Recognized by tax law ahead of books. Recognized on books ahead of tax law. Expenses: Recognized by tax law ahead of books. Recognized on books ahead of tax law. FAQ: Which creates deferred debt? …deferred receivable?

Temporary differences classified as taxable amounts lead to the recognition of deferred tax liabilities: End of period cumulative temporary taxable amounts ×tax rates (for years in which the difference is expected to reverse) =ending balance in deferred income tax liability

Temporary differences classified as deductible amounts lead to the recognition of deferred tax assets: End of period cumulative temporary deductible amounts ×tax rates (for years in which the difference is expected to reverse) =ending balance in deferred income tax asset

Deferred Income Tax Related Accounts’ Presentation The classification of “deferred income tax” accounts depends on the current or noncurrent classifications in the event(s) generating the “deferred tax” item. Examples follow: –The deferred income liability associated with depreciable noncurrent assets is classified as noncurrent.

–The deferred income tax asset associated with estimated warranty accruals (to be paid within one year) is classified as current because the warranty liability is current. –Any deferred income tax asset associated with estimated warranty liabilities (to be paid beyond one year) is classified as noncurrent because the warranty liability is noncurrent.

Income Tax Expense (Provision for Income Taxes) On the income statement: –Income tax expense is reported below “Income before income taxes” (i.e., pretax income). –Income tax expense is separated into current and deferred components on the income statement.

Income before income taxes*$5,000,000 Income tax expense: Current$2,200,000 Noncurrent( 300,000)1,900,000 Net Income$3,100,000 *Pretax Income

Current portion of income tax expense: the amount of income taxes owed to Federal, State, and Local taxing authorities for the current year. Noncurrent portion of income tax expense: the net change in the “deferred income tax” asset and liability accounts during the current year.

Net Operating Losses (NOLs) NOLs can be carried back if the corporation elects to do so; else, the NOL is carried forward (carried back for two years and forward for twenty years). The tax consequences of an NOL are dependent upon the tax rates in the years to which the NOL is ultimately applied.

When an NOL is used, it is applied against taxable incomes on the various tax returns, thereby reducing income taxes payable. –An NOL carryback generates an income tax refund receivable, the offset being a income tax benefit during the current year.

–An NOL carryforward generates a deferred income tax asset and creates an income tax benefit for the current period, given that it is more likely than not that the NOL carryforward will be applied in the next (per current law) 20 years –If it is more likely than not that the NOL carryforward will be less than fully applied in the next 20 years, then... –A valuation allowance is used to reduce the deferred income tax asset, and the income tax expense is reduced by the allowance.

Effects of Income Tax Rate Change When enacted, any change in income tax rates requires the deferred income tax amounts to be recalculated to conform to new tax rates. Pay me now, or pay me later!

Intraperiod Income Tax Allocation to Extraordinary Items, Discontinued Operations, and Cumulative Effects of Accounting Changes Extraordinary items, discontinued operations, and cumulative effects are shown at the bottom of the income statement, net of income tax effects. Example: Shane Company’s 2004 Partial Income Statement follows...

Income from continuing operations before income taxes $3,000,000 Provision for income taxes1,200,000 Income from continuing operations1,800,000 Discontinued operations, net of tax of $200,000( 300,000) Extraordinary item, net of tax of $300,000450,000 Cumulative effect of accounting change, net of tax of $120,000( 180,000) Net Income$1,770,000

Note: To compute total income tax expense, the provision for income taxes of $1,200,000 would be combined with the income tax effects of the three items presented net of tax: Provision for income tax$1,200,000 Discontinued operations( 200,000) Extraordinary Item300,000 Cumulative Effect of Accounting Change( 120,000) Total Income Tax Expense$1,180,000

Effective Income Tax Rate If a corporation’s effective tax rate is different from the Federal statutory tax rate (currently 35%), then the firm presents a reconciliation from the statutory rate to the effective tax rate in a footnote.

The Provision for Income Taxes exceeds the U.S. Federal Statutory Rate as a Result of the Following Differences Example:Current Year Prior Year U.S. Statutory Rate35.0% State/other income taxes, net of federal income tax benefit3.5% Nondeductible stock option exp.2.3%2.5% Other, net( 0.7%)0.1% Effective tax rate40.1%41.1%

Example: One Permanent Difference, Two Temporary Differences Facts: The Petersen Co. began operations on January 1, The following information is presented for 2004 and –All book and tax amounts were the same except for three items. –Assume that all items are treated the same for Federal and State income tax purposes.

Income before income taxes (per books)$1,200,000$2,300,000 Municipal bond income (qualifies as tax exempt)$10,000 Depreciation Books$60,000 Tax$83,000$76,000

(con’t) Warranty expense (assume a one- year warranty on sales): Books (accrual basis)$15,000$18,000 Tax (amount paid and deductible for tax purposes)$6,000$21,000 Tax rates (Federal tax rate of 35%; state income tax rate of 3%)38%

Compute Corporate Taxable Income and Income Taxes Payable Form 1120

Income before income taxes (per books)$1,200,000$2,300,000 Permanent difference: Municipal bond income ( 10,000) Temporary differences: Excess of tax over book depreciation expense ( 23,000)( 16,000) Excess (deficit) of tax com- pared to book warranty expense 9,000( 3,000) Taxable income$1,176,000$2,271,000

Annual Taxes Federal income taxes (35%)$411,600$794,850 State income taxes (3%) 35,280 68,130 Total Federal and State income taxes$446,880$862,980

Income Statement Presentation Income before income taxes (per books)$1,200,000$2,300,000 Income tax expense Current446,880862,980 Deferred (computation follows) 5,320 7,220 Net income$747,800$1,429,800

Deferred Income Taxes Computed on Temporary Differences Computation of year-end deferred income tax amounts Depreciable asset (cumulative tem- porary differences × 38%) creates a deferred tax liability $23,000 × 38%$8,740 $39,000 × 38%$14,820

Summary Difference is a taxable amount; the ending deferred tax amount is a deferred income tax liability. Deferred tax amount is noncurrent because property, plant, and equipment is noncurrent. Increase in a deferred income tax liability increases income tax expense.

Warranty liability (cumulative temporary difference × 38%) creates a deferred tax asset $9,000 × 38%$3,420 $6,000 × 38%$2,280 Difference is a deductible amount; the ending deferred tax amount is a deferred income tax asset. Deferred tax amount is current because the warranty liability is current. Increase in a deferred income tax asset decreases income tax expense.

Change Deferred Tax Asset 3,4202,280(1,140) Deferred Tax Liability 8,74014,8206,080 Net liability $5,320 Net liability $12,540 Increase net liability $7,720

Balance Sheet Presentation Assume that during the year Petersen Co. made tax payments equal to 90% of income taxes payable for the year. Therefore, the FYE tax liability is the remaining 10% of the total amount.

Current liabilities: Income taxes payable $446,880 × 10%$44,688 $862,980 × 10%$86,298 Current assets: Deferred income tax assets$ 3,420$ 2,280 Noncurrent liabilities: Deferred income taxes payable$ 8,740$14,820 Petersen Co.:

Statement of Cash Flows Income taxes are an operating activity –Direct method: amount of taxes paid –Indirect method: change in taxes payable and deferred tax accounts are adjustments to net income

End of Chapter 11