Slide C3-1 Assignments For Next Class: Read Chapter 3, pages 24-38

Chapter 3 3 The Corporate Income Tax

GAAP Tax Accounting and Reconciliation from Book Income to Taxable Income

Book-Tax Differences Contrasting principles of conservatism GAAP conservatism principle Protect shareholders and creditors Curb management tendencies to overstate revenues and understate expenses for book purposes Tax conservatism principle Protect government revenues Curb taxpayer tendencies to understate income and overstate deductions

Book-Tax Differences Permanent differences = items included in book income that are never recognized for tax purposes or vice versa Temporary differences = items that are included in book income and recognized for tax purposes but in different taxable years (the difference will “reverse” over time)

Book-Tax Differences – Permanent Examples of permanent book-tax differences Tax-exempt state and local bond interest income Nondeductible expenses incurred to generate state and local bond interest income Life insurance proceeds (death benefits) Premiums on key-man life insurance 50% of meals and entertainment Political contributions Fines and penalties Bribes, kickbacks and illegal payments Dividends-received deduction

Book-Tax Differences – Temporary Examples of temporary book-tax differences: Depreciation versus cost recovery (and gains/losses on sales of property with different book/tax bases) Accrued liabilities not meeting the all events and/or economic performance tests Prepaid income Related party accruals Accrued compensation Bad debt expense Net operating losses Charitable contributions in excess of limitation Capital loss carryovers

GAAP Tax Expense GAAP total tax expense (benefit) = current tax expense (benefit) plus deferred tax expense (benefit)

GAAP Tax Expense GAAP current tax expense (benefit) = estimated tax payable (refund receivable) based on estimated taxable income for the current year Exception: Effects of stock options compensation and “other comprehensive income” items are booked directly to retained earnings

GAAP Tax Expense GAAP deferred tax expense (benefit) = estimated tax effects of temporary differences (those differences that will reverse in future years) Differences that make taxable income lower than book income at origination create deferred tax liabilities Differences that make taxable income higher than book income at origination create deferred tax assets

GAAP Tax Expense GAAP (SFAS109) uses the Balance Sheet approach to calculating deferred tax expense Calculate deferred tax liability or asset on cumulative temporary differences at the beginning of the year and again at the end of the year Deferred tax liability increase (deferred tax asset decrease) => deferred tax expense Deferred tax liability decrease (deferred tax asset increase) => deferred tax benefit

Slide C3-12 Example 13: GAAP Tax Expense A corporation has book income before taxes of $1,000,000. It has only two book-tax differences as follows: The accumulated depreciation for book purposes was $350,000 at the beginning of the year and current year depreciation expense is $50,000. The accumulated MACRS was $475,000 at the beginning of the year and current year MACRS deduction is $80,000. The total meals deducted per books was $82,000. What is the corporation’s tax expense (current and deferred) and net book income?

Slide C3-13 Example 13: GAAP Tax Expense Net book income before taxes$1,000,000 Meals not deductible (50% x $82,000)41,000 Book - tax depreciation difference (50,000 – 80,000) (30,000) Estimated taxable income$1,011,000 Current tax expense (1,011,000 x 34%)$343,740

Slide C3-14 Example 13: GAAP Tax Expense Beg. of YearEnd of Year Cumulative MACRS over book depreciation $125,000$155,000 Tax rate x 34% Deferred liability$42,500$52,700 Deferred tax expense$10,200

Slide C3-15 Example 13: GAAP Tax Expense Income before taxes per books$1,000,000 Current tax expense$343,740 Deferred tax expense 10,200 Total tax expense353,940 Net income per books$646,060

GAAP Tax Expense In simple situations: Adjusted book income = pre-tax book income plus or minus all permanent book-tax differences Total tax expense per books = (adjusted book income X tax rate) minus tax credits Deferred tax expense (benefit) = total tax expense (benefit) less current tax expense (benefit) Gives the same number as that calculated under SFAS 109 using the balance sheet approach if the tax rate does not change during the year

Slide C3-17 Example 13: GAAP Tax Expense Income before taxes per books$1,000,000 Permanent differences 41,000 Adjusted book income$1,041,000 Tax rate x 34% Total tax expense$353,940 Less: Current tax expense343,740 Deferred tax expense$10,200

Slide C3-18 Schedules M-1 and M-3 Corporations are required to provide, with their tax return, a reconciliation from their GAAP financial statement income to taxable income Corporations with total assets of $10 million or more must use Schedule M-3 (requires breakdown of temporary and permanent differences)Schedule M-3 Other corporations may use Schedule M-1 (requires breakdown by four categories)Schedule M-1

Slide C3-19 Example 13: GAAP Tax Expense Schedule M-1: 1. Net income per books$646, Federal income tax per books353, Expenses per book not deducted c. Travel and Entertainment 41, Deductions per return not in books a. Depreciation (30,000) Taxable Income$1,011,000

Slide C3-20 GAAP Tax Expense Example 14

Slide C3-21 Problems Chapter 3: C3-58, C3-59, and C3-61