1 Income Taxes

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

3  Schedule future tax rates, and determine the effect on tax assets and liabilities.  Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities.  Comply with income tax disclosure requirements associated with the statement of cash flows. Learning Objectives

4  Describe how, with respect to deferred income taxes, international accounting standards have converged toward the U.S. treatment. EXPANDED MATERIALS  Perform intraperiod tax allocation.

5 Deferred Tax Liabilities Defined: Income taxes expected to be paid on future taxable amounts resulting from temporary differences between financial and taxable income.

6 Deferred Tax Liabilities 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.

7 Deferred Tax Assets Defined: An expected benefit in the form of tax savings on future deductible amounts resulting from deductible temporary differences between financial and taxable income.

8 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. Deferred Tax Assets

9 Permanent and 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.

10 Illustration of Permanent and Temporary Differences For the year ended December 31, 2002, 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.

11 Illustration 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

12  Because the assets and liabilities recorded under this method are in agreement with the FASB definitions of financial statement elements, the method is conceptually consistent with other standards. Advantages of the Asset and Liability Method

13  The asset and liability method is a flexible method that recognizes changes in circumstances and adjusts the reported amounts accordingly. This flexibility may improve the predictive value of the financial statements. Advantages of the Asset and Liability Method

14 Annual Computation of Deferred Tax Liabilities and Assets Identify type and amounts of existing temporary differences. Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized. Measure the deferred tax liability for taxable temporary differences (use enacted rates). Measure the deferred tax asset for deductible temporary differences (use enacted rates).

15 Rodney’s Burger Barn had GAAP income of $4,200. Rodney identified the following possible differences between GAAP and Taxable income: –Interest from municipal bonds$ 100 –Premium for Life Insurance on Joe$ 50 –Straight-Line Depreciation$ 100 –MACRS Depreciation$ 200 –Franchising Fees Earned$ 500 –Cash Franchising Fees Received$ 800 Rodney’s enacted tax rate is 40%. Example: Computation of Deferred Tax Liabilities and Assets

16 Annual Computation of Deferred Tax Liabilities and Assets Identify type and amounts of existing temporary differences. Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized. Measure the deferred tax liability for taxable temporary differences (use enacted rates). Measure the deferred tax asset for deductible temporary differences (use enacted rates).

17 Difference Temporary/ Permanent Type Interest on bondsPermanent Reduction in Taxable Income Life Insurance Permanent Increase in Taxable Income Net Depreciation Temporary Deferred Tax Liability Net Franchising Fees Temporary Deferred Tax Asset Example: Identifying Type(s) of Differences for Rodney’s

18 Example: Identifying Amount of Differences for Rodney’s Pretax income$4,200 Add (deduct) permanent differences: Interest on municipal bonds$(100) Life insurance 50 (50) Income subject to tax$4,150 Add (deduct) temporary differences: Net depreciation ($100 - $200) $(100) Net fran. revenue ($800 - $500) Taxable income$4,350

19 Annual Computation of Deferred Tax Liabilities and Assets Identify type and amounts of existing temporary differences. Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized. Measure the deferred tax liability for taxable temporary differences (use enacted rates). Measure the deferred tax asset for deductible temporary differences (use enacted rates).

20 Example: Measure Deferred Tax Liabilities for Rodney’s Depreciation for financial income$100 Depreciation for taxable income 200 Net deferred amount $100 Tax rate x 40% Deferred tax liability$ 40

21 Annual Computation of Deferred Tax Liabilities and Assets Identify type and amounts of existing temporary differences. Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized. Measure the deferred tax liability for taxable temporary differences (use enacted rates). Measure the deferred tax asset for deductible temporary differences (use enacted rates).

22 Example: Measure Deferred Tax Assets for Rodney’s Franchising revenue for financial revenue$(500) Franchising revenue for taxable revenue 800 Net deferred amount$ 300 Tax rate x 40% Deferred tax asset$ 120

23 Deferred Tax Asset Some possible sources of taxable income to be considered in evaluating the realistic value of a deferred tax asset are:  Future reversals of existing taxable temporary differences.  Future taxable income exclusive of reversing temporary differences.  Taxable income in prior (carryback) years.

24 Deferred Tax Asset A typical journal entry to record the deferred portion of income tax expense is: Deferred Tax Asset--Currentxxx Deferred Tax Asset--Noncurrentxxx Allowance to Reduce Deferred Tax Asset to Realizable Value-- Currentxxx Allowance to Reduce Deferred Tax Asset to Realizable Value-- Noncurrent xxx Deferred Tax Liability--Noncurrentxxx

25 Taxable Income Pretax financial income +/-Permanent differences =Financial income subject to tax +/-Temporary differences =Taxable income Commonly Confused Relationships: Income Statement

26 Net Operating Losses (NOL)-- Alternative Elections Loss Year -2 Year +20 Carryback Election Carryforward Election

27 Accounting for NOL Carryback Journal Entry in 2003: Income Tax Refund Receivable 6,200 Income Tax Benefit From NOL Carryback 6,200 [$3,500 + (30% x $9,000)] YearTax Rate Income Tax 2001$10,000 35%$3, ,000 30%4, (19,000)30%0 Income (Loss)

28 The only loss remaining against which operating income can be applied is $5,000 from This leaves $30,000 to be carried forward from 2004 as a future tax benefit of $9,000 ($30,000 x.30). Accounting for NOL Carryforward Year Income (Loss) Tax Rate Income Tax 2003$(19,000) 30%$0 2004(35,000) 30%0

29 Journal Entry: Deferred Tax Asset--NOL Carryforward 9,000 Income Tax Benefit From NOL Carryforward 9,000 Accounting for NOL Carryforward The journal entry recorded at the end of 2004 indicates that is more likely than not that the carryforward benefit will be realized in full.

30 Journal Entry: Income Tax Expense15,000 Income Taxes Payable6,000 Deferred Tax Asset--NOL Carryforward 9,000 Accounting for NOL Carryforward 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.

31 Accounting for NOL Carryforward What if, due to a declining market, management believes that losses will continue in the future and the tax benefit will not be realized?

32 Accounting for NOL Carryforward Journal Entry: Deferred Tax Asset--NOL Carryforward9,000 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.

33 Presentation in Financial Statements Balance Sheet Classify deferred taxes as current or noncurrent based on asset or liability to which they relate. Report a net current and a net noncurrent amount. Income Statement Report current tax expense (benefit) and deferred tax expense (benefit) and total income tax expense (benefit).

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

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

36 Approaches to Deferred Tax Accounting 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.

37 Intraperiod Tax Allocation Using interperiod tax allocation, the income tax effect of each special item is reported with the individual item rather than being included with income tax expense related to current operations.

38 The End