1 Accounting for Income Taxes Chapter 19 Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Prepared by Coby Harmon, University of California, Santa Barbara

Fundamental Differences between Financial and Tax Reporting

3 Background Deferral approach to tax allocation (APB Opinion 11) –Income tax expense = amount of taxes that would be paid if income statement numbers appeared on the current year's tax return. Deferred taxes was the plug figure (difference between taxes payable and tax expense). The effect of subsequent changes in tax rates on deferred tax account were essentially ignored. Matching Approach

4 Background A method that was proposed theoretically (but has never been GAAP in US) –Assets and liabilities would be recorded NET of any deferred tax related to the item Net-of-Tax Approach

5 Background Liability approach to tax allocation (FASB 96, 109) –Income tax expense = taxes currently payable plus change in deferred taxes. If tax rates change, the effect on deferred tax amounts affect income tax expense in the year the change is enacted. If there are no changes in tax rates, income tax expense should be approximately the same as under APB Opinion 11. Asset/Liability Measurement Approach

6 Tax Code Exchanges Investors and Creditors Financial Statements Pretax Financial Income GAAP Income Tax Expense Taxable Income Income Tax Payable Tax Return vs.   Fundamentals of Accounting for Income Taxes LO 1 Identify differences between pretax financial income and taxable income.

7 Illustration Assume the company reports revenue in 2007, 2008, and 2009 of $130,000, respectively. The revenue is reported the same for both GAAP and tax purposes. For simplification, assume the company reports one expense, depreciation, over the three years applying the straight-line method for financial reporting purposes (GAAP) and MACRS (IRS) for the tax return. What is the effect on the accounts of using the two different depreciation methods? LO 1 Identify differences between pretax financial income and taxable income. Fundamentals of Accounting for Income Taxes

8 Revenues Expenses (S/L depreciation) Pretax financial income Income tax expense (40%) $130,000 30,000 $100,000 $40,000 $130, ,000 $100,000 $40,000 $130, ,000 $100,000 $40,000 $390,000 Total 90,000 $300,000 $120,000 GAAP Reporting Revenues Expenses (MACRS depreciation) Pretax financial income Income tax payable (40%) $130, ,000 $90,000 $36,000 $130, ,000 $100,000 $40,000 $130, ,000 $110,000 $44,000 $390,000 Total 90,000 $300,000 $120,000 Tax Reporting 2007 LO 1 Identify differences between pretax financial income and taxable income. Book vs. Tax Difference

9 Income tax expense (GAAP) Income tax payable (IRS) Difference $40,000 36,000 $4,000 $40, ,000 $0 $40, ,000 $(4,000) $120,000 Total 120,000 $0 ComparisonComparison 2007 Are the differences accounted for in the financial statements? YearReporting Requirement LO 1 Identify differences between pretax financial income and taxable income. Book vs. Tax Difference

10 Balance Sheet Assets: Liabilities: Equity: Income tax expense 40,000 Income Statement Revenues: Expenses: Net income (loss) 2007 Where does the “deferred tax liability” get reported in the financial statements? Income tax payable 36,000 LO 1 Identify differences between pretax financial income and taxable income. Financial Reporting for 2007

11 A Temporary Difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years. Future Taxable Amounts Future Deductible Amounts Deferred Tax Liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year. Deferred Tax Asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year. Illustration Examples of Temporary Differences LO 2 Describe a temporary difference that results in future taxable amounts. Temporary Differences

12 Example – Deferred Tax Liability Assume that Sales Company recognizes $15,000 gross profit from installment sales for financial accounting in The gross profit will be taxable at $3,000 each year for the next five years. The company earns $10,000 additional income each year and the tax rate is 40%. The following schedule shows taxable income, income tax payable, financial income, and income tax expense for the five year period.

13 Solution – Sales Company For tax purposes, we are postponing recognition of revenue until later years. This revenue will be reported on future tax returns and the taxes will be paid at that time (rather than immediately)

14 Sales Co. - Solution - continued

15 Example – Deferred Tax Asset Financial Magazine Company received $15,000 of subscriptions in advance for Subscription revenue will be recognized equally in 2007, 2008, and 2009, for financial accounting purposes but all of the $15,000 will be recognized in 2006 for tax purposes. There is additional income of $50,000 each year and the tax rate is 40%.

16 Financial Magazine Co. Solution Continued

17 Financial Magazine Co. Solution Continued

18 E19-1 South Carolina Corporation has one temporary difference at the end of 2007 that will reverse and cause taxable amounts of $55,000 in 2008, $60,000 in 2009, and $65,000 in South Carolina’s pretax financial income for 2007 is $300,000, and the tax rate is 30% for all years. There are no deferred taxes at the beginning of Instructions a)Compute taxable income and income taxes payable for b)Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for South Carolina Corporation

19 South Carolina Corporation a. a.

20 LO 2 Describe a temporary difference that results in future taxable amounts. South Carolina Corp. (Solution) a. a.

21 Columbia Corporation has one temporary difference at the end of 2007 that will reverse and cause deductible amounts of $50,000 in 2008, $65,000 in 2009, and $40,000 in Columbia’s pretax financial income for 2007 is $200,000 and the tax rate is 34% for all years. There are no deferred taxes at the beginning of Columbia expects to be profitable in the future. Instructions a)Compute taxable income and income taxes payable for b)Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for Columbia Corporation

22 Columbia Corporation a. a.

Temporary Differences (1) Revenues and gains, recognized in financial income, are later taxed for income tax purposes. –Installment sales Expenses and losses are deducted for income tax purposes before they are recognized in financial income. –MACRS depreciation –Goodwill deduction on tax return Called “taxable temporary differences”

Revenues and gains are taxed for income tax purposes before they are recognized in financial income. –Subscription revenue –Prepaid rent Expenses and losses, recognized in financial income, are later deducted for income tax purposes. –Warranty expense Called “deductible temporary differences” Temporary Differences (2)

Transaction When recorded in books When recorded on tax return Deferred tax effect Rev or GainEarlierLater Liability Rev or GainLaterEarlier Asset Exp or LossEarlierLater Asset Exp or LossLaterEarlier Liability Summary of Temporary Differences

26 Sources of Permanent Differences No deferred tax effects for permanent differences Some items are recorded in Books but NEVER on tax return Other items are NEVER recorded in books but recorded on tax return Permanent Differences

27 Permanent Differences: Examples Items, recognized for financial accounting purposes, but not for income tax purposes: –Interest revenue on Municipal Bonds –Life insurance premiums and proceeds when corporation is beneficiary –Fines and penalties Items, recognized for tax purposes, but not for financial accounting purposes: –Dividend exclusion –Statutory depletion

Deferred Tax Asset & Deferred Tax Liability: Sources Deferred taxes may be a: –Deferred tax liability, or –Deferred tax asset Deferred tax liability arises due to net taxable amounts in the future. Deferred tax asset arises due to net deductible amounts in the future.

If the deferred tax asset appears doubtful, a Valuation Allowance account is needed. Journal entry : Income Tax Expense $$ Allowance to Reduce Deferred Tax Asset to Expected Realizable Value $$ The entry records a potential future tax benefit that is not expected to be realized in the future. Valuation Allowance for Deferred Tax Assets

The deferred tax classification relates to its underlying asset or liability. –Classify the deferred tax amounts as current or non-current. Presentation is –NET amount related to current items If DR>CR, current deferred tax asset If DR<CR, current deferred tax liability –NET amount related to noncurrent items If DR>CR, noncurrent deferred tax asset If DR<CR, noncurrent deferred tax liability Balance Sheet Presentation

Basic Rule: Apply the yearly tax rate to calculate deferred tax effects. –If future tax rates change: use the enacted tax rate expected to apply in the future year. –If new rates are not yet enacted into law for future years, the current rate should be used. The appropriate enacted rate for a year is the average tax rate [based on graduated tax brackets]. What Tax Rate to Apply

Let’s do an example Second Best Company –Working paper style – working paper blank will be provided on Exam 2 32

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34 Net operating loss is tax terminology. A net operating loss occurs when tax deductions for a year exceed taxable revenues. Net loss or operating loss is a financial accounting term. Net Operating Loss (NOL)

35 NOL Rule (subject to change) NOL for each tax year is computed. The NOL of one year can be applied to offset taxable income of other years, possibly resulting in tax refunds Current rule: NOLs can be: –carried back 2 years and carried forward 20 years (carryback option), –or carried forward 20 years (carryforward only)

NOL 2004 NOL 2004 Tax years Apply first nextLoss carryforward 20 years forward Expect tax refund here Expect tax refund here Record all tax effects here Record all tax effects here Expect tax shield here Expect tax shield here NOL Carryback

NOL 2004 NOL 2004 Tax years Loss carryforward 20 years forward Record all tax effects here Record all tax effects here Expect tax shield here Expect tax shield here Forgo 2 year rule NOL Carryforward

38 Zoop Inc. incurred a net operating loss of $500,000 in Taxable income was $200,000 for 2005 and $200,000 for The tax rate for all years is 40%. Zoop elects the carryback option. Prepare the journal entries to record the benefits of the loss carryback and the loss carryforward. Zoop Inc. (NOL) LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.

39 Zoop Inc. (NOL)

40 Zoop Inc. (NOL) - Solution $160,000 Deferred Tax Asset

41 Zoop’s Journal Entries for 2007 Zoop Inc. (NOL) - Solution LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.

42 Now assume that it is more likely than not that the entire net operating loss carryforward will not be realized by Zoop Inc. in future years. Prepare all the journal entries necessary at the end of Zoop Inc. (Variation) LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.

43 Zoop Inc. - Journal Entries for 2007 Zoop Inc. (Variation) - Solution

44 Whether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period. Valuation Allowance Revisited Text Illustration Possible Sources of Taxable Income If any one of these sources is sufficient to support a conclusion that a valuation allowance is unnecessary, a company need not consider other sources. Text Illustration Evidence to Consider in Evaluating the need for a Valuation Account

45 Valis Corporation had the following tax information. Valis Corporation (NOL) LO 8 Apply procedures for a loss carryback and a loss carryforward. In 2007 Valis suffered a net operating loss of $450,000, which it elected to carry back. The 2007 enacted tax rate is 29%. Prepare Valis’s entry to record the effect of the loss carryback.

46 Valis Corporation – Solution (NOL)

47 Valis Corp - Journal Entry for 2007 Valis Corporation – Solution (NOL)

At the end of 2002, the corporate tax rate is changed from 40% to 35%. The new rate is effective January 1, The deferred tax account (1/1/2002) is as follows: Excess tax depreciation: $3 million Deferred tax liability:$1.2 million Related taxable amounts are expected to occur equally over 2003, 2004, and Provide the journal entry to reflect the change. Example: Revision of Future Tax Rate

The deferred tax liability end of 2005 is as follows: Future tax inc $1,000,0001,000,0001,000,000 Tax rate 40% 35% 35% Deferred tax $400, , ,000 liability Entry: Deferred Tax Liability$100,000 Income Tax Expense $100,000* *$1,200,000 – $1,100,000 Example: Revision of Future Tax Rate

Let’s return to Second Best In the third year: –A change in enacted tax rates –A net operating loss 50

Income tax expense, is allocated to: Continuing operations Discontinued operations Extraordinary items Cumulative effect of an accounting change,– we won’t see this one any more after FAS154 Prior period adjustments Disclose other significant components, such as : current tax expense, deferred tax expense/benefit, etc. Intraperiod Tax Allocation

52 Other Items Affected Comprehensive income items –Holding gain/loss on AFS securities –Certain gains/losses related to foreign currency and derivatives –Pension & post-retirement benefit amounts not yet recognized on income statement Correction of error/change in accounting principle that affects beginning retained earnings Expenses for employee stock-based compensation Existing deferred amounts in quasi- reorganization

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54 First Place Example Go to Excel and work the problem –Identify temporary and permanent differences –Compute tax payable (or refund) –Compute change in deferred taxes and income tax expense –Show where deferred tax will be reported on the balance sheet

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Deferred Taxes IAS 12 vs FAS 109 versu s

US GAAP Enacted tax rates Which Tax Rate to Use Enacted or substantively enacted tax rat IFRS

US GAAP Use an allowance account to reduce to net realizable value Uses same “more likely than not” criteria Deferred Tax Assets Don’t recognize at all unless it is “more likely than not” to be usable in the future IFRS

US GAAP Current items netted Noncurrent items netted Balance Sheet Presentation Always is noncurrent Plans to revise to do it the FASB way IFRS

Essential Knowledge Be able to tell a permanent difference from a temporary difference Know the impact of temporary differences: –Is it a future deductible item? –Is it a future taxable item? Textbook Illustrations & 19-24: –If all else fails, memorize! –I’ll also provide a “study guide” for Exam 2 60

A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for current year. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards. The measurement of current and deferred tax liabilities and assets is based on provisions of enacted tax law, effects of future changes in tax law or rates are not anticipated. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized. Review – Basic Principles

62 Do the following generate: Future Deductible Amount = Deferred Tax Asset Future Taxable Amount = Deferred Tax Liability A Permanent Difference 1. The MACRS depreciation system is used for tax purposes, and the straight-line depreciation method is used for financial reporting purposes. 2. A landlord collects some rents in advance. Rents received are taxable in the period when they are received. 3. Expenses are incurred in obtaining tax-exempt income. 4. Costs of guarantees and warranties are estimated and accrued for financial reporting purposes. Specific Differences LO 6 Describe various temporary and permanent differences.

63 Do the following generate: Future Deductible Amount = Deferred Tax Asset Future Taxable Amount = Deferred Tax Liability A Permanent Difference 5. Sales of investments are accounted for by the accrual method for financial reporting purposes and the installment method for tax purposes. 6. Proceeds are received from a life insurance company because of the death of a key officer (the company carries a policy on key officers). 7. Estimated losses on pending lawsuits and claims are accrued for books. These losses are tax deductible in the period(s) when the related liabilities are settled.. Specific Differences LO 6 Describe various temporary and permanent differences.

64 Zurich Company reports pretax financial income of $70,000 for The following items cause taxable income to be different than pretax financial income. (1) Depreciation on the tax return is greater than depreciation on the income statement by $16,000. (2) Rent collected on the tax return is greater than rent earned on the income statement by $22,000. (3) Fines for pollution appear as an expense of $11,000 on the income statement. Zurich’s tax rate is 30% for all years, and the company expects to report taxable income in all future years. There are no deferred taxes at the beginning of Instructions Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for Review Problem

65 Review Problem – Abbreviated Working Paper

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