16-1 Intermediate Accounting James D. Stice Earl K. Stice © 2012 Cengage Learning PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University Income Taxes Chapter th Edition

16-2 Deferred Income Tax Overview Corporations in the United States compute two different income numbers:  Financial income for reporting to stockholders and  Taxable income for reporting to the Internal Revenue Service (IRS). (continued)

16-3 The primary goal of financial accounting is to provide useful information to management, stockholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system is the equitable collection of revenue. Deferred Income Tax Overview (continued)

16-4 The difficulty of determining what is “income tax expense” stems from two basic considerations: 1.How to account for revenues and expenses that have already been recognized and reported to shareholders in a company’s financial statements but will not affect taxable income until subsequent years. Deferred Income Tax Overview (continued)

How to account for revenues and expenses that have already been reported to the IRS but will not be recognized in the financial statements until subsequent years. Deferred Income Tax Overview

16-6 In 2013, Ibanez Company earned revenues of $30,000. Ibanez has no expenses other than income taxes. In this case, the income tax law specifies that income is taxed when received in cash and that Ibanez received $10,000 in 2013 and expects to receive $20,000 in The income tax rate is 40% and it is expected to remain the same into the foreseeable future. (continued) Example 1: Simple Deferred Income Tax Liability

16-7 Income Tax Expense12,000 Income Taxes Payable4,000 Deferred Tax Liability8,000 $30,000 ×.40 $10,000 ×.40$20,000 ×.40 $4,000 current year + $8,000 deferred The journal entry to record all the tax-related information for Ibanez for 2013 is as follows: (continued) Example 1: Simple Deferred Income Tax Liability

16-8 Ibanez Company Income Statement For the Year Ended December 31, 2013 Revenues$30,000 Income tax expense: Current$4,000 Deferred 8,000 12,000 Net income$18,000 Example 1: Simple Deferred Income Tax Liability

16-9 In 2013, its first year of operation, Gupta Company generated service revenues totaling $60,000, all taxable in No warranty claims were made in 2013, but Gupta estimates that in 2014 warranty costs of $10,000 will be incurred for claims related to 2013 service revenues. Assume a 40% tax rate and that Gupta Company had no expenses in 2013 other than warranty costs and income taxes. (continued) Example 2: Simple Deferred Income Tax Asset

16-10 Income Tax Expense20,000 Deferred Tax Asset4,000 Income Taxes Payable24,000 $50,000 ×.40 $10,000 ×.40$60,000 ×.40 $24,000 current year – $4,000 deferred The journal entry to record all the tax-related information for Gupta for 2013 is as follows: (continued) Example 2: Simple Deferred Income Tax Asset

16-11 Gupta Company Income Statement For the Year Ended December 31, 2013 Revenues$60,000 Warranty expense 10,000 Income before taxes $50,000 Income tax expense: Current$24,000 Deferred benefit (4,000) 20,000 Net income$30,000 Example 2: Simple Deferred Income Tax Asset

16-12 Permanent differences are created by political and social pressures to favor certain segments of society or to promote certain industries or economic activities.  Nontaxable revenue—proceeds from insurance policies; interest received on municipal bonds  Nondeductible expenses—fines for violations of laws; payment of insurance premiums Permanent and Temporary Differences (continued)

16-13 More commonly, differences between pretax financial income and taxable income arise from business events that are recognized for both financial reporting and tax purposes but in different time periods. These differences are referred to as temporary differences. Permanent and Temporary Differences (continued)

16-14 The first category includes differences, called taxable temporary differences, that will result in taxable amounts in future years. The second category includes differences, called deductible temporary differences, that will result in deductible amounts in future years. Permanent and Temporary Differences

16-15 The permanent differences are not included in either the financial income subject to tax or the taxable income. Permanent differences have no impact on income taxes payable in subsequent periods. In general, the accounting for temporary differences is referred to as interperiod tax allocation. Illustration of Permanent and Temporary Differences

16-16 Annual Computation of Deferred Tax Liabilities and Assets FASB ASC Topic 740 reflects the Board’s preference for the asset and liability method of interperiod tax allocation, which emphasizes the measurement and reporting of balance sheet amounts. One drawback of this method is that in some ways, it is still too complicated. (continued)

Assets and liabilities are recorded in agreement with FASB definitions of financial statement elements. 2.This method is flexible and recognizes changes in circumstances and adjusts the reported amounts accordingly. This flexibility may improve the predictive value of the financial statements. Annual Computation of Deferred Tax Liabilities and Assets The major advantages of the asset and liability method of accounting for deferred taxes are as follows: (continued)

16-18 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). Identify type and amounts of existing temporary differences. Annual Computation of Deferred Tax Liabilities and Assets

16-19 For 2013, Roland computes pretax financial income of $75,000. The only difference between financial and taxable income is depreciation. Roland uses the straight-line method of depreciation for financial reporting purposes and ACRS on its tax return. (continued) Example 3: Deferred Tax Liability

16-20 Financial income subject to tax$75,000 Deduct temporary difference: Excess of tax depreciation ($40,000) over book depreciation ($25,000) (15,000) Taxable income$60,000 (continued) The enacted tax rate for 2013 and future years is 40%. Roland’s taxable income for 2013 is $60,000, computed as follows: Tax ($60,000 x 0.40)$24,000 Example 3: Deferred Tax Liability

16-21 Income Tax Expense30,000 Income Taxes Payable24,000 Deferred Tax Liability— Noncurrent6,000 $30,000 – $6,000 $15,000 ×.40 Roland’s Journal Entry for 2013 $24,000 current + $6,000 deferred (continued) Example 3: Deferred Tax Liability

16-22 Income taxes would be shown on Roland’s 2013 income statement as follow: Income before income taxes$75,000 Current$24,000 Deferred 6,000 30,000 Net income$45,000 The December 31, 2013, balance sheet would report a current liability of $24,000. Example 3: Deferred Tax Liability

16-23 Roland earns financial income of $75,000 in each of the years 2014 through Roland reports taxable income of $70,000, computed as follows: Financial income subject to tax$75,000 Deduct temporary difference: Excess of tax depreciation ($30,000) over book depreciation ($25,000) (5,000) Taxable income$70,000 Tax ($70,000 × 0.40)$28,000 (continued) Example 3: Deferred Tax Liability

16-24 Income Tax Expense30,000 Income Taxes Payable28,000 Deferred Tax Liability— Noncurrent2,000 Roland’s Journal Entry for 2014 Roland’s Journal Entry for 2014 $5,000 x 0.40 $28,000 current + $2,000 deferred (continued) $30,000 – $2,000 Example 3: Deferred Tax Liability

16-25 Depreciation expense in 2015 is the same for both financial and tax, so the entry is simple. Income Tax Expense30,000 Income Taxes Payable30,000 $75,000 × 0.40 (continued) Example 3: Deferred Tax Liability

16-26 For 2016, Roland earns income of $75,000 and the taxable income is $95,000, computed as follows: Financial income subject to tax$75,000 Add temporary difference: Excess of book depreciation ($25,000) over tax depreciation ($5,000) 20,000 Taxable income$95,000 Tax ($95,000 × 0.40)$38,000 (continued) Example 3: Deferred Tax Liability

16-27 Income Tax Expense30,000 Deferred Tax Liability— Noncurrent8,000 Income Taxes Payable38,000 Roland’s Journal Entry for 2016 $95,000 × 0.40 $38,000 current – $8,000 deferred benefits (continued) Example 3: Deferred Tax Liability

16-28 Effect of Currently Enacted Changes in Future Tax Rates If changes in future tax rates have been enacted, the deferred tax liability (or asset) is measured during the enacted tax rate for the future years when the temporary difference is expected to reverse. Under IAS 12, deferred tax items are to be measured at the income tax rates “that have been enacted or substantively enacted by the end of the reporting period.”

16-29 Subsequent Changes in Enacted Tax Rates Using the Roland, Inc. example, assume that the enacted rate for 2016 changed from 40% to 35% during The balance in the deferred tax liability at the beginning of 2014 is $6,000. The following adjusting entry would be made for 2016: Deferred Tax Liability— Noncurrent750 Income Tax Benefit—Rate Change750 $15,000 x 0.05

16-30 Example 4: Deferred Tax Asset Taxable income for 2013 is computed as follows: Financial income subject to tax$22,000 Add temporary difference: Excess of warranty expense over warranty deductions 18,000 Taxable income$40,000 Taxable income ($40,000 × 0.40)$16,000 (continued)

16-31 Income Tax Expense8,800 Deferred Tax Asset—Current2,400 Deferred Tax Asset— Noncurrent4,800 Income Taxes Payable16,000 1/3 × $7,200 Sandusky’s Journal Entry for /3 × $7,200 $16,000 current – $7,200 deferred benefits (continued) Example 4: Deferred Tax Asset

16-32 Income before income taxes$22,000 Income tax expense: Current$16,000 Deferred (benefit) (7,200) 8,800 Net income$13,200 Sandusky’s 2013 income statement would present income tax expense as follows: (continued) Example 4: Deferred Tax Asset

16-33 In the years 2014 through 2016, taxable income would be equal to $16,000, computed as follows: Income subject to tax$22,000 Reversal of temporary difference: Excess of warranty deductions (1/3 × $18,000) over warranty expense ($0) (6,000) Taxable income$16,000 Tax ($16,000 ×.40) $ 6,400 Example 4: Deferred Tax Asset

16-34 For 2013, Hsieh reported pretax financial income of $38,000. As of December 31, 2013, the actual depreciation expense was $25,000 and the actual warranty expense was $18,000. For income tax reporting, these expenses were $40,000 and $0, respectively. Example 5: Deferred Tax Liabilities and Assets

16-35 Financial income subject to tax$38,000 Add (deduct) temporary differences: Excess of warranty expense over warranty deductions 18,000 Excess of tax depreciation over book depreciation (15,000) Taxable income$41,000 For 2013, taxable income would be computed as follows: Tax ($41,000 ×.40)$16,400 (continued) Example 5: Deferred Tax Liabilities and Assets

16-36 Income Tax Expense16,400 Income Taxes Payable16,400 Heich’s December 31, 2013 Entries Deferred Tax Asset—Current2,400 Deferred Tax Asset— Noncurrent4,800 Income Tax Benefit1,200 Deferred Tax Liability— Noncurrent6,000 These two are netted against one another and a single $1,200 amount is shown as a noncurrent tax liability ($6,000 – $4,800). Example 5: Deferred Tax Liabilities and Assets

16-37 Valuation Allowance for Deferred Tax Assets A deferred tax asset represents future income tax benefits. The tax benefit will be realized only if there is sufficient taxable income from which the deductible amount can be deducted. Topic 740 requires that the deferred tax asset be reduced by a valuation allowance, a contra asset account that reduces the asset to its expected realizable value. (continued)

16-38 Some possible sources of taxable income to be considered in evaluating the realizable value of a deferred tax asset are as follows: 1.Future reversals of existing taxable temporary differences 2.Future taxable income exclusive of reversing temporary differences 3.Taxable income in prior (carryback) years Valuation Allowance for Deferred Tax Assets

16-39 Valuation Allowance for Deferred Tax Assets In 2013, Hsieh Company has a $15,000 excess of aggregate tax depreciation over aggregate book depreciation. The reversal of this temporary difference will provide taxable income in the future against which the $18,000 warranty deduction can be offset. Accordingly, the total deferred tax asset is $7,200 ($18,000 x 0.40), but the realized amount is only $6,000 ($15,000 x 0.40). The $1,200 difference would be recorded as a valuation allowance. (continued)

16-40 Valuation Allowance for Deferred Tax Assets (continued) First, the deferred tax asset and liability are recognized, as follows: Deferred Tax Asset—Current2,400 Deferred Tax Asset— Noncurrent4,800 Income Tax Benefit1,200 Deferred Tax Liability— Noncurrent6,000 A subtraction from income tax expense Note that this is the same as the deferred tax journal entry shown earlier on Slide

16-41 Valuation Allowance for Deferred Tax Assets The second journal entry represents the fact that it is more likely than not that $1,200 of the deferred tax asset will not be realized. Income Tax Expense1,200 Allowance to Reduce Deferred Tax Asset to Realizable Value— Current400 Allowance to Reduce Deferred Tax Asset to Realizable Value— Noncurrent800

16-42 Valuation Allowance Under IAS 12 Under the provisions of IAS 12, there is no valuation allowance. Instead, deferred tax assets are recognized only “to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised [utilized].”

16-43 Accounting for Uncertain Tax Positions Topic 740 requires the use of a 2-step process to determine the recognition of any tax benefit associated with an uncertain tax position. 1.Step 1—Determine if it is more likely than not that a tax position would be sustained if it were examined, and it must be assumed that the tax position will be examined. (continued) 2.Step 2—The measurement of the tax benefit is based on a probability assessment of the likelihood of specific outcomes and the amounts of those outcomes.

16-44 Accounting for Uncertain Tax Positions Case 1: Highly Certain Tax Position If the probability that the tax benefit of $100 would be achieved were greater than 50%, this would be deemed a “highly certain” position. In other words, it is more likely than not that the position taken and the amount in question would be upheld if reviewed.

16-45 Case 2: Uncertain Tax Position— More Likely Than Not Case 2: Uncertain Tax Position— More Likely Than Not Assume the following assessment of probabilities: (continued) Accounting for Uncertain Tax Positions

16-46 Case 3: Uncertain Tax Position— NOT More Likely Than Not Case 3: Uncertain Tax Position— NOT More Likely Than Not If the company completes Step 1 of the analysis and determines that it is NOT more likely than not that the tax position will be sustained, then the entire amount of the position must be recognized as a liability. Income Tax Expense100 Unrecognized Tax Benefit100 Accounting for Uncertain Tax Positions

16-47 Net Operating Loss (NOL) Carryforward If an operating loss exceeds income for the two preceding years, the remaining unused loss may be applied against income earned over the next 20 years as a net operating loss (NOL) carryforward. A valuation allowance is used to reduce the asset if it is more likely than not that some or all of the future benefits will not be realized.

16-48 Financial Statement Presentation and Disclosure The income statement must show, either in the body of the statement or in a note, the following components of income taxes related to continuing operations. 1.Current tax expense or benefit 2.Deferred tax expense or benefit 3.Investment tax credits 4.Government grants recognized as tax reductions (continued)

Benefits of operating loss carryforwards 6.Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of an enterprise 7.Adjustments in beginning-of-the-year valuation allowance because of a change in circumstances Financial Statement Presentation and Disclosure

16-50 Deferred Taxes and the Statement of Cash Flows FASB ASC Topic 230 requires a separate disclosure of the amount of cash paid for income taxes during a period. This separate disclosure is required for just two items:  Cash paid for income taxes  Cash paid for interest Income taxes affect the Operating Activities section of the statement of cash flows. (continued)

16-51 Revenue (all cash) $30,000 Income tax expense: Current $10,300 Deferred 1,700 12,000 Net income $18,000 (continued) Collazo Company had the following information for 2013: Deferred Taxes and the Statement of Cash Flows

16-52 Cash collected from customers$30,000 Income taxes paid (13,300) Cash provided by operating activities$16,700 (continued) The operating activities section of Collazo’s statement of cash flows is as follows if the direct method is used. Deferred Taxes and the Statement of Cash Flows

16-53 Collazo Company Statement of Cash Flows (Partial) (Indirect Approach) Cash provided by operating activities: Net income$18,000 Decrease in income tax refund receivable(2,000) Decrease in income taxes payable(1,000) Increase in deferred tax liability 1,700 Cash provided by operating activities$16,700 If the indirect method is used, the amount of cash paid for income taxes, $13,300, must be separately disclosed either in the SCF or in the notes to the financial statements. Deferred Taxes and the Statement of Cash Flows

16-54 International Accounting for Deferred Taxes No-deferral approach: Using this approach, the differences are ignored. Income tax expense equal to the amount of tax payable for the year is reported. Comprehensive recognition approach: Deferred taxes are included in the computation of income tax expense and reported on the balance sheet. The IASB has embraced this approach. (continued)

16-55 Partial recognition approach: Historically, the United Kingdom employed this innovate technique. A deferred tax liability is recorded only to the extent that the deferred taxes are actually expected to be paid in the future. In recent years, this method has lost favor internationally because it is so subjective (relying heavily on management expectations about future events). International Accounting for Deferred Taxes

16-56 Chapter 16 The End $

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