Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 13 Income Tax Reporting Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 13 Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Learning objectives The different objectives underlying income determination for financial reporting (book) purposes versus tax purposes. The distinction between temporary (timing) and permanent differences, the items that cause these differences, and how each affects book income versus taxable income. The distortions created when the deferred tax effects of temporary differences are ignored. How tax expense is determined with interperiod tax allocation and the relation between taxes payable, changes in deferred taxes and tax expense. Measuring and reporting valuation differences for deferred tax assets. 13-2

Learning objectives: Concluded How changes in tax rates are measured and recorded. The reporting rules for net operating loss carrybacks and carry-forwards. How to read and interpret tax note disclosures and how these footnotes can be used to enhance comparisons across firms. Financial statement disclosures on uncertain tax positions. How tax notes disclosures can be used to improve financial statement analysis. Key differences between IFRS and U.S. GAAP rules for reporting of income taxes. 13-3

Book income and taxable income Income computed for financial reporting purposes Taxable Income: Income computed for tax compliance purposes ≠ Intended to reflect increases in the firm’s “well-offness”. Includes all earned inflows of net assets, even when the inflow is not immediately convertible into cash. Reflects expenses as they accrue, not just when they are paid. Governed by the “constructive receipt/ability to pay” doctrine. The timing of taxation usually (but not always) follows the inflow of cash or equivalents. Deductions generally are allowed only when the expenditures are made or when a loss occurs. Divergence complicates the way income taxes are reflected in financial reports 13-4

Understanding income tax reporting: Timing differences Book Income Depreciation expense Bad debt expense Installment sales Revenues received in advance Timing differences: ≠ Permanent differences Taxable Income A timing difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period. Current period Later period $100 $0 Originating Reversing Book income Taxable income Type Timing differences give rise to deferred tax assets and deferred tax liabilities because they are temporary (they eventually reverse): 13-5

Understanding income tax reporting: Permanent differences Book Income Timing differences: ≠ Interest on state and municipal bonds. Goodwill write-offs Permanent differences Taxable Income Statutory depletion in excess of cost-based depletion Dividend received deduction Permanent differences are caused by income items that: Enter into book income but never affect taxable income. Enter into taxable income but never affect book income. Because permanent differences do not reverse, they do not give rise to deferred tax assets or liabilities. 13-6

Mitchell Corporation buys new equipment for $10,000 on January 1, 2014 Mitchell Corporation buys new equipment for $10,000 on January 1, 2014. The asset has a five-year life and no salvage value. It will be depreciated using the straight-line method for book purposes, but for tax purposes the sum-of-the-years’-digits method will be used. (Technically, firms are required to use MACRS depreciation for tax purposes.) Straight-line SYD method 13-7

Understanding income tax reporting: Mitchell’s income tax payable Assume for Mitchell Corporation that depreciation is the only book versus tax difference. If income before depreciation is expected to be $20,000 each year over the next five years, and the statutory tax rate is 35%, then: Taxes Due 13-8

Understanding income tax reporting: Mitchell’s temporary differences Depreciation Expense Income 13-9

Understanding income tax reporting: The mismatch problem If book income tax expense is set equal to actual taxes payable each year, then: Expense increases with taxes due Book income declines 13-10

Understanding income tax reporting: A financial reporting distortion When book income tax expense is set equal to the actual taxes payable each year, there is a mismatch: Figure 13.2 MITCHELL CORPORATION Tax Expense without Interperiod Tax Allocation 13-11

Understanding income tax reporting: The FASB’s solution Interperiod tax allocation overcomes the mismatch problem. The “extra” tax depreciation in early years will be offset by lower tax depreciation in later years. The “extra” tax depreciation thus generates a liability for future taxes. Recording this deferred tax liability as it accrues eliminates the mismatch. $3,333 $1,333 of “extra” depreciation in year 1 Tax depreciation $2,000 Future tax liability is $1,333 X 35% or $467 Book depreciation 13-12

Deferred income tax accounting: Interperiod tax allocation FASB ASC Topic 740, Income Taxes, requires that the journal entry for income taxes reflect both: Taxes currently due Any liability for future taxes arising from current period book-versus-tax differences that will reverse in later periods. Originating Reversing 13-13

Deferred income tax accounting: Calculating tax expense Relation between tax expense, taxes payable, and changes in deferred tax liabilities 13-14

Deferred income tax accounting: The mismatch is eliminated Figure 13.4 MITCHELL CORPORATION Tax Expense with Interperiod Tax Allocation 13-15

Deferred income tax assets: Computing income tax expense Relation between tax expense, taxes payable, and changes in deferred tax assets and liabilities 13-16

Deferred income tax assets: Valuation allowances The FASB requires firms with deferred tax assets to assess the likelihood that those assets may not be fully realized in future periods. Realization depends on whether or not the firm has future taxable income. 0% 50% 100% “More likely than not ” DTA carrying value is reduced until the new amount falls within this range Probability that DTA will NOT be realized Deferred tax asset (DTA) valuation allowance is then required 13-17

Deferred income tax assets: Valuation allowance example Norman Corporation records a deferred tax asset in 2014 related to accrued warranty expenses: In early 2015, Norman determines that it is unlikely to earn enough taxable income in future years to realize more than $200,000 of the deferred tax asset. The entry made in 2015 is: 13-18

Net operating losses: Carrybacks and carryforwards example Unfortunato Corporation experienced a $1 million pre-tax operating loss in 2014. Under U.S. Income Tax Code, the company can either: Figure 13.6 Illustration of Tax Loss Carryback/ Carryforward Provision Figure 13.6 Illustration of Tax Loss Carryforward Provision 13-19

Net operating losses: Carryback and carryforward entries Suppose Unfortunato had the following operating profit history: The following entry would be made to reflect the carryback: =$750,000 x 35% If future pre-tax operating profits are expected to exceed $250,000, then the carryforward entry would be : $250,000 x 35% 13-20

Deferred income tax accounting: When tax rates change When tax rates change, the tax effects of “reversals” change as well. GAAP adopts the “liability approach” to measure deferred income taxes in this situation. In any year current or future tax rates are changed: The income tax expense number absorbs the full effect of the change The relationship between that year’s tax expense and book income is destroyed. Year 1 Year 2 Reversal Tax effect at 35% at new 30% $1,000 350 300 $700 Deferred tax liability 13-21

Deferred income tax accounting: When tax rates change $760 Deferred tax liability after the tax rate change = ($1,333 + $667) x .38 $700 = ($1,333 + $667) x .35 Deferred tax liability before the tax rate change Under the FASB ASC Topic 740, Income Taxes,“liability approach”, income tax expense for 2016 would be: 2016 13-22

Deferred income tax accounting: When tax rates change Tax rate changes can inject one-shot (transitory) adjustments to earnings. The earnings impact depends on: Whether the tax rates are increased or decreased. Whether the firm has net deferred tax assets or net deferred tax liabilities. The magnitude of the deferred tax balance. 13-23

Understanding income tax note disclosures: Tax expense components Taxes due Due to temporary differences in revenue and expense items reported on Deere’s 2012 GAAP income statement versus what was reported on its 2012 tax return. GAAP tax expense 13-24

Understanding the tax footnote: Intraperiod tax allocation This reconciliation is required under GAAP rules for income tax disclosure The divergence between the statutory tax rate and the effective tax rate arises from: Permanent difference items State and local taxes Differential tax rates in foreign jurisdictions Various tax credits 13-25

Understanding the tax footnote: Intraperiod tax allocation Items 6 and 7 represent the deferred tax item balances at December 31, 2012 13-26

Measuring and Reporting Uncertain Tax Positions Tax position – refers to a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current taxes payable or deferred income taxes. Uncertain tax positions arise, for example, when the firm claims a deduction for an expense that the IRS auditors may later disallow GAAP procedures require a two-step process to determine how much benefit to recognize from an uncertain tax position and how to report its tax contingency reserve as a liability for unrecognized tax benefits. Step 1 – determine if the threshold of more likely than not (more than 50%) is applicable. Step 2 – measure the tax benefit as the largest amount of benefit that is greater than 50% likely of being realized. Recorded as an increase in the Tax Contingency Reserve account 13-27

Assessing Disclosures on Uncertain Tax Positions 13-28

Understanding the tax note: Analytical insights Large increases in deferred income tax liabilities are a potential sign of deteriorating earnings quality. Consider ChipPAC. The depreciation-induced increase in the company’s deferred tax liability could be due to: Growth in capital expenditures Change in estimated useful lives of existing equipment Sudden decreases in deferred income tax assets are also a potential sign of deteriorating earnings quality. 13-29

Extracting Analytical Insights from Note Disclosures Elsewhere ChipPAC said it increased the estimated useful lives of certain equipment from 5 to 8 years. This change decreased depreciation expense for the year by $29 million. 13-30

Understanding the tax footnote: Using Deferred Tax Footnotes to Assess Earnings Quality On January 1, 2014 Carson Company begins offering a one-year warranty on all sales. Its 2014 sales were $20 million, and Carson estimates that warranty expenses will be 1% of sales or $200,000. Warranty expense of $200,000 is deducted on Carson’s books in 2014. Tax deductions for warranties in 2014 are zero. Shows that the deferred income tax asset balance will remain stable if the warranty estimate is accurate and if sales volume is unchanged. 13-31

Using Tax Notes to Improve Interfirm Comparability Cubic’s10-K states: Nanometrics’10-K states: 13-32

Using Tax Notes to Improve Interfirm Comparability 13-33

Global Vantage Point Key differences between IFRS and U.S. GAAP income tax accounting rules Difference GAAP IFRS Approach for recognizing deferred tax assets Uses a valuation account for deferred tax asset if book basis is different from the tax basis No valuation account Reconciliation of statutory and effective tax rates Uses the domestic federal statutory rate Uses a statutory rate Reporting of deferred taxes on the balance sheet Classifies deferred tax assets and liabilities as current or noncurrent depending on the nature of the temporary difference Deferred tax assets and liabilities are reported as noncurrent Disclosure of income tax amount recognized directly in equity Not required Must disclose the aggregate amount of current or deferred income tax income or expense to Other Comprehensive Income Uncertain tax positions Extensive guidance under FASB ASC 740 No specific guidance. IAS 12 calls for tax assets and liabilities to be measured at the amount expected to be paid 13-34

Summary The rules for computing income for financial reporting purposes—book income—differ from those for computing income for tax purposes. The differences between book income and taxable income are caused by both permanent and temporary (timing) differences in the revenue and expense items reported on a company’s books versus its tax return. Temporary differences give rise to both deferred tax assets and deferred tax liabilities. Deferred tax accounting allows firms to report tax costs (or benefits) on the income statement in the same period as the related revenue or expense items are reported (matching principle). 13-35

Summary concluded The income tax foot provides useful information for understanding how much tax is paid and how much is deferred each year. Tax notes also help explain why effective tax rates may differ from the statutory rate. Tax notes provide useful information that can be exploited to improve interfirm comparability and evaluate firms’ earnings quality. GAAP disclosures are useful in assessing a firm’s uncertain tax positions and whether the firm is aggressive or conservative in recognizing the benefits associated with these positions. There are a number of differences between IFRS and U.S. GAAP rules for accounting for income taxes that you should be aware of. 13-36