Intermediate Accounting

Intermediate Accounting
kieso weygandt warfield INTERMEDIATE ACCOUNTING team for success Intermediate Accounting F I F T E E N T H E D I T I O N Intermediate Accounting Prepared by Coby Harmon University of California, Santa Barbara Westmont College Edited by Dr. Joe Morris Southeastern Louisiana University Prepared by Coby Harmon University of California, Santa Barbara Westmont College Prepared by Coby Harmon University of California, Santa Barbara

Intermediate Accounting Kieso Weygandt Warfield
PREVIEW OF CHAPTER 19 Intermediate Accounting 15th Edition Kieso Weygandt Warfield

19 Accounting for Income Taxes LEARNING OBJECTIVES
After studying this chapter, you should be able to: Identify differences between pretax financial income and taxable income. Describe a temporary difference that results in future taxable amounts. Describe a temporary difference that results in future deductible amounts. Explain the purpose of a deferred tax asset valuation allowance. Describe the presentation of income tax expense in the income statement. Describe various temporary and permanent differences. Explain the effect of various tax rates and tax rate changes on deferred income taxes. Apply accounting procedures for a loss carryback and a loss carryforward. Describe the presentation of deferred income taxes in financial statements. Indicate the basic principles of the asset-liability method.

Accounting for Income Taxes

Corporations must file income tax returns following the guidelines developed by the Internal Revenue Service (IRS). Because GAAP and tax regulations differ in a number of ways, the amounts reported for the following will differ: income tax expense (GAAP) income tax payable (Internal Revenue Code). LO 1

Pretax Financial Income
Accounting for Income Taxes Financial Statements Tax Return vs.  Pretax Financial Income Taxable Income GAAP Tax Code  Income Tax Expense Income Taxes Payable LO 1

Illustration: Chelsea, Inc. reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations. For tax purposes, Chelsea reported the same expenses to the IRS in each of the years. Chelsea reported taxable revenues of $100,000 in 2014, $150,000 in 2015, and $140,000 in What is the effect on the accounts of reporting different amounts of revenue for GAAP versus tax? LO 1

Book vs. Tax Differences
(Books: Income Statement) Illustration 19-2 GAAP Reporting 2014 2015 2016 Total Revenues $130,000 $130,000 $130,000 $390,000 Expenses 60,000 60,000 60,000 180,000 Pretax financial income $70,000 $70,000 $70,000 $210,000 Income tax expense (40%) $28,000 $28,000 $28,000 $84,000 (Tax Return) Illustration 19-3 Tax Reporting 2014 2015 2016 Total Revenues $100,000 $150,000 $140,000 $390,000 Expenses 60,000 60,000 60,000 180,000 Taxable income $40,000 $90,000 $80,000 $210,000 Income tax payable (40%) $16,000 $36,000 $32,000 $84,000 LO 1

Book vs. Tax Differences
Illustration 19-4 Comparison 2014 2015 2016 Total Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000 Income tax payable (IRS) 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) $0 Income tax expense (40%) $28,000 $28,000 $28,000 $84,000 Are the differences accounted for in the financial statements? Yes Year Reporting Requirement 2014 Deferred tax liability account increased to $12,000 2015 Deferred tax liability account reduced by $8,000 2016 Deferred tax liability account reduced by $4,000 LO 1

Financial Reporting for 2014
Balance Sheet Income Statement 2014 2014 Assets: Revenues: Expenses: Liabilities: Deferred taxes ,000 Income taxes payable 16,000 Income tax expense 28,000 Equity: Net income (loss) Where does the “deferred tax liability” get reported in the financial statements? LO 1

Future Taxable and Deductible Amounts
Temporary Differences Taxable temporary differences create Deferred tax liabilities on the balance sheet Deductible temporary differences create Deferred tax assets on the balance sheet LO 6 Describe various temporary and permanent differences.

Future Taxable and Deductible Amounts
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 create DTLs Future Deductible Amounts create DTAs 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 in the text and Sides through in the notes provide Examples of Temporary Differences LO 2

Future Taxable Amounts
Illustration: In Chelsea’s situation, the only difference between the book basis and tax basis of the assets and liabilities relates to accounts receivable that arose from revenue recognized for book purposes. Chelsea reports accounts receivable at $30,000 in the December 31, 2014, GAAP-basis balance sheet. However, the receivables have a zero tax basis. Illustration 19-5 [See Slide 8: Sales are $130,000 (recognized per books) and collections are $100,000 (recognized per tax return).] LO 2

(Originating Difference) (Reversing Differences)
Future Taxable Amounts Illustration: Reversal of Temporary Difference, Chelsea Inc. Illustration 19-6 (Originating Difference) (Reversing Differences) Chelsea assumes that it will collect the accounts receivable and report the $30,000 collection as taxable revenues in future tax returns. Chelsea does this by recording a deferred tax liability. LO 2

Deferred Taxes Deferred Tax Liability
A 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. Illustration 19-4 2014 2015 2016 Total Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000 Income tax payable (IRS) 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) $0 LO 2

Deferred Tax Liability
Illustration: Because it is the first year of operations for Chelsea, there is no deferred tax liability at the beginning of the year. Chelsea computes the income tax expense for 2014 as follows: Illustration 19-9 LO 2

Illustration 19-9 Computation of Income Tax Expense, 2014 Chelsea makes the following entry at the end of 2014 to record income taxes. Income Tax Expense 28,000 Income Taxes Payable 16,000 Deferred Tax Liability 12,000 LO 2

Illustration 19-10 Computation of Income Tax Expense for 2015 Chelsea makes the following entry at the end of 2015 to record income taxes. Income Tax Expense 28,000 Deferred Tax Liability 8,000 Income Taxes Payable 36,000 Chelsea makes the following entry at the end of 2016 to record income taxes: Income Tax Expense 28,000 Deferred Tax Liability 4,000 Income Tax Payable 32,000 LO 2

The entry to record income taxes at the end of 2016 reduces the Deferred Tax Liability by $4,000. The Deferred Tax Liability account appears as follows at the end of 2016. Illustration 19-11 LO 2

Illustration: Starfleet Corporation has one temporary difference at the end of 2014 that will reverse and cause taxable amounts of $55,000 in 2015, $60,000 in 2016, and $75,000 in Starfleet’s pretax financial income for 2014 is $400,000, and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2014. Instructions Compute (1) taxable income and (2) income taxes payable for Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014. LO 2

LO 2

Future Deductible Amounts
Illustration: During 2014, Cunningham Inc. estimated its warranty costs related to the sale of microwave ovens to be $500,000, paid evenly over the next two years. For book purposes, in 2014 Cunningham reported warranty expense and a related estimated liability for warranties of $500,000 in its financial statements. For tax purposes, the warranty tax deduction is not allowed until paid. Illustration 19-12 LO 3

Illustration: Reversal of Temporary Difference. Illustration 19-13 2014 2015 2016 When Cunningham pays the warranty liability, it reports an expense (deductible amount) for tax purposes. Cunningham reports this future tax benefit in the December 31, 2014, balance sheet as a deferred tax asset. If the tax rate is 40% for all years the deferred tax asset would be $200,000 ($500,000 x 40%). LO 3

Deferred Tax Asset A 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. In other words, future deductions are tax benefits to the company, and thus recorded as assets at the balance sheet date. LO 3

Deferred Tax Asset Illustration: Hunt Co. accrues a loss and a related liability of $50,000 in 2014 for financial reporting purposes because of pending litigation. Hunt cannot deduct this amount for tax purposes until the period it pays the liability, expected in 2015. Illustration 19-14 LO 3

Deferred Tax Asset Assume that 2014 is Hunt’s first year of operations, and income tax payable is $100,000, compute income tax expense. Illustration 19-16 Prepare the entry at the end of 2014 to record income taxes. Income Tax Expense 80,000 Deferred Tax Asset 20,000 Income Taxes Payable 100,000 LO 3

Deferred Tax Asset Computation of Income Tax Expense for 2015 assuming income tax payable of $140,000. Illustration 19-17 Prepare the entry at the end of 2015 to record income taxes. Income Tax Expense 160,000 Deferred Tax Asset 20,000 Income Taxes Payable 140,000 LO 3

Deferred Tax Asset The entry to record income taxes at the end of 2015 reduces the Deferred Tax Asset by $20,000. Illustration 19-18 LO 3

Deferred Tax Asset Illustration: Columbia Corporation has one temporary difference at the end of 2014 that will reverse and cause deductible amounts of $50,000 in 2015, $65,000 in 2016, and $40,000 in Columbia’s pretax financial income for 2014 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 Compute taxable income and income taxes payable for 2014. Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014. LO 3

Advance slide in presentation mode to reveal answers.
Deferred Tax Asset a. a. Advance slide in presentation mode to reveal answers. LO 3

Deferred Tax Asset—Valuation Allowance A company should reduce a deferred tax asset by a valuation allowance if it is more likely than not that it will not realize some portion or all of the deferred tax asset. “More likely than not” means a level of likelihood of at least slightly more than 50 percent. LO 4

Deferred Tax Asset—Valuation Allowance Now assume in the Columbia illustration that it is more likely than not that $30,000 of the deferred tax asset of $52,700 recorded will not be realized, prepare the additional journal entry required for 2014. Income Tax Expense ,000 Allowance to Reduce Deferred Tax Asset to ERV 30,000 LO 4 Explain the purpose of a deferred tax asset valuation allowance.

Deferred Tax Asset—Valuation Allowance Balance Sheet Presentation: The balance of the Deferred Tax Asset account would be shown on the face of the balance sheet as: LO 4 Explain the purpose of a deferred tax asset valuation allowance.

Income Statement Presentation Formula to Compute Income Tax Expense Illustration 19-20 Income Taxes Payable Or Refundable Change In Deferred Income Taxes Income Tax Expense or Benefit +- = In the income statement or in the notes to the financial statements, a company should disclose the significant components of income tax expense (current and deferred). LO 5

Income Statement Presentation
Given the previous information related to Chelsea Inc., Chelsea reports its income statement as follows. Illustration 19-21 LO 5

Specific Differences Temporary Differences Taxable temporary differences - Deferred tax liability Deductible temporary differences - Deferred tax Asset LO 6

Temporary Differences
Illustration 19-22 Examples of Temporary Differences Revenues or gains are taxable after they are recognized in financial income. An asset (e.g., accounts receivable or investment) may be recognized for revenues or gains that will result in taxable amounts in future years when the asset is recovered. Examples: Sales accounted for on the accrual basis for financial reporting purposes and on the installment (cash) basis for tax purposes (Chelsea example). Contracts accounted for under the percentage-of-completion method for financial reporting purposes and a portion of related gross profit deferred for tax purposes. LO 6

Illustration 19-22 Examples of Temporary Differences Expenses or losses are deductible after they are recognized in financial income. A liability (or contra asset) may be recognized for expenses or losses that will result in deductible amounts in future years when the liability is settled. Examples: Product warranty liabilities.. Litigation accruals. LO 6

Illustration 19-22 Examples of Temporary Differences Revenues or gains are taxable before they are recognized in financial income. A liability may be recognized for an advance payment for goods or services to be provided in future years. For tax purposes, the advance payment is included in taxable income upon the receipt of cash. Future sacrifices to provide goods or services (or future refunds to those who cancel their orders) that settle the liability will result in deductible amounts in future years. Examples: Subscriptions received in advance. Advance rental receipts. LO 6

Illustration 19-22 Examples of Temporary Differences Expenses or losses are deductible before they are recognized in financial income. The cost of an asset may have been deducted for tax purposes faster than it was expensed for financial reporting purposes. Amounts received upon future recovery of the amount of the asset for financial reporting (through use or sale) will exceed the remaining tax basis of the asset and thereby result in taxable amounts in future years. Examples: Depreciable property, depletable resources, and intangibles. Prepaid expenses that are deducted on the tax return in the period paid. LO 6

Specific Differences Originating and Reversing Aspects of Temporary Differences. Originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability. Reversing difference occurs when eliminating a temporary difference that originated in prior periods and then removing the related tax effect from the deferred tax account. LO 6

Specific Differences Permanent differences result from items that (1) enter into pretax financial income but never into taxable income or (2) enter into taxable income but never into pretax financial income. Permanent differences affect only the period in which they occur. They do not give rise to future taxable or deductible amounts. There are no deferred tax consequences to be recognized. LO 6

Permanent Differences
Illustration 19-24 Examples of Permanent Differences Items are recognized for financial reporting purposes but not for tax purposes. Examples: Interest received on state and municipal obligations. Expenses incurred in obtaining tax-exempt income. Proceeds from life insurance carried by the company on key officers or employees. Premiums paid for life insurance carried by the company on key officers or employees (company is beneficiary). Fines and expenses resulting from a violation of law. Items are recognized for tax purposes but not for financial reporting purposes. Examples: The deduction for dividends received from U.S. corporations, generally 70% or 80%. LO 6

Future Deductible Amount
Specific Differences Illustration Do the following generate: Future Deductible Amount (and a Deferred Tax Asset) Future Taxable Amount (and a Deferred Tax Liability) Permanent Difference The MACRS depreciation system is used for tax purposes, and the straight-line depreciation method is used for financial reporting purposes. A landlord collects some rents in advance. Rents received are taxable in the period when they are received. Expenses are incurred in obtaining tax-exempt income. Future Taxable Amount Liability Future Deductible Amount Asset Permanent Difference LO 6

Future Deductible Amount
Specific Differences Illustration Do the following generate: Future Deductible Amount (and a Deferred Tax Asset) Future Taxable Amount (and a Deferred Tax Liability) Permanent Difference Future Deductible Amount Costs of guarantees and warranties are estimated and accrued for financial reporting purposes. Installment sales of investments are accounted for by the accrual method for financial reporting purposes and the installment-sales method for tax purposes. Proceeds are received from a life insurance company because of the death of a key officer (the company carries a policy on key officers). Asset Future Taxable Amount Liability Permanent Difference LO 6

Specific Differences Illustration: Havaci Company reports pretax financial income of $80,000 for The following items cause taxable income to be different than pretax financial income. Depreciation on the tax return is greater than depreciation on the income statement by $16,000. Rent collected on the tax return is greater than rent earned on the income statement by $27,000. Fines for pollution appear as an expense of $11,000 on the income statement. Havaci’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 2014. LO 6

Specific Differences Advance slide in presentation mode to reveal answers. LO 6

Tax Rate Considerations Future Tax Rates When scheduling temporary differences, a company must consider presently enacted changes in the tax rate that become effective for a particular future year(s). In determining the appropriate enacted tax rate for a given year, companies must use the average tax rate. LO 7

Tax Rate Considerations Revision of Future Tax Rates When a change in the tax rate is enacted, companies should record its effect on the existing deferred income tax accounts immediately. A company reports the effect as an adjustment to income tax expense in the period of the change. Example JE for an increase in future tax rate(s): Income tax expense xxx Deferred tax liability xxx LO 7

Accounting for Net Operating Losses
Net operating loss (NOL) = tax-deductible expenses exceed taxable revenues (on the tax return). The federal tax laws permit taxpayers to use the losses of one year to offset the profits of other years (loss carryback and loss carryforward). LO 8

Loss Carryback Back 2 years and forward 20 years Losses must be applied to earliest year first Illustration 19-29 LO 8

Loss Carryforward May elect to forgo loss carryback and Carryforward losses 20 years Illustration 19-30 LO 8

Illustration: Conlin Corporation had the following tax information. In 2015 Conlin suffered a net operating loss of $480,000, which it elected to carry back. The 2015 enacted tax rate is 29%. Prepare Conlin’s entry to record the effect of the loss carryback. LO 8

Accounting for Net Operating Losses $144,000 Advance slide in presentation mode to reveal answers. LO 8

$144,000 Journal Entry for 2015: Income Tax Refund Receivable 144,000 Benefit Due to Loss Carryback 144,000 LO 8

Illustration: Rode Inc. incurred a net operating loss of $500,000 in Combined income for 2012 and 2013 was $350,000. The tax rate for all years is 40%. Rode elects the carryback option. Prepare the journal entries to record the benefits of the loss carryback and the loss carryforward. LO 8

Accounting for Net Operating Losses Refund $140,000 Advance slide in presentation mode to reveal answers. LO 8

Journal Entries for 2014 Income Tax Refund Receivable 140,000 Benefit Due to Loss Carryback 140,000 LO 8

Journal Entries for 2014 Deferred Tax Asset 60,000 Benefit Due to Loss Carryforward 60,000 LO 8

Illustration: Rode Inc. incurred a net operating loss of $500,000 in Combined income for 2012 and 2013 was $350,000. The tax rate for all years is 40%. Rode elects the carryback option. Assume that it is more likely than not that the entire net operating loss carryforward will not be realized in future years. Prepare all the journal entries necessary at the end of 2014. LO 8

Journal Entries for 2014 Income Tax Refund Receivable 140,000 Benefit Due to Loss Carryback 140,000 Deferred Tax Asset 60,000 Benefit Due to Loss Carryforward 60,000 Benefit Due to Loss Carryforward 60,000 Allowance for Deferred Tax Asset 60,000 Advance slide in presentation mode to reveal journal entry to recognize the valuation allowance. LO 8

Financial Statement Presentation
Balance Sheet Enron LO 9

Balance Sheet Presentation: An individual deferred tax liability or asset is classified as current or noncurrent based on the classification of the related asset or liability for financial reporting purposes. Companies should classify deferred tax accounts on the balance sheet in two categories: one for the net current amount, and one for the net noncurrent amount. LO 9

Balance Sheet LO 9 ILLUSTRATION 19-39
Classification of Temporary Differences as Current or Noncurrent Netting for Balance Sheet Purposes $214,000 Noncurrent Liability $9,000 Current Asset LO 9

Income Statement Presentation: Companies should allocate income tax expense (or benefit) to continuing operations, discontinued operations, extraordinary items, and prior period adjustments (intraperiod tax allocation). Companies should disclose the significant components of income tax expense attributable to continuing operations (current tax expense, deferred tax expense, etc.). LO 9

Review of the Asset-Liability Method
The FASB believes that the asset-liability method (sometimes referred to as the liability approach) is the most consistent method for accounting for income taxes. Illustration 19-42 Basic Principles of the Asset-Liability Method LO 10

Review of the Asset-Liability Method
Illustration 19-43 Procedures for Computing and Reporting Deferred Income Taxes LO 10

RELEVANT FACTS - Similarities
Similar to GAAP, IFRS uses the asset and liability approach for recording deferred taxes. New RELEVANT FACTS - Differences According to IFRS, the only income statement item reported separately net of tax is a gain or loss from discontinued operations. LO 12 Compare the accounting for income taxes under GAAP and IFRS.

RELEVANT FACTS - Differences
The classification of deferred taxes under IFRS is always non-current. As indicated in the chapter, GAAP classifies deferred taxes based on the classification of the asset or liability to which it relates. Under IFRS, an affirmative judgment approach is used, by which a deferred tax asset is recognized up to the amount that is probable to be realized. GAAP uses an impairment approach. In this approach, the deferred tax asset is recognized in full. It is then reduced by a valuation account if it is more likely than not that all or a portion of the deferred tax asset will not be realized. IFRS uses the enacted tax rate or substantially enacted tax rate. (“Substantially enacted” means virtually certain.) For GAAP, the enacted tax rate must be used. LO 12

IFRS SELF-TEST QUESTION
Which of the following statements is correct with regard to IFRS and GAAP? Under GAAP, all potential liabilities related to uncertain tax positions must be recognized. The tax effects related to certain items are reported in equity under GAAP; under IFRS, the tax effects are charged or credited to income. IFRS uses an affirmative judgment approach for deferred tax assets, whereas GAAP uses an impairment approach for deferred tax assets. IFRS classifies deferred taxes based on the classification of the asset or liability to which it relates. LO 12

IFRS SELF-TEST QUESTION
Under IFRS: “probable” is defined as a level of likelihood of at least slightly more than 60%. a company should reduce a deferred tax asset when it is likely that some or all of it will not be realized by using a valuation allowance. a company considers only positive evidence when determining whether to recognize a deferred tax asset. deferred tax assets must be evaluated at the end of each accounting period. LO 12

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