1. CHAPTER 12 ACCOUNTING FOR INCOME TAXES

2. Introduction Income taxes are an expense Consistent with the proprietary theory definition of comprehensive income Accounting for income taxes is a controversial issue

3. Historical Perspective Income taxes first became a significant issue because of the emerging facilities exception during World War II ARB No. 23 required the allocation of some deferred income taxes did not provide clear measurement guidelines The allocation of income taxes to the periods impacted is termed interperiod tax allocation APB Opinion No. 11 extended interperiod tax allocation to all timing differences criticism because resulting balance sheet items did not reflect future tax consequences result FASB Statement No. 96 later FASB Statement No. 109

4. The Income Tax Allocation Issue Most economic events have tax cash flow consequences These cash consequences are reported on tax returns in accordance with the Internal Revenue Code (IRC) The objective of financial accounting provide information about the amount and timing of future cash flows

5. The Income Tax Allocation Issue The goal of the IRC is to raise revenue to run the government and in some cases to regulate the economy These same economic events are reported for financial accounting purposes under GAAP

6. The Income Tax Allocation Issue The goals of the IRC and GAAP sometimes result in reporting revenues and expenses in different accounting periods creating an originating difference In subsequent years these differences will reverse creating a reversing difference This issue is termed the income tax allocation issue 2003 2004 Revenue Expense

7. Permanent and Temporary Differences Permanent differences are differences between taxable income and financial accounting that will never reverse federal economic policy or to alleviate a provision of the IRC that falls too heavily on one segment of the economy Taxable income Financial income

8. Permanent and Temporary Differences Temporary differences will reverse in a subsequent period some temporary differences are timing differences others occur because of different measurement bases

9. Permanent Differences Occur because provisions of the IRC exempt certain types of revenue from taxation or prohibit the deduction of certain expenses Taxable income Financial income

10. Types of Permanent Differences Revenue recognized for financial accounting purposes that is never taxable interest on municipal bonds Expenses recognized for financial accounting purposes that are never deductible for tax purposes life insurance premiums Income tax deductions that do not qualify as expenses under GAAP life insurance proceeds Taxable income Financial income

11. Temporary Differences Create timing differences Result in assets and liabilities having differing bases for financial accounting and taxation purposes Originating differences when they reverse create Taxable amounts Deductible amounts

12. Temporary Differences Categories of timing differences Current financial accounting income exceeds current taxable income Current financial accounting income is less than current taxable income

13. Additional Temporary Differences 1Reduction in the tax basis of depreciable assets because of tax credits 2The ITC accounted for by the deferred method 3Foreign operations for which the reporting currency is the functional currency 4An increase in the tax basis of assets because of indexing for inflation 5Business combinations accounted for by the purchase method

14. Net Operating Losses Occurs when tax deductions are greater than taxable income in a period IRC allows for these losses to be carried back three years and forward fifteen years Should the benefits of NOL’s be recognized?

15. Conceptual Issues Allocation versus Nonallocation Comprehensive versus Partial allocation Discounting deferred taxes

16. Alternative Interperiod Tax Allocation Methods Deferred method uses rates in effect when difference originates Asset/liability method uses rates expected to be in effect when the difference reverses Net of tax method use one of the above methods to adjust balance sheet items that caused the temporary difference e. g. depreciable assets

17. FASB Dissatisfaction With the Deferred Method APB Opinion No. 11 required the use of the deferred method Did not meet SFAS No. 6 definition of assets and liabilities

18. Measurement and Reporting Under SFAS No. 96 Required the asset/liability approach to allocation Deferred tax liability Deferred tax asset SFAS No. 96 limited the recognition of deferred tax assets created by NOLs zero future income assumption

19. Business Dissatisfaction With SFAS No. 96 The cost of scheduling necessary under its provision Loss of deferred tax assets under zero future income assumption

20. SFAS No. 109 Board remained committed to the asset/liability method Allowed for the separate recognition and measurement of deferred tax assets and liabilities without regard to future income considerations More likely than not criteria for deferred tax assets rather than zero future income assumption

21. Determining Deferred Asset and Liability Balances 1Identify temporary differences, NOL carryforwards, and unused tax credits 2Measure the total deferred tax liability by applying the expected tax rate to the future taxable amount 3Measure the total deferred tax asset by applying the expected future rate to future deductible amounts and NOL carryforwards 4Measure deferred tax assets for each type of unused tax credit 5Measure the valuation allowance based on the more likely than not criterion

22. The Valuation Allowance There may be insufficient future taxable income to derive the benefit from a deferred tax asset Use allowance to reduce the deferred tax asset to amount expected to be realized under the more likely than not criterion

23. Do Assets and Liabilities Created by SFAS No. 109 Meet the Definitions in SFAC No. 6? Deferred tax liability - meets the three characteristics of liabilities Deferred tax asset - meets the three characteristics of assets

24. Financial Statement Disclosures Income statement Balance sheet SEC disclosure requirements

25. Financial Analysis of Income Taxes Disclosure requirements allow financial statement users to make better decisions including: 1Assessing the quality of earnings 2Assessing future cash flows 3Calculation of actual tax rates

26. Financial Analysis of Income Taxes The footnotes provide information on: 1Information on the amount of taxes that would be paid at the federal statutory rate and the amount actually paid 2Changes in the deferred tax asset and liability accounts 3Information concerning income tax carrybacks and carryforwards

27. Financial Analysis of Income Taxes The earnings conservatism ratio Pretax accounting income a Taxable income a In the event a company reports material permanent income tax differences, the amount of these differences adjusts the numerator.

28. Financial Analysis of Income Taxes Earnings conservatism ratios for Best Buy and Circuit City

29. IAS No. 12: Accounting for Taxes on Income Recently amended to require the liability (asset/liability) method Considering other issues: 1Do tax consequences of recovery amounts of assets and liabilities depend on the manner of recovery? 2Disclosure of reconciliation between income tax expense and accounting profit No FASB staff review

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