1. ACCOUNTING FOR INCOME TAXES
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
The objective of financial accounting
provide information about the amount and timing of future cash flows
Most economic events have tax cash flow consequences
These cash consequences are reported on tax returns in accordance with the Internal Revenue Code (IRC)

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
Revenue
Expense
2005
2004

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
Financial income
Taxable income

8. Permanent and 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
Financial income
Taxable income

10. Types of Permanent Differences
Financial income
Taxable income
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

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
Reduction in the tax basis of depreciable assets because of tax credits
The ITC accounted for by the deferred method
Foreign operations for which the reporting currency is the functional currency
An increase in the tax basis of assets because of indexing for inflation
Business 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 two years and forward twenty 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
Identify temporary differences, NOL carryforwards, and unused tax credits
Measure the total deferred tax liability by applying the expected tax rate to the future taxable amount
Measure the total deferred tax asset by applying the expected future rate to future deductible amounts and NOL carryforwards
Measure deferred tax assets for each type of unused tax credit
Measure 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
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. FIN No. 48: Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Stmt No. 109
Tax contingencies too flexible
Used to manipulate earnings
Reporting & disclosure of tax positions lacked transparency
FIN 48 establishes proper accounting treatment for uncertain tax positions.

26. FIN No. 48: Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Stmt No. 109
Evaluation of tax position is a 2-step process
Recognition
Measurement

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

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

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

30. Financial Analysis of Income Taxes
Earnings conservatism ratios for Hershey and Tootsie

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

32. Prepared by Kathryn Yarbrough, MBA
End of Chapter 12
Prepared by Kathryn Yarbrough, MBA
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