1. ACCOUNTING FOR INCOME TAXES Chapter 16 © 2009 The McGraw-Hill Companies, Inc.

2. McGraw-Hill /Irwin Slide 2 The Internal Revenue Code is the set of rules for preparing tax returns. Financial statement income tax expense. IRS income taxes payable. GAAP is the set of rules for preparing financial statements. Usually... Results in... The objective of accounting for income taxes is to recognize a deferred tax liability or deferred tax asset for the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions or events that already have occurred. Deferred Tax Assets and Deferred Tax Liabilities

3. McGraw-Hill /Irwin Slide 3 Temporary Differences These are called temporary differences. Often, the difference between pre-tax accounting income and taxable income results from items entering the income computations at different times.

4. McGraw-Hill /Irwin Slide 4 Temporary differences will reverse out in one or more future periods. Temporary Differences Accounting Income>Taxable Income Future Taxable Amounts Deferred Tax Liability Accounting Income<Taxable Income Future Deductible Amounts Deferred Tax Asset

5. McGraw-Hill /Irwin Slide 5 Deferred tax liabilities result in taxable amounts in the future. Deferred tax assets result in deductible amounts in the future.

6. McGraw-Hill /Irwin Slide 6 Deferred Tax Liabilities In 2009, Baxter reports $300,000 of pretax income. Included in this amount is $100,000 resulting from revenue earned from an installment sale for which no cash was collected. The revenue will be taxed as the cash is collected in 2010 and 2011. Baxter expects to collect $70,000 in 2010 and the remaining $30,000 in 2011. In 2010 and 2011, Baxter reports $200,000 of pretax income. The company is subject to a 32% tax rate. There are no other temporary differences. In 2009, Baxter reports $300,000 of pretax income. Included in this amount is $100,000 resulting from revenue earned from an installment sale for which no cash was collected. The revenue will be taxed as the cash is collected in 2010 and 2011. Baxter expects to collect $70,000 in 2010 and the remaining $30,000 in 2011. In 2010 and 2011, Baxter reports $200,000 of pretax income. The company is subject to a 32% tax rate. There are no other temporary differences.

7. McGraw-Hill /Irwin Slide 7 Deferred Tax Liabilities 2009 Income tax payable = $200,000 × 32% = $64,000 2009 Deferred tax liability change = ($100,000 × 32%) - $0 = $32,000 2009 Income tax payable = $200,000 × 32% = $64,000 2009 Deferred tax liability change = ($100,000 × 32%) - $0 = $32,000

8. McGraw-Hill /Irwin Slide 8 Deferred Tax Liabilities The Deferred Tax Liability represents the future taxes Baxter will pay in 2010 and 2011.

9. McGraw-Hill /Irwin Slide 9 Deferred Tax Liabilities Recall this information for Baxter. 2010 Income tax payable = $270,000 × 32% = $86,400 2010 Deferred tax liability change = ($30,000 × 32%) - $32,000 = $22,400 2010 Income tax payable = $270,000 × 32% = $86,400 2010 Deferred tax liability change = ($30,000 × 32%) - $32,000 = $22,400

10. McGraw-Hill /Irwin Slide 10 Deferred Tax Liabilities Future Taxable Amount Schedule The Deferred Tax Liability represents the future taxes Baxter will pay in 2011.

11. McGraw-Hill /Irwin Slide 11 Deferred Tax Liabilities Recall this information for Baxter. 2011 Income tax payable = $230,000 × 32% = $73,600 2011 Deferred tax liability change = ($0 × 32%) - $9,600 = $9,600 2011 Income tax payable = $230,000 × 32% = $73,600 2011 Deferred tax liability change = ($0 × 32%) - $9,600 = $9,600

12. McGraw-Hill /Irwin Slide 12 Deferred Tax Liabilities Future Taxable Amount Schedule The Deferred Tax Liability represents the future taxes Baxter will pay.

13. McGraw-Hill /Irwin Slide 13 Health Magazine received $150,000 of subscriptions in advance during 2009. Subscription revenue will be earned equally in 2010, 2011 and 2012 for financial accounting purposes. The entire $150,000 will be taxed in 2009. There is additional income of $500,000 in each year. The company is subject to a 30% tax rate in each year. Deferred Tax Assets

14. McGraw-Hill /Irwin Slide 14 Deferred Tax Assets Now, let’s record the income tax entry for 2009. This is the computation for the Deferred Tax Asset.

15. McGraw-Hill /Irwin Slide 15 Deferred Tax Assets 2009 Income tax payable = $650,000 × 30% = $195,000 2009 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000 2009 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000 2009 Income tax payable = $650,000 × 30% = $195,000 2009 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000 2009 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000

16. McGraw-Hill /Irwin Slide 16 Deferred Tax Assets After posting the entry, the Deferred Tax Asset account will have the desired ending balance of $45,000.

17. McGraw-Hill /Irwin Slide 17 Deferred Tax Assets 2010 Income tax payable = $500,000 × 30% = $150,000 2010 Deferred tax asset change = [($100,000) × 30%] - $45,000 = ($15,000) 2010 Income tax payable = $500,000 × 30% = $150,000 2010 Deferred tax asset change = [($100,000) × 30%] - $45,000 = ($15,000)

18. McGraw-Hill /Irwin Slide 18 Deferred Tax Assets In 2010, the balance in the Deferred Tax Asset should decrease to $30,000. Can you prepare the entries for 2011 and 2012?

19. McGraw-Hill /Irwin Slide 19 Deferred Tax Assets This would be the entry for 2011 and 2012. At the end of 2012, the balance in the Deferred Tax Asset would be zero.

20. McGraw-Hill /Irwin Slide 20 A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized. The deferred tax asset is then reported at its estimated net realizable value. A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized. The deferred tax asset is then reported at its estimated net realizable value. Valuation Allowance

21. McGraw-Hill /Irwin Slide 21 Nontemporary Differences Created when an income item is included in taxable income or accounting income but will never be included in the computation of the other. Example: Interest on tax-free municipal bonds is included in accounting income but is never included in taxable income. Also called permanent differences.

22. McGraw-Hill /Irwin Slide 22 Tax Rate Considerations Deferred tax assets and liabilities should be determined using the future tax rates, if known. The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs. Deferred tax assets and liabilities should be determined using the future tax rates, if known. The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs. Internal Revenue Code

23. McGraw-Hill /Irwin Slide 23 Multiple Temporary Differences It would be unusual for any but a very small company to have only a single temporary difference in any given year. Categorize all temporary differences according to whether they create … Future taxable amounts Future deductible amounts

24. McGraw-Hill /Irwin Slide 24 Net Operating Losses (NOL) Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or subsequent periods. When used to offset earlier taxable income: Called: operating loss carryback. Result: tax refund. When used to offset earlier taxable income: Called: operating loss carryback. Result: tax refund. When used to offset future taxable income: Called: operating loss carryforward. Result: reduced tax payable. When used to offset future taxable income: Called: operating loss carryforward. Result: reduced tax payable.

25. McGraw-Hill /Irwin Slide 25 Net Operating Losses (NOL) Current Year -2 Carryback Period +3+2+1... +20+4+5 Carryforward Period The NOL may first be applied against taxable income from two previous years. Unused NOL may be carried forward for 20 years. The NOL may first be applied against taxable income from two previous years. Unused NOL may be carried forward for 20 years.

26. McGraw-Hill /Irwin Slide 26 Net Operating Losses (NOL) In 2009 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a 30% tax rate. In 2007, Garson reported taxable income of $20,000, and in 2008, taxable income was $10,000. The company elects to carryback the NOL. Let’s look at the tax benefits of the operating loss carryback and carryforward.

27. McGraw-Hill /Irwin Slide 27 Net Operating Losses (NOL)

28. McGraw-Hill /Irwin Slide 28 Net Operating Losses (NOL) The deferred tax asset account created by the benefit of the carryforward will be used to lower income taxes payable in future years.

29. McGraw-Hill /Irwin Slide 29 Disclose the following: Total of all deferred tax liabilities. Total of all deferred tax assets. Total valuation allowance recognized. Net change in valuation account. Approximate tax effect of each type of temporary difference (and carryforward). Disclose the following: Total of all deferred tax liabilities. Total of all deferred tax assets. Total valuation allowance recognized. Net change in valuation account. Approximate tax effect of each type of temporary difference (and carryforward). Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability. Balance Sheet Classification

30. McGraw-Hill /Irwin Slide 30 Current portion of tax expense (benefit) Deferred portion of tax expense (benefit), with separate disclosure for Portion that does not include the effect of the following separately disclosed amounts. Operating loss carryforwards. Adjustments due to changes in tax laws or rates. Adjustments to the beginning-of-the-year valuation allowance due to revised estimates. Investment tax credits. Current portion of tax expense (benefit) Deferred portion of tax expense (benefit), with separate disclosure for Portion that does not include the effect of the following separately disclosed amounts. Operating loss carryforwards. Adjustments due to changes in tax laws or rates. Adjustments to the beginning-of-the-year valuation allowance due to revised estimates. Investment tax credits. Additional Disclosures

31. McGraw-Hill /Irwin Slide 31 Coping with Uncertainty in Income Taxes FASB Interpretation No. 48 Step 1. A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits. Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50-percent likely to be realized. Not “more likely than not” = none of the tax benefit is allowed to be recorded

32. McGraw-Hill /Irwin Slide 32 Intraperiod Tax Allocation SFAS No. 109 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items. SFAS No. 109 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items.

33. McGraw-Hill /Irwin Slide 33 Conceptual Concerns Should deferred taxes be recognized? Should deferred taxes be recognized for only some items? Should deferred taxes be discounted? Should classification be based on the timing of temporary difference reversals? Some accountants disagree with the FASB’s approach to accounting for income taxes.

34. McGraw-Hill /Irwin End of Chapter 16 © 2008 The McGraw-Hill Companies, Inc.