1. 1 Accounting for Income Taxes C hapter 18 An electronic presentation by Douglas Cloud Pepperdine University An electronic presentation by Douglas Cloud Pepperdine University

2. 2 1.Understand permanent and temporary differences. 2. Explain the conceptual issues regarding interperiod tax allocation. 3. Record and report deferred tax liabilities. 4.Record and report deferred tax assets. 5.Explain an operating loss carryback and carryforward. Objectives ContinueContinue

3. 3 6.Account for an operating loss carryback. 7.Account for an operating loss carryforward. 8.Apply intraperiod tax allocation. 9.Classify deferred tax liabilities and assets. 10.Discuss the additional conceptual issues concerning interperiod income tax allocation (Appendix). Objectives

4. 4 Overview and Definitions The objective of financial reporting is to provide useful information about companies to decision makers. Income State- ment Income Tax Return

5. 5 Overview and Definitions Income State- ment Income Tax Return Frees Corporation Income Statement For Year Ended 12/31/04 Revenues$180,000 Cost of goods sold (78,000) Gross profit$105,000 Other expenses (60,000) Pretax income from continuing operations$ 45,000 Income taxes (11,000) Net income$ 34,000

6. 6 Overview and Definitions Income State- ment Income Tax Return Frees Corporation Income Tax Return For Year Ended 12/31/04 Revenues$170,000 Cost of goods sold (70,000) Gross profit$100,000 Other expenses (60,000) Pretax income from continuing operations$ 40,000 Income taxes ( 9,200) Net income$ 30,800

7. 7 Causes of Differences Permanent differences. Temporary differences. Operating loss carrybacks and carryforwards. Tax credits. Intraperiod tax allocations. Permanent differences. Temporary differences. Operating loss carrybacks and carryforwards. Tax credits. Intraperiod tax allocations.

8. 8 Permanent Differences Some items of revenue and expense that a corporation reports for financial accounting purposes are never reported for income tax purposes. These permanent differences never reverse in a later accounting period.

9. 9 Permanent Differences 1. Nontaxable Revenues 2. Nondeductible Expenses 3. Allowable Deductions For Example Interest on municipal bonds Life insurance proceeds For Example Life insurance premiums Fines For Example Percentage depletion Special dividend deduction

10. 10 Revenues that are recognized for financial reporting purposes but are never taxable (e.g., interest on municipal bonds, life insurance proceeds payable to a corporation upon death of insured). Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes (e.g., life insurance premiums on officers, fines) Revenues that are recognized for financial reporting purposes but are never taxable (e.g., interest on municipal bonds, life insurance proceeds payable to a corporation upon death of insured). Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes (e.g., life insurance premiums on officers, fines) Permanent Differences ContinuedContinued

11. 11 Deductions that are allowed for income tax purposes but do not qualify as expenses under generally accepted accounting principles (e.g., percentage depletion in excess of cost depletion, special dividend deduction). Permanent Differences Permanent differences affect either a corporation’s reported pretax financial income or its taxable income, but not both.

12. 12 Temporary Differences A temporary difference causes a difference between a corporation’s pretax financial income and taxable income that “originates” in one or more years and “reverses” in later years.

13. 13 Temporary Differences Revenues or gains are included in pretax financial income prior to the time they are included in taxable income. For example, gross profit on installment sales normally is recognized at the point of sale for financial reporting purposes, but for income tax purposes, in certain situations it is recognized as cash is collected. ContinuedContinued Future Taxable Income Will Be More Than Future Pretax Financial Income

14. 14 Temporary Differences Expenses and losses are deducted to compute taxable income prior to the time they are subtracted to compute pretax financial income. For example, a depreciable asset may be depreciated using MACRS over the prescribed tax life for income purposes, but using straight-line depreciation over a longer life for financial reporting purposes. Future Taxable Income Will Be More Than Future Pretax Financial Income ContinuedContinued

15. 15 Temporary Differences Revenue or gains are included in taxable income prior to the time they are included in pretax financial income. For example, items such as rent, interest, and royalties received in advance are taxable when received but are not reported for financial reporting purposes until the service actually has been provided. Future Taxable Income Will Be Less Than Future Pretax Financial Income ContinuedContinued

16. 16 Temporary Differences Expenses or losses are subtracted to compute pretax financial income prior to the time they are deducted to compute taxable income. For example, product warranty costs may be estimated and recorded as expenses in the current year for financial reporting purposes but deducted, as actually incurred, for the determination of taxable income. Future Taxable Income Will Be Less Than Future Pretax Financial Income

17. 17 Conceptual Issues 1.Should corporations be required to make interperiod income tax allocations for temporary differences, or should there be no interperiod tax allocation? 2.If interperiod tax allocation is required, should it be based on a comprehensive approach for all temporary differences or on a partial approach for certain temporary differences? 3.Should interperiod tax allocation be applied using the asset/liability method, the deferred method, or the net-of-tax method?

18. 18 Conceptual Issues The FASB concluded that--  Interperiod income tax allocation of temporary differences is appropriate.  The comprehensive allocation approach is to be applied.  The asset/liability method of income tax allocation is to be used.

19. 19 The FASB established four basic principles that a corporation is to apply in accounting for its income taxes at the date of its financial statements. Conceptual Issues

20. 20 1.A current tax liability or asset is recognized for the estimated income tax obligation or refund on its income tax return for the current year. 2.A deferred tax liability or asset is recognized for the estimated future tax effects of each temporary difference. Conceptual Issues ContinuedContinued

21. 21 3.The measurement of deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax law or rates are not anticipated. 4.The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized.

22. 22 Conceptual Issues Income Taxes Interperiod Tax Allocation (Income tax expense = Current income tax obligation) Interperiod Tax Allocation (temporary differences) Partial Allocation Asset/Liability Method (using enacted future tax rates) Deferred Method (using originating tax rates) Net-of-Tax Method Conceptual AlternativesCurrent GAAP (FASB Statement No. 109) Comprehensive Allocation

23. 23 Measurement 1.The applicable income tax rates. 2.Whether a valuation allowance should be established for deferred tax assets. The FASB addressed two issues regarding the measurement of deferred tax liabilities or deferred tax asset in its financial statements.

24. 24 Steps in Recording and Reporting of Current and Deferred Taxes Step 1.Measure the income tax obligation by applying the applicable tax rate to the current taxable income. Step 2.Identify the temporary differences and classify each as either“taxable” or “deductible.” Step 3.Measure the deferred tax liability for each taxable temporary difference using the applicable tax rate. ContinuedContinued

25. 25 Steps in Recording and Reporting of Current and Deferred Taxes Step 4.Measure the deferred tax asset for each deductible temporary difference using the applicable tax rate. Step 5.Reduce deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Step 6.Record the income tax expense income tax obligation, change in deferred tax liabilities and/or deferred tax assets, and change in valuation allowance (if any).

26. 26 Basic Entries In 2004 Track Company purchased an asset at a cost of $6,000. For financial reporting purposes, the asset has a 4-year life, no residual value, and is depreciated by the units-of-output method over 6,000 units (2004: 1,600 units). For income tax purposes the asset is depreciated under MACRS using the 3-year life (33.33% for 2004). The taxable income is $7,500 and the income tax rate is 30%. This button will be used later

27. 27 Step 1. $7,500 (taxable income) x 30% Step 2.The depreciation difference is identified as the only taxable temporary difference. Step 3.The $120 total deferred tax liability is calculated by multiplying the total taxable temporary difference ($400) times the future tax rate (30%). Steps 4 and 5. No deferred tax asset, so not required. Step 6.A journal entry is made. Basic Entries ContinuedContinued

28. 28 Example 1—Single Difference Income Tax Expense 2,370 Income Taxes Payable2,250 Deferred Tax Liability120 $2,250 + $120

29. 29 Example 2—Multiple Rates Assume the same facts as in Slide 26, except that the income tax rate for 2004 for 40%, but Congress has enacted tax rates of 35% for 2005, 33% for 2006, and 30% for 2007 and beyond. Financial Income Tax Year Depreciation Depreciation 2004$2,800$2,667 20051,100889 2006500444 Click here to review Slide 26, then click the button on Slide 26 to return.

30. 30 2004 2005 2006 Deferred Tax Liability Financial depreciation$2,800 $1,100 $500 Income tax depreciation(2,667) (889)(444) Taxable amount$ 133 $ 211 $ 56 = $400 Income tax rate 0.35 0.33 0.30 Deferred tax liability$ 47 $ 70 $ 17 = $134 Income Tax Expense 3,134 Income Taxes Payable3,000 Deferred Tax Liability134 Example 2—Multiple Rates

31. 31 Example 3: Deferred Tax Asset Klemper Company sells a product on which it provides a 3-year warranty. For financial reporting purposes, the company estimates its future warranty costs and records a warranty expense/liability at year-end. For income tax purposes the company deducts its warranty costs when paid. Continued

32. 32 At the beginning of 2004, the company had a deferred tax asset of $330 related to its warranty plan. At the end of 2004, the company estimates that its ending warranty liability is $1,400. In 2004 the company has taxable income of $5,000 and a tax rate of 30%. Income Tax Expense1,410 Deferred Tax Asset 90 Income Taxes Payable 1,500 Example 3: Deferred Tax Asset $1,500 – $90 $420 – $330 $5,000 x 30%

33. 33 Operating Loss Carrybacks and Carryforwards 2004 Operating Loss Carryback Carryback Period (2 years) 2002 2003 Previous Previous Taxable Taxable Income Income Continued

34. 34 Carryforward Period (20 years) 2005 2006 …2024 Future Future Future Taxable Taxable Taxable Income Income Income Operating Loss Carrybacks and Carryforwards Carryforward 2004 Operating Loss

35. 35 Conceptual Issues FASB concluded in FASB Statement No. 109 that GAAP for operating carrybacks and carryforwards are... Continued

36. 36 1.A corporation must recognize the tax benefit of an operating loss carryback in the period of the loss as an asset on its balance sheet and as a reduction of the operating loss on its income statement. 2.A corporation must recognize the tax benefit of an operating loss carryforward in the period of the loss as a deferred tax asset. However, it must reduce the deferred tax asset by a valuation allowance if it is more likely than not that the corporation will not realize some or all of the deferred tax asset. Conceptual Issues

37. 37 Operating Loss Carryback Example Monk Company reports a pretax operating loss of $90,000 in 2004 for both financial reporting and income tax purposes, and that reported pretax financial income and taxable income for the previous 2 years had been: 2002—$40,000 (tax rate 25%); and 2003—$70,000 (tax rate 30%). Income Tax Refund Receivable25,000 Income Tax Benefit From Operating Loss Carryback25,000 2002 $40,000 x 0.25 =$10,000 2003 $50,000 x 0.30 = 15,000 $25,000

38. 38 Operating Loss Carryforward Example Lake Company reports a pretax operating loss of $60,000 in 2004 for both financial reporting and income tax purposes. The income tax rate is 30% and no change in the tax rate has been enacted for future years. The deferred tax asset is calculated to be $18,000 ($60,000 x 0.30). Deferred Tax Asset18,000 Income Tax Benefit From Operating Loss Carryforward18,000 ContinuedContinued

39. 39 Operating Loss Carryforward Example If the company establishes a valuation allowance for the entire amount of the deferred tax asset, it also makes the following journal entry at the end of 2004. Income Tax Benefit From Operating Loss Carryforward18,000 Allowance to Reduce Deferred Tax Asset to Realizable Value18,000 ContinuedContinued

40. 40 Operating Loss Carryforward Example In 2005, Lake Company operates successfully and earns pretax operating income of $100,000 for both financial reporting and tax purposes. Income Tax Expense12,000 Allowance to Reduce Deferred Tax Asset to Realizable Value18,000 Income Taxes Payable12,000 Deferred Tax Asset18,000 $40,000 x 0.30

41. 41 Intraperiod Tax Allocation Income tax allocation within a period is mandatory under GAAP. Kalloway Company reports the following items of pretax financial and taxable income for 2004: [Continued] Kalloway Company reports the following items of pretax financial and taxable income for 2004: [Continued]

42. 42 Intraperiod Tax Allocation Income from continuing operations [$270,000 (revenues) – $190,000 (expenses)]$80,000 Gain on disposal of discontinued Segment X18,000 Loss from operations of discontinued Segment X(5,000) Extraordinary loss on bond redemption(10,000) Cumulative effect of change in accounting principle (accelerated depreciation to S/L)15,000 Prior period adjustment (error) (8,000) Amount subject to income taxes$90,000 ContinuedContinued

43. 43 Intraperiod Tax Allocation Kalloway Company is subject to income tax rates of 20% on the first $50,000 of income and 30% on all income in excess of $50,000. Let’s take a look at Kalloway Company’s schedule of income tax expense for 2004. ContinuedContinued

44. 44 Intraperiod Tax Allocation Pretax Amount Income Tax Rate Income Tax Expense (Cr.) Component (Pretax) Income from continuing operations$50,0000.20$10,000 30,0000.309,000 Gain on disposal of discontinued Division X18,0000.305,400 Extraordinary loss from tornado(5,000)0.30(1,500) x = ContinuedContinued

45. 45 Intraperiod Tax Allocation Pretax Amount Income Tax Rate Income Tax Expense (Cr.) Component (Pretax) Cumulative effect of change in accounting principle on prior year’s income$15,0000.20$ 4,300 Prior period adjustment(8,000)0.30 (2,400) Total income tax expense$22,000 x =

46. 46 Intraperiod Tax Allocation Now, let’s examine Kalloway Company’s income statement for 2004.

47. 47 (0.20 x $50,000) + (0.30 x $30,000) Revenues (listed separately)$270,000 Expenses (listed separately)(190,000) Pretax income from continuing operations$ 80,000 Income tax expense (19,000) Income Statement for Year Ended December 31, 2004

48. 48 Income Statement for Year Ended December 31, 2004 Revenues (listed separately)$270,000 Expenses (listed separately)(190,000) Pretax income from continuing operations$ 80,000 Income tax expense (19,000) Income from continuing operations$ 61,000 Results of discontinued operations: Gain on disposal of discontinued Segment X (net of $5,400 tax)$12,600 Loss from operations of discontinued Segment X (net of $1,500 tax credit) (3,500) 9,100 Income before extraordinary item$ 70,100 ContinuedContinued $18,000 x 0.30 ($5,000) x 0.30

49. 49 Income before extraordinary item$70,100 Extraordinary loss on bond redemption (net of $3,000 income tax credit)(7,000) Cumulative effect of change in accounting principle (net of $4,500 income taxes)10,500 Net Income$73,600 ($10,000) x 0.30 $15,000 x 0.30 Prior period adjustments on the statement of retained earnings also would be shown net of tax.

50. 50 Intraperiod Tax Allocation Kalloway Company makes the following journal entry to record the 2004 intraperiod tax allocation: Income Tax Expense19,000 Gain on Disposal of Division X5,400 Cumulative Effect of Change in Accounting Principle4,500 Loss from Operations of Discontinued Division X1,500 Extraordinary Loss from Tornado3,000 Retained Earnings (prior period adj.)2,400 Income Taxes Payable22,000

51. 51 Balance Sheet Presentation A corporation must report its deferred tax liabilities and assets in two classifications... …a net current amount and a net noncurrent amount.

52. 52 Balance Sheet Presentation Account Related Balance Deferred Tax Accounts Balance Sheet Account Deferred Tax Liabilities Installment sales$ 6,000 creditAccounts receivable Depreciation12,000 creditProperty, plant, and equipment Deferred Tax Assets Warranty costs$ 3,400 debitWarranty liability Rent revenue $ 2,500 debitUnearned revenue Current Noncurrent Current Noncurrent

53. 53 Press this button to skip the Appendix. Click anywhere else to go to Appendix material.

54. 54 Comprehensive Allocation Under comprehensive allocation, the income tax expense that a corporation reports in an accounting period is affected by all the transactions and events that it includes in determining its pretax financial income for that period.

55. 55 Partial Allocation Under partial allocation, the income tax expense that a corporation reports in an accounting period is affected only by those temporary differences that it expects to reverse in the foreseeable future.

56. 56 Comprehensive income tax allocation is more widely accepted for the following reasons: 1.Individual temporary differences do reverse. 2.Accounting is primarily historical. 3.A corporation should report the income tax effects of temporary differences in the same period that it includes the related transactions and events in its pretax financial statement. 4.Accounting results should not be subject to manipulation by management.

57. 57 Alternative Allocation Methods (1)The asset/liability method (2)The deferred method (3)The net-of-tax method

58. 58 C hapter 18 The End

59. 59