1. Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 13
Income Tax Reporting
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 13
Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

2. Learning objectives
The different objectives underlying income determination for financial reporting (book) purposes versus tax purposes.
The distinction between temporary (timing) and permanent differences, the items that cause these differences, and how each affects book income versus taxable income.
The distortions created when the deferred tax effects of temporary differences are ignored.
How tax expense is determined with interperiod tax allocation and the relation between taxes payable, changes in deferred taxes and tax expense.
Measuring and reporting valuation differences for deferred tax assets.
13-2

3. Learning objectives: Concluded
How changes in tax rates are measured and recorded.
The reporting rules for net operating loss carrybacks and carry-forwards.
How to read and interpret tax note disclosures and how these footnotes can be used to enhance comparisons across firms.
Financial statement disclosures on uncertain tax positions.
How tax notes disclosures can be used to improve financial statement analysis.
Key differences between IFRS and U.S. GAAP rules for reporting of income taxes.
13-3

4. Book income and taxable income
Income computed for
financial reporting purposes
Taxable Income:
Income computed for
tax compliance purposes ≠
Intended to reflect increases in the firm’s “well-offness”.
Includes all earned inflows of net assets, even when the inflow is not immediately convertible into cash.
Reflects expenses as they accrue, not just when they are paid.
Governed by the “constructive receipt/ability to pay” doctrine.
The timing of taxation usually (but not always) follows the inflow of cash or equivalents.
Deductions generally are allowed only when the expenditures are made or when a loss occurs.
Divergence complicates the way income taxes are reflected in financial reports
13-4

5. Understanding income tax reporting: Timing differences
Book Income
Depreciation expense
Bad debt expense
Installment sales
Revenues received in advance
Timing
differences: ≠
Permanent
differences
Taxable Income
A timing difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period.
Current period
Later period
$100 $0
Originating
Reversing
Book income
Taxable income
Type
Timing differences give rise to deferred tax assets and deferred tax liabilities because they are temporary (they eventually reverse):
13-5

6. Understanding income tax reporting: Permanent differences
Book Income
Timing
differences: ≠
Interest on state and municipal bonds.
Goodwill write-offs
Permanent
differences
Taxable Income
Statutory depletion in excess of
cost-based depletion
Dividend received deduction
Permanent differences are caused by income items that:
Enter into book income but never affect taxable income.
Enter into taxable income but never affect book income.
Because permanent differences do not reverse, they do not give rise to deferred tax assets or liabilities.
13-6

7. Mitchell Corporation buys new equipment for $10,000 on January 1, 2014
Mitchell Corporation buys new equipment for $10,000 on January 1, The asset has a five-year life and no salvage value. It will be depreciated using the straight-line method for book purposes, but for tax purposes the sum-of-the-years’-digits method will be used. (Technically, firms are required to use MACRS depreciation for tax purposes.)
Straight-line
SYD method
13-7

8. Understanding income tax reporting: Mitchell’s income tax payable
Assume for Mitchell Corporation that depreciation is the only book versus tax difference.
If income before depreciation is expected to be $20,000 each year over the next five years, and the statutory tax rate is 35%, then:
Taxes Due
13-8

9. Understanding income tax reporting: Mitchell’s temporary differences
Depreciation Expense
Income
13-9

10. Understanding income tax reporting: The mismatch problem
If book income tax expense is set equal to actual taxes payable each year, then:
Expense increases with taxes due
Book income declines
13-10

11. Understanding income tax reporting: A financial reporting distortion
When book income tax expense is set equal to the actual taxes payable each year, there is a mismatch:
Figure 13.2
MITCHELL CORPORATION
Tax Expense without Interperiod Tax Allocation
13-11

12. Understanding income tax reporting: The FASB’s solution
Interperiod tax allocation overcomes the mismatch problem.
The “extra” tax depreciation in early years will be offset by lower tax depreciation in later years.
The “extra” tax depreciation thus generates a liability for future taxes.
Recording this deferred tax liability as it accrues eliminates the mismatch.
$3,333
$1,333 of “extra”
depreciation
in year 1
Tax depreciation
$2,000
Future tax liability is $1,333 X 35% or $467
Book depreciation
13-12

13. Deferred income tax accounting: Interperiod tax allocation
FASB ASC Topic 740, Income Taxes, requires that the journal entry for income taxes reflect both:
Taxes currently due
Any liability for future taxes arising from current period book-versus-tax differences that will reverse in later periods.
Originating
Reversing
13-13

14. Deferred income tax accounting: Calculating tax expense
Relation between tax expense, taxes payable, and changes in deferred tax liabilities
13-14

15. Deferred income tax accounting: The mismatch is eliminated
Figure 13.4
MITCHELL CORPORATION
Tax Expense with Interperiod Tax Allocation
13-15

16. Deferred income tax assets: Computing income tax expense
Relation between tax expense, taxes payable, and changes in deferred tax assets and liabilities
13-16

17. Deferred income tax assets: Valuation allowances
The FASB requires firms with deferred tax assets to assess the likelihood that those assets may not be fully realized in future periods.
Realization depends on whether or not the firm has future taxable income. 0%
50%
100%
“More likely than not ”
DTA carrying value is reduced until the new amount falls within this range
Probability that DTA will NOT be realized
Deferred tax asset (DTA) valuation allowance is then required
13-17

18. Deferred income tax assets: Valuation allowance example
Norman Corporation records a deferred tax asset in 2014 related to accrued warranty expenses:
In early 2015, Norman determines that it is unlikely to earn enough taxable income in future years to realize more than $200,000 of the deferred tax asset. The entry made in 2015 is:
13-18

19. Net operating losses: Carrybacks and carryforwards example
Unfortunato Corporation experienced a $1 million pre-tax operating loss in Under U.S. Income Tax Code, the company can either:
Figure 13.6
Illustration of Tax Loss Carryback/
Carryforward Provision
Figure 13.6
Illustration of Tax Loss Carryforward Provision
13-19

20. Net operating losses: Carryback and carryforward entries
Suppose Unfortunato had the following operating profit history:
The following entry would be made to reflect the carryback:
=$750,000 x 35%
If future pre-tax operating profits are expected to exceed $250,000, then the carryforward entry would be :
$250,000 x 35%
13-20

21. Deferred income tax accounting: When tax rates change
When tax rates change, the tax effects of “reversals” change as well.
GAAP adopts the “liability approach” to measure deferred income taxes in this situation. In any year current or future tax rates are changed:
The income tax expense number absorbs the full effect of the change
The relationship between that year’s tax expense and book income is destroyed.
Year 1
Year 2
Reversal
Tax effect at 35%
at new 30%
$1,000
350
300
$700
Deferred tax liability
13-21

22. Deferred income tax accounting: When tax rates change
$760
Deferred tax liability after the tax rate change
= ($1,333 + $667) x .38
$700
= ($1,333 + $667) x .35
Deferred tax liability before the tax rate change
Under the FASB ASC Topic 740, Income Taxes,“liability approach”, income tax expense for 2016 would be:
2016
13-22

23. Deferred income tax accounting: When tax rates change
Tax rate changes can inject one-shot (transitory) adjustments to earnings. The earnings impact depends on:
Whether the tax rates are increased or decreased.
Whether the firm has net deferred tax assets or net deferred tax liabilities.
The magnitude of the deferred tax balance.
13-23

24. Understanding income tax note disclosures: Tax expense components
Taxes due
Due to temporary differences in revenue and expense items reported on Deere’s 2012 GAAP income statement versus what was reported on its 2012 tax return.
GAAP tax expense
13-24

25. Understanding the tax footnote: Intraperiod tax allocation
This reconciliation is required under GAAP rules for income tax disclosure
The divergence between the statutory tax rate and the effective tax rate arises from:
Permanent difference items
State and local taxes
Differential tax rates in foreign jurisdictions
Various tax credits
13-25

26. Understanding the tax footnote: Intraperiod tax allocation
Items 6 and 7 represent the deferred tax item balances at December 31, 2012
13-26

27. Measuring and Reporting Uncertain Tax Positions
Tax position – refers to a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current taxes payable or deferred income taxes. Uncertain tax positions arise, for example, when the firm claims a deduction for an expense that the IRS auditors may later disallow
GAAP procedures require a two-step process to determine how much benefit to recognize from an uncertain tax position and how to report its tax contingency reserve as a liability for unrecognized tax benefits.
Step 1 – determine if the threshold of more likely than not (more than 50%) is applicable.
Step 2 – measure the tax benefit as the largest amount of benefit that is greater than 50% likely of being realized.
Recorded as an increase in the Tax Contingency Reserve account
13-27

28. Assessing Disclosures on Uncertain Tax Positions
13-28

29. Understanding the tax note: Analytical insights
Large increases in deferred income tax liabilities are a potential sign of deteriorating earnings quality.
Consider ChipPAC. The depreciation-induced increase in the company’s deferred tax liability could be due to:
Growth in capital expenditures
Change in estimated useful lives of existing equipment
Sudden decreases in deferred income tax assets are also a potential sign of deteriorating earnings quality.
13-29

30. Extracting Analytical Insights from Note Disclosures
Elsewhere ChipPAC said it increased the estimated useful lives of certain equipment from 5 to 8 years. This change decreased depreciation expense for the year by $29 million.
13-30

31. Understanding the tax footnote: Using Deferred Tax Footnotes to Assess Earnings Quality
On January 1, 2014 Carson Company begins offering a one-year warranty on all sales. Its 2014 sales were $20 million, and Carson estimates that warranty expenses will be 1% of sales or $200,000. Warranty expense of $200,000 is deducted on Carson’s books in Tax deductions for warranties in 2014 are zero.
Shows that the deferred income tax asset balance will remain stable if the warranty estimate is accurate and if sales volume is unchanged.
13-31

32. Using Tax Notes to Improve Interfirm Comparability
Cubic’s10-K states:
Nanometrics’10-K states:
13-32

33. Using Tax Notes to Improve Interfirm Comparability
13-33

34. Global Vantage Point
Key differences between IFRS and U.S. GAAP income tax accounting rules
Difference
GAAP
IFRS
Approach for recognizing deferred tax assets
Uses a valuation account for deferred tax asset if book basis is different from the tax basis
No valuation account
Reconciliation of statutory and effective tax rates
Uses the domestic federal statutory rate
Uses a statutory rate
Reporting of deferred taxes on the balance sheet
Classifies deferred tax assets and liabilities as current or noncurrent depending on the nature of the temporary difference
Deferred tax assets and liabilities are reported as noncurrent
Disclosure of income tax amount recognized directly in equity
Not required
Must disclose the aggregate amount of current or deferred income tax income or expense to Other Comprehensive Income
Uncertain tax positions
Extensive guidance under FASB ASC 740
No specific guidance. IAS 12 calls for tax assets and liabilities to be measured at the amount expected to be paid
13-34

35. Summary
The rules for computing income for financial reporting purposes—book income—differ from those for computing income for tax purposes.
The differences between book income and taxable income are caused by both permanent and temporary (timing) differences in the revenue and expense items reported on a company’s books versus its tax return.
Temporary differences give rise to both deferred tax assets and deferred tax liabilities.
Deferred tax accounting allows firms to report tax costs (or benefits) on the income statement in the same period as the related revenue or expense items are reported (matching principle).
13-35

36. Summary concluded
The income tax foot provides useful information for understanding how much tax is paid and how much is deferred each year. Tax notes also help explain why effective tax rates may differ from the statutory rate.
Tax notes provide useful information that can be exploited to improve interfirm comparability and evaluate firms’ earnings quality.
GAAP disclosures are useful in assessing a firm’s uncertain tax positions and whether the firm is aggressive or conservative in recognizing the benefits associated with these positions.
There are a number of differences between IFRS and U.S. GAAP rules for accounting for income taxes that you should be aware of.
13-36