Presentation on theme: "Income Taxes RCJ Chapter 13. Paul Zarowin2 Key Issues 1.Book (financial statement) vs. taxable income 2.Permanent differences 3.Effective vs. statutory."— Presentation transcript:
Paul Zarowin2 Key Issues 1.Book (financial statement) vs. taxable income 2.Permanent differences 3.Effective vs. statutory tax rates 4.Temporary (timing) differences 5.Deferred taxes: Assets, Liabilities, Expense 6.Possible cases and examples 7.Components of income tax expense (current vs deferred) 8.Tax journal entries 9.Originating vs reversing differences 10.Asset, Liability (B/S) method vs I/S method 11.NOL carryback and carryforward 12.Deferred tax asset valuation allowance 13.Footnote disclosures:
Paul Zarowin3 3 Parts of Tax Disclosure 1.Current vs. deferred expense 2.Reconciliation between statuary vs. effective tax rates 3.Changes in Deferred Tax (DT) assets/liabilities and/or components of DT expense.
Paul Zarowin4 Key Identity Pre-tax book (accounting) income ± Permanent differences ± Temporary differences = pre-tax taxable income ex. E13-7, E13-8 (Kent), P13-4 (Joy)
Paul Zarowin5 Permanent Differences Definition: Items of revenue or expense that are in book (or taxable) income of a period, but never part of taxable (or book) income. 2 types: 1.non-taxable revenues 2.non-deductible expenses (ex. GW amortization) ex. E13-7 Exhibit 13.2, Pg. 690 (ex. interest income on municipal bonds)
Paul Zarowin6 Importance of Permanent Differences: Effective vs. Statutory Tax Rate def: effective tax rate (ETR) = def: statutory tax rate (STR) = rate set by government permanent diffs cause ETR STR non-taxable revenues lower the ETR non-deductible expenses raise the ETR ex. E13-7, E13-8 (Kent) tax expense pre-tax (book) income
Paul Zarowin7 Temporary (Timing) Differences Temp. diff. cause deferred tax assets, liabilities, expense Definitions: Temp diff: item of revenue or expense that are part of book and taxable income, in different periods Deferred tax asset: future tax deductible due to current timing difference Deferred tax liability: future tax payable due to current timing difference Q: What is sum of temporary differences over firm ’ s life? ex. E13-7
Paul Zarowin8 4 Possible Types of Timing Differences RevenuesExpenses recognize for books before taxes 1. Accrued (asset) revenue 3. Accrued (liab) expense recognize for taxes before books 2. Deferred (unearned) revenue 4. Deferred (prepaid) expense
Paul Zarowin9 Ex. 1. accrued asset, receivable Books = accrual accounting Taxes = cash accounting DR CR DR CR A/R 100 Rev 100 N/A DR CR DR CR Cash 100 A/R 100 Cash 100 Rev 100 Note: total revenue is the same, just timing differs period 1: period 2:
Paul Zarowin10 Ex. 2. unearned revenue Books = accrual accounting Taxes = cash accounting DR CR DR CR Cash 100 Liab 100 Cash 100 Rev 100 DR CR DR CR Liab 100 Rev 100 N/A Note: total revenue is the same, just timing differs period 1: period 2:
Paul Zarowin11 Ex. 3. accrued liability, payable Books = accrual accounting Taxes = cash accounting DR CR DR CR Exp 100 Liab 100 N/A DR CR DR CR Liab 100 Cash 100 Exp 100 Cash 100 Note: total expense is the same, just timing differs period 1: period 2:
Paul Zarowin12 Ex. 4. prepaid expense Books = accrual accounting Taxes = cash accounting DR CR DR CR Asset 100 Cash 100 Exp 100 Cash 100 DR CR DR CR Exp 100 Asset 100 N/A Note: total expense is the same, just timing differs period 1: period 2:
Paul Zarowin13 Timing Differences: Relation to Deferred Tax Assets, Liab. RevenuesExpenses recognize for books before taxes 1. Deferred tax liability 3. Deferred tax asset recognize for taxes before books 2. Deferred tax asset 4. Deferred tax liability
Paul Zarowin14 Components of Tax Expense and Tax JE Components of tax expense: 1.DR current tax expense a CRCash or taxes payable a) Current tax expense = taxable inc.*current statutory tax rate 2.DR deferred tax expense b CRDeferred tax asset/liability b) Deferred tax expense = net in deferred tax asset/liability Assumes positive taxable income 1. current (pay now); and 2. deferred (paid before or after) can DR or CR deferred tax expense, depending on net deferred tax asset/liability
Paul Zarowin15 Components of Tax Expense (cont ’ d) Alternatively, 3.DR total tax expense c CRDeferred tax asset/liability CR Cash c) Total tax expense = current + deferred ex. E13-7
Paul Zarowin16 Deferred Tax Accounting = Inter-period Tax Allocation T otal income tax expense = Current (paid now) +Deferred (paid both before or after)
Paul Zarowin17 Originating vs. Reversing Timing Diff. Originating differences create deferred tax assets (DR); and liabilities (CR) Reversing differences reduce deferred tax assets (CR) and liabilities (DR)
Paul Zarowin18 Examples of Deferred Tax Assets/Liab 1.Installment sale; revenue is recognized up front for financial reporting, but is recognized for tax purposes later, when cash is received each period. 2.Prepayment; revenue is recognized for tax purposes up front as cash is received, while accrual accounting delays revenue recognition until revenue is earned later. 3.Bad debts expense. The allowance method for books recognizes the expense in the period of sale by the adjusting entry (matching principle), while the direct write-off method recognizes the expense in a later period, when the receivable is actually written off.
Paul Zarowin19 Examples of Deferred Tax Assets/ Liab (cont ’ d) 4.depreciation expense; firms use an accelerated method for taxes and SL for books. This combination recognizes some depreciation for taxes first and for books later. RCJ give additional examples of revenues and expenses that produce deferred tax assets and liabilities in Exhibit 13.1, Pg. 689-90.
Paul Zarowin20 Calculation of Deferred Tax Expense, Asset, Liability: B/S Method 1.deferred tax asset/liability = cumulative timing difference * STR 2.deferred tax expense = net in deferred tax asset/liability B/S method (also called asset/liability method) use STR expected to be in effect when timing difference reverses so, if STR changes, calculate deferred tax asset/liability as per (2), and calculate deferred tax expense = deferred tax asset/liability I/S method for constant STR only, deferred tax expense = current year’s timing difference * STR B/S method is or constant or changing STR ex. E13-3 different rates over time, vs. E13-2 change in rates
Paul Zarowin21 Deferred Tax Asset, Liability and Expense Depend on Tax Rate Key point: Deferred tax asset, deferred tax liability and deferred tax expense depend on the tax rate. Ex. E13-8, E13-9, E13-10
Paul Zarowin23 Net Operating Loss (NOL) NOL = negative taxable income Book income may be either positive or negative NOL can be carried back or forward NOL carryback: Get a refund of past taxes paid: DRcash or tax refund receivable CR(current) income tax expense The maximum carryback period is 2 years (offset the earlier year first, as in FIFO)
Paul Zarowin24 Net Operating Loss (cont ’ d) NOL carryforward: Offset future income (also FIFO), reducing future taxes payable: DRdeferred tax asset CR(deferred) income tax expense This is another reason for deferred tax asset in addition to timing differences. A firm can carryforward an NOL for up to 20 years. EX. E13-13, 14, 16
Paul Zarowin25 Incentives for Carryback vs. Carryforward 1.Can ’ t carryback because of 2 years of losses 2.Time value of money: get the cash ASAP carryback 3.If tax rates are expected to rise, a dollar of deduction will be worth more carryforward ex. P13-7
Paul Zarowin26 Deferred Tax Asset Valuation Allowance 1.Record the deferred tax asset in the usual way (as if there were no valuation allowance) 2.Make an additional entry: DR (deferred) income tax expense CRdeferred tax asset valuation allowance increasing (decreasing) the allowance increases (decreases) deferred income tax expense allowance’s existence and magnitude reveals management’s expectation of future earnings. management can use changes in the allowance to manipulate NI, by affecting income tax expense. ex. E13-17 Contra-asset account (CR balance on the B/S ; eg, acc’d depreciation or AUA) that reduces the deferred tax asset to its expected realizable value
Paul Zarowin27 Financial Statement Disclosures I/S : total income tax expense B/S: net current and net non-current deferred tax asset or liability Footnote disclosure: 1.Current and deferred components of total income tax expense (from Income From Continuing Operations, because the below the line components are shown net of tax). 2.Reconciliation between the federal statutory and effective tax rates (in $ and/or %). C13-1, 2, 3, 5, 6
Paul Zarowin28 Financial Statement Disclosures (cont ’ d) 3a. components of deferred tax assets and liabilities and/or 3b. Components of deferred tax expense (e.g., revenue and expense items that cause the deferred tax expense, assets, liabilities, such as depreciation, bad debts, installment sales, etc.)
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