1. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Income Taxes Chapter 16 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

2. Learning Objectives 1.Understand the concept of deferred taxes and the distinction between permanent and temporary differences. 2.Compute the amount of deferred tax liabilities and assets. 3.Explain the provisions of tax loss carrybacks and carryforwards, and be able to account for these provisions.

3. Learning Objectives 4.Schedule future tax rates, and determine the effect on tax assets and liabilities. 5.Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities. 6.Comply with income tax disclosure requirements associated with the statement of cash flows. 7.Describe how, with respect to deferred income taxes, International Accounting Standards have converged toward the U.S. Treatment.

4. Overview The primary goal of financial accounting is to provide useful information to management, stockholders, creditors, and other properly interested. The primary goal of the income tax system is the equitable collection of revenue.

5. Deferred Income Tax Overview Two basic considerations in U.S. corporations computed net income. 1.How to account for revenues and expenses that have already been recognized and reported to shareholders in a company’s financial statements but will not affect taxable income until subsequent years.

6. Deferred Income Tax Overview Two basic considerations in U.S. corporations computed net income. 2.How to account for revenues and expenses that have already been reported to the IRS but will not be recognized in the financial statements until subsequent years.

7. Stop and Think This discussion mentions two sets of books the financial and the income tax records. Which ONE of the following is the most important third set of accounting records in a well-run business?

8. Simple Deferred Income Tax Liability Examples: –Revenues (or gains) taxable after they are recognized for financial reporting, such as receivables from installment sales. –Expenses (or losses) deductible for tax purposes before they are recognized for financial reporting purposes, such as accelerated tax depreciation.

9. Simple Deferred Tax Liability In 2007, Hernandez Company earned revenues of $30,000. Hernandez has no expenses other than income taxes. In this case, Hernandez is taxed on cash received. The company received $10,000 in 2007 and $20,000 in 2008. The income tax rate is 40% and it is expected to remain the same into the foreseeable future.

10. Simple Deferred Tax Liability Income Tax Expense12,000 Income Taxes Payable4,000 Deferred Tax Liability8,000 $30,000 x.40 $10,000 x.40$20,000 x.40 Hernandez Company Income Statement For the Year Ended December 31, 2007 Revenues$30,000 Income tax expense: Current$4,000 Deferred 8,000 Net income$18,000

11. Simple Deferred Income Tax Asset Examples: –Expenses (or losses) that are deductible for tax purposes after they are recognized for financial reporting purposes, such as warranty expenses. –Revenues (or gains) that are taxable before they are recognized for financial reporting purposes, such as subscriptions received in advance.

12. Simple Deferred Tax Asset In 2007, Shah Corporation generated service revenues totaling $60,000, all taxable in 2007. No warranty claims were made in 2007, but Gupta estimates that in 2008 warranty costs of $10,000 will incurred for claims related to 2007 service revenues. Assume a 40% tax rate.

13. Simple Deferred Tax Asset Income Tax Expense20,000 Deferred Tax Asset4,000 Income Taxes Payable24,000 $30,000 x.40 $10,000 x.40$20,000 x.40 Shah Company Income Statement For the Year Ended December 31, 2007 Revenues$60,000 Less: Warranty Expense 10,000 Income before taxes 50,000 Income tax expense: Current$24,000 Deferred benefit (4,000)20,000 Net income$30,000

14. Temporary Differences Permanent Differences- Nondeductible expenses or nontaxable revenues that are recognized for financial reporting purposes but are never part of taxable income. Temporary Differences- Differences between pretax financial income and taxable income arising from business events that are recognized for both financial and tax purposes, but in different time periods.

15. Stop and Think How can a company have both deferred tax assets and deferred tax liabilities at the same time?

16. Example of Permanent and Temporary Differences For the year ended December 31, 2007, Monroe Corporation reported net income before taxes of $420,000. This amount includes $20,000 of nontaxable revenues and $5,000 of nondeductible expenses. The depreciation method used for tax purposes allowed a deduction that exceeded the book approach by $30,000.

17. Example of Permanent and Temporary Differences Pretax income from income statement$420,000 Add (deduct) permanent differences: Nontaxable revenues$(20,000) Nondeductible expenses 5,000 (15,000) Financial income subject to tax$405,000 Add (deduct) temporary differences: Excess of tax depreciation over book depreciation (30,000) Taxable income$375,000 Tax on taxable income (income taxes payable): $375,000 x.35 $131,250

18. Annual Computation of Deferred Tax Liabilities & Assets Advantages of the asset and liability method: 1.Assets and liabilities are recorded in agreement with FASB definitions of financial statement elements. 2.Method is flexible and recognizes changes in circumstances and adjusts the reported amounts accordingly. 3.Has better predictive value.

19. Annual Computation of Deferred Tax Liabilities and Assets Identify type and amounts of existing temporary differences. Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized. Measure the deferred tax liability for taxable temporary differences (use enacted rates). Measure the deferred tax asset for deductible temporary differences (use enacted rates).

20. Example 3 Deferred Tax Liability For 2007, Roland computes pretax financial income of $75,000. The only difference between financial and taxable income is depreciation. The enacted tax rate is 40%. The 2007 tax is $24,000 (40% of $60,000). Financial income subject to tax$75,000 Deduct temporary difference: Excess of tax depreciation ($40,000) over book depreciation ($25,000) (15,000) Taxable income$60,000

21. Example 3 Deferred Tax Liability Income Tax Expense30,000 Income Taxes Payable24,000 Deferred Tax Liability— Noncurrent6,000 $30,000 – $6,000 $15,000 x.40 Journal entry for 2007

22. Stop and Think How might the current and deferred income tax numbers for 2008 change if the 2008 income tax rate were 40% but Roland expected tax rates in future periods to be 30% instead of 40%.

23. Example 3 Deferred Tax Liability For 2008, Roland earned income of $75,000 and the taxable income is $70,000, or a tax of $28,000. Financial income subject to tax$75,000 Deduct temporary difference: Excess of tax depreciation ($30,000) over book depreciation ($25,000) (5,000) Taxable income$70,000 Tax @ 40%$28,000

24. Example 3 Deferred Tax Liability Income Tax Expense30,000 Income Taxes Payable28,000 Deferred Tax Liability— Noncurrent2,000 $30,000 – 2,000 $5,000 x.40 Journal entry for 2008 Depreciation expense in 2009 is the same for both financial and tax, so the entry is simple. Income Tax Exp.30,000 Income Taxes Pay.30,000

25. Example 3 Deferred Tax Liability For 2010, Roland earned income of $75,000 and the taxable income is $95,000, or a tax of $38,000. Financial income subject to tax$75,000 Add temporary difference: Excess of book depreciation ($25,000) over tax depreciation ($5,000) 20,000 Taxable income$95,000 Tax @ 40%$38,000

26. Example 4: Deferred Tax Asset Income Tax Expense30,000 Deferred Tax Liability— Noncurrent8,000 Income Taxes Payable38,000 $30,000 +8,000 $20,000 x.40 Journal entry for 2010

27. Example 4: Deferred Tax Asset Some possible sources of taxable income to be considered in evaluating the realistic value of a deferred tax asset are: Future reversals of existing taxable temporary differences. Future taxable income exclusive of reversing temporary differences. Taxable income in prior (carryback) years.

28. Example 4: Deferred Tax Asset For 2007, Sandusky Inc. computes pretax financial income of $22,000. The only difference between financial and taxable income is the recognition of warranty expense. Accrued warranty expense for 2007 was $18,000; no actual warranty expenditures were made in 2007. The warranty obligation is considered one-third current and two- thirds noncurrent.

29. Example 4: Deferred Tax Asset Financial income subject to tax$22,000 Add temporary difference: Excess of warranty expense ($18,000) over warranty deductions ($0) 18,000 Taxable income$40,000 Taxable income in 2007 is calculated as follows: Tax ($40,000 x.40)$16,000

30. Example 4: Deferred Tax Asset Income Tax Expense8,800 Deferred Tax Asset—Current2,400 Deferred Tax Asset— Noncurrent4,800 Income Taxes Payable16,000 1/3 x $7,200 Journal entry for 2007 $18,000 x. 40 = $7,200 2/3 x $7,200 $16,000 – 7,200

31. Example 4: Deferred Tax Asset In the years 2008 through 2010, taxable income would be $16,000, computed as follows: Financial income subject to tax$22,000 Reversal of temporary difference: Excess of warranty deductions (1/3 x $18,000) over warranty expense ($0) (6,000) Taxable income$16,000 Tax ($16,000 x.40)$ 6,400

32. Example 4: Deferred Tax Asset Income Tax Expense11,200 Deferred Tax Asset— Current2,400 Deferred Tax Asset— Noncurrent2,400 Income Taxes Payable6,400 Journal entry for 2008

33. Example 4: Deferred Tax Asset Income Tax Expense11,200 Deferred Tax Asset— Current2,400 Deferred Tax Asset— Noncurrent2,400 Income Taxes Payable6,400 Journal entry for 2009

34. Example 4: Deferred Tax Asset Income Tax Expense8,800 Deferred Tax Asset— Current2,400 Income Taxes Payable6,400 Journal entry for 2010

35. Example 5: Deferred Tax Liabilities and Assets For 2007, Hsieh reported pretax financial income of $38,000. As of December 31, 2007, the actual depreciation expense was $25,000 and the actual warranty expense was $18,000. For income tax reporting, these expenses were $40,000 and $0, respectively.

36. Example 5: Deferred Tax Liabilities and Assets Financial income subject to tax$38,000 Add (deduct) temporary difference: Excess of warranty expense over warranty deductions 18,000 Excess of tax depreciation over book depreciation(15,000) Taxable income$41,000 Taxable income in 2007 is calculated as follows: Tax ($41,000 x.40)$16,400

37. Example 5: Deferred Tax Liabilities and Assets Income Tax Expense16,400 Income Taxes Payable16,400 Journal entry for 2007 Deferred Tax Asset—Current2,400 Deferred Tax Asset— Noncurrent4,800 Income Tax Benefit1,200 Deferred Tax Liability— Noncurrent6,000

38. Valuation Allowance for Deferred Tax Asset Statement No. 109 stipulates that both positive and negative evidence be considered when determining whether deferred tax assets will be fully realized.

39. Stop and Think In what way do the data regarding deferred tax assets and liabilities provide valuable information to current and potential investors and creditors?

40. Carryback and Carryforward of Operating Losses Loss Year -2 Year +20 Carryback Election Carryforward Election

41. Stop and Think These net operating loss carrybacks sound like a great feature of the tax law. However, what did the company have to do to take advantage of this aspect of the law?

42. Net Operating Loss (NOL) Carryback YearTax Rate Income Tax Income (Loss) 2007$10,00035%$3,500 200814,000304,200 2009(19,000)300 Journal Entry in 2009: Income Tax Refund Receivable 6,200 Income Tax Benefit From NOL Carryback 6,200 [ $3,500 + (30% x $9,000) ]

43. Accounting for NOL Carryforward Continuing with the Prairie Company illustration, assume that in 2010 the firm incurred an operating loss of $35,000. Year Income (Loss) Tax Rate Income Tax 2009$(19,000) 30%$0 20010(35,000) 30%0 The only loss remaining against which operating income can be applied is $5,000 from 2008 ($14,000 – $9,000). This leaves $30,000 to be carried forward from 2009 as a future tax benefit of $9,000 ($30,000 x.30).

44. Accounting for NOL Carryforward Income Tax Refund Receivable1,500 Deferred Tax Asset—NOL Carryforward9,000 Income Tax Benefit from NOL Carryback1,500 Income Tax Benefit from NOL Carryforward9,000 The journal entry for 2010 to record the tax benefits :

45. Accounting for NOL Carryforward Journal Entry: Income Tax Expense15,000 Income Taxes Payable6,000 Deferred Tax Asset—NOL Carryforward 9,000 The firm reports a taxable income of $50,000 in 2011. The tax carryforward allows management to deduct the carryforward from the $15,000 tax ($50,000 x.30) that would be due without the carryforward.

46. Accounting for NOL Carryforward If management believes that losses will continue in the future and the tax benefit will not be realized: Journal Entry: Income Tax Refund Receivable1,500 Deferred Tax Asset—NOL Carryforward9,000 Income Tax Benefit from NOL Carryback1,500 Allowance to Reduce Deferred Tax Assets to Realizable Value— NOL Carryforward9,000 As a result of this entry, the deferred tax asset is zero—the expected realizable value.

47. Scheduling for Enacted Future Tax Rates Proper recognition of deferred tax assets and liabilities is required when future tax rates are expected to differ from current tax rates. The firm must determine the temporary differences that will reverse. Statement No. 109 eliminates much of the need for scheduling through the “more- likely-than-not” criterion for future income.

48. Financial Statement Presentation and Disclosure The following items must appear in the income statement or an accompanying note: Current tax expense or benefit Deferred tax expense or benefit Investment tax credits Government grants recognized as tax reductions

49. Financial Statement Presentation and Disclosure The following items must appear in the income statement or an accompanying note: Benefits of NOL carryforwards Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of an enterprise Adjustments in beginning-of-the-year valuation allowance because of a change in circumstances

50. Stop and Think What is the rationale behind excluding from a corporation’s taxable income dividends received from another corporation?

51. Deferred Taxes and the Statement of Cash Flows Callazo Company had the following information for 2007: Revenue (all cash) $30,000 Income tax expense: Current $10,300 Deferred 1,700(12,000) Net income $18,000 Cash paid for income taxes during 2007 totaled $13,300.

52. Deferred Taxes and the Statement of Cash Flows 12/31/07 Income tax refund receivable$2,000$ 0 Income taxes payable01,000 Deferred tax liability9,7008,000 Analysis Income Statement Adjustment SCF Revenue (all cash), $30,000No adjustment$30,000 cash collected from customers

53. Deferred Taxes and the Statement of Cash Flows Analysis Income Statement Adjustment SCF Income tax expense—current–$2,000—$(13,300) Cash $(10,300)Increase inpaid for taxes tax receivable –$1,000— Decrease in taxes payable

54. Deferred Taxes and the Statement of Cash Flows Analysis Income Statement Adjustment SCF Income tax expense—deferred+$2,000— No effect $(1,700)Increase in deferred tax liability

55. Deferred Taxes and the Statement of Cash Flows Analysis Income Statement Adjustment SCF Net income, $18,000–$1,300$16,700 Cash flow from operations Collazo Company Statement of Cash Flows (Direct Approach) Cash collected from customers$30,000 Income taxes paid(13,300) Cash provided by operating activities$16,700

56. Deferred Taxes and the Statement of Cash Flows Collazo Company Statement of Cash Flows (Indirect Approach) Net income$18,000 Decrease in income tax refund receivable(2,000) Decrease in income taxes payable(1,000) Increase in deferred tax liability 1,700 Cash provided by operating activities$16,700

57. International Accounting for Deferred Taxes No-Deferral Approach- Ignore the differences and report income tax expense equal to the amount of tax payable for the year. Comprehensive Recognition Approach- Deferred taxes are included in the computation of income tax expense and reported on the balance sheet. Partial Recognition Approach- A deferred tax liability is recorded only to the extent that the deferred taxes are actually expected to be paid in the future.