Presentation on theme: "Accounting for Income Taxes"— Presentation transcript:
1 Accounting for Income Taxes ACCTG 5120David Plumlee
2 Accounting for Income Taxes Why do accountants record Deferred Taxes?Income is measured in two different ways, taxable income and GAAP income. Deferred taxes result from timing differences between these two.
3 Accounting Income = Taxable Income Why are GAAP and tax income computed differently?Tax income is intended toraise sufficient tax revenuesstimulate or depress certain sectors of the economyGAAP is intended to provide relevant, reliable and representationally faithfulGAAP is full accrual, while tax is accrual with some cash basis adjustments.
4 Inter-period Tax Allocation From an income statement perspective what is the justification for inter-period tax allocation?It improves matching of tax expense to related accounting income.From a balance sheet perspective what is the justification for inter-period tax allocation?to summarize:I can offer to arguments to justify interperiod tax allocationfirst: from an income statement perspective - accountants do interperiod tax allocation because they want to do a better job of matching tax expense to accounting income than would be possible without itsecond: from an income statement perspective - accountants want to disclose the fact that from an accounting perspective taxes may be prepaid giving rise to a deferred tax asset that should be recorded on the balance sheet or taxes may be underpaid giving rise to a deferred tax liability that needs to be recordedreally these are two sides of the same cointhink back to our last examplesince we paid $2,700 in taxes in the first year but only expensed $1,350 the extra $1,350 represents a prepayment of tax -- a deferred tax asset to the company that will get consumed in 1995so the income statement impact of the allocation is that we get better matching and the balance sheet impact is that we get to record an asset representing the taxes paid but not incurred by the end of 1994questions on this?these are not easy concepts so be patient...It allows recognition of deferred tax assets and liabilities associated with future deductible and future taxable amounts.
5 A Simple ExampleAssume that $9,000 is received on day 1, year 1 in payment of year 1 and year 2 rent ($4,500/year). What is the taxable and accounting income for each of these years?
6 “Cash” Basis No matching of Tax Expense to related accounting income. Assume a tax rate of 30%, then the $2,700 of income tax would be paid in 2003.What is wrong with this approach?No matching of Tax Expense to related accounting income.
7 “Accrual” Basis Using Interperiod Tax Allocation: Total tax expense is still $2,750, but:net income better reflects “effort”effective tax rate reflects statutory rateless volatility in earnings
8 Is a deferred tax really a liability? Some say yeseventually the timing difference will be reversed and the tax recorded in the deferred tax liability account will become payablefuture cash outflow in the amount of the deferred tax liability (asset) will occurSome say nomany reversing temporary differences continually replaced with new originating temporary differencesin reality deferred income tax liabilities continually grownet temporary differences do not require future cash outflowsnot a legal obligation of the firm until tax return filed
9 Permanent Differences A difference arising from an item that enters into accounting income but never taxable income (interest on state issued bonds)or enters into taxable income but never accounting income (excess depletion on wasting assets)lets start with permanent differences and illustrate why permanent differences do not give rise to deferred tax balancesa permanent difference arises when an item gets included in accounting income that will never get included in taxable income or gets included in taxable income that will never get included in accounting incomeit is very important that we be able to distinguish between permanent differences and temporary differences because we never want to record deferred taxes or tax expense on permanent differences, while we do record deferred taxes arising from permanent differencesto see why lets consider interest income on a state bonds
10 Examples of Permanent Differences Interest on state/municipal bondsProceeds from executive life insurancePremiums paid on executive life insuranceFines due to violations of the lawDividend received deduction - 70% - 80% of dividends received from U. S. corporationsExcess depletion on wasting assetshere’s a listwe just finished looking at interest on government bonds - this is interest income that is included in accounting income but will never be subject to income taxproceeds from a life insurance policy we had on one of our executives - considered accounting income but never taxableetc.dividend received deduction - when one us company gets dividends from another us company they don’t have to pay tax on a large portion of the dividends (usually, depending on percentage ownership 70-80% is sheltered from tax)100% of the dividends are considered income for accounting purposes under FAS 115 but only 20% is ever taxed the other 80% gives rise to a permanent differencequestionswell if that’s a permanent difference what’s a temporary difference?
11 Example: Interest Income on State Bonds A company receives $1,000 in interest income on state bonds and tax rate is 45%. The company NEVER pays tax on this income. What if we did this?tax expensedeferred tax liability 450lets say company A receives 1,000 in interest income on state bondsassume that this is the only income the company had and it has no expensesinterest income on government bonds is not taxablebut what if we ignored that and went ahead and did an entry to record tax expense on the interest income anywayso we debit tax expense 450 and since we aren’t paying the tax this year we credit a deferred tax liability 450what’s wrong with this picture?when is the $450 in tax ever become do and payable? - neverso when is the deferred tax liability ever going to get paid off? - neverso the deferred tax liability would just sit on the balance sheet foreveralso, does it make sense to record tax expense when in fact there never will be any taxes paid on the interest income? - noso what should the company do? they should make no entry to record tax expense on items that are identified as permanent differencesso if this were a real company that we were dealing with they would say well we have accounting income of $450 and tax expense of $0what are some other kinds of items that cause permanent differences between accounting income and taxable income?Deferred tax would stay on the books forever!
12 Temporary Differences A difference between an asset or liability’s tax basis and its amount for accounting purposes that will result in taxable or deductible amounts in future yearsOr, a difference between in the financial and tax amounts for income (or expense) in a given year (or years)a temporary difference is an item that enters into both the computation of accounting income and taxable income but at different points in timein other words because of differences in timing these are items that cause accounting income and taxable income to be different but only temporarilyfor example, earlier we talked about depreciable property where the tax department allows the company to write the cost off over two years but for accounting purposes the cost is written off over ten yearsover the entire ten year period the same total cost will be written off for both accounting and tax purposes but the timing of the write off will be different so that from year 1 through 10 there will be differences between accounting income and taxable income even though over the entire ten year period total accounting income and total taxable income would be equalbecause we are depreciating the asset at different rates for tax and accounting purposes the NBV of the asset from a tax point of view (refer to this as the tax basis of the asset) and the NBV of the asset from an accounting point of view (refer to this as the accounting basis of the asset) will be differentit is this difference that is referred to in the definition of a temporary differencespecifically, a temporary difference is defined as the difference between the tax basis of an asset or liability and its reported amount for accounting purposes that will result in taxable or deductible amounts in future yearssince this may still not be perfectly clear lets look at a simple example
13 How do we get taxable income? Start with GAAP/financial ‘books’Make tax-related adjustmentspermanent items that are in accounting income but not taxable or vice versatemporary/timing items that are included in financial income at a different time than taxable incomeComplete tax return and pay required taxes (taxes payable)
14 Temporary Difference - Example A company purchases an asset for $100,000.Depreciation expense:accounting - straight-line over 4 yearstax - straight-line over 2 years
18 AJE to Record Tax Expense What is the balance in Deferred Tax Liability at the end of year 2?($25,000+25,000) x 40% = $20,000What is adjusting entry at the end of year 2?tax expense $40,000tax payable $30,000deferred tax liability $10,000
20 AJE to Record Tax Expense What is the balance in Deferred Tax Liability at the end of year 3?($25,000+25,000-25,000) x 40% = $10,000What is the entry to record tax expense for year 3?so the journal entry to record tax expense in year 3 would look like thisnotice that as the temporary differences reverse, the balance in the deferred tax account is drawn downby the end of year three - the cumulative temporary difference is sitting at $25,000 (the difference between the accounting basis and the tax basis of the asset)and the deferred tax liability associated with that cumulative difference (computed at a rate of 40%) has dropped to 10,000 - the opening balance in the deferred tax liability account of $20,000 minus this years reduction in liability of $10,000if we were to look at the entry for year four what would we see happening to the deferred tax liability - it would be reduced by another $10,000 to zeroand the cumulative temporary differences at that point in time would be zero alsothe example we just looked at was just one kind of temporary difference - the difference arising because we typically depreciate assets faster for tax purposes than we depreciate then for accounting purposeshowever, there are many items which eventually impact both accounting income and taxable income by the same amount but only the timing of the inclusion is differentthe handout entitled “temporary differences” lists the more common onesgo through handoutquestions so far?Tax Expense $72,000Deferred Tax Liability $10,000Tax Payable $82,000
22 AJE to Record Tax Expense What is the balance in Deferred Tax Liability at the end of year 4?Should be $0, but ($25, ) x 40% +(-25,000)x 30% = 2500What is the entry to record tax expense for year 4?so the journal entry to record tax expense in year 3 would look like thisnotice that as the temporary differences reverse, the balance in the deferred tax account is drawn downby the end of year three - the cumulative temporary difference is sitting at $25,000 (the difference between the accounting basis and the tax basis of the asset)and the deferred tax liability associated with that cumulative difference (computed at a rate of 40%) has dropped to 10,000 - the opening balance in the deferred tax liability account of $20,000 minus this years reduction in liability of $10,000if we were to look at the entry for year four what would we see happening to the deferred tax liability - it would be reduced by another $10,000 to zeroand the cumulative temporary differences at that point in time would be zero alsothe example we just looked at was just one kind of temporary difference - the difference arising because we typically depreciate assets faster for tax purposes than we depreciate then for accounting purposeshowever, there are many items which eventually impact both accounting income and taxable income by the same amount but only the timing of the inclusion is differentthe handout entitled “temporary differences” lists the more common onesgo through handoutquestions so far?Tax Expense $21,000Deferred Tax Liability $ 7,500Tax Payable $28,500
23 Computing Tax Expense*differences that will reverse in the future. If differences are permanent, ignore!Find cumulative temp. basis differences = book - tax *Compute ending deferred tax balance. Prepare a schedule of anticipated reversals and applying appropriate enacted tax ratesComputetaxes payableand so this is why we compute tax expense not by looking directly at accounting income but by computing the changes to deferred taxes and taxes payable and then plugging tax expense to balance the entrythis is summarized by this flow chart which shows the procedures that are followed under FAS 109 to compute tax expensewe went through these steps last class when we looked at a simple example so hopefully they are somewhat familiarfirst we compute the cumulative temporary differences by taking the difference between the book basis and the tax basis for items giving rise to temporary differencesso for depreciable property for example the cumulative temporary difference is the difference between the book value of the asset for accounting purposes and the book value of the asset for tax purposesthis is the sum of all of the temporary differences arising to date on the item under considerationthen we prepare a schedule of when we expect the temporary differences to reverse and multiply those amounts by the enacted tax rates that are expected to be in effect at the timeadding all of the amounts together gives the balance in the deferred tax asset or liability that we want to show on our balance sheetwe then compute the change in deferred taxes by comparing the closing balance just computed to the balance currently sitting in the accountthis gives us the amount that we need to debit or credit to deferred taxesthen we compute taxable income just like we did before, starting with accounting income and making all the necessary adjustments to come down to taxable incomeand then multiplying taxable income by current tax rate to figure out how much tax we actually owewe then plug tax expense for the sum of these two amounts or the difference between them depending on the direction of the deferred tax entryCompute change in Deferred Tax balanceTax Expense = tax payable +/- change in Deferred Tax balance
24 Example Year 2000 pretax accounting income = $500,000 Current tax rate = 40%Deferred Tax liability (Jan 1, 2000) = $320,000Year 2000 depreciationaccounting = $200,000tax = $400,000Municipal Bond Interest $10,000lets say pretax accounting income is, what the current tax rate is and what the opening balance in the deferred tax liability account isand how much was taken for depreciation for accounting purposes this year and how much is allowed for tax purposes this yeargiven that there is still some amount being taken for tax purposes while the year end tax value is zero implies that this was the last year for which any tax depreciation was avail.after this year the asset is fully depreciated for tax purposes and the temporary differences will begin to reverse
25 Example (continued) As at the end of year 2000: Book basis of depreciable assets $1,000,000Tax basis of depreciable assetsCumulative temporary difference $1,000,000Additional information:enacted tax rates as shown in scheduletemporary differences expected to reverse as shown in schedulepiece of cake right!well just in case it’s not perfectly clear lets illustrate with an examplesay that depreciable assets is the only item the company has that gives rise to a temporary differencesay that at the end of the current year the book basis of the depreciable assets is $1millionand the tax basis is $0 giving rise to cumulative temporary differences of $1,000,000will this difference have given rise to a deferred tax asset or a deferred tax liabilitysince the book basis is greater than the tax basis this implies that in the past we have taken less depreciation for accounting purposes than for tax purposeswhich implies that accounting income was higher than taxable incomewhich implies that tax expense > taxes payablewhich implies that debits exceeded credits giving rise to the need for a deferred tax liabilityor go to the chart we looked at last day - this is an example of an item which was deductible for tax purposes before it was deductible for accounting purposesas a result compared to accounting we actually paid to little tax in the past so need to set a liability for the tax that will become payable when tax depreciation runs out before accounting deprecation doesin any event the $1,000,000 represents an amount that will give rise to future taxes payable or a deferred tax liability
26 Change in Deferred Tax Balance in class all this information is given to us in reality the first thing the accountant would have to do is prepare a schedule showing when he/she thinks the $1,000,000 cumulative temporary difference will reversethen multiply these amounts by the tax rates expected to be in effect at the time that the reversal is expected to occurin this case the ending deferred tax liability is computed to be $350,000the opening deferred tax liability was $320,000so we have an increase in the liability of $30,000i.e. we are going to have to credit deferred tax liabilities for $30,000Closing deferred tax liability $350,000Opening deferred tax liability ,000Net increase in deferred tax liability $ 30,000
27 Compute Taxes Payable Pre-tax accounting income $500,000 add accounting depr ,000subtract tax depr. (400,000)subtract non-taxable interest ( 10,000)Taxable income $290,000tax rate x 40%Tax Payable (per tax return) $ 116,000next we need to compute how much tax we actually owewe prepare a schedule just like the center column of the worksheet we looked at earlierwe start with accounting income and then add or subtract the necessary amounts to get us down to taxable incomethe non-taxable interest income is a permanent difference so we don’t have to worry about any deferred tax balances related to it so now we have all the information we need to make the entry
28 Journal Entry tax expense (plug) 146,000 tax payable 116,000 deferred tax liability* ,000*since we have a starting balance in DTL account, need to adjust to correct balancethe entry to record tax expense for the year is going to have to credit taxes payable for the amount we actually have to payit credits deferred taxes for the amount needed to adjust the deferred tax balance to the correct closing balance in this case $8,000and the ‘plug’ to balance the entry is a debit to tax expense for $58,000I want to stop here for now and hand back exams
29 Net Operating Losses (NOL) 20 yearsCarry ForwardIf a carryforward thenfuture deductible itemrecord deferred tax asset based on future enacted rate2 yearsCarryBackIf a carryback thenreceive a refund of previous tax paidrecord tax receivable based on prior year rateNOLYearthe next topic we are going to look at is net operating lossesa net operating loss for tax purposes arises when a company has negative taxable incomewhen this occurs the company has a choiceit can carry the loss back an apply it against prior years taxable incomeif the company does this they will receive a refund of taxes paid in the past so we will need to make an entry debiting a income tax refund receivable and crediting income tax expensesince we are getting a refund of prior year taxes paid the amount of the refund we are entitled to will be based on the tax rate that was in effect when the tax was paid originallyso for example, say the tax rate is currently 46% but prior to this year we were only paying at a rate of 34%obviously if we carry back a loss of 100 and claim a refund of taxes previously paid the government is not going to give us $46 when we only paid $34 in the first placenow if the company carries the loss back but even going back the allowable three years does not have enough prior year taxable income to absorb the loss they can carry the loss forward and reduce future taxable income up to 15 years into the futurealternatively the company may choose not to carry the loss back at all even if they could but may choose to carry the full amount forwardwhy might a company do this? - if tax rates in the future are higher than tax rates in the pastwell regardless when a company carries a NOL forward they have a future deductible amount which gives rise to a deferred tax asset
30 Deferred Tax Asset Valuation Allowance Based on all available evidence it is more likely than not that some portion will not be realizedIntended to adjust Deferred Tax asset to expected net realizable valuetax expense xxvaluation allowance xxAdjust to required ending balance each periodthe next topic we are going to spend a few minutes with is the valuation allowancevaluation allowances apply to deferred tax assets onlya valuation allowance should be set up when based on all available evidence, it is more likely than not that some portion of the deferred tax asset will not be realizedfor example, say we set up an accrual for litigation expenses but there is some reason to believe that the company may not have the opportunity to deduct all or a portion of the litigation expenses from taxable incomeperhaps the company is not expected to report enough taxable income to absorb the expenseif this is the case we still go ahead and record the deferred tax asset associated with the litigation expensebut in addition, the company should set up a valuation allowance intended to reduce the deferred tax asset to its expected net realizable valuethe entry to set up the valuation allowance debits tax expense and credits valuation allowance, a contra-account, contra to deferred tax assetat the end of each period the valuation allowance is reconsidered and any adjustments to the balance are made by a debit or credit to the valuation allowance and an offsetting entry to tax expense
31 Deferred Tax Asset Valuation Allowance In year of expected reversal future deductible amounts > future taxable amountsWill there be sufficient future taxable income to absorb the excess?Could the excess be carried back to prior years?if answer is NO - valuation allowance requiredhow does the accountant go about determining if a valuation allowance is necessary and how much it should be?well a good start would be to schedule out the future reversals of deductible and taxable amounts to see if future taxable amounts are sufficient to cover the future taxable amountsif not, then the accountant should ask him or herself two questionsfirst, do I think there will be sufficient future taxable income to absorb the excess of deductible amounts?in other words do I think there will be sufficient taxable income in the future to allow me to deduct these items that are giving rise to the deferred tax assets and if not would I be able to carry back any of the resulting loss associated with an excess of deductible amounts to the preceding three yearsif the answer to these questions is no such that it does not look like the company will be able to use all of its future deductible amounts then a valuation allowance will be needed.we are actually going to come back and look at valuation allowances in detail in P17-15 so unless you have specific questions we’ll leave it for now and come back to the detailed computations on Monday
32 Balance Sheet Presentation Classify deferred tax balances based onclassification of related asset/liabilityexpected reversal date if not relatedFor reporting purposesnet current deferred tax balancenet non-current deferred tax balanceshow deferred tax assets net of valuation allowanceone thing we haven’t talked about at all yet is how deferred tax balances should be disclosed on the balance sheetdeferred tax balances must be classified as current or long-termif the deferred tax balance is related to a particular asset or liability then the classification of the deferred tax balance depends on the classification of the related itemfor example - how would the following deferred tax balances be classifieddeferred tax balance related to differences in depreciation (long-term)deferred tax balance related to warranty liability classified as current (current)deferred tax balance related to installment sales to be collected over a five year period (long-term), some current if there is a current portionwhen a deferred tax item arises due to the difference between the tax basis of a particular asset or liability and its book basis it makes sense that the deferred taxes should be classified on the balance sheet according to the classification to the item but if the deferred tax balance is not associated with any particular asset or liability it is then classified according to the expected reversal dateloss carryforwards give rise to deferred tax assets which are not related to any particular reported asset or liabilityas a result deferred tax assets arising from loss carryforwards are classified as current or long-term based on expected reversal datefor reporting purposes current deferred tax liabilities and assets should be netted together as are long-term deferred tax liabilities and assetsin addition, deferred tax assets should be reported net of a valuation allowance if such an allowance is deemed necessary
33 Intraperiod Tax Allocation Allocation of tax across different sources of income/loss within a given period including:income from continuing operationsdiscontinued operationsextraordinary itemscumulative changes in accounting policyitems charged directly to retained earnings, for exampleprior period adjustmentsmark-to-market adjustments under FAS 115well we’re getting close to this hodge podge of deferred tax items that we had left to look atthe next thing I want to illustrate is intraperiod tax allocationas I’ve stated before intra period tax allocation is the allocation of taxes within a given accounting period across various sources of income or lossit is not to be confused with interperiod tax allocation which is the allocation of taxes through time and the reason why we have deferred tax balancesthe kinds of items that need to have tax allocated to them include.....
34 Intraperiod Tax Allocation A company has ordinary income of $50,000 and extraordinary income of $100,000tax rate is 45%no permanent or temporary differencestax payableon ordinary income = $22,500on extraordinary income = $45,000any way -- why do we do intraperiod tax allocation?because our income statement would look pretty stupid if we didn’t!to illustrate this consider the following simple example...
35 Intraperiod Tax Allocation see how the income statement would appear both with and without intra period tax allocationnotice on the without column that it appears that the company had a whopping tax bill on its income from ordinary operations enough to wipe out income and leave them in a loss positiondoes this make any sense - no!the problem is that the tax expense associated with the extra ordinary item is being matched on the statement against the ordinary incomethis is a bit problematic because analysts and users like to rely on the income from continuing operations as a measure of sustainable incomecharging the extra tax on the extraordinary item with is not expected to happen again by definition through tax expense muddies these waters considerablyso an easy way of getting around this is just to make sure that the tax associated with the extraordinary item gets netted out of the extraordinary item itselfthis gives much better presentation although it does not change the net income figure for the yearany questions on this?