1. Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 18 Income Taxes Chapter 18 Income Taxes

2. 2 Income Taxes Current Income Taxes Accounting income and taxable income Calculation of taxable income Calculation of current income taxes Income Tax Loss Carryover Benefits Introduction to tax losses Loss carryback illustrated Loss carryforward illustrated Carryforward with valuation allowance Review of future income tax asset account Future/Deferred Income Taxes Tax basis Future income tax liabilities Future income tax assets Income tax accounting objectives Multiple differences illustrated Tax rate considerations Presentation, Disclosure, and Analysis Balance sheet presentation Income and other statement presentation Disclosure requirements Analysis Outstanding conceptual questions IFRS / Private Entity GAAP Comparison Comparison chart Looking ahead

3. 3 Income Taxes Current Income Taxes Accounting income and taxable income Calculation of taxable income Calculation of current income taxes Income Tax Loss Carryover Benefits Introduction to tax losses Loss carryback illustrated Loss carryforward illustrated Carryforward with valuation allowance Review of future income tax asset account Future/Deferred Income Taxes Tax basis Future income tax liabilities Future income tax assets Income tax accounting objectives Multiple differences illustrated Tax rate considerations Presentation, Disclosure, and Analysis Balance sheet presentation Income and other statement presentation Disclosure requirements Analysis Outstanding conceptual questions IFRS / Private Entity GAAP Comparison Comparison chart Looking ahead

4. 4 Fundamentals Accounting income (per GAAP) ≠ Taxable income (per Income Tax Act) Accounting income → Income tax expense (current and future) Taxable income → Income tax payable and current income tax expense Income tax expense ≠ Income tax payable

5. 5 Accounting Income and Taxable Income: Reconciliation of Accounting Income and Taxable Income: Accounting income ± differences = Taxable income Taxable income × current tax rate = taxes payable and current income tax expense

6. 6 Future Tax Liability Example Chelsea Inc. - 2010 AccountingTax Revenue$130,000$100,000 Expenses 60,000 Income$ 70,000$ 40,000 Tax @ 40%$ 28,000$ 16,000

7. 7 Future Tax Liability Example Chelsea Inc. 20102011 Accounting Income$70,000 Adjust for revenue taxable in future period (30,000) 20,000 Taxable Income$ 40,000$ 90,000 Tax payable @ 40% $ 16,000$ 36,000 2012 $70,000 10,000 $ 80,000 $ 32,000

8. 8 Permanent, Timing, and Temporary Differences Taxable income is determined by starting with accounting income and adjusting it for permanent and reversible (or timing) differences in the year

9. 9 Permanent Differences - Examples Items, recognized on income statement, but never for income tax purposes: Non-tax-deductible expenses (e.g. fines, golf dues, expenses related to non-taxable revenue) Dividends from taxable Canadian corporations Items, recognized for tax purposes, but not for financial accounting purposes: Depletion allowance of natural resources in excess of cost

10. 10 Summary of Permanent Differences Sources of PERMANENT DIFFERENCES Some items are recorded in books but never on tax return Other items are never recorded in books but recorded on tax return No future tax effects for permanent differences

11. 11 Reversible Differences Are treated the same for books and tax—but in different periods. Relate to income statement differences Cause the balance of a temporary difference to change from period to period Originating timing difference –Cause of the initial difference (e.g. the $30,000 non taxable revenue in 2010 in Chelsea example) Reversing timing difference –Causes a temporary difference to decrease (e.g. the $20,000 and $10,000 amounts taxed in 2011 and 2012 in Chelsea example)

12. 12 Calculation of Current Income Taxes Two methods: 1.Taxes payable method Allowed under PE GAAP Current Income Taxes = Taxable income x Tax rate 2.Future income taxes method Called balance sheet liability method in IFRS Required by IFRS and option under PE GAAP Starts with Current Income Taxes and Adjusts for future (or “deferred”) income tax assets and liabilities, To also get future (or “deferred”) income tax expense

13. 13 Terminology PE GAAP and IFRS use different terminology for the asset and liability approach to income taxes Under PE GAAP –This method is called the future income taxes method –Related tax accounts are called future income tax assets, future income tax liabilities, and future income tax expense Under IFRS –This method is called the balance sheet liability method –Related tax accounts are called deferred income tax assets, deferred income tax liabilities, and deferred income tax expense As a result, you will see the terms “future” and “deferred” used interchangeably.

14. 14 Income Taxes Current Income Taxes Accounting income and taxable income Calculation of taxable income Calculation of current income taxes Income Tax Loss Carryover Benefits Introduction to tax losses Loss carryback illustrated Loss carryforward illustrated Carryforward with valuation allowance Review of future income tax asset account Future/Deferred Income Taxes Tax basis Future income tax liabilities Future income tax assets Income tax accounting objectives Multiple differences illustrated Tax rate considerations Presentation, Disclosure, and Analysis Balance sheet presentation Income and other statement presentation Disclosure requirements Analysis Outstanding conceptual questions IFRS / Private Entity GAAP Comparison Comparison chart Looking ahead

15. 15 Temporary Differences = accumulated timing differences = difference between book value of an asset or liability and its tax value Is either a deductible temporary difference (i.e. will be deducted from accounting income in calculating taxable income in the future), giving rise to a future tax asset, OR

16. 16 Temporary Differences …a taxable temporary difference (i.e. will be added to accounting income in calculating taxable income in the future), giving rise to a future tax liability.

17. 17 Future Tax Asset and Future Tax Liability - Sources Future tax accounts on the balance sheet may be a: –Future income (or “deferred”) tax liability, or –Future income (or “deferred”) tax asset

18. 18 Future Tax Asset and Future Tax Liability - Sources Future tax liability –When the future recovery of an asset, or future settlement of a liability, that is reported on the balance sheet will result in paying future income taxes –Arises from taxable temporary differences Future tax asset –When the recovery of an asset or settlement of a liability results in future income tax reductions or benefits –Arises from deductible temporary differences

19. 19 Future Tax Liability Example Chelsea Inc. - 2010 Books Tax Accounts receivable $30,000 0 Income reported in 2010 $70,000 $40,000 Tax rate = 40% Future Income tax liability (30,000 x 40%) 12,000 Income tax payable (40,000 x 40%) 16,000 Income Tax Expense (total) 28,000

20. 20 Chelsea Inc. – example continued Total $30,000 40% $ 12,000 20112012 Future taxable amounts $20,000$10,000 Future tax rate40% Future income tax liability $ 8,000$ 4,000

21. 21 Recording Journal Entries – e.g. Chelsea Inc. -2010 Journal Entries: Current Income Tax Expense 16,000 Income Tax Payable 16,000 Future Income Tax Expense 12,000 Future Income Tax Liability 12,000

22. 22 Future Income Tax Liability Net Assets reported End of 2010 End of 2011 Accounts receivable (in assets) $30,000$10,000 Future income tax liability (in liabilities) 12,000 4,000 Net assets reported$ 18,000$ 6,000 Note: Balance sheet reflects eventual cash impact of recovering the A/R

23. 23 Future Tax Asset – Example Cunningham Inc. sells microwave ovens with a 2 year warranty In 2011, estimated warranty expense is $500,000 Actual warranty costs are $300,000 in 2012 and $200,000 in 2013

24. 24 Future Income Tax Asset: Example Books Tax Warranty liability $500,000 0 Tax rate = 40% Future Income tax asset (500,000 x 40%) 200,000 Income tax payable (assumed) (Taxable Income x 40%) 600,000 Income Tax Expense (total) 400,000

25. 25 Future Income Tax Asset: Example Journal Entries: Current Income Tax Expense 600,000 Income Tax Payable 600,000 Future Income Tax Asset 200,000 Future Income Tax Expense 200,000 The total income tax expense of $400,000 is made up of a current tax expense of $600,000 and a future income tax benefit of $200,000

26. 26 Future Income Tax Asset: Example In subsequent years (2012 and 2013): -warranty expense of $500,000 deducted for tax, but not for books -Income taxes payable reduced by $500,000 × 40% = $200,000 -Entry in future, therefore: Income tax expense$x Future income tax asset $ 200,000 Income taxes payable$x − 200,000

27. 27 Valuation of Future Income Tax Asset Income tax assets and liabilities meet the conceptual framework conditions for recognition as “asset” or “liability” Future income tax assets must be reviewed at year end to ensure they are not reported at more than recoverable amount –This depends on whether taxable income will be earned in the future, against which temporary differences can be deducted

28. 28 Income Tax Expense = total of current tax expense (or benefit) and future tax expense (or benefit) Current income tax expense (or benefit) = income taxes payable/receivable, based on taxable income for current year Future income tax expense (or benefit) = amount of adjustment needed to the future income tax asset/liability account on the balance sheet

29. 29 Future Tax Rates Should use the rates that are expected to apply when the tax assets are realized or the tax liabilities are settled –i.e. the enacted rate (or substantively enacted) at the balance sheet date

30. 30 Future Tax Rates The effect of future tax rate changes should be immediately recognized on all future tax accounts Rate changes are treated as an adjustment to the future income tax expense/benefit Accounting standards prohibit discounting of future income tax assets and liabilities IFRS requires separate disclosure of future tax expense or benefit due to a change in tax rates

31. 31 Future Tax Rate - example Hostel Corp. had the following at end of 2009: Property, plant, and equipment: Net book value (NBV) = $4,000,000 Tax value (Undepreciated capital cost, UCC) = 1,000,000 Taxable temporary difference = 3,000,000 (to reverse by $1,000,000 each year in 2011, 2012 and 2013) Tax rate 40% Future tax liability 1,200,000

32. 32 Future Tax Rate - example Assume a new income tax rate is enacted from 40% to 35%, effective January 1, 2012 Recalculate Future tax liability as follows: 2011$1,000,000 x 40% = $400,000 2012$1,000,000 x 35% = $350,000 2013$1,000,000 x 35% = $350,000 Total $1,100,000 Required Adjusting Entry: Future Income Tax Liability100,000 Future Income Tax Benefit100,000 (1,200,000 - 1,100,000)

33. 33 Income Taxes Current Income Taxes Accounting income and taxable income Calculation of taxable income Calculation of current income taxes Income Tax Loss Carryover Benefits Introduction to tax losses Loss carryback illustrated Loss carryforward illustrated Carryforward with valuation allowance Review of future income tax asset account Future/Deferred Income Taxes Tax basis Future income tax liabilities Future income tax assets Income tax accounting objectives Multiple differences illustrated Tax rate considerations Presentation, Disclosure, and Analysis Balance sheet presentation Income and other statement presentation Disclosure requirements Analysis Outstanding conceptual questions IFRS / Private Entity GAAP Comparison Comparison chart Looking ahead

34. 34 The amount reported is the tax calculated from the loss May be carried back three years, or forward for the next twenty years When applying the carry back, it is usually applied to the oldest available year first The benefit of a tax loss carryforward is recorded (i.e. booked) if it is more likely than not that taxable income will be earned in future periods to apply it against Tax Loss Carryback and Carryforward

35. 35 Tax Loss Carryback Refile prior year’s tax returns, reduce prior taxable incomes with current year’s loss Claim back taxes previously paid: Income Tax Refund Receivablexx Current Income Tax Benefitxx If loss still remains, carry it forward

36. 36 Tax Loss Carryforward Can you recognize (book) the tax benefit of a loss carryforward? If more likely than not (i.e. probable) that benefit will be realized (i.e. company will generate taxable income in the future to apply loss against), then recognize tax benefit as an asset: Future Income Tax Assetxx Future Income Tax Benefit xx

37. 37 Tax Loss Carryforward (Cont’d) If future taxable income not likely (i.e. not likely that benefit will be realized), then do not record the tax benefit Instead, report existence of loss carryforward in notes to the financial statements Disclose the amounts and expiry dates of unrecognized income tax assets related to the carryforward of unused tax losses

38. 38 Tax Loss Carryforward (Cont’d) Assuming tax benefit was recognized as a Future Tax Asset, when co. applies the losses against taxable income in the future: Future income tax expensexx Future income tax assetxx

39. 39 Tax Loss Carryforward (Cont’d) If benefit was not “booked” and company does generate taxable income in the future and uses the unrecognized losses to reduce taxable income: Income tax payablexx Current income tax benefitxx Separate disclosure of the tax benefit from realization of unrecorded loss carryforward is not required under PE GAAP, but is required under IFRS if it makes up a major component of tax expense

40. 40 Carryforward with Valuation Allowance This approach permitted under PE GAAP (but not permitted under IFRS) Assuming a $150,000 loss carryforward where it is unlikely that benefit will be realized in the future: Future Income Tax Asset 60,000 Future Income Tax Benefit 60,000 (150,000 x 40%) Future Income Tax Expense 60,000 Allowance to Reduce Future Income Tax Asset to Expected Realizable Value 60,000

41. 41 Carryforward with Valuation Allowance (continued) The second entry indicates that the company cannot conclude that it is more likely than not that the company will benefit from the tax loss in the future The financial statements would be the same whether the allowance method is used or the future income tax asset is not recognized at all

42. 42 Income Taxes Current Income Taxes Accounting income and taxable income Calculation of taxable income Calculation of current income taxes Income Tax Loss Carryover Benefits Introduction to tax losses Loss carryback illustrated Loss carryforward illustrated Carryforward with valuation allowance Review of future income tax asset account Future/Deferred Income Taxes Tax basis Future income tax liabilities Future income tax assets Income tax accounting objectives Multiple differences illustrated Tax rate considerations Presentation, Disclosure, and Analysis Balance sheet presentation Income and other statement presentation Disclosure requirements Analysis Outstanding conceptual questions IFRS / Private Entity GAAP Comparison Comparison chart Looking ahead

43. 43 Under IFRS –All deferred tax assets and liabilities are recorded as noncurrent Under PE GAAP –Future tax asset or liability is classified as current or noncurrent based on the classification of the underlying asset or liability giving rise to the specific temporary difference –If the a future asset or liability is not related to specific asset or liability (e.g. expensed research costs deferred for tax purposes), classification is based on date that temporary difference is expected to reverse or tax benefit expected to be realized Balance Sheet Presentation

44. 44 Intraperiod Tax Allocation Income tax expense is reported with its related item, such as discontinued operations, other comprehensive income, adjustments to RE, etc. Intraperiod Tax Allocation –Tax expense is allocated within the financial statements of the current period Interperiod Tax Allocation –Tax expense is allocated between years, and results in the recognition of future income taxes

45. 45 Intraperiod Tax Allocation: Example Assume the following information for Copy Doctor Inc.: –Tax rate of 35% –A loss from continuing operations of $500,000 –Income from discontinued operations of –Unrealized holding gain of $25,000 on investment accounted for at FV-OCI Prepare the journal entries to record current and future tax expenses

46. 46 Intraperiod Tax Allocation: Example Current Income Tax Expense (discontinued operations)241,500 Current Income Tax Benefit (continuing operations)175,000 Income Tax Payable 66,500 Calculations: income of 690,000 x 35% = 241,500 expense loss of 500,000 x 35% = 175,000 benefit

47. 47 Intraperiod Tax Allocation: Example Future Income Tax Expense (OCI)8,750 Future Income Tax Liability 8,750 Calculations: 25,000 x 35% = 8,750

48. 48 Disclosure Requirements IFRS has more extensive disclosure requirements than PE GAAP, including: –Major components of income tax expense or benefits –Sources of both current and future taxes –Amount of current and future tax recognized in equity –Reconciliation of effective and statutory tax rates –Information about unrecognized future tax assets –Information about each type of temporary difference and future tax asset or liability recognized on statement of financial position

49. 49 Analysis Extensive disclosure help users asses quality of earnings, as well as assist in better prediction of future cash flows

50. 50 Outstanding Conceptual Issues Asset-liability method (or balance sheet liability approach) is considered most conceptually sound method of income tax accounting Significant conceptual questions remain about: –Lack of discounting (and therefore, no difference between short-term deferral and long-term deferral) –Recognition of future tax assets

51. 51 Income Taxes Current Income Taxes Accounting income and taxable income Calculation of taxable income Calculation of current income taxes Income Tax Loss Carryover Benefits Introduction to tax losses Loss carryback illustrated Loss carryforward illustrated Carryforward with valuation allowance Review of future income tax asset account Future/Deferred Income Taxes Tax basis Future income tax liabilities Future income tax assets Income tax accounting objectives Multiple differences illustrated Tax rate considerations Presentation, Disclosure, and Analysis Balance sheet presentation Income and other statement presentation Disclosure requirements Analysis Outstanding conceptual questions IFRS / Private Entity GAAP Comparison Comparison chart Looking ahead

52. 52 Looking Ahead Additional changes are expected as IASB and FASB revisit the income tax standard

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