1. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-1 Accounting Clinic VI

2. Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University

3. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-3 Deferred Taxes: Basics Deferred taxes arise when income tax expense differs from income tax liability The income tax liability is based on income determined under provisions of the United States Internal Revenue Code and foreign, state, and other taxes (including franchise taxes) based on income. The tax expense is the amount of income taxes (whether or not currently payable or refundable) allocable to a period in the determination of net income. Some of these differences are temporary and some are permanent

4. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-4 Why do we need Deferred Taxes? Main issue: the need to match tax expense to related accounting income so appropriate after-tax income is reported, independent of when taxes on that income is assessed by tax authorities. Advantages of deferred taxes: Smoothing of earnings Better relationship between earnings and income tax expense effective tax rate reflects statutory rate

5. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-5 Temporary and Permanent Differences Temporarydifference. Temporary difference. Differences between the taxable amount of a revenue or expense and its reported amount in the financial statements that result in taxable or deductible amounts in future years when the revenue or expense enters the tax return. Permanent differences Permanent differences. Permanent differences arise from statutory provisions under which specified revenues are exempt from taxation and specified expenses are not allowable as deductions in determining taxable income. Other permanent differences arise from items entering into the determination of taxable income which are not components of pretax accounting income in any period.

6. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-6 Examples of Permanent Differences Interest received on municipal obligations premiums paid on officers' life insurance. Fines and other expenses that result from a violation of law. Deduction for dividend received from U.S. corporations. Percentage depletion of natural resources in excess of their cost.

7. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-7 Examples of Temporary differences 1.Revenues or gains that are taxable after they are recognized in financial income. An asset (for example, a receivable from an installment sale) may be recognized for revenues or gains that will result in future taxable amounts when the asset is recovered. 2.Expenses or losses that are deductible after they are recognized in financial income. A liability (for example, a product warranty liability) may be recognized for expenses or losses that will result in future tax deductible amounts when the liability is settled.

8. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-8 Examples of Temporary differences 3.Revenues or gains that are taxable before they are recognized in financial income. A liability (for example, subscriptions received in advance) may be recognized for an advance payment for goods or services to be provided in future years. For tax purposes, the advance payment is included in taxable income upon the receipt of cash. Future sacrifices to provide goods or services (or future refunds to those who cancel their orders) will result in future tax deductible amounts when the liability is settled.

9. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-9 Examples of Temporary differences 4.Expenses or losses that are deductible before they are recognized in financial income. The cost of an asset (for example, depreciable personal property) may have been deducted for tax purposes faster than it was depreciated for financial reporting. Amounts received upon future recovery of the amount of the asset for financial reporting will exceed the remaining tax basis of the asset, and the excess will be taxable when the asset is recovered. 5.A reduction in the tax basis of depreciable assets because of tax credits. Amounts received upon future recovery of the amount of the asset for financial reporting will exceed the remaining tax basis of the asset, and the excess will be taxable when the asset is recovered.

10. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-10 Deferred Tax Liability A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years. For example, a temporary difference is created between the reported amount and the tax basis of an installment sale receivable if, for tax purposes, some or all of the gain on the installment sale will be included in the determination of taxable income in future years. Because amounts received upon recovery of that receivable will be taxable, a deferred tax liability is recognized in the current year for the related taxes payable in future years.

11. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-11 Deferred Tax Asset A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards. For example, a temporary difference is created between the reported amount and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated expenses are not deductible until a future year. Settlement of that liability will result in tax deductions in future years, and a deferred tax asset is recognized in the current year for the reduction in taxes payable in future years.

12. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-12 Temporary Differences Effect

13. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-13 Basic Journal Entry to Record Deferred Taxes Tax Liability Income Tax Expense xxx Def.Tax Liability xxx Taxes Payable xxx Tax Asset Income Tax Expense xxx Def. Tax Asset xxx Taxes Payable xxx

14. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-14 Recording a Valuation Allowance for Doubtful Deferred Tax Assets more likely than not A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. The net deferred tax asset should equal that portion of the deferred tax asset which, based on the current available evidence, will not be realized. Journal entry: Income Tax Expense xxx Allowance to Reduce Deferred Tax Asset to Expected Realizable Value xxx

15. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-15 Example – Deferred Tax Liability - Depreciation Bryant Corporation purchased a new machine for $100,000 on January 1, 2004. The machine has a four-year estimated service life and no salvage value. Bryant’s pretax income for each year 2004 - 2007 is 200,000 before depreciation and taxes.

16. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-16 Bryant Corp. uses straight-line depreciation on its books and MACRS for tax reporting. For tax purposes the machine is also depreciated over 4 years using MACRS (an accelerated depreciation method). The depreciation percentages for each of the years are 33%, 44%, 15% and 8%. Assume a 40% tax rate.

17. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-17 A.Compute financial (book) income after depreciation but before taxes. What is income tax expense? B.Compute taxable income. What is income tax payable? C.Give the journal entries to record taxes. D.Give the balance of the deferred tax liability at the end of each of the years.

18. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-18 Solution Financial (book) income2004200520062007 Income before Depreciation Depreciation Expense ($100,000/4) Income after depreciation but before taxes Income Tax Expense (40%) $200,000 (25,000) $175,000 $70,000 $200,000 (25,000) $175,000 $70,000 $200,000 (25,000) $175,000 $70,000 $200,000 (25,000) $175,000 $70,000 A.

19. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-19 2004200520062007 Pre-Tax Income before Depreciation$200,000 Depreciation Deduction:(33,000)(44,000)(15,000)(8,000) Taxable Income$167,000$156,000$185,000$192,000 Income Taxable Payable (40%)$66,800$62,400$74,000$76,800 B.

20. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-20 C. Journal entries: 2004 Income Tax Expense Tax Payable Deferred Tax Liability 70,000 66,800 3,200 2005 Income Tax Expense Tax Payable Deferred Tax Liability 70,000 62,400 7,600

21. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-21 2006 Income Tax Expense70,000 Deferred Tax Liability Tax Payable 4,000 74,000 2007 Income Tax Expense70,000 Deferred Tax Liability Tax Payable 6,800 76,800

22. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-22 D. The deferred tax liability account Dr.Cr. 3,2002004 entry 3,20012/31/2004 7,6002005 entry 10,80012/31/2005 4,0002006 entry 6,80012/31/2006 6,8002007 entry 012/31/2007 The liability has reversed itself

23. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-23 Example - Deferred Tax Liability – Advances from Customers Miller Co. received $30,000 of subscriptions in advance at the end of 2004. Subscription revenue will be equally recognized in 2005, 2006, and 2007, for financial accounting purposes but all of the $30,000 will be recognized in 2004 for tax purposes. Miller’s pretax income for each year 2004- 2007 is $100,000 before taxes. Assume a 40% tax rate.

24. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-24 A.Compute Financial (book) income including subscription revenue but excluding taxes. What is income tax expense? B.Compute taxable income. What is income tax payable? C.Give the journal entries to record taxes. D.Give the balance of the deferred tax asset at the end of each of the years.

25. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-25 E.For this requirement only, assume that as a result of examining available evidence in 2004, it is more likely than not that $10,000 of the deferred tax asset will not be realized. Give the journal entry to record this reduction.

26. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-26 Solution 2004200520062007 Financial (book) income Income before subscription100,000 Subscription revenue received in 2004 0 10,000 Income before taxes100,000110,000 Income tax expense (40%) 40,000 44,000 A.

27. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-27 2004200520062007 Pretax income100,000 Subscription received in 200430,000--- Taxable Income130,000100,000 Taxes Payable (40%)52,00040,000

28. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-28 C. Journal entries 2004 Income tax expense 40,000 Deferred tax asset 12,000 Tax payable52,000 2005 - 2007 Income tax expense44,000 Deferred tax asset 4,000 Tax payable40,000

29. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-29 D. The deferred tax asset account Db.Cr. 12,0002004 entry 12,00012/31/2004 4,0002005 entry 8,00012/31/2005 4,0002006 entry 4,00012/31/2006 4,0002007 entry 012/31/2007 The asset has reversed itself.

30. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-30 Income Tax Expense10,000 Allowance to Reduce Deferred Tax Asset To Expected Realizable Value10,000 To record the reduction in the deferred tax asset E.

31. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-31 Example - Permanent Differences Calculation Hunter Corporation reports the following information for 2004: Financial (Book) Income before Income Taxes $548,000 Income Taxes Payable (for 2004) 157,500 Income Tax Expense 210,000 Hunter Corp. has both temporary and permanent differences between book income and taxable income. The temporary difference results from depreciation. The permanent difference results from a fine that the company has to pay (but can not be deducted on its tax return).

32. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-32 What is the amount of the permanent difference for the year? The tax rate is 35%

33. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-33 Solution Step 1: Find the change in the deferred tax liability Income Tax Expense (Book) $210,000 Income Taxes Payable 157,500 ∆ Deferred Tax Liability 52,500 Step 2: Find the temporary difference ∆ Deferred Tax Liability/0.35 $52,500/0.35= 150,000 Step 3: Find taxable income Income Taxes Payable (from current year)/0.35$157,500/0.35= 450,000

34. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-34 Solution (Cont.) Step 4: Find the permanent difference Taxable Income (IRS) $450,000 Temporary Differences 150,000 Financial (Book) Income before Taxes Excluding Permanent Differences 600,000 Permanent Differences (P.N) 52,000 Financial (Book) Income before Taxes 548,000

35. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-35 Financial Statement Presentation On the balance sheet, an enterprise should separate deferred tax liabilities and assets into a current amount and a noncurrent amount. Deferred tax liabilities and assets should be classified as current or noncurrent based on the classification of the related asset or liability for financial reporting.

36. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved. Clinic 6-36 Financial Statement Presentation A deferred tax liability or asset that is not related to an asset or liability for financial reporting, including deferred tax assets related to carryforwards, should be classified according to the expected reversal date of the temporary difference. The valuation allowance for a particular tax jurisdiction should be allocated between current and noncurrent deferred tax assets for that tax jurisdiction on a pro rata basis.