1. 1 Chapter 14: Accounting for Income Taxes Fundamentals of Intermediate Accounting Weygandt, Keiso and Warfield Prepared by Bonnie Harrison, College of Southern Maryland, LaPlata, Maryland

2. 2 Chapter 14 Accounting for Income Taxes After studying this chapter, you should be able to: Identify differences between pretax financial income and taxable income. Describe a temporary difference that results in future taxable amounts. Describe a temporary difference that results in future deductible amounts. Explain the purpose of a deferred tax asset valuation allowance. Describe the presentation of income tax expense in the income statement. 1 2 3 4 5

3. 3 Chapter 14 Accounting for Income Tax After studying this chapter, you should be able to: Describe the various temporary and permanent differences. Explain the effect of various tax rates and tax rate changes on deferred income taxes. Apply accounting procedures for a loss carryback and a loss carryforward. Describe the presentation of deferred income taxes in financial statements. Indicate the basic principles of the asset-liability method. 6 7 8 9 10

4. 4 Deferred Taxes: Basics u Deferred taxes arise when income tax expense differs from income tax liability u The tax expense is determined under GAAP u The income tax liability is determined under the Internal Revenue Code u Some of these differences are temporary and reverse over time u Others are permanent and do not reverse

5. 5 Temporary Differences: Examples  Revenues and Gains, recognized in financial income, are later taxed for income tax purposes  Expenses and losses, recognized in financial income, are later deducted for income tax purposes  Revenues and gains are taxed for income tax purposes before they are recognized in financial income  Expenses and losses are deducted for income tax purposes before they are recognized in financial income

6. 6 Summary of Temporary Differences Transaction When recorded in books When recorded on tax return Deferred tax effect Rev or GainEarlierLater Liability Rev or GainLaterEarlier Asset Exp or LossEarlierLater Asset Exp or LossLaterEarlier Liability

7. 7 Permanent Differences: Examples  Items, recognized for financial accounting purposes, but not for income tax purposes: è interest income received on tax exempt securities è fines and expenses resulting from violations of law è Premiums paid for life insurance on key officers/employees  Items, recognized for tax purposes, but not for financial accounting purposes: è the dividends received deduction under the Code è percentage depletion of natural resources in excess of their cost

8. 8 Summary of Permanent Differences Sources of PERMANENT DIFFERENCES No deferred tax effects for permanent differences No deferred tax effects for permanent differences Some items are recorded in Books are recorded in Books but NEVER on tax return but NEVER on tax return Other items are NEVER recorded in books are NEVER recorded in books but recorded on tax return but recorded on tax return

9. 9 Deferred Tax Asset & Deferred Tax Liability: Sources v Deferred taxes may be a: Deferred tax liability, or Deferred tax asset v Deferred tax liability arises due to net taxable amounts in the future. v Deferred tax asset arises due to net deductible amounts in the future.

10. 10 Recording a Valuation Allowance for Doubtful Deferred Tax Assets u If the deferred tax asset appears doubtful, a Valuation Allowance account is needed. u Journal entry : Income Tax Expense $$ Allowance to Reduce Deferred Tax Asset to Expected Realizable Value $$ u The entry records a potential future tax benefit that is not expected to be realized in the future.

11. 11 Deferred Taxes: Applying Tax Rates n Basic Rule: Apply the yearly tax rate to calculate deferred tax effects. n If future tax rates change: use the enacted tax rate expected to apply in the future year n If new rates are not yet enacted into law for future years, the current rate should be used n The appropriate enacted rate for a year is the average tax rate [based on graduated tax brackets].

12. 12 Revision of Future Tax Rates n When a change in tax rate is enacted, its effect should be recorded immediately n The effect is reported as an adjustment to tax expense in the period of change n Changes in tax rates are treated just like any other change in estimate, prospectively n See example following slide

13. 13 Revision of Future Tax Rates: Example uEnd of 2002, corporate tax rate is changed from 40% to 35% uThe new rate is effective January 1, 2004 uThe deferred tax account (1/1/2002) is as follows: u Excess tax depreciation:$3 million u Deferred tax liability:$1.2 million. uRelated taxable amounts are expected to occur equally over 2003, 2004, and 2005. è Provide the journal entry to reflect the change.

14. 14 Revision of Future Tax Rates: Example uThe deferred tax liability end of 2005 is as follows: 2003 2004 2005 Future tax inc$1,000,0001,000,0001,000,000 Tax rate40%35%35% Deferred tax liability$400,000350,000350,000 uEntry: Deferred Tax Liability $100,000 Income Tax Expense $100,000* *$1,200,000 - $1,100,000

15. 15 Financial Statement Presentation uBalance Sheet Presentation:  The deferred tax classification relates to its underlying asset or liability  Classify the deferred tax amounts as current or noncurrent  Sum the various deferred tax assets and liabilities classified as current  Sum the various deferred tax assets and liabilities classified as noncurrent

16. 16 Financial Statement Presentation uBalance Sheet Presentation:  Sum the various deferred tax assets and liabilities classified as current: èIf net result is an asset, report as current asset èIf net result is a liability, report as current liability  Sum the various deferred tax assets and liabilities classified as noncurrent èIf net result is an asset, report as long-term asset èIf net result is a liability, report as long-term liability

17. 17 Income Statement Presentation uIncome tax expense, as allocated to: 1. Continuing operations 2. Discontinued operations 3. Extraordinary items 4. Cumulative effect of an accounting change, and 5. Prior period adjustments uDisclose other significant components, such as: current tax expense, deferred tax expense/benefit,etc.

18. 18 Net Operating Losses [NOLs]: Basic Terminology l Net operating loss is a tax terminology l A net operating loss occurs when tax deductions for a year exceed taxable revenues l Net loss or operating loss is a financial accounting term l NOL can be derived from net loss: but these two amounts must be kept separately

19. 19 NOLs: Rules of Application v NOL for each tax year is computed v The NOL of one year can be applied to offset taxable income of other years, possibly resulting tax refunds v NOLs can be: ò carried back 2 years and carried forward 20 years (carryback option), or ò carried forward 20 years (carryforward only)

20. 20 Net Operating Loss: Carryback rules. n If NOLs are carried back 2 years and carried forward 20 years: n NOL is applied to the earlier of the 2 year period, then to the immediately preceding year etc n Remaining NOLs are applied to the following 20 year period n Any tax refunds are reported in the year of the original net operating loss

21. 21 NOL Carryback Rules: continued 2001 2002 2003 2004 2005 2006 2007 2024 2001 2002 2003 2004 2005 2006 2007 2024 NOL 2004 NOL 2004 Tax years Apply first nextLoss carryforward 20 years forward Expect tax refund here Expect tax refund here Record all tax effects here Record all tax effects here Expect tax shield here Expect tax shield here

22. 22 NOL Carryforward Rules 2001 2002 2003 2004 2053 2006 2007 2024 2001 2002 2003 2004 2053 2006 2007 2024 NOL 2004 NOL 2004 Tax years Loss carryforward 20 years forward Record all tax effects here Record all tax effects here Expect tax shield here Expect tax shield here Forgo 2 year rule

23. 23 Basic Principles of Asset-Liability Method n A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for current year n A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards n The measurement of current and deferred tax liabilities and assets is based on provisions of enacted tax law, effects of future changes in tax law or rates are not anticipated n The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized

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