Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

C H A P T E R 19 Income Taxes

1. Explain the difference between accounting income and taxable income. 2. Explain what a taxable temporary difference is and why a future tax liability is recognized. 3. Explain what a deductible temporary difference is and why a future tax asset is recognized. 4. Differentiate among timing, temporary, and permanent differences. Learning Objectives

5. Prepare analyses and related journal entries to record income tax expense when there are multiple temporary differences. 6. Explain the effect of various tax rates and tax rate changes on future income tax accounts. 7. Apply accounting procedures for a tax loss carryback. 8. Apply accounting procedures and disclosure requirements for a tax loss carryforward. Learning Objectives

9. Explain why the future income tax asset account is reassessed at the balance sheet date. 10. Explain the need for and be able to apply intraperiod tax allocation. 11. Identify the reporting and disclosure requirements for corporate income taxes. 12. Describe the differential reporting option for income taxes. 13. Describe the key aspects of the asset-liability method, and identify outstanding issues with this approach. Learning Objectives

Accounting for Income Taxes Income Tax Fundamentals Accounting income and taxable income Future taxable amounts and future taxes Future deductible amounts and future taxes Calculation of taxable income Tax rate considerations The Asset- Liability Method Differential Reporting Review and some conceptual questions Comprehensi ve Illustration Income Tax Loss Carryover Benefits Introduction Loss carryback illustrated Loss carryforward illustrated Carryforward with valuation allowance Review of future tax asset Intraperiod Tax Allocation Objective Financial Statement Presentation Balance sheet presentation Income statement presentation Other disclosures Perspectives

Fundamentals Accounting income (per GAAP) ≠ Taxable income (per Income Tax Act) Accounting income → Income tax expense Taxable income → Income tax payable Income tax expense ≠ Income tax payable

Fundamentals To determine income taxes payable: Accounting income ± differences = Taxable income Taxable income × tax rate = taxes payable

Fundamentals Same revenue and expenses usually included in income statement and in taxable income, Same revenue and expenses usually included in income statement and in taxable income, but…. but…. ….often in different accounting periods ….often in different accounting periods

Fundamentals If expense deducted in Year 1’s accounting income, and Year 2’s taxable income: If expense deducted in Year 1’s accounting income, and Year 2’s taxable income: -Year 1’s taxable income is higher than Year 1’s accounting income -The expense is deductible for tax purposes in the future -At end Year 1, company has a future deductible amount -Future deductible amount x tax rate = future income tax asset

Fundamentals If expense deducted in Year 1’s taxable income, but Year 2’s accounting income: If expense deducted in Year 1’s taxable income, but Year 2’s accounting income: -Year 1’s taxable income is lower than Year 1’s accounting income -The expense will have to be added in calculating taxable income in the future -At end Year 1, company has a future taxable amount -Future taxable amount x tax rate = future income tax liability

Fundamentals Also… Also… Future tax assets and future tax liabilities also arise from revenue being reported in different accounting periods for income statement and tax purposes. Future tax assets and future tax liabilities also arise from revenue being reported in different accounting periods for income statement and tax purposes.

Future Tax Asset and Future Tax Liability - Sources Future taxes may be a:Future taxes may be a: –Future tax liability, or –Future tax asset Future tax liability arises due to net taxable amounts in the futureFuture tax liability arises due to net taxable amounts in the future Future tax asset arises due to net deductible amounts in the futureFuture tax asset arises due to net deductible amounts in the future

Future Tax Liability Example Chelsea Inc AccountingTaxRevenue$130,000$100,000 Expenses 60,000 60,000 Income $ 70,000 $ 40,000 40% $ 28,000 $ 16,000

Recording Future Tax Liability – Example Income tax expense = $28,000 Income tax expense = $28,000 Income tax liability = $16,000 Income tax liability = $16,000 Journal Entry: Income Tax Expense 28,000 Future Tax Liability 4,000 Tax Payable 16,000 Journal Entry: Income Tax Expense 28,000 Future Tax Liability 4,000 Tax Payable 16,000

Future Tax Liability Example (Cont’d) Chelsea Inc AccountingTaxRevenue$130,000$150,000 Expenses 60,000 60,000 Income $ 70,000 $ 90,000 40% $ 28,000 $ 36,000

Recording Future Tax Liability – Example Income tax expense = $28,000 Income tax expense = $28,000 Income tax liability = $36,000 Income tax liability = $36,000 Journal Entry: Income Tax Expense 28,000 Future Tax Liability 8,000 Tax Payable 36,000 Journal Entry: Income Tax Expense 28,000 Future Tax Liability 8,000 Tax Payable 36,000 Assuming there are no other differences the future tax liability will reduce to a zero balance. Assuming there are no other differences the future tax liability will reduce to a zero balance.

Future Tax Liability Is it a Liability? Sometimes dismissed by analystsSometimes dismissed by analysts Meets CICA Handbook, Section 1000 definition of a liability:Meets CICA Handbook, Section 1000 definition of a liability: 1.Results from a past transaction 2.It is a present obligation 3.It represents a future sacrifice

Future Tax Asset Example Cunningham Inc BooksTax Warranty expense deducted, ,000 0 deducted, ,000 0 Tax rate = 40% Income reported in ,000,000 1,500,000 in ,000,000 1,500,000 Income tax exp. 400,000 Income tax pay.600,000

Recording Future Tax Asset – e.g. Cunningham Inc Journal Entry: Income Tax Exp. 400,000 Income Tax Exp. 400,000 Future income tax asset 200,000 Income Tax Payable 600,000 Income Tax Payable 600,000

Future Tax Asset In subsequent years: -warranty exp. 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

Future Tax Asset Is it an Asset? Meets all necessary criteria from CICA Handbook, Section 1000:Meets all necessary criteria from CICA Handbook, Section 1000: 1.It will contribute to future net cash flows 2.Access to benefits are controlled by the entity 3.It results from a past transaction or event

Permanent, Timing, and Temporary Differences Taxable income is determined by starting with accounting income and adjusting it for permanent and timing differences in the yearTaxable income is determined by starting with accounting income and adjusting it for permanent and timing differences in the year The accounting for future tax liabilities and future tax assets is based on the tax impact of the accumulated timing differences = temporary differencesThe accounting for future tax liabilities and future tax assets is based on the tax impact of the accumulated timing differences = temporary differences

Permanent Differences - Examples Items, recognized on income statement, but never for income tax purposes:Items, recognized on income statement, but never for income tax purposes: Non-tax-deductible expenses (fines, expenses relating to non-taxable revenue)Non-tax-deductible expenses (fines, expenses relating to non-taxable revenue) Dividends from taxable Canadian corporationsDividends from taxable Canadian corporations Items, recognized for tax purposes, but not forItems, recognized for tax purposes, but not for financial accounting purposes: Depletion allowance of natural resources in excess of costDepletion allowance of natural resources in excess of cost

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

Timing Differences Are treated the same for books and tax—but in different periods.Are treated the same for books and tax—but in different periods. Relate to income statement differencesRelate to income statement differences Cause the balance of a temporary difference to change from period to periodCause the balance of a temporary difference to change from period to period Originating timing differenceOriginating timing difference –Cause of the initial difference Reversing timing differenceReversing timing difference –Causes a temporary difference to decrease

Temporary Differences = accumulated timing differences= accumulated timing differences = difference between book value of an asset or liability and its tax value= 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, ORIs 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

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.…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.

Temporary Differences - Examples Property, plant, and equipment: Net book value (NBV) = 43,500 Tax value (Undepreciated capital cost, UCC) = 37,000 capital cost, UCC) = 37,000 Taxable temporary difference = 6,500 If tax rate is 30%, future tax liability = 6,500 × 30%= 1,950 liability = 6,500 × 30%= 1,950

Temporary Differences – Examples (cont’d) Estimated warranty liability:Estimated warranty liability: NBV= 3,000 Tax value= 0 Therefore, deductible temporary difference= 3,000 temporary difference= 3,000 If the tax rate is 30%, future tax asset = 3,000 × 30% = 900 future tax asset = 3,000 × 30% = 900

Exercise 19-1: Temporary and Permanent Differences a)A timing difference that will result in future deductible amounts, and therefore, will usually give rise to a future income tax asset b)A timing difference that will result in future taxable amounts and, therefore, will usually give rise to a future income tax liability c)A permanent difference

Exercise 19-1: Temporary and Permanent Differences 1.CCA is used for tax purposes, and straight-line amortization used for financial reporting purposes. A 20% rate used for both. Assume no ½ year rule. 2.A landlord collects rents in advance. Rents are taxable in the period received. 3.Non-deductible expenses are incurred in obtaining tax-exempt income. 4.Costs of guarantees and warranties are estimated and accrued for financial reporting purposes. 5.Installment sales are accounted for by the accrual method for financial reporting purposes and cash basis for tax purposes

Exercise 19-1: Temporary and Permanent Differences 6.For some assets, straight-line amortization is used for both financial reporting and tax purposes, but assets’ lives shorter for tax purposes. 7.Pension expense reported on the income statement before it is funded. Pension costs are deductible only when funded. 8.Proceeds received from life insurance on the death of a key officer. 9.Tax return reports no revenue from dividends received from taxable Canadian corps. They are reported as investment income on the income statement. 10.Estimated losses on pending lawsuits accrued for financial reporting purposes. The losses are tax deductible in the period when the related liabilities are settled.

Exercise 19-1: Temporary and Permanent Differences 1.(b)6. (b) 2.(a)7. (a) 3.(c)8. (c) 4.(a)9. (c) 5.(b)10. (a)

Income Tax Expense = total of current tax expense (benefit) and future tax expense (benefit) Current income tax expense (benefit) Current income tax expense (benefit) = income taxes payable/receivable, based on taxable income for current year

Income Tax Expense (cont’d) Future income tax expense (benefit) = amount of adjustment needed to the future income tax asset/liability account on the balance sheet

Future Tax Expense: Example Example 1: Future tax asset before adjustment 1,000 dr. Correct balance determined to be 2,400 dr. Entry: Future income tax asset 1,400 Future income tax benefit 1,400

Future Tax Expense: Example Example 2: Future tax asset before adjustment 1,000 dr. Correct balance determined to be 200 dr. Entry: Future income tax expense 800 Future income tax asset 800

Future Tax Rates CICA Handbook, Section 3465CICA Handbook, Section 3465 The effect of future tax rate changes should be immediately recognized on all future tax accountsThe effect of future tax rate changes should be immediately recognized on all future tax accounts Treated as an adjustment to the future income tax expense/benefitTreated as an adjustment to the future income tax expense/benefit

Use separate accounts, but remember to report the net effectsUse separate accounts, but remember to report the net effects A future tax asset or liability is classified as long-term if the item which originated or caused the future tax amount is long-termA future tax asset or liability is classified as long-term if the item which originated or caused the future tax amount is long-term Future tax amounts have no impact on current income tax expenseFuture tax amounts have no impact on current income tax expense On the income statement, report current income tax expense/benefit separately from future income tax expense/benefitOn the income statement, report current income tax expense/benefit separately from future income tax expense/benefit The Future Income Tax Asset account is periodically reassessed to ensure realizableThe Future Income Tax Asset account is periodically reassessed to ensure realizable Future Taxes – Final Notes

The amount reported is the tax calculated from the lossThe amount reported is the tax calculated from the loss May be carried back three years, or forward for the next seven yearsMay be carried back three years, or forward for the next seven years When applying the carry back, always apply to the oldest available year firstWhen applying the carry back, always apply 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 againstThe 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

Tax Loss Carryback Reopen prior year’s tax returns, reduce prior taxable incomes with current year’s loss Claim back taxes previously paid:Reopen prior year’s tax returns, reduce prior taxable incomes with current year’s loss Claim back taxes previously paid: Income taxes receivablexx Current income tax benefitxx If loss still remains, carry it forward

Tax Loss Carryforward Can you recognize (book) the tax benefit of a loss carryforward? It depends... …if more likely than not that benefit will be realized (i.e. co. will generate taxable income in the future to apply loss against), then recognize tax benefit as an asset:

Tax Loss Carryforward (Cont’d) Future income tax assetxx Future income tax benefitxx …if not more likely than not that benefit will be realized, then – NO – just report existence of loss carryforward in notes to the financial statements.

Tax Loss Carryforward (Cont’d) If benefit 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

Tax Loss Carryforward (Cont’d) If benefit 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 benefit*xx * Due to realization of unrecognized loss carryforward

Intraperiod Tax Allocation Income tax expense is reported with its related item, such as discontinued operations, extraordinary item, error correction in RE, etc.Income tax expense is reported with its related item, such as discontinued operations, extraordinary item, error correction in RE, etc. Intraperiod Tax AllocationIntraperiod Tax Allocation –Tax expense is allocated within the financial statements of the current period Interperiod Tax AllocationInterperiod Tax Allocation –Tax expense is allocated between years

Differential Reporting Available to organizations thatAvailable to organizations that –Are non publicly accountable –Owners have unanimously consented Income tax reporting follows the taxes payable basis:Income tax reporting follows the taxes payable basis: Income tax expense = taxes currently payable

The Asset-Liability Method Asset-liability method objectivesAsset-liability method objectives –Recognize taxes payable (refundable) amount for the current year –Recognize future tax liabilities or assets for events (transactions) that have been included in the current year’s financial statements or tax returns Basic principles to achieve these objectivesBasic principles to achieve these objectives

Basic Principles of Accounting for Income Tax 1.Current tax liability or asset is based on current year’s taxes payable (or refundable) and is recognized in the current year 2.A future tax liability or asset is recognized for future tax effects of temporary differences and carryforwards 3.Measurement of current and future tax liabilities and assets is based on the tax rate expected at the time the liability will be settled or asset realized 4.Future tax asset is reduced by any tax benefits not expected to be realized

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