1. Accounting for Income Taxes
Chapter 16
Accounting for Income Taxes
Chapter 16: Accounting for Income Taxes.
© 2009 The McGraw-Hill Companies, Inc.

2. Deferred Tax Assets and Deferred Tax Liabilities
The Internal Revenue Code is the set of rules for preparing tax returns.
GAAP is the set of rules for preparing financial statements.
Results in . . .
Results in . . .
Usually. . .
Financial statement income tax expense.
IRS income taxes payable.
Part I
Generally accepted accounting principles is a set of rules for preparing financial statements. Following these principles result in financial statement income tax expense.
Part II
The Internal Revenue Code is the set of rules for preparing tax returns. Following this code results in the income tax payable to the Internal Revenue Service.
Usually, the income tax expense determined using generally accepted accounting principles and the income tax payable determined using the Internal Revenue Code do not equal. The rules used to determine taxable income and those for financial reporting purposes often cause amounts to be included in taxable income in a year later—or earlier—than the year in which they are recognized for financial reporting purposes, or not to be included in taxable income at all. For example, income from selling properties on an installment basis is reported on the tax return as it actually is received. This means taxable income might be less than accounting income in the year of an installment sale but higher than accounting income in later years when installment income is collected.
The situation just described creates what’s referred to as a temporary difference between pretax accounting income and taxable income.
The objective of accounting for income taxes is to recognize a deferred tax liability or deferred tax asset for the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions or events that already have occurred.
The objective of accounting for income taxes is to recognize a deferred tax liability or deferred tax asset for the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions or events that already have occurred.

3. Temporary Differences
Often, the difference between pre-tax accounting income and taxable income results from items entering the income computations at different times.
Often, the difference between pre-tax accounting income and taxable income results from items entering the income computations at different times. These are called temporary differences.
These are called temporary differences.

4. Temporary Differences
Temporary differences will reverse out in one or more future periods.
Accounting Income>Taxable Income
Future Taxable Amounts
Deferred Tax Liability
Accounting Income<Taxable Income
Future Deductible Amounts
Deferred Tax Asset
Temporary differences will reverse out in one or more future periods.
When temporary differences cause accounting income to be greater than taxable income, the result is future taxable amounts and a deferred tax liability.
When temporary differences cause accounting income to be less than taxable income, the result is future deductible amounts and a deferred tax asset.
Let’s look at some examples of items that cause deferred tax liabilities and assets.

5. Deferred tax assets result in deductible amounts in the future.
Part I
The temporary differences in the gray boxes create deferred tax liabilities because they result in taxable amounts in the future. Items reported on the tax return after the income statement that result in deferred tax liabilities include installment sales of property when the installment method is used for taxes and unrealized gain from recording investments at fair value which is taxable when asset is sold.
Items reported on the tax return before the income statement that result in deferred tax liabilities include accelerated depreciation on the tax return when straight-line is used on the income statement and prepaid expenses that are tax deductible when paid.
Part II
The temporary differences in the yellow boxes create deferred tax assets because they result in deductible amounts in the future. Items reported on the tax return after the income statement that result in deferred tax assets include estimated expenses and losses that are not tax deductible until paid and unrealized loss from recording investments at fair value or inventory at Lower-of-Cost-or-Market which is tax deductible when the asset is sold.
Items reported on the tax return before the income statement that result in deferred tax assets include rent or subscriptions collected in advance and other revenue collected in advance.
Deferred tax assets result in deductible amounts in the future.
Deferred tax liabilities result in taxable amounts in the future.

6. Nontemporary Differences
Created when an income item is included in taxable income or accounting income but will never be included in the computation of the other.
Example: Interest on tax-free municipal bonds is included in accounting income but is never included in taxable income.
Nontemporary differences are created when an income item is included in taxable income or accounting income but will never be included in the computation of the other. An example is interest on tax-free municipal bonds that is included in accounting income but is never included in taxable income.
Nontemporary, or permanent, differences are disregarded when determining both the tax payable currently and the deferred tax asset or liability.
Also called permanent differences.

7. Multiple Temporary Differences
It would be unusual for any but a very small company to have only a single temporary difference in any given year.
Categorize all temporary differences according to whether they create …
Future taxable amounts
Future deductible amounts
It would be unusual for any but a very small company to have only a single temporary difference in any given year. Having multiple temporary differences doesn’t change any of the principles you have learned so far in connection with single differences. All that’s necessary is to categorize all temporary differences according to whether they create future taxable amounts or future deductible amounts. The total of the future taxable amounts is multiplied by the future tax rate to determine the appropriate balance for the deferred tax liability, and the total of the future deductible amounts is multiplied by the future tax rate to determine the appropriate balance for the deferred tax asset.

8. Net Operating Losses (NOL)
Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or subsequent periods.
When used to offset earlier taxable income:
Called: operating loss carryback.
Result: tax refund.
When used to offset future taxable income:
Called: operating loss carryforward.
Result: reduced tax payable.
Tax laws often allow a company to use tax net operating losses to offset taxable income in earlier or subsequent periods. When a net operating loss is used to offset earlier taxable income it is called an operating loss carryback and results in a tax refund. When a net operating loss is used to offset future taxable income it is called an operating loss carryforward and results reduced tax payable.

9. Net Operating Losses (NOL)
Carryback Period +3 +2 +1
. . .
+20 +4 +5
Carryforward Period -1 -2
Current Year
The NOL may first be applied against taxable income from two previous years.
Unused NOL may be carried forward for 20 years.
The net operating loss may first be applied against taxable income from two previous years. Unused net operating losses may be carried forward for 20 years.
Let’s look at an example.

10. Balance Sheet Classification
Disclose the following:
Total of all deferred tax liabilities.
Total of all deferred tax assets.
Total valuation allowance recognized.
Net change in valuation account.
Approximate tax effect of each type of temporary difference (and carryforward).
Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability.
Part I
Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability.
Part II
Disclose the following:
Total of all deferred tax liabilities.
Total of all deferred tax assets.
Total valuation allowance recognized.
Net change in valuation account and
Approximate tax effect of each type of temporary difference (and carryforward).

11. Additional Disclosures
Current portion of tax expense (benefit)
Deferred portion of tax expense (benefit), with separate disclosure for
Portion that does not include the effect of the following separately disclosed amounts.
Operating loss carryforwards.
Adjustments due to changes in tax laws or rates.
Adjustments to the beginning-of-the-year valuation allowance due to revised estimates.
Investment tax credits.
Additional disclosures include the current portion of tax expense (or benefit) and the deferred portion of tax expense, with separate disclosure for
The portion that does not include the effect of the following separately disclosed amounts,
Operating loss carryforwards,
Adjustments due to changes in tax laws or rates,
Adjustments to the beginning-of-the-year valuation allowance due to revised estimates and
Investment tax credits.

12. Coping with Uncertainty in Income Taxes
FASB Interpretation No. 48
Step 1. A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits.
Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50-percent likely to be realized.
Part I
Most companies’ tax returns will include many tax positions inherent to normal business activities that are subject to multiple interpretations. Despite good faith positions taken in preparing tax returns, those judgments may not ultimately prevail if challenged by the IRS. Judgments frequently are subjected to legal scrutiny before the uncertainty ultimately is resolved. FASB Interpretation No. 48 indicates how companies should deal with this type of uncertainty in income taxes. This guidance allows companies to recognize in the financial statements the tax benefit of a position it takes only if it is “more likely than not” (greater than 50% chance) to be sustained if challenged. Guidance also prescribes how to measure the amount to be recognized. The decision is a two-step process.
Step 1. A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits.
Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50-percent likely to be realized.
Part II
If in step one it is determined that the more-likely-than-not criterion is not met, this means that none of the tax benefit is allowed to be recorded.
Not “more likely than not” = none of the tax benefit is allowed to be recorded

13. Intraperiod Tax Allocation
SFAS No. 109 requires intraperiod tax allocation for:
Income from continuing operations.
Discontinued operations.
Extraordinary items.
Statement of Financial Accounting Standards Number109 requires intraperiod tax allocation for:
Income from continuing operations.
Discontinued operations and
Extraordinary items.

14. Conceptual Concerns
Some accountants disagree with the FASB’s approach to accounting for income taxes.
Should deferred taxes be recognized?
Should deferred taxes be recognized for only some items?
Should deferred taxes be discounted?
Should classification be based on the timing of temporary difference reversals?
Some accountants disagree with the FASB’s approach to accounting for income taxes. Some of the most persistent objections include the following questions.
Should deferred taxes be recognized? Some feel the income tax expense for a reporting period should be the income tax actually payable currently.
Should deferred taxes be recognized for only some items? Critics sometimes argue that the tax liability for certain recurring events will never be paid and therefore do not represent a liability. An example often cited is the temporary difference due to depreciation.
Should deferred taxes be discounted? Some accountants contend that deferred tax assets and liabilities should reflect the time value of money by determining those amounts on a discounted (present value) basis.
Should classification be based on the timing of temporary difference reversals? Some feel that deferred tax assets and liabilities should be classified in a balance sheet as current or noncurrent according to the timing of the reversal of the temporary differences that gave rise to them.

15. End of Chapter 16 End of Chapter 16.
© 2008 The McGraw-Hill Companies, Inc.