1. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 16 Accounting for Income Taxes

2. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-2 The Internal Revenue Code is the set of rules for preparing tax returns. Financial statement income tax expense. IRS income taxes payable. GAAP is the set of rules for preparing financial statements. Usually... Results in... The difference between tax expense and tax payable is referred to as deferred taxes. Deferred Tax Assets/Liabilities

3. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-3 Deferred Tax Assets/Liabilities Example Examine the December 31, 2003, information for X-Off Inc. X-Off uses straight-line depreciation for financial reporting and accelerated depreciation for income tax reporting. X-Off’s tax rate is 30%.

4. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-4 Deferred Tax Assets/Liabilities Example Compute X-Off’s income tax expense and income tax payable.

5. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-5 Deferred Tax Assets/Liabilities Example Compute X-Off’s income tax expense and income tax payable. The income tax amount computed based on financial statement income is income tax expense for the period.

6. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-6 Deferred Tax Assets/Liabilities Example Next, compute income taxes for the tax return. Compute X-Off’s income tax expense and income tax payable.

7. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-7 Deferred Tax Assets/Liabilities Example Income taxes based on tax return income are the taxes payable for the period. Compute X-Off’s income tax expense and income tax payable.

8. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-8 Deferred Tax Assets/Liabilities Example The deferred tax for the period of $36,000 is the difference between income tax expense of $45,000 and income tax payable of $9,000. Compute X-Off’s income tax expense and income tax payable.

9. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-9 Deferred Tax Assets/Liabilities Example The entry to record the deferred taxes would appear as follows:

10. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-10 Temporary Differences These are called temporary differences. Often, the difference between pretax accounting income and taxable income results from items entering the income computations at different times.

11. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-11 Temporary differences will reverse out in one or more future periods. Temporary Differences Financial Income > Taxable Income Future Taxable Amounts Deferred Tax Liability Financial Income < Taxable Income Future Deductible Amounts Deferred Tax Asset

12. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-12 The temporary differences in the yellow boxes create deferred tax assets because they result in deductible amounts in the future.

13. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-13 The temporary differences in the gray boxes create deferred tax liabilities because they result in taxable amounts in the future.

14. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-14 Deferred Tax Liabilities In 2001, Baxter records $100,000 on its books resulting from revenue earned. The revenue will be taxed as the cash is collected in 2002 and 2003. Baxter expects to collect $70,000 in 2002 and the remaining $30,000 in 2003. The company is subject to a 32% tax rate. There are no other temporary differences. In 2001, Baxter records $100,000 on its books resulting from revenue earned. The revenue will be taxed as the cash is collected in 2002 and 2003. Baxter expects to collect $70,000 in 2002 and the remaining $30,000 in 2003. The company is subject to a 32% tax rate. There are no other temporary differences. Let’s look at Baxter’s 2001 tax entry.

15. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-15 Deferred Tax Liabilities Income tax expense = $300,000 × 32% = $96,000 Income tax payable = $200,000 × 32% = $64,000 Income tax expense = $300,000 × 32% = $96,000 Income tax payable = $200,000 × 32% = $64,000

16. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-16 Deferred Tax Liabilities The Deferred Tax Liability represents the future taxes Baxter will pay in 2002 and 2003.

17. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-17 Deferred Tax Liabilities Recall this information for Baxter for 2002. Income tax expense = $200,000 × 32% = $64,000 Income tax payable = $270,000 × 32% = $86,400 Income tax expense = $200,000 × 32% = $64,000 Income tax payable = $270,000 × 32% = $86,400

18. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-18 Deferred Tax Liabilities Originating difference Reversing difference

19. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-19 Deferred Tax Liabilities Future Taxable Amount Schedule The Deferred Tax Liability represents the future taxes Baxter will pay in 2003.

20. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-20 Income tax expense = $200,000 × 32% = $64,000 Income tax payable = $230,000 × 32% = $73,600 Income tax expense = $200,000 × 32% = $64,000 Income tax payable = $230,000 × 32% = $73,600 Recall the information for Baxter, Inc. for 2003: Deferred Tax Liabilities

21. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-21 Reversing difference Deferred Tax Liabilities

22. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-22 Health Magazine received $150,000 of subscriptions in advance during 2001. Subscription revenue will be earned equally in 2002, 2003 and 2004 for financial accounting purposes. The entire $150,000 will be taxed in 2001. There is additional income of $500,000 in each year. The company is subject to a 30% tax rate in each year. Deferred Tax Assets

23. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-23 Deferred Tax Assets Now, let’s record the income tax entry for 2001. This is the computation for the Deferred Tax Asset.

24. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-24 Income tax expense = $500,000 × 30% = $150,000 Income tax payable = $650,000 × 30% = $195,000 Income tax expense = $500,000 × 30% = $150,000 Income tax payable = $650,000 × 30% = $195,000 Deferred Tax Assets

25. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-25 Deferred Tax Assets After posting this entry, the Deferred Tax Asset account will have a balance of $45,000.

26. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-26 Deferred Tax Assets Income tax expense = $550,000 × 30% = $165,000 Income tax payable = $500,000 × 30% = $150,000 Income tax expense = $550,000 × 30% = $165,000 Income tax payable = $500,000 × 30% = $150,000 Let’s see the income tax entry for 2002. In 2002, the balance in the Deferred Tax Asset should decrease to $30,000. In 2002, Health Magazine earns $50,000 for financial reporting purposes.

27. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-27 Deferred Tax Assets Income tax expense = $550,000 × 30% = $165,000 Income tax payable = $500,000 × 30% = $150,000 Income tax expense = $550,000 × 30% = $165,000 Income tax payable = $500,000 × 30% = $150,000 Reversing difference Originating difference

28. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-28 Deferred Tax Assets This is the computation for the Deferred Tax Asset. Can you finish Health Magazine’s income tax entries for 2003 and 2004?

29. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-29 Deferred Tax Assets This would be the entry for 2003 and 2004. At the end of 2004, the balance in the Deferred Tax Asset would be zero.

30. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-30 Sharpen Your Pencil... There Is Still More!!

31. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-31 Valuation Allowance  A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized.  The deferred tax asset is then reported at its net realizable value.  A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized.  The deferred tax asset is then reported at its net realizable value.

32. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-32 Non-Temporary 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 excluded from taxable income

33. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-33 Non-Temporary Differences Also called permanent differences. Disregarded when determining both taxes payable and the deferred tax asset or liability.

34. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-34 Tax Rate Considerations  Deferred tax assets and liabilities should be determined using the future tax rates, if known.  The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs.  Deferred tax assets and liabilities should be determined using the future tax rates, if known.  The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs. IRC

35. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-35 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 in a tax refund. When used to offset earlier taxable income: Called: operating loss carryback. Result in a tax refund. When used to offset future taxable income: Called: operating loss carryforward. Result in reduced tax payable. When used to offset future taxable income: Called: operating loss carryforward. Result in reduced tax payable.

36. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-36 Carryback and Carryforward Current Year -2 Carryback Period +3+2+1... +20+4+5 Carryforward Period The NOL may first be applied against taxable income from two previous years. Unused NOL may be carried forward for 20 years. The NOL may first be applied against taxable income from two previous years. Unused NOL may be carried forward for 20 years.

37. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-37 Net Operating Losses (NOL) In 2003 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a 30% tax rate. In 2001, Garson reported taxable income of $20,000, and in 2002, taxable income was $10,000. The company elects to carryback the NOL.

38. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-38 Net Operating Losses (NOL) In 2003, no taxes are paid and Garson claims a tax refund of $9,000 for taxes paid in 2001 and 2002.

39. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-39 Net Operating Losses (NOL) Garson’s Income Statement for 2003 looks like this... Now let’s look at the treatment of the remaining NOL of $55,000 ($85,000 - $20,000 - $10,000).

40. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-40 Net Operating Losses (NOL) Garson prepares this estimate of taxable income based upon the best available evidence at 12/31/03. The NOL carryforward will provide a tax benefit of $17,000.

41. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-41 Net Operating Losses (NOL) It is likely that Garson will receive the benefits of the NOL in future periods. As a result, the following journal entry is made...... Garson’s income statement for 2003 will look like this...

42. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-42 Net Operating Losses (NOL) The deferred tax asset account created by the benefit of the carryforward will be used to lower income taxes payable in future years.

43. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-43 Disclose the following:  Total of all deferred tax liabilities and assets.  Total valuation allowance recognized.  Net change in valuation account.  Approximate tax effect of each type of temporary difference (and carryforward). Disclose the following:  Total of all deferred tax liabilities and 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. Balance Sheet Classification

44. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-44  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.  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

45. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-45 Intraperiod Tax Allocation  SFAS No. 109 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items. Changes in accounting principle. Prior period adjustments (to the beginning retained earnings).  SFAS No. 109 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items. Changes in accounting principle. Prior period adjustments (to the beginning retained earnings).

46. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 16-46 End of Chapter 16