1. Module 5, Part 2: Deferred Income Taxes 1

2. 2 IT Expense and Deferred Income Taxes Financial versus tax accounting – Financial income based on GAAP. – Taxable income based on tax laws. – The difference between financial income and taxable income is generally leads to something called “deferred income taxes. Historical treatment of income taxes – Recognize income tax expense based on financial income. – Recognize income tax payable based on taxable income. – The difference is a “plug,” and represents the timing difference between taxable and financial income.

3. 3 Problems with Historical Treatment Journal entry for historical treatment: I. T. Expensexxnet income x % DIT(debit or credit)xx / xxplug I. T. Payablexxtax income x % Problems: – after many years, the difference, primarily due to things like depreciation, had become one of the larger liabilities on the balance sheet. – in some cases, the liability was greater than anything else in the balance sheet. Solution (in SFAS 109): prepare a detailed schedule to calculate the amount for IT Payable and DIT, and let IT Expense be the plug.

4. 4 SFAS 109 Journal entry for SFAS 109: I. T. Expensexxplug DITxx / xxschedule I. T. Payablexxschedule Before developing the schedule, we first need to discuss what items need to go into the schedule. – Permanent differences (like income on municipal bonds) are excluded from the DIT schedule. – Only temporary differences are included in the schedule. Temporary differences fall into two categories: – those differences that lead to lower taxable income at the time of origination (future taxable). – those differences that lead to higher taxable income at the time of origination (future deductible).

5. 5 SFAS 109 - Future Taxable Items Future taxable (FT) items are amounts that are taxable in the future, because they are not taxable now. They represent the difference between financial and taxable income in the year of origination. They include: – Revenues or gains that are recognized in taxable income after they are recognized in financial income (such as income from equity investments in excess of dividends received). – Expenses or losses that are recognized in taxable income before they are recognized in financial income (such as MACRS depreciation used for taxable income, while straight-line depreciation used for financial income.)

6. 6 SFAS 109 - Future Deductible Items Future deductible (FD) items are amounts that lead to more tax now, but less tax in the future They represent the difference between financial and taxable income in the year of origination. They include: – Revenues or gains that are recognized in taxable income before they are recognized in financial income (such as cash received in advance for future services: unearned revenues). – Expenses or losses that are recognized in taxable income after they are recognized in financial income (this includes most estimates, such as bad debt expense, warranty expense loss contingencies, and pension expense in excess of cash paid).

7. 7 SFAS 109 - Future Deductible Items Future deductible (FD) items also include the net operating loss carryforward. The NOL carryforward occurs when a company generates a loss, rather than income, in a particular period. The loss may be carried back and applied to recent previous income, and the company may receive a tax refund. The loss may also be carried forward to future periods, and be offset against future income, to reduce future taxes.

8. 8 Illustration of Schedule in First Year Current year Future years I. T. Payable Deferred I.T. Pretax financial income $ xx Future deductible: Rev: customer advances +- Exp: estimated expenses +- Future taxable: Rev: excess equity income-+ Exp: excess MACRS depr.-+ Taxable income $ xx Note: if you schedule -1,000 for excess MACRS for the IT Payable column, then you would schedule +1,000 in the DIT column. Any originating amounts must reverse out in future periods in order to be considered for DIT. Effect in schedule is shown on the next slide.

9. 9 Illustration of Schedule in First Year Assume a 30% tax rate for current and future years. Current year Future years I. T. Payable Deferred I.T. Pretax financial income $100,000 Future taxable: Exp: excess MACRS depr. (1,000)1,000 Taxable income Deferred amount Tax rate.30.30 Income tax payable Deferred tax liability Journal entry (income tax expense is the plug): $ 99,000 1,000 $29,700 $300 Income tax expense 30,000 Income tax payable 29,700 Deferred tax liability 300

10. Disclosure of Deferred Income Taxes The footnote disclosure indicates the components of deferred income taxes, both Deferred Tax Assets and Deferred Tax Liabilities. For future deductible items, such as the NOL carryforward, the company must estimate the likelihood of the deferred tax asset being used, and establish a valuation allowance (reduction) for the portion that might not be used. 10