1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Accounting for Income Taxes 16

2. 16-2 Learning Objectives Describe the types of temporary differences that cause deferred tax liabilities and determine the amounts needed to record periodic income taxes. Identify and describe the types of temporary differences that cause deferred tax assets.

3. 16-3 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 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. Deferred Tax Assets/Liabilities

4. 16-4 Temporary Differences These are called temporary differences. Often, the difference between pre-tax accounting income and taxable income results from items entering the income computations at different times.

5. 16-5 Temporary differences will reverse out in one or more future periods. Temporary Differences Accounting Income>Taxable Income Future Taxable Amounts Deferred Tax Liability Accounting Income<Taxable Income Future Deductible Amounts Deferred Tax Asset

6. 16-6 The temporary differences in the yellow boxes create deferred tax assets because they result in deductible amounts in the future.

7. 16-7 The temporary differences in the gray boxes create deferred tax liabilities because they result in taxable amounts in the future.

8. 16-8 Deferred Tax Liabilities In 2006, Baxter reports $300,000 of pretax income. Included in this amount is $100,000 resulting from revenue earned from an installment sale for which no cash was collected. The revenue will be taxed as the cash is collected in 2007 and 2008. Baxter expects to collect $70,000 in 2007 and the remaining $30,000 in 2008. In 2007 and 2008, Baxter reports $200,000 of pretax income. The company is subject to a 32% tax rate. There are no other temporary differences. In 2006, Baxter reports $300,000 of pretax income. Included in this amount is $100,000 resulting from revenue earned from an installment sale for which no cash was collected. The revenue will be taxed as the cash is collected in 2007 and 2008. Baxter expects to collect $70,000 in 2007 and the remaining $30,000 in 2008. In 2007 and 2008, Baxter reports $200,000 of pretax income. The company is subject to a 32% tax rate. There are no other temporary differences.

9. 16-9 Deferred Tax Liabilities 2006 Income tax payable = $200,000 × 32% = $64,000 2006 Deferred tax liability change = ($100,000 × 32%) - $0 = $32,000 2006 Income tax payable = $200,000 × 32% = $64,000 2006 Deferred tax liability change = ($100,000 × 32%) - $0 = $32,000

10. 16-10 Deferred Tax Liabilities The Deferred Tax Liability represents the future taxes Baxter will pay in 2007 and 2008.

11. 16-11 Deferred Tax Liabilities Recall this information for Baxter. 2007 Income tax payable = $270,000 × 32% = $86,400 2007 Deferred tax liability change = ($30,000 × 32%) - $32,000 = $22,400 2007 Income tax payable = $270,000 × 32% = $86,400 2007 Deferred tax liability change = ($30,000 × 32%) - $32,000 = $22,400

12. 16-12 Deferred Tax Liabilities Future Taxable Amount Schedule The Deferred Tax Liability represents the future taxes Baxter will pay in 2008. Originating difference Reversing difference

13. 16-13 Deferred Tax Liabilities Recall this information for Baxter. 2008 Income tax payable = $230,000 × 32% = $73,600 2008 Deferred tax liability change = ($0 × 32%) - $9,600 = $9,600 2008 Income tax payable = $230,000 × 32% = $73,600 2008 Deferred tax liability change = ($0 × 32%) - $9,600 = $9,600

14. 16-14 Deferred Tax Liabilities Reversing difference Future Taxable Amount Schedule The Deferred Tax Liability represents the future taxes Baxter will pay.

15. 16-15 Health Magazine received $150,000 of subscriptions in advance during 2006. Subscription revenue will be earned equally in 2007, 2008 and 2009 for financial accounting purposes. The entire $150,000 will be taxed in 2006. 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

16. 16-16 Deferred Tax Assets Now, let’s record the income tax entry for 2006. This is the computation for the Deferred Tax Asset.

17. 16-17 Deferred Tax Assets 2006 Income tax payable = $650,000 × 30% = $195,000 2006 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000 2006 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000 2006 Income tax payable = $650,000 × 30% = $195,000 2006 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000 2006 Deferred tax asset change = [($150,000 × 30%] - $0 = $45,000

18. 16-18 Deferred Tax Assets After posting the entry, the Deferred Tax Asset account will have the desired ending balance of $45,000.

19. 16-19 Deferred Tax Assets 2007 Income tax payable = $500,000 × 30% = $150,000 2007 Deferred tax asset change = [($100,000) × 30%] - $45,000 = ($15,000) 2007 Income tax payable = $500,000 × 30% = $150,000 2007 Deferred tax asset change = [($100,000) × 30%] - $45,000 = ($15,000)

20. 16-20 Deferred Tax Assets In 2007, the balance in the Deferred Tax Asset should decrease to $30,000. Reversing difference Originating difference Can you prepare the entries for 2008 and 2009?

21. 16-21 Deferred Tax Assets This would be the entry for 2008 and 2009. At the end of 2009, the balance in the Deferred Tax Asset would be zero.

22. 16-22 Learning Objectives Describe when and how a valuation allowance is recorded for deferred tax assets.

23. 16-23  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 estimated 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 estimated net realizable value. Valuation Allowance

24. 16-24 Learning Objectives Explain why nontemporary differences have no deferred tax consequences.

25. 16-25 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.

26. 16-26 Nontemporary Differences Also called permanent differences. Disregarded when determining both taxes payable currently and the deferred tax asset or liability.

27. 16-27 Learning Objectives Explain how a change in tax rates affects the measurement of deferred tax amounts.

28. 16-28 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. Internal Revenue Code

29. 16-29 Learning Objectives Determine income tax amounts when multiple temporary differences exist.

30. 16-30 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

31. 16-31 Learning Objectives Describe when and how an operating loss carryforward and an operating loss carryback are recognized in the financial statements.

32. 16-32 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 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. When used to offset future taxable income: Called: operating loss carryforward. Result: reduced tax payable.

33. 16-33 Net Operating Losses (NOL) 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.

34. 16-34 Net Operating Losses (NOL) In 2006 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a 30% tax rate. In 2004, Garson reported taxable income of $20,000, and in 2005, taxable income was $10,000. The company elects to carryback the NOL. Let’s look at the tax benefits of the operating loss carryback and carryforward.

35. 16-35 Net Operating Losses (NOL)

36. 16-36 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.

37. 16-37 Learning Objectives Explain how deferred tax assets and deferred tax liabilities are classified and reported in a classified balance sheet and describe related disclosures.

38. 16-38 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). 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. Balance Sheet Classification

39. 16-39  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

40. 16-40 Learning Objectives Explain intraperiod tax allocation.

41. 16-41 Intraperiod Tax Allocation  SFAS No. 109 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items.  SFAS No. 109 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items.

42. 16-42 End of Chapter 16