1. 1 Income Taxes chapter chapter 16

2. 2 1. Understand the concept of deferred taxes and the distinction between permanent and temporary differences. 2. Compute the amount of deferred tax liabilities and assets. 3. Explain the provisions of tax loss carrybacks and carryforwards, and be able to account for these provisions. 4. Schedule future tax rates, and determine the effect on tax assets and liabilities. Learning Objectives

3. 3 5. Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities. 6.Comply with income tax disclosure requirements associated with the statement of cash flows. 7.Describe how, with respect to deferred income taxes, international accounting standards have converged toward the U.S. treatment. Learning Objectives

4. 4 Deferred Income Taxes: An Overview The primary goal of financial accounting is to provide useful information to management, stockholders, creditors, and other properly interested. The primary goal of the income tax system is the equitable collection of revenue.

5. 5 Deferred Income Taxes: An Overview Two basic considerations in U.S. corporations computed net income. 1.How to account for revenues and expenses that have already been recognized and reported to shareholders in a company’s financial statements but will not affect taxable income until subsequent years.

6. 6 Deferred Income Taxes: An Overview Two basic considerations in U.S. corporations computed net income. 2.How to account for revenues and expenses that have already been reported to the IRS but will not be recognized in the financial statements until subsequent years.

7. 7 Examples –Revenues (or gains) taxable after they are recognized for financial reporting, such as receivables from installment sales. –Expenses (or losses) deductible for tax purposes before they are recognized for financial reporting purposes, such as accelerated tax depreciation. Simple Deferred Tax Liabilities

8. 8 In 2005, Ibanez Company earned revenues of $30,000. Ibanez has no expenses other than income taxes. In this case, Ibanez is taxed on cash received. The company received $10,000 in 2005 and $20,000 in 2006. The income tax rate is 40% and it is expected to remain the same into the foreseeable future. ContinuedContinued

9. 9 Simple Deferred Tax Liabilities Income Tax Expense12,000 Income Taxes Payable4,000 Deferred Tax Liability8,000 $30,000 x.40 $20,000 x.40

10. 10 Simple Deferred Tax Liabilities Ibanez Company Income Statement For the Year Ended December 31, 2005 Revenues$30,000 Income tax expense: Current$4,000 Deferred 8,000 Net income$18,000

11. 11 Simple Deferred Tax Asset Examples –Expenses (or losses) that are deductible for tax purposes after they are recognized for financial reporting purposes, such as warranty expenses. –Revenues (or gains) that are taxable before they are recognized for financial reporting purposes, such as subscriptions received in advance. Realization of a Deferred Tax Asset depends on the existence of taxable income in future years

12. 12 Simple Deferred Tax Asset In 2005, Gupta Corporation generated service revenues totaling $60,000, all taxable in 2005. No warranty claims were made in 2005, but Gupta estimates that in 2006 warranty costs of $10,000 will incurred for claims related to 2005 service revenues. Assume a 40% tax rate. ContinuedContinued

13. 13 Simple Deferred Tax Asset Income Tax Expense20,000 Deferred Tax Asset4,000 Income Taxes Payable24,000 $60,000 x.40 $10,000 x.40 ContinuedContinued

14. 14 Simple Deferred Tax Asset Gupta Company Income Statement For the Year Ended December 31, 2005 Revenues$60,000 Less: Warranty expense 10,000 Income before taxes$50,000 Income tax expense: Current$24,000 Deferred benefit (4,000)20,000 Net income$30,000

15. 15 Permanent and Temporary Differences Permanent Differences: Nondeductible expenses or nontaxable revenues that are recognized for financial reporting purposes but are never part of taxable income. Temporary Differences: Differences between pretax financial income and taxable income arising from business events that are recognized for both financial and tax purposes, but in different time periods.

16. 16 Illustration of Permanent and Temporary Differences For the year ended December 31, 2005, Monroe Corporation reported net income before taxes of $420,000. This amount includes $20,000 of nontaxable revenues and $5,000 of nondeductible expenses. The depreciation method used for tax purposes allowed a deduction that exceeded the book approach by $30,000. ContinuedContinued

17. 17 Pretax income from income statement$420,000 Add (deduct) permanent differences: Nontaxable revenues$(20,000) Nondeductible expenses 5,000 (15,000) Financial income subject to tax$405,000 Add (deduct) temporary differences: Excess of tax depreciation over book depreciation (30,000) Taxable income$375,000 Tax on taxable income (income taxes payable): $375,000 x.35 $131,250 Illustration of Permanent and Temporary Differences

18. 18 1.Because the assets and liabilities recorded under this method are in agreement with the FASB definitions of financial statement elements, the method is conceptually consistent with other standards. Advantages of the Asset and Liability Method Annual Computation of Deferred Tax Liabilities and AssetsContinuedContinued

19. 19 2.The asset and liability method is a flexible method that recognizes changes in circumstances and adjusts the reported amounts accordingly. This flexibility may improve the predictive value of the financial statements. Annual Computation of Deferred Tax Liabilities and Assets

20. 20 Identify type and amounts of existing temporary differences. Establish valuation allowance account if more likely than not ( >50%) some portion or all of the deferred tax asset will not be realized. Measure the deferred tax liability for taxable temporary differences (use enacted rates). Measure the deferred tax asset for deductible temporary differences (use enacted rates). Annual Computation of Deferred Tax Liabilities and Assets

21. 21 For 2005, Roland computes pretax financial income of $75,000. The only difference between financial and taxable income is depreciation. The enacted tax rate is 40%. The 2005 tax is $24,000 (40% of $60,000). Example 3: Deferred Tax Liability Financial income subject to tax$75,000 Deduct temporary difference: Excess of tax depreciation ($40,000) over book depreciation ($25,000) (15,000) Taxable income$60,000 ContinuedContinued

22. 22 Income tax expense = Pre-tax financial income (or financial income subject to tax i.e. excluding permanent differences) X Tax % Note – the above is true only if future tax rates do not change

23. 23 Example 3: Deferred Tax Liability Income Tax Expense30,000 Income Taxes Payable24,000 Deferred Tax Liability— Noncurrent6,000 $30,000 – $6,000 $15,000 x.40 ContinuedContinued Journal entry for 2005

24. 24 Example 3: Deferred Tax Liability For 2006, Roland earned income of $75,000 and the taxable income is $70,000, or a tax of $28,000. ContinuedContinued Financial income subject to tax$75,000 Deduct temporary difference: Excess of tax depreciation ($30,000) over book depreciation ($25,000) (5,000) Taxable income$70,000 Tax @ 40%$28,000

25. 25 Example 3: Deferred Tax Liability Income Tax Expense30,000 Income Taxes Payable28,000 Deferred Tax Liability— Noncurrent2,000 $30,000 – $2,000 $5,000 x.40 ContinuedContinued Journal entry for 2006

26. 26 Example 3: Deferred Tax Liability Depreciation expense in 2007 is the same for both financial and tax, so the entry is simple. Income Tax Exp.30,000 Income Taxes Pay.30,000

27. 27 Example 3: Deferred Tax Liability For 2008, Roland earned income of $75,000 and the taxable income is $95,000, or a tax of $38,000. ContinuedContinued Financial income subject to tax$75,000 Add temporary difference: Excess of book depreciation ($25,000) over tax depreciation ($5,000) 20,000 Taxable income$95,000 Tax @ 40%$38,000

28. 28 Example 3: Deferred Tax Liability Income Tax Expense30,000 Deferred Tax Liability— Noncurrent8,000 Income Taxes Payable38,000 $30,000 + $8,000 $20,000 x.40 Journal entry for 2008

29. 29 Changes in Tax Rates If changes in future tax rates hare enacted, the deferred tax liability (or asset) is measured using the enacted tax rate for future years when the temporary difference is expected to reverse. Subsequent changes in tax rates after a deferred tax/liability has already been computed, requires an adjustment to the income tax expense for the year of the change e.g. for a tax reduction, the adjustment entry would be Dr. Deferred Tax Liability –Cr. Income Tax Expenses

30. 30 Example 4: Deferred Tax Asset Some possible sources of taxable income to be considered in evaluating the realistic value of a deferred tax asset are: Future reversals of existing taxable temporary differences. Future taxable income exclusive of reversing temporary differences. Taxable income in prior (carryback) years.

31. 31 Example 4: Deferred Tax Asset For 2005, Sandusky Inc. computes pretax financial income of $22,000. The only difference between financial and taxable income is the recognition of warranty expense. Accrued warranty expense for 2005 was $18,000; no actual warranty expenditures were made in 2005. The warranty obligation is considered one-third current and two-thirds noncurrent. ContinuedContinued

32. 32 Financial income subject to tax$22,000 Add temporary difference: Excess of warranty expense ($18,000) over warranty deductions ($0) 18,000 Taxable income$40,000 Example 4: Deferred Tax Asset Taxable income in 2005 is calculated as follows: Tax ($40,000 x.40)$16,000ContinuedContinued

33. 33 Example 4: Deferred Tax Asset Income Tax Expense8,800 Deferred Tax Asset—Current2,400 Deferred Tax Asset— Noncurrent4,800 Income Taxes Payable16,000 Journal entry for 2005 ContinuedContinued

34. 34 Example 4: Deferred Tax Asset In the years 2006 through 2008, taxable income would be $16,000, computed as follows: Financial income subject to tax$22,000 Reversal of temporary difference: Excess of warranty deductions (1/3 x $18,000) over warranty expense ($0) (6,000) Taxable income$16,000 Tax ($16,000 x.40)$ 6,400

35. 35 Income Tax Expense8,800 Deferred Tax Asset— Current2,400 Income Taxes Payable 6,400 Deferred Tax Asset— Current2,400 Deferred Tax Asset— Noncurrent2,400 Journal entry for 2006 ContinuedContinued Example 4: Deferred Tax Asset

36. 36 Income Tax Expense8,800 Deferred Tax Asset— Current2,400 Income Taxes Payable6,400 Deferred Tax Asset— Current2,400 Deferred Tax Asset— Noncurrent2,400 Journal entry for 2007 Example 4: Deferred Tax Asset

37. 37 Income Tax Expense8,800 Deferred Tax Asset— Current2,400 Income Taxes Payable6,400 Journal entry for 2008 Example 4: Deferred Tax Asset

38. 38 Example 5: Deferred Tax Liabilities and Assets For 2005, Hsieh reported pretax financial income of $38,000. As of December 31, 2005, the actual depreciation expense was $25,000 and the actual warranty expense was $18,000. For income tax reporting, these expenses were $40,000 and $0, respectively. ContinuedContinued

39. 39 Example 5: Deferred Tax Liabilities and Assets Financial income subject to tax$38,000 Add (deduct) temporary difference: Excess of warranty expense over warranty deductions 18,000 Excess of tax depreciation over book depreciation(15,000) Taxable income$41,000 Taxable income in 2005 is calculated as follows: Tax ($41,000 x.40)$16,400ContinuedContinued

40. 40 Example 5: Deferred Tax Liabilities and Assets Income Tax Expense15,200 Journal entry for 2005 Deferred Tax Asset—Current2,400 Deferred Tax Asset— Noncurrent4,800 Deferred Tax Liability— Noncurrent6,000 Income Taxes Payable16,400

41. 41 Valuation Allowance for Deferred Tax Assets Statement No. 109 stipulates that both positive and negative evidence be considered when determining whether deferred tax assets will be fully realized.

42. 42 Loss Year -2 Year +20 Carryback Election Carryforward Election Net Operating Loss (NOL) Carryback

43. 43 Net Operating Loss (NOL) Carryback YearTax Rate Income Tax Income (Loss) 2004$10,00035%$3,500 200514,000304,200 2006(19,000)300 Journal Entry in 2006: Income Tax Refund Receivable 6,200 Income Tax Benefit From NOL Carryback (Income Tax Expense) 6,200 [$3,500 + (30% x $9,000)]

44. 44 Accounting for NOL Carryforward Continuing with the Prairie Company illustration, assume that in 2007 the firm incurred an operating loss of $35,000. Year Income (Loss) Tax Rate Income Tax 2006$(19,000) 30%$0 2007(35,000) 30%0 ContinuedContinued

45. 45 The only loss remaining against which operating income can be applied is $5,000 from 2005 ($14,000 – $9,000). This leaves $30,000 to be carried forward from 2007 as a future tax benefit of $9,000 ($30,000 x.30). Accounting for NOL CarryforwardContinuedContinued

46. 46 Income Tax Refund Receivable1,500 Deferred Tax Asset—NOL Carryforward9,000 Income Tax Benefit from NOL Carryback1,500 Income Tax Benefit from NOL Carryforward9,000 Accounting for NOL Carryforward The journal entry at the end of 2007 to record the tax benefits would be as follows:

47. 47 Journal Entry: Income Tax Expense15,000 Income Taxes Payable6,000 Deferred Tax Asset—NOL Carryforward 9,000 Accounting for NOL Carryforward The firm reports a taxable income of $50,000 in 2008. The tax carryforward allows management to deduct the carryforward from the $15,000 tax ($50,000 x.30) that would be due without the carryforward.

48. 48 Accounting for NOL Carryforward What if, due to a declining market, management believes that losses will continue in the future and the tax benefit will not be realized?

49. 49 Accounting for NOL Carryforward Journal Entry: Income Tax Refund Receivable1,500 Deferred Tax Asset—NOL Carryforward9,000 Income Tax Benefit from NOL Carryback1,500 Allowance to Reduce Deferred Tax Assets to Realizable Value— NOL Carryforward9,000 As a result of this entry, the deferred tax asset is zero— the expected realizable value.

50. 50 Financial Statement Presentation and Disclosure Current tax expense or benefit Deferred tax expense or benefit Investment tax credits Government grants recognized as tax reductions The following items must appear in the income statement or an accompanying note: Continued

51. 51 Benefits of NOL carryforwards Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of an enterprise Adjustments in beginning-of-the-year valuation allowance because of a change in circumstances Financial Statement Presentation and Disclosure The following items must appear in the income statement or an accompanying note:

52. 52 Deferred Taxes and the Statement of Cash Flows Callazo Company had the following information for 2005: Revenue (all cash)$30,000 Income tax expense: Current$10,300 Deferred 1,700(12,000) Net income$18,000 Cash paid for income taxes during 2005 totaled $13,300. Callazo Company had the following information for 2005: Revenue (all cash)$30,000 Income tax expense: Current$10,300 Deferred 1,700(12,000) Net income$18,000 Cash paid for income taxes during 2005 totaled $13,300. Continued

53. 53 Deferred Taxes and the Statement of Cash Flows 12/31/05 Income tax refund receivable$2,000$ 0 Income taxes payable01,000 Deferred tax liability9,7008,000 Analysis Income Statement Adjustment SCF Revenue (all cash), $30,000No adjustment$30,000 cash collected from customers Continued

54. 54 Analysis Income Statement Adjustment SCF Income tax expense—current–$2,000—$(13,300) Cash $(10,300)Increase inpaid for taxes tax receivable –$1,000— Decrease in taxes payable Continued Deferred Taxes and the Statement of Cash Flows

55. 55 Analysis Income Statement Adjustment SCF Income tax expense—deferred+$2,000—No effect $(1,700)Increase in deferred tax liability Continued Deferred Taxes and the Statement of Cash Flows

56. 56 Analysis Income Statement Adjustment SCF Net income, $18,000–$1,300$16,700 Cash flow from operations Deferred Taxes and the Statement of Cash Flows Collazo Company Statement of Cash Flows (Direct Approach) Cash collected from customers$30,000 Income taxes paid(13,300) Cash provided by operating activities$16,700 Continued

57. 57 Deferred Taxes and the Statement of Cash Flows Collazo Company Statement of Cash Flows (Indirect Approach) Net income$18,000 Decrease in income tax refund receivable(2,000) Decrease in income taxes payable(1,000) Increase in deferred tax liability 1,700 Cash provided by operating activities$16,700

58. 58 International Accounting for Deferred Taxes No-Deferral Approach: Ignore the differences and report income tax expense equal to the amount of tax payable for the year. Comprehensive Recognition Approach: Deferred taxes are included in the computation of income tax expense and reported on the balance sheet. Partial Recognition Approach: A deferred tax liability is recorded only to the extent that the deferred taxes are actually expected to be paid in the future.

59. 59 The End chapter 16