1. © 2004 McGraw-Hill Ryerson. McGraw-Hill Ryerson Chapter 16 Accounting for Income Taxes

2. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-2 The CRA administers the rules for preparing tax returns. Financial statement income tax expense. CRA 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 Future Income Taxes. Future Income Tax Assets/Liabilities

3. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-3 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.

4. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-4 Temporary differences will reverse out in one or more future periods. Temporary Differences Accounting Income>Taxable Income Future Taxable Amounts Future Income Tax Liability Accounting Income<Taxable Income Future Deductible Amounts Future Income Tax Asset

5. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-5 Kent Land Management reported pretax income of $100 million in 2005, 2006 and 2007, plus additional 2005 income of $40 million from installment sales of property. The installment sales income is reported on the tax return when it is collected in 2006 ($10 million) and in 2007 ($30 million). The enacted tax rate is 40% each year. Future Income Tax Liabilities

6. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-6 Future Income Tax Liabilities In this case there is no receivable for tax purposes since the installment is taken into taxable income when received. The carrying (book) value is reduced as the cash is received, which in turn reduces the temporary difference. In this case there is no receivable for tax purposes since the installment is taken into taxable income when received. The carrying (book) value is reduced as the cash is received, which in turn reduces the temporary difference.

7. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-7 The temporary differences in the yellow boxes create Future Income Tax assets because they result in deductible amounts in the future.

8. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-8 Future Income Tax Assets/Liabilities Example Compute income tax expense and income tax payable.

9. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-9 Woods reported pretax income in 2005, 2006, 2007 and 2008 of $100 million. In 2005 an asset is acquired for $100 million. It is amortized for financial reporting purposes over 4 years on a straight-line basis with no residual value. For tax purposes the CCA for the period 2005-2008 is as follows: $33 million, $44 million, $15 million and $8 million. The enacted tax rate is 40%. Future Income Tax Assets/Liabilities

10. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-10 Future Income Tax Assets/Liabilities Example Compute Woods income tax expense and income tax payable. The income tax amount computed based on financial statement income is income tax expense for the period.

11. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-11 Future Income Tax Assets/Liabilities Example Income taxes based on tax return income are the taxes payable for the period. Compute Woods income tax expense and income tax payable.

12. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-12 Future Income Tax Assets/Liabilities Example The Future Income Tax for the period of $3.2 million, the difference between income tax expense of $40 million and income tax payable of $36.8 million. Compute Woods income tax expense and income tax payable.

13. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-13 Future Income Tax Assets/Liabilities Example The entry to record the Future Income Taxes would appear as follows:

14. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-14 Future Income Tax Assets Lane Electronics reported pretax income in 2005, 2006 and 2007 of $70 million, $100 million and $100 million respectively. The 2005 income statement includes a warranty expense that is deducted for tax purposes when paid in 2006 ($15 million) and 2007 ($15 million). The company is subject to a 40% tax rate. There are no other temporary differences. Lane Electronics reported pretax income in 2005, 2006 and 2007 of $70 million, $100 million and $100 million respectively. The 2005 income statement includes a warranty expense that is deducted for tax purposes when paid in 2006 ($15 million) and 2007 ($15 million). The company is subject to a 40% tax rate. There are no other temporary differences.

15. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-15 Future Income Tax Assets Income tax expense = $70 × 40% = $28 Income tax payable = $100 × 40% = $40 Income tax expense = $70 × 40% = $28 Income tax payable = $100 × 40% = $40

16. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-16 Future Income Tax Assets The Future Income Tax Asset represents the Future Income Taxes Baxter will recover in 2006 and 2007.

17. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-17 Future Income Tax Assets Recall this information for Baxter for 2005. Income tax expense = $100 × 40% = $40 Income tax payable = $85 × 40% = $34 Income tax expense = $100 × 40% = $40 Income tax payable = $85 × 40% = $34

18. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-18 Future Income Tax Liabilities Reversing differences Originating difference

19. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-19 Tomorrow Publishing reported pretax income in 2005, 2006 and 2007 of $80 million, $155 million and $105 respectively. The 2005 income statement does not include $20 million of magazine revenue received in that year for one and two-year subscriptions. The revenue is reported for tax purposes in 2005 and is earned in 2006 ($15 million) and 2007 ($5 million). The income tax rate is 40% for each year. Future Income Tax Assets

20. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-20 Future Income Tax Assets Now, let’s record the income tax entry for 2005. This is the computation for the Future Income Tax Asset.

21. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-21 Income tax expense = $80m × 40% = $32 Income tax payable = $100 × 40% = $40 Income tax expense = $80m × 40% = $32 Income tax payable = $100 × 40% = $40 Future Income Tax Assets

22. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-22 Future Income Tax Assets After posting the previous entry, the Future Income Tax Asset account will have a balance of $8 million.

23. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-23 Future Income Tax Assets Income tax expense = $115 × 40% = $46 Income tax payable = $100 × 40% = $40 Income tax expense = $115 × 40% = $46 Income tax payable = $100 × 40% = $40 Let’s see the income tax entry for 2006. In 2006, the balance in the Future Income Tax Asset should decrease to $2m. In 2006, Tomorrow earns $115m for financial reporting purposes.

24. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-24 Future Income Tax Assets Reversing difference Originating difference

25. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-25 Future Income Tax Assets This is the computation for the Future Income Tax Asset. Can you finish Tomorrow’s income tax entries for 2007?

26. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-26 Future Income Tax Assets This would be the entry for 2007. At the end of 2007, the balance in the Future Income Tax Asset would be zero.

27. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-27 Sharpen Your Pencil... There Is Still More!!

28. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-28 Valuation Allowance  A valuation allowance account is required when it is more likely than not that some portion of the Future Income Tax asset will not be realized.  The Future Income 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 Future Income Tax asset will not be realized.  The Future Income Tax asset is then reported at its net realizable value.

29. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-29 Valuation Allowances Remember that a future deductible amount reduces taxable income and saves taxes only if there is taxable income to be reduced when the future deduction is available. A valuation allowance is needed if taxable income is anticipated to be insufficient to realize the tax benefit.

30. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-30 Valuation Allowances The valuation allowance must be re- evaluated at the end of each accounting period like all other allowances. The appropriate balance is decided and the balance is adjusted to create that balance. The account commonly used is Valuation allowance – future income tax asset.

31. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-31 Permanent 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.

32. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-32  Dividends between taxable Canadian corporations  Equity in earnings of significantly- influenced investees  50% of capital gains  Golf and social club dues  50% of meals and entertainment  Interest and penalty on taxes  Dividends between taxable Canadian corporations  Equity in earnings of significantly- influenced investees  50% of capital gains  Golf and social club dues  50% of meals and entertainment  Interest and penalty on taxes Permanent Differences - Examples

33. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-33  Political contributions  Fines and penalties  Expenses related to earning nontaxable income  Nontaxable revenue  Proceeds from life insurance policies carried by the company on key officers and employees  Political contributions  Fines and penalties  Expenses related to earning nontaxable income  Nontaxable revenue  Proceeds from life insurance policies carried by the company on key officers and employees Permanent Differences - Examples

34. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-34 Permanent Differences Disregarded when determining both taxes payable and the Future Income Tax asset or liability.

35. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-35 Kent Land Management reported pretax income in 2005 of $100 million, except for additional income of $40 million from installment sales of property and $5 million dividends from Canadian corporations in 2005. The installment income is reported for tax purposes in 2006 ($10 million) and 2007 ($30 million). The enacted tax rate is 40% each year. Permanent Differences - Example

36. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-36 Permanent Differences - Example Originating difference Reversing differences

37. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-37 Permanent Differences - Example The 2005 journal entry is as follows:

38. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-38 Tax Rate Considerations  Future Income Tax assets and liabilities should be determined using the Future Income Tax rates, if known.  The Future Income Tax asset or liability must be adjusted if a change in a tax law or rate occurs.  Future Income Tax assets and liabilities should be determined using the Future Income Tax rates, if known.  The Future Income Tax asset or liability must be adjusted if a change in a tax law or rate occurs. CRA

39. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-39 Tax Rate Considerations  Let’s use the previous Kent Land Management example to demonstrate this concept.  Let’s assume that the enacted tax rates are 40% for 2005 and 2006, and 35% for 2007.  Let’s use the previous Kent Land Management example to demonstrate this concept.  Let’s assume that the enacted tax rates are 40% for 2005 and 2006, and 35% for 2007. CRA

40. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-40 Tax Rate Changes - Example

41. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-41 Tax Rate Changes - Example The 2005 journal entry is as follows:

42. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-42 Tax Rate Changes - Example Income tax expense = $100 x 40% = $40 Change in FITL = $14.5 - $10.5 = $4 Change in FITL = $14.5 - $10.5 = $4 Income tax payable = $110 × 40% = $44 Income tax expense = $100 x 40% = $40 Change in FITL = $14.5 - $10.5 = $4 Change in FITL = $14.5 - $10.5 = $4 Income tax payable = $110 × 40% = $44 In 2006 the Future income tax liability must be adjusted to $10.5 million.

43. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-43 Tax Rate Changes Now let’s assume that government passes a new tax law in 2006 that will cause the 2007 tax rate to be 30% instead of the previously scheduled 35% rate. 30%35% Fiscal 2006 Fiscal 2007 2007 Tax Rate Change

44. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-44 Tax Rate Changes When a change in the tax rate is enacted into law its effect on the future income tax asset and liability accounts should be recorded immediately as an adjustment to income tax expense in the period of the change.

45. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-45 Tax Rate Changes - Example $30 million x 30% Note that the balance in the future income tax liability account is based on the new rate being applied to the temporary differences.

46. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-46 Tax Rate Changes - Example Income tax expense = $38.5 Change in FITL = $14.5 - $9 = $5.5 Change in FITL = $14.5 - $9 = $5.5 Income tax payable = $110 × 40% = $44 Income tax expense = $38.5 Change in FITL = $14.5 - $9 = $5.5 Change in FITL = $14.5 - $9 = $5.5 Income tax payable = $110 × 40% = $44 In 2006 the Future income tax liability must be adjusted to $9 million ($30 million x 30%).

47. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-47 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.

48. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-48 Net Operating Losses (NOL) The general principle is that the tax benefits of losses should be recognized in the period of the loss to the extent possible. It is usually advantageous to carry back losses by filing an amended tax return to realize the benefit sooner.

49. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-49 Carryback and Carryforward Current Year -2 Carryback Period +3+2+1 +6 +7+4+5 Carryforward Period The NOL may be applied against taxable income from three previous years. Unused NOL may be carried forward for 7 years. The NOL may be applied against taxable income from three previous years. Unused NOL may be carried forward for 7 years. -3

50. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-50 Net Operating Losses (NOL) During 2005, its first year of operations, Atlantic reported an operating loss of $125 million for financial reporting and tax purposes. The enacted tax rate is 40%. Let’s assume that the company determines that it is more likely than not to generate sufficient taxable income in future so that the benefit can be realized. During 2005, its first year of operations, Atlantic reported an operating loss of $125 million for financial reporting and tax purposes. The enacted tax rate is 40%. Let’s assume that the company determines that it is more likely than not to generate sufficient taxable income in future so that the benefit can be realized.

51. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-51 Net Operating Losses (NOL) In 2005, no taxes are paid and Atlantic will carry forward the benefit of the loss carryforward.

52. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-52 Net Operating Losses (NOL) Atlantic’s Income Statement for 2005 looks like this...

53. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-53 NOL – Future Taxable Income Not Likely Assume that Atlantic’s future is uncertain and that there is insufficient evidence about the possibility of future taxable income to recognize the income tax asset and benefit related to the $125 million of income tax losses. In this case there would not be any income tax entry for 2005. WHY?

54. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-54 NOL – Future Taxable Income Not Likely The amounts do not meet the definition of assets per the conceptual framework. There is no evidence of future economic benefits. The amounts and expiry dates of unrecognized income tax asset related to the carryforwards of unused tax losses must be disclosed.

55. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-55 Net Operating Losses (NOL) During 2005 Atlantic reported an operating loss of $125 million for financial reporting and tax purposes. The enacted tax rate is 40% for 2005. Taxable income, tax rates and income taxes paid in the two previous years were as follows: During 2005 Atlantic reported an operating loss of $125 million for financial reporting and tax purposes. The enacted tax rate is 40% for 2005. Taxable income, tax rates and income taxes paid in the two previous years were as follows:

56. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-56 Net Operating Losses (NOL) The total loss was $125 million. $20 m was carried back to eliminate the 2003 income and $55 m was carried back to eliminate the 2004 income. The remaining $50 m will be carried forward.

57. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-57 Net Operating Losses (NOL) To recognize the carrybacks and the carryforward, the following entry is made:... Atlantic’s income statement for 2005 will look like this...

58. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-58 Net Operating Losses (NOL)

59. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-59 Net Operating Losses (NOL) Let’s assume that Atlantic makes accounting income of $15 million in 2006. $15m of the $50m loss carryforward will be applied to the 2006 taxable income.

60. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-60 Net Operating Losses (NOL) The loss carryforward now stands at $35 million and the resulting tax benefit is 40% or $14 million. Therefore the following journal entry I required to reduce the benefit from $20 million to $14 million.

61. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-61 Net Operating Losses (NOL) Using the previous example, let’s assume that the company’s future is uncertain on December 31, 2005 and there is insufficient evidence about the possibility of future taxable income. The only entry required would be to recognize loss carryback.

62. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-62 Net Operating Losses (NOL) Now let’s assume the company generates pretax income of $65 million in 2006. After applying the $50 million loss carryforward, tax is payable on only $15 million income. With a tax rate of 40% the following entry is made:

63. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-63 Net Operating Losses (NOL) The potential tax benefit associated with the losscarryforward was not recognized in 2005 as an asset; therefore, it is recognized in 2006.

64. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-64 Net Operating Losses (NOL) The $6 million current tax expense is made up of two components: income tax expense of $26 million accrued on the 2006 income of $65 million and the $20 million tax benefit due to the realization of the unrecorded loss carryforward. CICA HB 3465 suggests that these be disclosed separately.

65. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-65 Net Operating Losses (NOL) The 2006 income statement would appear as follows:

66. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-66 Disclose the following:  Total of all Future Income Tax liabilities and assets.  Total valuation allowance recognized (current vs non current).  Net change in valuation account.  Approximate tax effect of each type of temporary difference (and carryforward). Disclose the following:  Total of all Future Income Tax liabilities and assets.  Total valuation allowance recognized (current vs non current).  Net change in valuation account.  Approximate tax effect of each type of temporary difference (and carryforward). Future Income Tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability. Balance Sheet Classification

67. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-67  Current portion of tax expense (benefit)  Future 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)  Future 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

68. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-68  If this is the case it should be classified according to when underlying temporary difference reverses.  Operating Loss carryforwards are also unrelated to a specific asset or liability and are classified as current or non- current according to when there is sufficient income to use LCF.  If this is the case it should be classified according to when underlying temporary difference reverses.  Operating Loss carryforwards are also unrelated to a specific asset or liability and are classified as current or non- current according to when there is sufficient income to use LCF. Future Income Tax Not Related to a Specific Asset or Liability

69. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-69 Intraperiod Tax Allocation  CICA HB 3465 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items. Changes in accounting policy. Prior period adjustments (to the beginning retained earnings).  CICA HB 3465 requires intraperiod tax allocation for: Income from continuing operations. Discontinued operations. Extraordinary items. Changes in accounting policy. Prior period adjustments (to the beginning retained earnings).

70. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-70 Conceptual Concerns  Should Future Income Taxes Not Be Recognized?  Should Future Income Taxes Be Recognized for Only Some Items?  Should Future Income Taxes Be Discounted?  Should Classification Be Based on the Timing of Temporary Difference Reversals?

71. © 2004 McGraw-Hill Ryerson McGraw-Hill Ryerson Slide 16-71 End of Chapter 16