1. Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Accounting for Income Taxes Chapter 16

2. 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 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 and Deferred Tax Liabilities Results in...

3. 16-3 Temporary Differences This results in temporary differences. The difference in the rules for computing between pretax accounting income (according to GAAP) and taxable income (according to the IRS) often causes amounts to be reported in different years.

4. 16-4 Temporary differences will reverse 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

5. 16-5 Deferred Tax Liabilities A temporary difference originates in one period and reverses, or turns around, in one or more subsequent periods. Kent Land Management reported pretax accounting income in 2013, 2014, and 2015 of $100 million, plus additional 2013 income of $40 million from installment sales of property. However, the installment sales income is reported on the tax return when collected, in 2014 ($10 million) and 2015 ($30 million). The enacted tax rate is 40% each year.

6. 16-6 Deferred Tax Liabilities Calculate income tax that is currently payable: $100 × 40% = $40 Calculate change in deferred tax liability: ($40 × 40%) = $16 Combine the two to get the income tax expense: $40 + $16 = $56 Calculate income tax that is currently payable: $100 × 40% = $40 Calculate change in deferred tax liability: ($40 × 40%) = $16 Combine the two to get the income tax expense: $40 + $16 = $56 Income tax expense 56 Income tax payable 40 Deferred tax liability16

7. 16-7 The FASB’s Balance Sheet Approach

8. 16-8 Types of Temporary Differences Deferred tax liabilities result in taxable amounts in the future. Deferred tax assets result in deductible amounts in the future.

9. 16-9 Deferred Tax Liabilities A temporary difference originates in one period and reverses, or turns around, in one or more subsequent periods. Courts Temporary Services reported pretax accounting income in 2013, 2014, 2015, and 2016 of $100 million. In 2013, an asset was acquired for $100 million. The asset is depreciated for financial reporting purposes over four years on a straight-line basis (no residual value). For tax purposes the asset’s cost is deducted (by MACRS) over 2013–2016 as follows: $33 million, $44 million, $15 million, and $8 million. No other depreciable assets were acquired. The enacted tax rate is 40% each year.

10. 16-10 Deferred Tax Liabilities Calculate income tax that is currently payable: $92 × 40% = $36.8 Calculate change in deferred tax liability: ($25 - $33) × 40% = $3.2 Combine the two to get the income tax expense: $36.8 + $3.2 = $40 Calculate income tax that is currently payable: $92 × 40% = $36.8 Calculate change in deferred tax liability: ($25 - $33) × 40% = $3.2 Combine the two to get the income tax expense: $36.8 + $3.2 = $40 Journal entry at the end of 2013 Income tax expense 40.0 Income tax payable 36.8 Deferred tax liability 3.2

11. 16-11 Deferred Tax Liabilities Calculate income tax that is currently payable: $81 × 40% = $32.4 Calculate change in deferred tax liability: (($25 - $44) × 40%)) = $7.6 Combine the two to get the income tax expense: $32.4 + $7.6 = $40 Calculate income tax that is currently payable: $81 × 40% = $32.4 Calculate change in deferred tax liability: (($25 - $44) × 40%)) = $7.6 Combine the two to get the income tax expense: $32.4 + $7.6 = $40 Journal entry at the end of 2014 Income tax expense 40.0 Income tax payable 32.4 Deferred tax liability 7.6

12. 16-12 Deferred Tax Liabilities Calculate income tax that is currently payable: $110 × 40% = $44 Calculate change in deferred tax liability: (($25 - $15) × 40%)) = $4 Combine the two to get the income tax expense: $44 – 4 = $40 Calculate income tax that is currently payable: $110 × 40% = $44 Calculate change in deferred tax liability: (($25 - $15) × 40%)) = $4 Combine the two to get the income tax expense: $44 – 4 = $40 Journal entry at the end of 2015 Income tax expense 40 Deferred tax liability 4 Income tax payable 44

13. 16-13 Deferred Tax Liabilities Journal entry at the end of 2016 Income tax expense 40.0 Deferred tax liability 6.8 Income tax payable 46.8

14. 16-14 Deferred Tax Assets

15. 16-15 Deferred Tax Assets Calculate income tax that is currently payable: $100 × 40% = $40 Calculate change in deferred tax asset: $30 × 40% = $12 Combine the two to get the income tax expense: $40 – 12 = $28 Calculate income tax that is currently payable: $100 × 40% = $40 Calculate change in deferred tax asset: $30 × 40% = $12 Combine the two to get the income tax expense: $40 – 12 = $28 Journal entry at the end of 2013 Income tax expense 28 Deferred tax asset 12 Income tax payable 40

16. 16-16 Deferred Tax Assets Journal entry at the end of 2014 and 2015 Income tax expense 40 Deferred tax asset 6 Income tax payable 34

17. 16-17 Valuation Allowance A valuation allowance account is needed if 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 needed if 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.

18. 16-18 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. Example: Interest on tax-free municipal bonds is included in accounting income but is never included in taxable income. Permanent differences are disregarded when determining both the tax payable currently and the deferred tax asset or liability.

19. 16-19 U.S. GAAP vs. IFRS  For example, U.S. GAAP requires a loss contingency be accrued if it is both probable and can be reasonably estimated. Accruing a loss contingency leads to a deferred tax asset. For loss contingencies, IFRS uses a “more likely than not” threshold, which is lower than the U.S. “probable” requirement. As a result, under the lower threshold of IFRS, a loss contingency and a deferred tax asset sometimes is recorded for IFRS but not for U.S. GAAP. Despite the similar approaches for accounting for income taxes under IFRS and U.S. GAAP, differences in reported amounts for deferred taxes are among the most frequent between the two reporting approaches.

20. 16-20 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.

21. 16-21 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

22. 16-22 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 future taxable income: Called: operating loss carryforward. Result: reduced tax payable.

23. 16-23 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.

24. 16-24 Operating Loss Carryforward Journal entry at the end of 2013 Deferred tax asset 50 Income tax benefit-operating loss 50

25. 16-25 Operating Loss Carryback The carryback of the NOL must be applied to the earlier year first and then to the next year. Any remaining NOL may be carried forward. The carryback of the NOL must be applied to the earlier year first and then to the next year. Any remaining NOL may be carried forward.

26. 16-26 Operating Loss Carryback Journal entry at the end of 2013 Receivable—income tax refund 29 Deferred tax asset20 Income tax benefit-operating loss 49

27. 16-27 Balance Sheet Classification A deferred tax asset that is not related to a specific asset or liability should be classified according to when the underlying temporary difference is expected to reverse. Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability.

28. 16-28 Disclosure Notes Deferred Tax Assets and Deferred Tax Liabilities 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). Operating Loss Carryforwards Amounts. Expiration dates. Income Tax Expense Current portion of the tax expense (or benefit). Deferred portion of the tax expense (or benefit) with separate disclosures of amounts attributable to several specific items.

29. 16-29 Coping with Uncertainty in Income Taxes Two-step Decision Process Step 1. A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits. Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50 percent likely to be realized. If the tax benefit is not “more likely than not,” then none of the tax benefit is allowed to be recorded.

30. 16-30 Intraperiod Tax Allocation Income Statement: Income from continuing operations. Discontinued operations. Extraordinary items. Other Comprehensive Income: Investments. Postretirement benefit plans. Derivatives. Foreign currency translation.

31. 16-31 U.S. GAAP vs. IFRS  GAAP separately reports both discontinued operations and extraordinary items on the income statement and each are shown net of tax. IFRS does not separately report extraordinary items on the income statement. As a result, the only income statement item reported separately net of tax using IFRS is discontinued operations. The approach for accounting for intraperiod tax allocation is the same under IFRS and U.S. GAAP, but the categories used on the income statement are different.

32. 16-32 End of Chapter 16