Post on 11-Jan-2016
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Accounting for Income Taxes
Accounting for Income Taxes
Chapter
19Intermediate Accounting12th Edition
Kieso, Weygandt, and Warfield
Prepared by Coby Harmon, University of California, Santa Barbara
Fundamental Differences between Financial and Tax
Reporting
Fundamental Differences between Financial and Tax
Reporting
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BackgroundBackground
• Deferral approach to tax allocation (APB Opinion 11)– Income tax expense = amount of taxes that
would be paid if income statement numbers appeared on the current year's tax return.
• Deferred taxes was the plug figure (difference between taxes payable and tax expense).
• The effect of subsequent changes in tax rates on deferred tax account were essentially ignored.
Matching Approach
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BackgroundBackground
• A method that was proposed theoretically (but has never been GAAP in US)– Assets and liabilities would be recorded NET of
any deferred tax related to the item
Net-of-Tax Approach
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BackgroundBackground
• Liability approach to tax allocation (FASB 96, 109)– Income tax expense = taxes currently payable
plus change in deferred taxes. • If tax rates change, the effect on deferred tax
amounts affect income tax expense in the year the change is enacted.
• If there are no changes in tax rates, income tax expense should be approximately the same as under APB Opinion 11.
Asset/Liability Measurement Approach
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Tax Code
Exchanges
Investors and Creditors
Financial Statements
Pretax Financial Income
GAAP
Income Tax Expense
Taxable Income
Income Tax Payable
Tax Return
vs.
Fundamentals of Accounting for Income Taxes
Fundamentals of Accounting for Income Taxes
LO 1 Identify differences between pretax financial income and taxable income.
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A Temporary Difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years.
Future Taxable Amounts
Future Deductible AmountsDeferred Tax Liability
represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year.
Deferred Tax Asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year.
Illustration 19-22 Examples of Temporary Differences
LO 2 Describe a temporary difference that results in future taxable amounts.
Temporary DifferencesTemporary Differences
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Example – Deferred Tax Liability
Example – Deferred Tax Liability
• Assume that Sales Company recognizes $15,000 gross profit from installment sales for financial accounting in 2006. The gross profit will be taxable at $3,000 each year for the next five years. The company earns $10,000 additional income each year and the tax rate is 40%. The following schedule shows taxable income, income tax payable, financial income, and income tax expense for the five year period.
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Solution – Sales CompanySolution – Sales Company
For tax purposes, we are postponing recognition of revenue until later years. This revenue will be reported on future tax returns and the taxes will be paid at that time (rather than immediately)
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Sales Co. - Solution - continued
Sales Co. - Solution - continued
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Example – Deferred Tax Asset
Example – Deferred Tax Asset
Financial Magazine Company received $15,000 of subscriptions in advance for 2006. Subscription revenue will be recognized equally in 2007, 2008, and 2009, for financial accounting purposes but all of the $15,000 will be recognized in 2006 for tax purposes. There is additional income of $50,000 each year and the tax rate is 40%.
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Financial Magazine Co. Solution Continued
Financial Magazine Co. Solution Continued
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Financial Magazine Co. Solution Continued
Financial Magazine Co. Solution Continued
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E19-1 South Carolina Corporation has one temporary difference at the end of 2007 that will reverse and cause taxable amounts of $55,000 in 2008, $60,000 in 2009, and $65,000 in 2010. South Carolina’s pretax financial income for 2007 is $300,000, and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2007.
Instructions
a) Compute taxable income and income taxes payable for 2007.
b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
South Carolina CorporationSouth Carolina Corporation
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South Carolina CorporationSouth Carolina Corporation
Ex. 19- 1 Current Yr.
INCOME: 2007 2008 2009 2010
Financial income (GAAP)
Temporary Diff .
Taxable income (IRS)
Tax rate
Income tax
b. Income tax expense (plug)
Income tax payable
Deferred tax liability
a.a.
a.a.
20LO 2 Describe a temporary difference that results in future taxable amounts.
South Carolina Corp. (Solution)South Carolina Corp. (Solution)
Ex. 19- 1 Current Yr.
I NCOME: 2007 2008 2009 2010
Financial income (GAAP) 300,000
Temporary Diff . (180,000) 55,000 60,000 65,000
Taxable income (I RS) 120,000 55,000 60,000 65,000
Tax rate 30% 30% 30% 30%
I ncome tax 36,000 16,500 18,000 19,500
b. I ncome tax expense (plug) 90,000
I ncome tax payable 36,000
Deferred tax liability 54,000
a.a.
a.a.
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Columbia Corporation has one temporary difference at the end of 2007 that will reverse and cause deductible amounts of $50,000 in 2008, $65,000 in 2009, and $40,000 in 2010. Columbia’s pretax financial income for 2007 is $200,000 and the tax rate is 34% for all years. There are no deferred taxes at the beginning of 2007. Columbia expects to be profitable in the future. Instructions
a) Compute taxable income and income taxes payable for 2007.
b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
Columbia CorporationColumbia Corporation
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Columbia Corp. Current Yr.
INCOME: 2007 2008 2009 2010
Financial income (GAAP)
Temporary Diff .
Taxable income (IRS)
Tax rate
Income tax
b. Income tax expense
Income tax payable
Deferred tax asset
Columbia CorporationColumbia Corporation
a.a.
a.a.
Temporary Differences (1)Temporary Differences (1)
• Revenues and gains, recognized in financial income, are later taxed for income tax purposes.– Installment sales
• Expenses and losses are deducted for income tax purposes before they are recognized in financial income.– MACRS depreciation– Goodwill deduction on tax return
Called “taxable temporary differences”
• Revenues and gains are taxed for income tax purposes before they are recognized in financial income.– Subscription revenue – Prepaid rent
• Expenses and losses, recognized in financial income, are later deducted for income tax purposes.– Warranty expense
Called “deductible temporary differences”
Temporary Differences (2)Temporary Differences (2)
TransactionWhen recorded
in booksWhen recordedon tax return
Deferredtax effect
Rev or Gain Earlier Later Liability
Rev or Gain Later Earlier Asset
Exp or Loss Earlier Later Asset
Exp or Loss Later Earlier Liability
Summary of Temporary Differences
Summary of Temporary Differences
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Sources of Permanent Differences
No deferred tax effectsfor permanent differences
Some items are recordedin Books
but NEVERon tax return
Other items are NEVERrecorded in books
but recordedon tax return
Permanent DifferencesPermanent DifferencesPermanent DifferencesPermanent Differences
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Permanent Differences: Examples
Permanent Differences: Examples
• Items, recognized for financial accounting purposes, but not for income tax purposes:– Interest revenue on Municipal Bonds– Life insurance premiums and proceeds when corporation is
beneficiary– Fines and penalties
• Items, recognized for tax purposes, but not for financial accounting purposes:– Dividend exclusion– Statutory depletion
Deferred Tax Asset & Deferred Tax Liability:
Sources
Deferred Tax Asset & Deferred Tax Liability:
Sources• Deferred taxes may be a:
– Deferred tax liability, or– Deferred tax asset
• Deferred tax liability arises due to net taxable amounts in the future.
• Deferred tax asset arises due to net deductible amounts in the future.
If the deferred tax asset appears doubtful, a Valuation Allowance account is needed.
Journal entry: Income Tax Expense $$
Allowance to ReduceDeferred Tax Asset toExpected Realizable Value $$
The entry records a potential future tax benefit that is not expected to be realized in the future.
Valuation Allowance for Deferred Tax AssetsValuation Allowance
for Deferred Tax Assets
• The deferred tax classification relates to its underlying asset or liability.– Classify the deferred tax amounts as current or
non-current.
• Presentation is – NET amount related to current items
• If DR>CR, current deferred tax asset• If DR<CR, current deferred tax liability
– NET amount related to noncurrent items • If DR>CR, noncurrent deferred tax asset• If DR<CR, noncurrent deferred tax liability
Balance Sheet Presentation
Balance Sheet Presentation
• Basic Rule: Apply the yearly tax rate to calculate deferred tax effects.– If future tax rates change: use the enacted tax rate
expected to apply in the future year.– If new rates are not yet enacted into law for future
years, the current rate should be used.
• The appropriate enacted rate for a year is the average tax rate [based on graduated tax brackets].
What Tax Rate to ApplyWhat Tax Rate to Apply
Let’s do an exampleLet’s do an example
• Second Best Company– Working paper style – working paper blank
will be provided on Exam 2
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Net operating loss is tax terminology.A net operating loss occurs when tax deductions for a year exceed taxable revenues.
Net loss or operating loss is a financial accounting term.
Net Operating Loss (NOL)Net Operating Loss (NOL)
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NOL Rule (subject to change)
NOL Rule (subject to change)
• NOL for each tax year is computed.• The NOL of one year can be applied to
offset taxable income of other years, possibly resulting in tax refunds
• Current rule: NOLs can be:– carried back 2 years and carried forward
20 years (carryback option), – or carried forward 20 years (carryforward
only)
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2001 2002 2003 2004 2005 2006 2007 2001 2002 2003 2004 2005 2006 2007
NOL2004
NOL2004
Tax years
Apply first
next
Loss carryforward20 years forward
Expect tax refund
here
Expect tax refund
hereRecord all
tax effects hereRecord all
tax effects here
Expecttax
shieldhere
Expecttax
shieldhere
NOL CarrybackNOL Carryback
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2001 2002 2003 2004 2053 2006 2007 2001 2002 2003 2004 2053 2006 2007
NOL2004NOL2004
Tax years
Loss carryforward20 years forward
Record alltax effects here
Record alltax effects here
Expecttax
shieldhere
Expecttax
shieldhere
Forgo 2year rule
NOL CarryforwardNOL Carryforward
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Zoop Inc. incurred a net operating loss of $500,000 in 2007. Taxable income was $200,000 for 2005 and $200,000 for 2006. The tax rate for all years is 40%. Zoop elects the carryback option. Prepare the journal entries to record the benefits of the loss carryback and the loss carryforward.
Zoop Inc. (NOL)Zoop Inc. (NOL)
LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
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Zoop Inc. (NOL)Zoop Inc. (NOL)Zoop Inc. 2005 2006 2007 2008
Financial income
Diff erence
Taxable income (loss)
Rate
Income tax
NOL Schedule
Taxable income
Carryback from 2007
Taxable income
Rate
Income tax (revised)
Refund
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Zoop Inc. (NOL) - SolutionZoop Inc. (NOL) - SolutionZoop Inc. 2005 2006 2007 2008
Financial income 200,000$ 200,000$
Diff erence
Taxable income (loss) 200,000 200,000 (500,000)
Rate 40% 40% 40%
Income tax 80,000$ 80,000$
NOL Schedule
Taxable income 200,000$ 200,000$ (500,000)
Carryback from 2007 (200,000) (200,000) 400,000
Taxable income - - (100,000)
Rate 40% 40% 40%
Income tax (revised) -$ -$ (40,000)
Refund 80,000$ 80,000$
$160,000$160,000 Deferred Tax AssetDeferred Tax Asset
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Zoop’s Journal Entries for 2007
I ncome tax refund receivable 160,000
Benefit due to loss carryback 160,000
Deferred tax asset 40,000
Benefit due to loss carryforward 40,000
Zoop Inc. (NOL) - SolutionZoop Inc. (NOL) - Solution
LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
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Now assume that it is more likely than not that the entire net operating loss carryforward will not be realized by Zoop Inc. in future years. Prepare all the journal entries necessary at the end of 2007.
Zoop Inc. (Variation)Zoop Inc. (Variation)
LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
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Zoop Inc. - Journal Entries for 2007
I ncome tax refund receivable 160,000
Benefit due to loss carryback 160,000
Deferred tax asset 40,000
Benefit due to loss carryforward 40,000
Benefit due to loss carryforward 40,000
Allowance for deferred tax asset 40,000
Zoop Inc. (Variation) - SolutionZoop Inc. (Variation) - Solution
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Whether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period.
Valuation Allowance Revisited
Valuation Allowance Revisited
Text Illustration 19-37 Possible Sources of Taxable Income
If any one of these sources is sufficient to support a conclusion that a valuation allowance is unnecessary, a company need not consider other sources.Text Illustration 19-38 Evidence to Consider in Evaluating the need for a Valuation Account
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Valis Corporation had the following tax information.
Valis Corporation (NOL)Valis Corporation (NOL)
LO 8 Apply procedures for a loss carryback and a loss carryforward.
Taxable Tax TaxesYear I ncome Rate Paid
2004 300,000$ 35% 105,000$
2005 325,000 30% 97,500
2006 400,000 30% 120,000
In 2007 Valis suffered a net operating loss of $450,000, which it elected to carry back. The 2007 enacted tax rate is 29%. Prepare Valis’s entry to record the effect of the loss carryback.
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Valis Corporation – Solution (NOL)
Valis Corporation – Solution (NOL)
Valis Corp. 2004 2005 2006 2007
Financial income
Diff erence
Taxable income (loss)
Rate
Income tax
NOL Schedule
Taxable income
Carryback from 2007
Taxable income
Rate
Income tax (revised)
Refund
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Valis Corp - Journal Entry for 2007
I ncome tax refund receivable 135,000
Benefit due to loss carryback 135,000
Valis Corporation – Solution (NOL)
Valis Corporation – Solution (NOL)
At the end of 2002, the corporate tax rate is changed from 40% to 35%. The new rate is effective January 1, 2004.The deferred tax account (1/1/2002) is as follows:
Excess tax depreciation: $3 million Deferred tax liability: $1.2 million
Related taxable amounts are expected to occur equally over 2003, 2004, and 2005.
Provide the journal entry to reflect the change.
Example: Revision of Future Tax Rate
Example: Revision of Future Tax Rate
The deferred tax liability end of 2005 is as follows: 2003 2004 2005Future tax inc $1,000,000 1,000,000 1,000,000Tax rate 40% 35% 35%Deferred tax $400,000 350,000 350,000liability Entry:
Deferred Tax Liability $100,000 Income Tax Expense
$100,000*
*$1,200,000 – $1,100,000
Example: Revision of Future Tax Rate
Example: Revision of Future Tax Rate
Let’s return to Second Best
Let’s return to Second Best
• In the third year:– A change in enacted tax rates– A net operating loss
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Income tax expense, is allocated to:• Continuing operations• Discontinued operations• Extraordinary items• Cumulative effect of an accounting change,– we
won’t see this one any more after FAS154
• Prior period adjustments
Disclose other significant components, such as:
• current tax expense, • deferred tax expense/benefit, etc.
Intraperiod Tax AllocationIntraperiod Tax Allocation
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Other Items AffectedOther Items Affected• Comprehensive income items
– Holding gain/loss on AFS securities– Certain gains/losses related to foreign currency
and derivatives– Pension & post-retirement benefit amounts not yet
recognized on income statement• Correction of error/change in accounting
principle that affects beginning retained earnings
• Expenses for employee stock-based compensation
• Existing deferred amounts in quasi-reorganization
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First Place ExampleFirst Place Example
• Go to Excel and work the problem– Identify temporary and permanent
differences– Compute tax payable (or refund)– Compute change in deferred taxes and
income tax expense– Show where deferred tax will be reported
on the balance sheet
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Deferred TaxesDeferred Taxes
IAS 12 vs FAS 109
versus
US GAAP
• Enacted tax rates
Which Tax Rate to UseWhich Tax Rate to Use
• Enacted or substantively enacted tax rat
IFRS
US GAAP
• Use an allowance account to reduce to net realizable value
• Uses same “more likely than not” criteria
Deferred Tax AssetsDeferred Tax Assets
• Don’t recognize at all unless it is “more likely than not” to be usable in the future
IFRS
US GAAP
• Current items netted
• Noncurrent items netted
Balance Sheet PresentationBalance Sheet Presentation
• Always is noncurrent
• Plans to revise to do it the FASB way
IFRS
Essential KnowledgeEssential Knowledge
• Be able to tell a permanent difference from a temporary difference
• Know the impact of temporary differences:– Is it a future deductible item?– Is it a future taxable item?
• Textbook Illustrations 19-22 & 19-24:– If all else fails, memorize!– I’ll also provide a “study guide” for Exam 2
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• A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for current year.
• A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards.
• The measurement of current and deferred tax liabilities and assets is based on provisions of enacted tax law, effects of future changes in tax law or rates are not anticipated.
• The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized.
Review – Basic PrinciplesReview – Basic Principles
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Do the following generate: • Future Deductible Amount = Deferred Tax Asset• Future Taxable Amount = Deferred Tax Liability• A Permanent Difference
1. The MACRS depreciation system is used for tax purposes, and the straight-line depreciation method is used for financial reporting purposes.2. A landlord collects some rents in advance. Rents received are taxable in the period when they are received.
3. Expenses are incurred in obtaining tax-exempt income.
4. Costs of guarantees and warranties are estimated and accrued for financial reporting purposes.
Specific DifferencesSpecific Differences
LO 6 Describe various temporary and permanent differences.
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Do the following generate: • Future Deductible Amount = Deferred Tax Asset• Future Taxable Amount = Deferred Tax Liability• A Permanent Difference
5. Sales of investments are accounted for by the accrual method for financial reporting purposes and the installment method for tax purposes.
6. Proceeds are received from a life insurance company because of the death of a key officer (the company carries a policy on key officers).
7. Estimated losses on pending lawsuits and claims are accrued for books. These losses are tax deductible in the period(s) when the related liabilities are settled..
Specific DifferencesSpecific Differences
LO 6 Describe various temporary and permanent differences.
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Zurich Company reports pretax financial income of $70,000 for 2007. The following items cause taxable income to be different than pretax financial income. (1) Depreciation on the tax return is greater than depreciation on the income statement by $16,000. (2) Rent collected on the tax return is greater than rent earned on the income statement by $22,000. (3) Fines for pollution appear as an expense of $11,000 on the income statement.
Zurich’s tax rate is 30% for all years, and the company expects to report taxable income in all future years. There are no deferred taxes at the beginning of 2007.
Instructions Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
Review ProblemReview Problem
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Review Problem – Abbreviated Working Paper
Review Problem – Abbreviated Working Paper
Current Yr. Deferred Deferred
INCOME: 2007 Asset Liability
Financial income (GAAP)
Permanent diff
Book TI
Temp diff
Temp diff
Taxable income (IRS)
Tax rate
Income tax
Income tax expense
Deferred tax asset
Deferred tax liability
Income tax payable