1 Accounting for Income Taxes ACCTG 5120 David Plumlee.

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Accounting for Income Taxes

ACCTG 5120David Plumlee

Accounting for Income Taxes

Income is measured in two different ways, taxable income and GAAP income. Deferred taxes result from timing differences between these two.

Why do accountants record Deferred Taxes?

Accounting Income = Taxable Income

Tax income is intended to raise sufficient tax revenues stimulate or depress certain sectors of the economy

GAAP is intended to provide relevant, reliable and representationally faithful GAAP is full accrual, while tax is accrual with some cash basis adjustments.

Why are GAAP and tax income computed differently?

Inter-period Tax AllocationFrom an income statement perspective what is the justification for inter-period tax allocation?

It improves matching of tax expense to related accounting income.From a balance sheet perspective what is

the justification for inter-period tax allocation?

It allows recognition of deferred tax assets and liabilities associated with future deductible and future taxable amounts.

A Simple Example

Accounting Income

Taxable Income

Year 1 $4,500 $9,000

Year 2 $4,500 $0 Total $9,000 $9,000

Assume that $9,000 is received on day 1, year 1 in payment of year 1 and year 2 rent ($4,500/year). What is the taxable and accounting income for each of these years?

“Cash” Basis 2003 2004

Income before tax $4,500 $4,500 Tax expense 2,700 --

Net income $1,800 $4,500 Implied Effective Tax Rate 60% 0%

No matching of Tax Expense to related accounting income.

Assume a tax rate of 30%, then the $2,700 of income tax would be paid in 2003.

What is wrong with this approach?

“Accrual” Basis

2003 2004 Income before tax $4,500 $4,500

Tax expense 1,350 1,350 Net income $3,150 $3,150

Implied Effective Tax Rate 30% 30%

Using Interperiod Tax Allocation:

Total tax expense is still $2,750, but: net income better reflects “effort” effective tax rate reflects statutory rate less volatility in earnings

Is a deferred tax really a liability?

Some say yes eventually the timing difference will be reversed and the tax

recorded in the deferred tax liability account will become payable

future cash outflow in the amount of the deferred tax liability (asset) will occur

Some say no many reversing temporary differences continually replaced

with new originating temporary differences in reality deferred income tax liabilities continually grow net temporary differences do not require future cash outflows not a legal obligation of the firm until tax return filed

Permanent Differences

A difference arising from an item that enters into accounting income but never taxable income (interest on state issued bonds)

or enters into taxable income but never accounting income (excess depletion on wasting assets)

Examples of Permanent Differences

Interest on state/municipal bonds

Proceeds from executive life insurance

Premiums paid on executive life insurance

Fines due to violations of the law

Dividend received deduction - 70% - 80% of dividends received from U. S. corporations

Excess depletion on wasting assets

Example: Interest Income on State Bonds

A company receives $1,000 in interest income on state bonds and tax rate is 45%. The company NEVER pays tax on this income. What if we did this?tax expense 450

deferred tax liability 450

Deferred tax would stay on the books forever!

Temporary DifferencesA difference between an asset or

liability’s tax basis and its amount for accounting purposes that will result in taxable or deductible amounts in future years

Or, a difference between in the financial and tax amounts for income (or expense) in a given year (or years)

How do we get taxable income? Start with GAAP/financial ‘books’ Make tax-related adjustments

permanent items that are in accounting income but not taxable or vice versa

temporary/timing items that are included in financial income at a different time than taxable income

Complete tax return and pay required taxes (taxes payable)

Temporary Difference - Example

A company purchases an asset for $100,000.Depreciation expense:

accounting - straight-line over 4 years tax - straight-line over 2 years

Tax Expense Book Value TemporaryBook Tax Book Tax Difference$25,000 $50,000 75,000$ 50,000$ 25,000$ $25,000 $50,000 50,000 - 50,000 $25,000 25,000 - 25,000

Reconciliation - Year 1Accounting Tax Temp Diff

Revenues 575,000$

Expenses* 375000

Pretax book income 200,000$ 200,000$

Depreciation:

Add back book depr 25,000 (25,000)

Subtract tax depr (50,000) 50,000

200,000$ 175,000$ 25,000$

Tax Expense Tax Payable Deferred taxes

@ 40% rate-tax 80,000$ 70,000$ 10,000$

* includes book depreciation expense!

AJE to Record Tax Expense

tax expense $80,000tax payable $70,000deferred tax liability

$10,000

What is adjusting entry at the end of year 1?

Reconciliation - Year 2Accounting Taxable Temporary

Income Income DifferencePretax income 100,000$ 100,000$ Depreciation: accounting 25,000 (25,000) taxable (50,000) 50,000

100,000$ 75,000$ 25,000$

Tax Tax DeferredExpense Payable Taxes

@ 40% rate ofincome tax 40,000$ 30,000$ 10,000$

Accounting Tax Temp Diff

Revenues 400,000$

Expenses* 300000


Depreciation:


Subtract tax depr (50,000) 50,000

100,000$ 75,000$ 25,000$


@ 40% rate-tax 40,000$ 30,000$ 10,000$



What is adjusting entry at the end of year 2?

What is the balance in Deferred Tax Liability at the end of year 2?

tax expense $40,000tax payable $30,000deferred tax liability $10,000

($25,000+25,000) x 40% = $20,000

Reconciliation - Year 3Accounting Tax Temp Diff

Revenues 400,000$

Expenses* 300000


Depreciation:


Subtract tax depr - -

180,000$ 205,000$ (25,000)$


@ 40% rate-tax 72,000$ 82,000$ (10,000)$



Tax Expense $72,000Deferred Tax Liability $10,000Tax Payable $82,000

($25,000+25,000-25,000) x 40% = $10,000

What is the entry to record tax expense for year 3?


Changes in tax rates across time?

Accounting Tax Temp Diff

Revenues 250,000$

Expenses* 180000


Depreciation:


Subtract tax depr - -

70,000$ 95,000$ (25,000)$


but, @ 30% rate-tax 21,000$ 28,500$ (7,500)$


Should be $0, but ($25,000+25000-25000) x 40% +(-25,000)x 30% = 2500

Tax Expense $21,000Deferred Tax Liability $ 7,500

Tax Payable $28,500

What is the entry to record tax expense for year 4?


Computing Tax Expense

Computetaxes payableCompute change in Deferred Tax balance

Find cumulative temp. basis differences = book - tax *

Tax Expense = tax payable +/- change in Deferred Tax balance

*differences that will reverse in the future. If differences are permanent, ignore!

Compute ending deferred tax balance. Prepare a schedule of anticipated reversals and applying appropriate enacted tax rates

Example

Year 2000 pretax accounting income = $500,000

Current tax rate = 40% Deferred Tax liability (Jan 1, 2000) = $320,000 Year 2000 depreciation

accounting = $200,000 tax = $400,000

Municipal Bond Interest $10,000

Example (continued)

As at the end of year 2000:Book basis of depreciable assets $1,000,000Tax basis of depreciable assets 0Cumulative temporary difference

$1,000,000

Additional information: enacted tax rates as shown in schedule temporary differences expected to reverse as

shown in schedule

Change in Deferred Tax Balance

2000 2001 2002 2003 2004 TotalReversal 200,000$ 200,000$ 200,000$ 200,000$ 200,000$ 1,000,000$ Enacted tax rates 40% 40% 35% 30% 30%Deferred tax liability 80,000$ 80,000$ 70,000$ 60,000$ 60,000$ 350,000$

Closing deferred tax liability $350,000Opening deferred tax liability 320,000Net increase in deferred tax liability $ 30,000

Compute Taxes Payable

Pre-tax accounting income $500,000add accounting depr. 200,000subtract tax depr. (400,000)subtract non-taxable interest ( 10,000)Taxable income $290,000

tax rate x 40%Tax Payable (per tax return) $ 116,000

Journal Entry

tax expense (plug) 146,000tax payable 116,000deferred tax liability* 30,000

*since we have a starting balance in DTL account, need to adjust to correct balance

Net Operating Losses (NOL)

NOLYear

2 years

CarryBack

If a carryback then• receive a refund of previous tax paid•record tax receivable based on prior year rate

20 years

Carry Forward

If a carryforward then•future deductible item•record deferred tax asset based on future enacted rate

Deferred Tax Asset Valuation Allowance

Based on all available evidence it is more likely than not that some portion will not be realized

Intended to adjust Deferred Tax asset to expected net realizable valuetax expense xx

valuation allowance xx Adjust to required ending balance

each period

Deferred Tax Asset Valuation Allowance

In year of expected reversal future deductible amounts > future taxable amounts

Will there be sufficient future taxable income to absorb the excess?

Could the excess be carried back to prior years?

if answer is NO - valuation allowance required

Balance Sheet Presentation

Classify deferred tax balances based on classification of related asset/liability expected reversal date if not related

For reporting purposes net current deferred tax balance net non-current deferred tax balance show deferred tax assets net of valuation

allowance

Intraperiod Tax Allocation

Allocation of tax across different sources of income/loss within a given period including: income from continuing operations discontinued operations extraordinary items cumulative changes in accounting policy items charged directly to retained earnings, for

example prior period adjustments mark-to-market adjustments under FAS 115


A company has ordinary income of $50,000 and extraordinary income of $100,000 tax rate is 45% no permanent or temporary differences tax payable

on ordinary income = $22,500 on extraordinary income = $45,000



Without With

Operating income 50,000 50,000

Tax expense 67.500 22,500

(17,500) 27,500

Extraordinary Gain 100,000 55,000

Net income 82,500 82,500

1 Accounting for Income Taxes ACCTG 5120 David Plumlee.

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