Lecture 20

Accounting for Income Taxes

Objectives• To understand the differences between financial accounting

and tax accounting:– Timing related Temporary differences– Scope related Permanent differences

• To understand the effects of certain events on income taxes– Net operating losses– Valuation allowance– Rate Reconciliation

• To interpret the income tax disclosures provided in the financial statements

GAAP vs Tax Code

• GAAP determines the amount of pre-tax income (revenues and expenses, etc.) to be reported in the income statement for each period.

• Tax code determines the amount of taxable income to be reported to the taxing authority for each period.

• GAAP (“Book”) pre-tax income is used as the basis for the determination of the income tax expense for a period that gets reported in the Income Statement.

• However, taxable income (determined in accordance with the tax code) is the basis for determining the amount of income taxes payable i.e. the payment due to the IRS for that period.

• There are many instances where GAAP and the tax code differ.

Some examples of differences:

Revenues: Amounts collected from customers in advance of providing goods or services (i.e. rent)

– GAAP: advances are included in income (recognized as revenue) in the period when they are earned

– Tax Code: advances are often taxable when they are received

Expenses: Depreciation of PP&E– GAAP: Different depreciation methods are permitted– Tax Code: Only Modified Accelerated Cost Recovery

System (MACRS) is allowed. Detailed tables and useful lives for each asset class published by IRS.

Other: Interest earned on tax exempt municipal bonds– GAAP: Included in income as it is earned (passage of time)– Tax Code: Never included (i.e. not federally taxable)

Temporary Differences in Taxable and GAAP Income

Timing Difference: An Illustration

• A firm purchased a piece of equipment at the beginning of 2010 at a cost of $100,000.

• The depreciation associated with the use of the asset was determined as follows:

For Financial Reporting

For Taxes

Depreciation Method

Straight-line MACRS

Useful life 3 years 2 years (60%, 40%)

Residual Value $10,000 $10,000• MACRS - Modified Accelerated Cost Recovery System (MACRS) is

the current tax depreciation system in the United States.

• Over the useful life of the asset, depreciation expense will be:

Depreciation Schedule

Year Book Dep’n Tax Dep’n TimingDifference

Accum. Diff.

2010 $30,000 $54,000 $24,000 $24,0002011 $30,000 $36,000 $6,000 $30,0002012 $30,000 $0 $(30,000) $0

• Over the useful life of the asset, the temporary differences wash out.

Accounting for a Timing Difference

• In 2010, the firm earned $75,000 before depreciation and taxes and its statutory income tax rate (i.e. IRS rate) was 35%.

• Its Income Statement and tax return for the year would be as follows:

Income Statement Tax ReturnIncome before depreciation & taxes $75,000 $75,000Depreciation $(30,000) $(54,000)Pre-Tax Income (I/S) $45,000

Taxable Income (IRS) $21,000

Tax Payable (@ 35%) $ 7,350

Tax Expense (@ 35%) $15,750

• For financial reporting, the tax expense is $15,750 rather than $7,350.

• What’s the journal entry?

Income Tax Expense 15,750Income Tax Payable 7,350Deferred Tax Liability8,400

• Deferred Tax Liability is a Balance Sheet account i.e. cumulative.

• Referred to as Deferred Tax Liability because the company records tax expense in the Income Statement before the payment is made to IRS.• Will have to pay higher income taxes (use cash) in

future, as in future the tax depreciation will be lower than book.

• So, for any period,

Income tax expense

= Current income tax payable + ∆Deferred tax liability/asset

• Ending balance in deferred tax liability/asset is the taxable difference multiplied by the applicable enacted tax rate.

• Asset-Liability Approach:– Emphasizes the balance sheet– First, calculate current tax liability (taxes payable) or asset

(refund)– Second, calculate deferred tax liability/asset– Adjust deferred tax liability/asset to desired ending balance– Tax expense follows from the above calculations

Deferred Taxes in the Long-Run• Deferred tax assets/liabilities which are caused by timing

differences (between book and tax revenues and expenses) are temporary because they are eliminated (reversed) over time as indicated below for the preceding example (tax rate = 35%)

YearGAAP Depreciation

TaxDepreciation

TimingDifference

CurrentDeferredTax Expense

Deferred Tax Liab

2010 30,000 54,000 24,000 8,400 8,4002011 30,000 36,000 6,000 2,100 10,5002012 30,000 0 (30,000) (10,500) 0

• Timing differences that create/increase a deferred tax asset/liability over time are referred to as originating differences.

• Timing differences that remove/decrease a deferred tax asset/liability over time are referred to as reversing differences.

Reversing diff

35%

Deferred Tax Assets: An Illustration

• In 2010, the firm earned income of $75,000 (GAAP and Tax) excluding rent associated with its properties during the year. Rent receipts totaled $100,000 for the year of which, $50,000 represented advance payments for 2011. The income tax rate was 35%.

• Its Income Statement and tax return for the year would be as follows: Income Statement Tax Return

Income before rent & taxes $ 75,000 $ 75,000Rent revenue $ 50,000 $100,000Income before taxes $125,000

Taxable Income $175,000

Tax Payable (@ 35%) $ 61,250

Tax Expense (@ 35%) $ 43,750

• In this case, because of the timing difference related to the recognition of rent revenues, the (GAAP) income tax expense is less than the amount of income tax payable for 2010, giving rise to a deferred tax asset (benefit).

• In 2011, other things equal, the timing difference will reverse, the (GAAP) income tax expense will exceed the amount of income taxes payable and the deferred tax asset will be eliminated.

Income Tax Expense 43,750Deferred Tax Asset 17,500

Income Tax Payable61,250

Net Operating Losses

Net Operating Losses• A net operating loss (NOL) occurs for tax purposes in a

year when tax-deductible expenses exceed taxable revenues.

• Federal tax law permits firms to use the losses of one year to offset the income of other years in order to reduce tax payments.

• This is effected through the loss carryback and carryforward provisions.– Through use of a loss carryback, a firm may carry a net

operating loss back two years to offset any income earned in those years and thereby receive refunds for the taxes paid. (The NOL must be applied to the income of the earlier year first.)

– The loss carryforward provision enables a firm to carry a NOL forward to offset any income earned in up to 20 years subsequent to the loss year.

NOL: An IllustrationA firm experienced the following:

Year Taxable Income (Loss)*

Tax Rate Tax Paid

2004 $ 50,000 35% 17,5002005 100,000 30% 30,0002006 200,000 40% 80,000

2007 (500,000) 35% --

2008 50,000 35% --

* There were no temporary differences.

• Of the $500,000 loss suffered in 2007, the company could1) Carry back $100,000 to 2005 to recover the $30,000

of taxes paid in that year.2) Then, carry back $200,000 to 2006 to recover the

$80,000 of taxes paid in that year.3) Carry forward $50,000 to apply to the income earned

in 2008, eliminating any tax payable for that year.4) Carry the remaining $150,000 forward to apply

against income earned for the years 2009 – 2027.

• Note: The firm is not required to carry a NOL back.

WHAT else could the firm do?

Carry it all forward

WHY might a firm choose not to carry a NOL back?

Deferred Tax Assets: Valuation Allowance

Deferred Tax Assets and the Valuation Allowance

• Recall that deferred tax assets represents taxes to be saved in future years as a result of existing deductible temporary differences.– i.e. in the future, the firm may be required to pay “less

tax, for some period(s), than it should”, (given its higher

GAAP income)

• However, the firm may not be able to realize the benefit (e.g., the firm never becomes profitable)

• If it is more likely than not (i.e. probability > 50%) that it will not realize some portion or all of its deferred tax benefit, GAAP requires that the deferred tax asset should be reduced by a valuation allowance (analogous to the allowance for uncollectibles)

Valuation Allowance: An example• At the end of 2008, Lambert Corp. had deferred tax assets

totaling $200,000. However, based on projections of its future profitability, it believed that it was more likely than not that $75,000 of the those benefits would not be realized.

• In this case, Lambert would be required to establish a contra asset account to record the expected unrealizable amount:

Income tax expense (I/S) 75,000Valuation allowance for DTA (B/S)

75,000

Effective Tax Rate (ETR)

The Effective Tax Rate• The effective tax rate is defined as

Income Tax Expense (GAAP)(GAAP) Income before Taxes

i.e. the effective tax rate is the rate inferred from the financial

statements.

• Of course, if the GAAP income before taxes and the taxable income are the same, then

Effective Tax Rate = Statutory Tax Rate

• The above equality is also true even if there are timing differences between GAAP pre-tax income and taxable income.

• In other words, it is permanent differences that result in a difference between the Effective Tax Rate and the Statutory Tax Rate.

Permanent Differences• A permanent difference arises when a revenue or an

expense is included in the determination of one measure of income (GAAP or Tax) but is never included in the computation of the other.

– One common example is interest income earned from investments in municipal bonds. That interest is included in the determination of GAAP pre-tax income but excluded from the computation of taxable income.

• Because a permanent difference will never reverse, it cannot give rise to a deferred tax (asset or liability).

Permanent Differences: An Illustration

• Baxter’s (GAAP and taxable) earnings before interest and taxes for 2008 was $50,000. In addition, it earned $10,000 of interest from its investment in municipal bonds. Baxter’s statutory tax rate for 2008 was 35%.

• Baxter’s income tax expense and taxes payable for 2008 are:GAAP Income Taxable

IncomeTax

ExpenseTaxes

PayableEBIT 50,000 50,000 17,500 17,500Interest

10,000 0 0

60,000 50,000 17,500 17,500

0

• Note that the effective tax rate is17,500 = 29.2% NOT 35%, the statutory rate60,000

Permanent Differences: Rate Reconciliation

Microsoft 2009 10-K (Footnote 13)

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Intercorporate Investments