1 accounting for income taxes c hapter 18 an electronic presentation by douglas cloud pepperdine...
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Accounting for Accounting for Income TaxesIncome Taxes
Accounting for Accounting for Income TaxesIncome Taxes
Chapter18
An electronic presentation by Douglas Cloud
Pepperdine University
An electronic presentation by Douglas Cloud
Pepperdine University
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1. Understand permanent and temporary differences.
2. Explain the conceptual issues regarding interperiod tax allocation.
3. Record and report deferred tax liabilities.4. Record and report deferred tax assets.5. Explain an operating loss carryback and
carryforward.
ObjectivesObjectives
ContinueContinueContinueContinue
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6. Account for an operating loss carryback. 7. Account for an operating loss carryforward. 8. Apply intraperiod tax allocation. 9. Classify deferred tax liabilities and assets.10. Discuss the additional conceptual issues
concerning interperiod income tax allocation (Appendix).
ObjectivesObjectives
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Overview and DefinitionsOverview and Definitions
The objective of financial reporting is to provide useful information about companies
to decision makers.
The objective of financial reporting is to provide useful information about companies
to decision makers.
Income State-ment
Income Tax
Return
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Overview and DefinitionsOverview and Definitions
Income State-ment
Income Tax
Return
Frees CorporationIncome Statement
For Year Ended 12/31/04Revenues $180,000 Cost of goods sold (78,000 )Gross profit $105,000 Other expenses (60,000 )Pretax income from continuing operations $ 45,000 Income taxes (11,000 )Net income $ 34,000
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Overview and DefinitionsOverview and Definitions
Income State-ment
Income Tax
Return
Frees CorporationIncome Tax Return
For Year Ended 12/31/04Revenues $170,000 Cost of goods sold (70,000 )Gross profit $100,000 Other expenses (60,000 )Pretax income from continuing operations $ 40,000 Income taxes ( 9,200 )Net income $ 30,800
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Causes of DifferencesCauses of Differences
• Permanent differences.
• Temporary differences.
• Operating loss carrybacks and carryforwards.
• Tax credits.
• Intraperiod tax allocations.
• Permanent differences.
• Temporary differences.
• Operating loss carrybacks and carryforwards.
• Tax credits.
• Intraperiod tax allocations.
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Permanent Differences Permanent Differences
Some items of revenue and expense that a corporation
reports for financial accounting purposes are never
reported for income tax purposes. These permanent differences never reverse in a
later accounting period.
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Permanent Differences
1. Nontaxable Revenues
2. Nondeductible Expenses
3. Allowable Deductions
For Example
Interest on municipal bonds
Life insurance proceeds
For Example
Life insurance premiums
Fines
For Example
Percentage depletion
Special dividend deduction
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Revenues that are recognized for financial reporting purposes but are never taxable (e.g., interest on municipal bonds, life insurance proceeds payable to a corporation upon death of insured).
Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes (e.g., life insurance premiums on officers, fines)
Revenues that are recognized for financial reporting purposes but are never taxable (e.g., interest on municipal bonds, life insurance proceeds payable to a corporation upon death of insured).
Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes (e.g., life insurance premiums on officers, fines)
Permanent Differences Permanent Differences
ContinuedContinuedContinuedContinued
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Deductions that are allowed for income tax purposes but do not qualify as expenses under generally accepted accounting principles (e.g., percentage depletion in excess of cost depletion, special dividend deduction).
Deductions that are allowed for income tax purposes but do not qualify as expenses under generally accepted accounting principles (e.g., percentage depletion in excess of cost depletion, special dividend deduction).
Permanent Differences Permanent Differences
Permanent differences affect either a corporation’s reported pretax financial
income or its taxable income, but not both.
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Temporary DifferencesTemporary Differences
A temporary difference causes a difference
between a corporation’s pretax financial income and taxable income that “originates” in one or
more years and “reverses” in later years.
A temporary difference causes a difference
between a corporation’s pretax financial income and taxable income that “originates” in one or
more years and “reverses” in later years.
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Temporary DifferencesTemporary Differences
Revenues or gains are included in pretax financial income prior to the time they are included in taxable income. For example, gross profit on installment sales normally is recognized at the point of sale for financial reporting purposes, but for income tax purposes, in certain situations it is recognized as cash is collected.
Revenues or gains are included in pretax financial income prior to the time they are included in taxable income. For example, gross profit on installment sales normally is recognized at the point of sale for financial reporting purposes, but for income tax purposes, in certain situations it is recognized as cash is collected.
ContinuedContinuedContinuedContinued
Future Taxable Income Will Be More Than Future Pretax Financial Income
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Temporary DifferencesTemporary Differences
Expenses and losses are deducted to compute taxable income prior to the time they are subtracted to compute pretax financial income. For example, a depreciable asset may be depreciated using MACRS over the prescribed tax life for income purposes, but using straight-line depreciation over a longer life for financial reporting purposes.
Expenses and losses are deducted to compute taxable income prior to the time they are subtracted to compute pretax financial income. For example, a depreciable asset may be depreciated using MACRS over the prescribed tax life for income purposes, but using straight-line depreciation over a longer life for financial reporting purposes.
Future Taxable Income Will Be More Than Future Pretax Financial Income
ContinuedContinuedContinuedContinued
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Temporary DifferencesTemporary Differences
Revenue or gains are included in taxable income prior to the time they are included in pretax financial income. For example, items such as rent, interest, and royalties received in advance are taxable when received but are not reported for financial reporting purposes until the service actually has been provided.
Revenue or gains are included in taxable income prior to the time they are included in pretax financial income. For example, items such as rent, interest, and royalties received in advance are taxable when received but are not reported for financial reporting purposes until the service actually has been provided.
Future Taxable Income Will Be Less Than Future Pretax Financial Income
ContinuedContinuedContinuedContinued
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Temporary DifferencesTemporary Differences
Expenses or losses are subtracted to compute pretax financial income prior to the time they are deducted to compute taxable income. For example, product warranty costs may be estimated and recorded as expenses in the current year for financial reporting purposes but deducted, as actually incurred, for the determination of taxable income.
Expenses or losses are subtracted to compute pretax financial income prior to the time they are deducted to compute taxable income. For example, product warranty costs may be estimated and recorded as expenses in the current year for financial reporting purposes but deducted, as actually incurred, for the determination of taxable income.
Future Taxable Income Will Be Less Than Future Pretax Financial Income
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Conceptual IssuesConceptual Issues
1. Should corporations be required to make interperiod income tax allocations for temporary differences, or should there be no interperiod tax allocation?
2. If interperiod tax allocation is required, should it be based on a comprehensive approach for all temporary differences or on a partial approach for certain temporary differences?
3. Should interperiod tax allocation be applied using the asset/liability method, the deferred method, or the net-of-tax method?
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Conceptual IssuesConceptual Issues
The FASB concluded that-- Interperiod income tax allocation of
temporary differences is appropriate.
The comprehensive allocation approach is to be applied.
The asset/liability method of income tax allocation is to be used.
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The FASB established four basic principles that a
corporation is to apply in accounting for its income
taxes at the date of its financial statements.
The FASB established four basic principles that a
corporation is to apply in accounting for its income
taxes at the date of its financial statements.
Conceptual IssuesConceptual Issues
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1. A current tax liability or asset is recognized for the estimated income tax obligation or refund on its income tax return for the current year.
2. A deferred tax liability or asset is recognized for the estimated future tax effects of each temporary difference.
Conceptual IssuesConceptual Issues
ContinuedContinuedContinuedContinued
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3. The measurement of deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax law or rates are not anticipated.
4. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized.
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Conceptual IssuesConceptual Issues
Income TaxesIncome Taxes
Interperiod Tax Allocation (Income tax
expense = Current income tax obligation)
Interperiod Tax Allocation Interperiod Tax Allocation (temporary differences)(temporary differences)
Partial Allocation
Asset/Liability Method (using Asset/Liability Method (using enacted future tax rates)enacted future tax rates)
Deferred Method (using originating tax rates)
Net-of-Tax Method
Conceptual AlternativesCurrent GAAP (FASB Statement No. 109)
Comprehensive Comprehensive AllocationAllocation
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MeasurementMeasurement
1. The applicable income tax rates.
2. Whether a valuation allowance should be established for deferred tax assets.
The FASB addressed two issues regarding the measurement of deferred tax liabilities or deferred tax asset in its financial statements.
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Steps in Recording and Reporting of Current and Deferred Taxes
Steps in Recording and Reporting of Current and Deferred Taxes
Step 1. Measure the income tax obligation by applying the applicable tax rate to the current taxable income.
Step 2. Identify the temporary differences and classify each as either“taxable” or “deductible.”
Step 3. Measure the deferred tax liability for each taxable temporary difference using the applicable tax rate.
ContinuedContinuedContinuedContinued
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Steps in Recording and Reporting of Current and Deferred Taxes
Steps in Recording and Reporting of Current and Deferred Taxes
Step 4. Measure the deferred tax asset for each deductible temporary difference using the applicable tax rate.
Step 5. Reduce deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
Step 6. Record the income tax expense income tax obligation, change in deferred tax liabilities and/or deferred tax assets, and change in valuation allowance (if any).
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Basic EntriesBasic Entries
In 2004 Track Company purchased an asset at a cost of $6,000. For financial reporting purposes, the asset has a 4-year life, no residual value, and
is depreciated by the units-of-output method over 6,000 units (2004: 1,600 units). For
income tax purposes the asset is depreciated under MACRS using the 3-year life (33.33% for
2004). The taxable income is $7,500 and the income tax rate is 30%.
In 2004 Track Company purchased an asset at a cost of $6,000. For financial reporting purposes, the asset has a 4-year life, no residual value, and
is depreciated by the units-of-output method over 6,000 units (2004: 1,600 units). For
income tax purposes the asset is depreciated under MACRS using the 3-year life (33.33% for
2004). The taxable income is $7,500 and the income tax rate is 30%.
This button will be used laterThis button will be used later
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Step 1. $7,500 (taxable income) x 30%Step 2. The depreciation difference is identified as the
only taxable temporary difference.Step 3. The $120 total deferred tax liability is
calculated by multiplying the total taxable temporary difference ($400) times the future tax rate (30%).
Steps 4 and 5. No deferred tax asset, so not required.Step 6. A journal entry is made.
Basic EntriesBasic Entries
ContinuedContinuedContinuedContinued
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Example 1—Single DifferenceExample 1—Single Difference
Income Tax Expense 2,370Income Taxes Payable 2,250Deferred Tax Liability 120
$2,250 + $120
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Example 2—Multiple RatesExample 2—Multiple Rates
Assume the same facts as in Slide 26, except that the income tax rate for 2004 for 40%, but
Congress has enacted tax rates of 35% for 2005, 33% for 2006, and 30% for 2007 and beyond.
Assume the same facts as in Slide 26, except that the income tax rate for 2004 for 40%, but
Congress has enacted tax rates of 35% for 2005, 33% for 2006, and 30% for 2007 and beyond.
Financial Income Tax Year Depreciation Depreciation
2004 $2,800 $2,6672005 1,100 8892006 500 444
Click here to review Slide 26, then click the button on Slide 26 to return.
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2004 2005 2006
Deferred Tax Liability
Financial depreciation $2,800 $1,100 $500
Income tax depreciation (2,667 ) (889 ) (444 )
Taxable amount $ 133 $ 211 $ 56 = $400
Income tax rate 0.35 0.33 0.30
Deferred tax liability $ 47 $ 70 $ 17 = $134
Income Tax Expense 3,134Income Taxes Payable 3,000Deferred Tax Liability 134
Example 2—Multiple RatesExample 2—Multiple Rates
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Example 3: Deferred Tax AssetExample 3: Deferred Tax Asset
Klemper Company sells a product on which it provides a 3-year warranty. For financial
reporting purposes, the company estimates its future warranty costs and records a warranty expense/liability at
year-end. For income tax purposes the company deducts its warranty costs when paid.
Klemper Company sells a product on which it provides a 3-year warranty. For financial
reporting purposes, the company estimates its future warranty costs and records a warranty expense/liability at
year-end. For income tax purposes the company deducts its warranty costs when paid.
ContinuedContinued
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At the beginning of 2004, the company had a deferred tax asset of $330 related to its warranty plan. At the end of 2004, the company estimates that its ending warranty
liability is $1,400. In 2004 the company has taxable income of $5,000 and a tax rate of 30%.
At the beginning of 2004, the company had a deferred tax asset of $330 related to its warranty plan. At the end of 2004, the company estimates that its ending warranty
liability is $1,400. In 2004 the company has taxable income of $5,000 and a tax rate of 30%.
Income Tax Expense 1,410Deferred Tax Asset 90
Income Taxes Payable 1,500
Example 3: Deferred Tax AssetExample 3: Deferred Tax Asset
$1,500 – $90$420 – $330
$5,000 x 30%
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Operating Loss Carrybacks and Carryforwards
Operating Loss Carrybacks and Carryforwards
2004 Operating
Loss Car
ryba
ckC
arry
back
Carryback Period (2 years)
2002 2003
Previous Previous Taxable Taxable Income Income
ContinuedContinued
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Carryforward Period (20 years)
2005 2006 …2024
Future Future Future Taxable Taxable Taxable Income Income Income
Operating Loss Carrybacks and Carryforwards
Operating Loss Carrybacks and Carryforwards
Car
ryfo
rwar
dC
arry
forw
ard
2004 Operating
Loss
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Conceptual IssuesConceptual Issues
FASB concluded in FASB Statement No. 109 that
GAAP for operating carrybacks and
carryforwards are...
FASB concluded in FASB Statement No. 109 that
GAAP for operating carrybacks and
carryforwards are...
ContinuedContinued
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1. A corporation must recognize the tax benefit of an operating loss carryback in the period of the loss as an asset on its balance sheet and as a reduction of the operating loss on its income statement.
2. A corporation must recognize the tax benefit of an operating loss carryforward in the period of the loss as a deferred tax asset. However, it must reduce the deferred tax asset by a valuation allowance if it is more likely than not that the corporation will not realize some or all of the deferred tax asset.
Conceptual IssuesConceptual Issues
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Operating Loss Carryback ExampleOperating Loss Carryback Example
Monk Company reports a pretax operating loss of $90,000 in 2004 for both financial reporting and
income tax purposes, and that reported pretax financial income and taxable income for the
previous 2 years had been: 2002—$40,000 (tax rate 25%); and 2003—$70,000 (tax rate 30%).
Monk Company reports a pretax operating loss of $90,000 in 2004 for both financial reporting and
income tax purposes, and that reported pretax financial income and taxable income for the
previous 2 years had been: 2002—$40,000 (tax rate 25%); and 2003—$70,000 (tax rate 30%).
Income Tax Refund Receivable 25,000 Income Tax Benefit From Operating Loss Carryback 25,000
2002 $40,000 x 0.25 =2002 $40,000 x 0.25 =
$10,000$10,0002003 $50,000 x 0.30 =2003 $50,000 x 0.30 =
15,000 15,000
$25,000$25,000
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Operating Loss Carryforward Example
Operating Loss Carryforward Example
Lake Company reports a pretax operating loss of $60,000 in 2004 for both financial reporting and
income tax purposes. The income tax rate is 30% and no change in the tax rate has been enacted for future
years. The deferred tax asset is calculated to be $18,000 ($60,000 x 0.30).
Lake Company reports a pretax operating loss of $60,000 in 2004 for both financial reporting and
income tax purposes. The income tax rate is 30% and no change in the tax rate has been enacted for future
years. The deferred tax asset is calculated to be $18,000 ($60,000 x 0.30).
Deferred Tax Asset 18,000 Income Tax Benefit From Operating Loss Carryforward 18,000
ContinuedContinuedContinuedContinued
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Operating Loss Carryforward Example
Operating Loss Carryforward Example
If the company establishes a valuation allowance for the entire amount of the deferred tax asset, it also
makes the following journal entry at the end of 2004.
If the company establishes a valuation allowance for the entire amount of the deferred tax asset, it also
makes the following journal entry at the end of 2004.
Income Tax Benefit From Operating Loss Carryforward 18,000 Allowance to Reduce Deferred Tax Asset to Realizable Value 18,000
ContinuedContinuedContinuedContinued
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Operating Loss Carryforward Example
Operating Loss Carryforward Example
In 2005, Lake Company operates successfully and earns pretax operating income of $100,000 for both
financial reporting and tax purposes.
In 2005, Lake Company operates successfully and earns pretax operating income of $100,000 for both
financial reporting and tax purposes.
Income Tax Expense 12,000Allowance to Reduce Deferred Tax Asset to Realizable Value 18,000 Income Taxes Payable 12,000 Deferred Tax Asset 18,000
$40,000 x 0.30$40,000 x 0.30
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Intraperiod Tax AllocationIntraperiod Tax Allocation
Income tax allocation within a period is
mandatory under GAAP.
Income tax allocation within a period is
mandatory under GAAP.
Kalloway Company reports the following items of pretax financial and taxable income for 2004:
[Continued]
Kalloway Company reports the following items of pretax financial and taxable income for 2004:
[Continued]
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Intraperiod Tax AllocationIntraperiod Tax Allocation
Income from continuing operations [$270,000 (revenues) – $190,000 (expenses)] $80,000 Gain on disposal of discontinued Segment X 18,000 Loss from operations of discontinued Segment X (5,000 )Extraordinary loss on bond redemption (10,000 )Cumulative effect of change in accounting principle (accelerated depreciation to S/L) 15,000 Prior period adjustment (error) (8,000 )Amount subject to income taxes $90,000
ContinuedContinuedContinuedContinued
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Intraperiod Tax AllocationIntraperiod Tax Allocation
Kalloway Company is subject to income tax rates of 20% on the first $50,000 of income and 30% on all income in excess
of $50,000.
Kalloway Company is subject to income tax rates of 20% on the first $50,000 of income and 30% on all income in excess
of $50,000.
Let’s take a look at Kalloway
Company’s schedule of income tax
expense for 2004.
Let’s take a look at Kalloway
Company’s schedule of income tax
expense for 2004.
ContinuedContinuedContinuedContinued
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Intraperiod Tax AllocationIntraperiod Tax Allocation
Pretax Amount
Income Tax Rate
Income Tax
Expense (Cr.)Component (Pretax)
Income from continuingoperations $50,000 0.20
$10,00030,000 0.30
9,000Gain on disposal of
discontinued Division X 18,000 0.305,400
Extraordinary loss from tornado (5,000 ) 0.30(1,500 )
x =
ContinuedContinuedContinuedContinued
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Intraperiod Tax AllocationIntraperiod Tax Allocation
Pretax Amount
Income Tax Rate
Income Tax
Expense (Cr.)Component (Pretax)
Cumulative effect of change in accounting principle on prior
year’s income$15,000 0.20$ 4,300
Prior period adjustment (8,000 ) 0.30 (2,400)
Total income tax expense$22,000
x =
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Intraperiod Tax AllocationIntraperiod Tax Allocation
Now, let’s examine Kalloway Company’s
income statement for 2004.
Now, let’s examine Kalloway Company’s
income statement for 2004.
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(0.20 x $50,000) + (0.30 x $30,000)
Revenues (listed separately) $270,000 Expenses (listed separately) (190,000 )Pretax income from continuing operations $ 80,000 Income tax expense (19,000 )
Income Statementfor Year Ended December 31, 2004
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Income Statementfor Year Ended December 31, 2004Revenues (listed separately) $270,000 Expenses (listed separately) (190,000 )Pretax income from continuing operations $ 80,000 Income tax expense (19,000 )Income from continuing operations $ 61,000 Results of discontinued operations: Gain on disposal of discontinued Segment X (net of $5,400 tax) $12,600
Loss from operations of discontinued Segment X (net of $1,500 tax credit) (3,500 ) 9,100
Income before extraordinary item $ 70,100
ContinuedContinuedContinuedContinued
$18,000 x 0.30$18,000 x 0.30
($5,000) x 0.30($5,000) x 0.30
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Income before extraordinary item $70,100 Extraordinary loss on bond redemption (net of $3,000 income tax credit) (7,000 )Cumulative effect of change in accounting principle (net of $4,500 income taxes) 10,500 Net Income $73,600
($10,000) x 0.30($10,000) x 0.30
$15,000 x 0.30$15,000 x 0.30
Prior period adjustments on the statement of retained earnings also would be
shown net of tax.
Prior period adjustments on the statement of retained earnings also would be
shown net of tax.
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Intraperiod Tax AllocationIntraperiod Tax Allocation
Kalloway Company makes the following journal entry to record the 2004 intraperiod tax allocation:
Income Tax Expense 19,000Gain on Disposal of Division X 5,400Cumulative Effect of Change in Accounting Principle 4,500
Loss from Operations of Discontinued Division X 1,500Extraordinary Loss from Tornado 3,000Retained Earnings (prior period adj.) 2,400Income Taxes Payable 22,000
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Balance Sheet PresentationBalance Sheet Presentation
A corporation must report its deferred tax liabilities
and assets in two classifications...
A corporation must report its deferred tax liabilities
and assets in two classifications...
…a net current amount and a net
noncurrent amount.
…a net current amount and a net
noncurrent amount.
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Balance Sheet PresentationBalance Sheet Presentation
Account Related BalanceDeferred Tax Accounts Balance Sheet Account
Deferred Tax Liabilities
Installment sales $ 6,000 credit Accounts receivable
Depreciation 12,000 credit Property, plant, and equipment
Deferred Tax Assets
Warranty costs $ 3,400 debit Warranty liability
Rent revenue $ 2,500 debit Unearned revenue
CurrentCurrent
NoncurrentNoncurrent
CurrentCurrent
NoncurrentNoncurrent
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Press this button to skip the Appendix. Click anywhere else to go to Appendix
material.
Press this button to skip the Appendix. Click anywhere else to go to Appendix
material.
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Comprehensive AllocationComprehensive Allocation
Under comprehensive allocation, the income tax expense that a
corporation reports in an accounting period is affected by all the
transactions and events that it includes in determining its pretax financial income for that period.
Under comprehensive allocation, the income tax expense that a
corporation reports in an accounting period is affected by all the
transactions and events that it includes in determining its pretax financial income for that period.
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Partial AllocationPartial Allocation
Under partial allocation, the income tax expense that a corporation
reports in an accounting period is affected only by those temporary
differences that it expects to reverse in the foreseeable future.
Under partial allocation, the income tax expense that a corporation
reports in an accounting period is affected only by those temporary
differences that it expects to reverse in the foreseeable future.
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Comprehensive income tax allocation is more widely accepted for the following reasons:
Comprehensive income tax allocation is more widely accepted for the following reasons:
1. Individual temporary differences do reverse.
2. Accounting is primarily historical.
3. A corporation should report the income tax effects of temporary differences in the same period that it includes the related transactions and events in its pretax financial statement.
4. Accounting results should not be subject to manipulation by management.
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Alternative Allocation MethodsAlternative Allocation Methods
(1) The asset/liability method
(2) The deferred method
(3) The net-of-tax method
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Chapter18
The EndThe EndThe EndThe End
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