1 income taxes chapter chapter 16. 2 1. understand the concept of deferred taxes and the distinction...

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Income Income TaxesTaxes

chapterchapter 16

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1. Understand the concept of deferred taxes and the distinction between permanent and temporary differences.

2. Compute the amount of deferred tax liabilities and assets.

3. Explain the provisions of tax loss carrybacks and carryforwards, and be able to account for these provisions.

4. Schedule future tax rates, and determine the effect on tax assets and liabilities.

Learning Objectives

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5. Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities.

6. Comply with income tax disclosure requirements associated with the statement of cash flows.

7. Describe how, with respect to deferred income taxes, international accounting standards have converged toward the U.S. treatment.

Learning Objectives

4Deferred Income Taxes: An Deferred Income Taxes: An OverviewOverview

The primary goal of financial accounting is to

provide useful information to management,

stockholders, creditors, and other properly interested.

The primary goal of financial accounting is to

provide useful information to management,

stockholders, creditors, and other properly interested.

The primary goal of the income tax system is the equitable collection of

revenue.

The primary goal of the income tax system is the equitable collection of

revenue.


Two basic considerations in U.S. corporations computed net income.

1. How to account for revenues and expenses that have already been recognized and reported to shareholders in a company’s financial statements but will not affect taxable income until subsequent years.


Two basic considerations in U.S. corporations computed net income.

2. How to account for revenues and expenses that have already been reported to the IRS but will not be recognized in the financial statements until subsequent years.

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• Examples– Revenues (or gains) taxable after they are

recognized for financial reporting, such as receivables from installment sales.

– Expenses (or losses) deductible for tax purposes before they are recognized for financial reporting purposes, such as accelerated tax depreciation.

Simple Deferred Tax Liabilities

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In 2005, Ibanez Company earned revenues of $30,000. Ibanez has no expenses other than

income taxes. In this case, Ibanez is taxed on cash received. The company received

$10,000 in 2005 and $20,000 in 2006. The income tax rate is 40% and it is expected to remain the same into the foreseeable future.

In 2005, Ibanez Company earned revenues of $30,000. Ibanez has no expenses other than

income taxes. In this case, Ibanez is taxed on cash received. The company received

$10,000 in 2005 and $20,000 in 2006. The income tax rate is 40% and it is expected to remain the same into the foreseeable future.

ContinuedContinuedContinuedContinued

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Income Tax Expense 12,000Income Taxes Payable 4,000Deferred Tax Liability 8,000

$30,000 x .40

$20,000 x .40

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Ibanez CompanyIncome Statement

For the Year Ended December 31, 2005

Revenues $30,000Income tax expense:

Current $4,000Deferred 8,000

Net income $18,000

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Simple Deferred Tax Asset

• Examples

– Expenses (or losses) that are deductible for tax purposes after they are recognized for financial reporting purposes, such as warranty expenses.

– Revenues (or gains) that are taxable before they are recognized for financial reporting purposes, such as subscriptions received in advance.

Realization of a Deferred Tax Asset depends on the existence of taxable income in future years

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In 2005, Gupta Corporation generated service revenues totaling $60,000, all taxable in 2005. No warranty claims

were made in 2005, but Gupta estimates that in 2006 warranty costs of $10,000 will incurred for claims related

to 2005 service revenues. Assume a 40% tax rate.

In 2005, Gupta Corporation generated service revenues totaling $60,000, all taxable in 2005. No warranty claims

were made in 2005, but Gupta estimates that in 2006 warranty costs of $10,000 will incurred for claims related

to 2005 service revenues. Assume a 40% tax rate.


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Income Tax Expense 20,000Deferred Tax Asset 4,000

Income Taxes Payable 24,000

$60,000 x .40

$10,000 x .40


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Gupta CompanyIncome Statement

For the Year Ended December 31, 2005

Revenues $60,000Less: Warranty expense 10,000Income before taxes $50,000Income tax expense:

Current $24,000Deferred benefit (4,000) 20,000

Net income $30,000

15Permanent and Temporary Differences

• Permanent Differences: Nondeductible expenses or nontaxable revenues that are recognized for financial reporting purposes but are never part of taxable income.

• Temporary Differences: Differences between pretax financial income and taxable income arising from business events that are recognized for both financial and tax purposes, but in different time periods.

16Illustration of Permanent and Temporary Differences

For the year ended December 31, 2005, Monroe Corporation reported net income before taxes of $420,000. This amount

includes $20,000 of nontaxable revenues and $5,000 of nondeductible expenses. The depreciation method used for tax purposes

allowed a deduction that exceeded the book approach by $30,000.

For the year ended December 31, 2005, Monroe Corporation reported net income before taxes of $420,000. This amount

includes $20,000 of nontaxable revenues and $5,000 of nondeductible expenses. The depreciation method used for tax purposes

allowed a deduction that exceeded the book approach by $30,000.


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Pretax income from income statement $420,000Add (deduct) permanent differences:

Nontaxable revenues $(20,000)Nondeductible expenses 5,000 (15,000)

Financial income subject to tax $405,000Add (deduct) temporary differences:

Excess of tax depreciation over book depreciation (30,000)

Taxable income $375,000Tax on taxable income (income taxes payable): $375,000 x .35 $131,250

Illustration of Permanent and Temporary Differences

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1. Because the assets and liabilities recorded under this method are in agreement with the FASB definitions of financial statement elements, the method is conceptually consistent with other standards.

1. Because the assets and liabilities recorded under this method are in agreement with the FASB definitions of financial statement elements, the method is conceptually consistent with other standards.

Advantages of the Asset and Liability Method

Annual Computation of Deferred Tax Liabilities and Assets


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2. The asset and liability method is a flexible method that recognizes changes in circumstances and adjusts the reported amounts accordingly. This flexibility may improve the predictive value of the financial statements.

2. The asset and liability method is a flexible method that recognizes changes in circumstances and adjusts the reported amounts accordingly. This flexibility may improve the predictive value of the financial statements.


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Identify type and amounts of existing temporary differences.

Establish valuation allowance account if more likely than not ( >50%) some portion or all of

the deferred tax asset will not be realized.

Establish valuation allowance account if more likely than not ( >50%) some portion or all of

the deferred tax asset will not be realized.

Measure the deferred tax Measure the deferred tax liability for taxable liability for taxable

temporary differences temporary differences (use enacted rates).(use enacted rates).

Measure the deferred tax Measure the deferred tax liability for taxable liability for taxable


Measure the deferred tax Measure the deferred tax asset for deductible asset for deductible


Measure the deferred tax Measure the deferred tax asset for deductible asset for deductible



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For 2005, Roland computes pretax financial income of $75,000. The only difference between financial and taxable income is depreciation. The enacted tax rate is 40%. The 2005 tax is $24,000 (40% of $60,000).

Example 3: Deferred Tax Liability

Financial income subject to tax $75,000Deduct temporary difference: Excess of tax depreciation ($40,000)

over book depreciation ($25,000) (15,000)Taxable income $60,000


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Income tax expense =

Pre-tax financial income (or financial income subject to tax i.e. excluding permanent differences)

X Tax %

Note – the above is true only if future tax rates do not change

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Income Tax Expense 30,000Income Taxes Payable 24,000Deferred Tax Liability— Noncurrent 6,000$30,000

–

$6,000 $15,000 x .40ContinuedContinuedContinuedContinued

Journal entry for 2005Journal entry for 2005

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For 2006, Roland earned income of $75,000 and the taxable income is $70,000, or a tax of $28,000.


Financial income subject to tax $75,000Deduct temporary difference: Excess of tax depreciation ($30,000)

over book depreciation ($25,000) (5,000)Taxable income $70,000Tax @ 40% $28,000

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Income Tax Expense 30,000Income Taxes Payable 28,000Deferred Tax Liability— Noncurrent 2,000

$30,000 – $2,000 $5,000 x .40ContinuedContinuedContinuedContinued


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Depreciation expense in 2007 is the same for both financial and tax, so the

entry is simple.

Depreciation expense in 2007 is the same for both financial and tax, so the

entry is simple.

Income Tax Exp. 30,000 Income Taxes Pay. 30,000

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For 2008, Roland earned income of $75,000 and the taxable income is $95,000, or a tax of $38,000.


Financial income subject to tax $75,000Add temporary difference: Excess of book depreciation

($25,000) over tax depreciation ($5,000) 20,000

Taxable income $95,000Tax @ 40% $38,000

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Income Tax Expense 30,000Deferred Tax Liability— Noncurrent 8,000


$30,000 + $8,000

$20,000 x .40


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Changes in Tax Rates

• If changes in future tax rates hare enacted, the deferred tax liability (or asset) is measured using the enacted tax rate for future years when the temporary difference is expected to reverse.

• Subsequent changes in tax rates after a deferred tax/liability has already been computed, requires an adjustment to the income tax expense for the year of the change e.g. for a tax reduction, the adjustment entry would be

• Dr. Deferred Tax Liability – Cr. Income Tax Expenses

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Example 4: Deferred Tax Asset

Some possible sources of taxable income to be considered in evaluating the realistic value of a deferred tax asset are:Future reversals of existing taxable

temporary differences.

Future taxable income exclusive of reversing temporary differences.

Taxable income in prior (carryback) years.

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For 2005, Sandusky Inc. computes pretax financial income of $22,000. The only difference

between financial and taxable income is the recognition of warranty expense. Accrued warranty expense for 2005 was $18,000; no

actual warranty expenditures were made in 2005. The warranty obligation is considered one-third

current and two-thirds noncurrent.

For 2005, Sandusky Inc. computes pretax financial income of $22,000. The only difference

between financial and taxable income is the recognition of warranty expense. Accrued warranty expense for 2005 was $18,000; no

actual warranty expenditures were made in 2005. The warranty obligation is considered one-third

current and two-thirds noncurrent.


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Financial income subject to tax $22,000Add temporary difference: Excess of warranty expense ($18,000) over warranty deductions ($0) 18,000Taxable income $40,000


Taxable income in 2005 is calculated as follows:

Tax ($40,000 x .40) $16,000


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Income Tax Expense 8,800Deferred Tax Asset—Current 2,400Deferred Tax Asset— Noncurrent 4,800




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In the years 2006 through 2008, taxable income would be $16,000, computed as follows:

In the years 2006 through 2008, taxable income would be $16,000, computed as follows:

Financial income subject to tax $22,000Reversal of temporary difference: Excess of warranty deductions (1/3 x $18,000) over warranty expense ($0) (6,000)Taxable income $16,000Tax ($16,000 x .40) $ 6,400

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Income Tax Expense 8,800Deferred Tax Asset— Current 2,400Income Taxes Payable 6,400

Deferred Tax Asset— Current 2,400Deferred Tax Asset— Noncurrent 2,400




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Deferred Tax Asset— Current 2,400Deferred Tax Asset— Noncurrent 2,400



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38Example 5: Deferred Tax Liabilities and Assets

For 2005, Hsieh reported pretax financial income of $38,000. As of December 31, 2005,

the actual depreciation expense was $25,000 and the actual warranty expense was $18,000. For income tax reporting, these expenses were

$40,000 and $0, respectively.

For 2005, Hsieh reported pretax financial income of $38,000. As of December 31, 2005,

the actual depreciation expense was $25,000 and the actual warranty expense was $18,000. For income tax reporting, these expenses were

$40,000 and $0, respectively.



Financial income subject to tax $38,000Add (deduct) temporary difference: Excess of warranty expense

over warranty deductions 18,000Excess of tax depreciation over

book depreciation (15,000)Taxable income $41,000

Taxable income in 2005 is calculated as follows:

Tax ($41,000 x .40) $16,400



Income Tax Expense 15,200


Deferred Tax Asset—Current 2,400Deferred Tax Asset— Noncurrent 4,800

Deferred Tax Liability— Noncurrent 6,000Income Taxes Payable 16,400

41Valuation Allowance for Valuation Allowance for Deferred Tax AssetsDeferred Tax Assets

Statement No. 109 stipulates that both positive and negative

evidence be considered when determining whether deferred tax

assets will be fully realized.

Statement No. 109 stipulates that both positive and negative

evidence be considered when determining whether deferred tax

assets will be fully realized.

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LossYear

Year-2

Year+20

Carryback Election

Carryforward Election

Net Operating Loss (NOL) Carryback

43Net Operating Loss (NOL) Carryback

Year Tax RateIncome

Tax Income (Loss)

2004 $10,000 35% $3,5002005 14,000 30 4,2002006 (19,000) 30 0

Journal Entry in 2006:Income Tax Refund Receivable 6,200 Income Tax Benefit From NOL Carryback (Income Tax Expense) 6,200 [$3,500 + (30% x $9,000)]

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Accounting for NOL Carryforward

Continuing with the Prairie Company illustration, assume that in 2007 the firm incurred an operating loss of $35,000.

Year Income (Loss) Tax Rate

IncomeTax

2006 $(19,000) 30% $0

2007 (35,000) 30% 0


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The only loss remaining against which operating income can be

applied is $5,000 from 2005 ($14,000 – $9,000). This leaves $30,000 to be carried forward from 2007 as a future tax benefit of $9,000 ($30,000 x .30).

The only loss remaining against which operating income can be

applied is $5,000 from 2005 ($14,000 – $9,000). This leaves $30,000 to be carried forward from 2007 as a future tax benefit of $9,000 ($30,000 x .30).



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Income Tax Refund Receivable 1,500Deferred Tax Asset—NOL Carryforward 9,000

Income Tax Benefit from NOL Carryback 1,500Income Tax Benefit from NOL Carryforward 9,000


The journal entry at the end of 2007 to record the tax benefits would be as follows:

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Journal Entry:Income Tax Expense 15,000

Income Taxes Payable 6,000Deferred Tax Asset—NOL Carryforward 9,000


The firm reports a taxable income of $50,000 in 2008. The tax carryforward allows

management to deduct the carryforward from the $15,000 tax ($50,000 x .30) that would be

due without the carryforward.

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What if, due to a declining market, management believes that losses will continue in the future and the tax benefit will

not be realized?

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Journal Entry:Income Tax Refund Receivable 1,500Deferred Tax Asset—NOL Carryforward 9,000

Income Tax Benefit from NOL Carryback 1,500Allowance to Reduce Deferred Tax Assets to Realizable Value— NOL Carryforward 9,000

As a result of this entry, the deferred tax asset is zero—the expected realizable value.

As a result of this entry, the deferred tax asset is zero—the expected realizable value.

50Financial StatementPresentation and Disclosure

• Current tax expense or benefit

• Deferred tax expense or benefit

• Investment tax credits

• Government grants recognized as tax reductions

The following items must appear in the income statement or an accompanying note:


ContinuedContinued

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• Benefits of NOL carryforwards

• Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of an enterprise

• Adjustments in beginning-of-the-year valuation allowance because of a change in circumstances

Financial StatementPresentation and Disclosure



52Deferred Taxes and the Statement of Cash Flows

Callazo Company had the following information for 2005:

Revenue (all cash)$30,000

Income tax expense:Current $10,300Deferred 1,700(12,000)

Net income$18,000

Cash paid for income taxes during 2005 totaled $13,300.

Callazo Company had the following information for 2005:

Revenue (all cash)$30,000

Income tax expense:Current $10,300Deferred 1,700(12,000)

Net income$18,000

Cash paid for income taxes during 2005 totaled $13,300.

ContinuedContinued


12/31/05 12/31/05Income tax refund receivable $2,000 $ 0Income taxes payable 0 1,000Deferred tax liability 9,700 8,000

AnalysisAnalysis

Income Statement Adjustment SCFRevenue (all cash),$30,000 No adjustment $30,000 cash

collected fromcustomersContinuedContinued

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AnalysisAnalysis

Income Statement Adjustment SCFIncome tax expense—current –$2,000— $(13,300) Cash $(10,300) Increase in paid for taxes

tax receivable–$1,000—Decrease in taxes payable

ContinuedContinued

Deferred Taxes and the Statement of Cash Flows

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AnalysisAnalysis

Income Statement Adjustment SCFIncome tax expense—deferred +$2,000— No effect $(1,700) Increase in

deferred taxliability

ContinuedContinued


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AnalysisAnalysis

Income Statement Adjustment SCFNet income, $18,000 –$1,300 $16,700 Cash

flow fromoperations


Collazo CompanyStatement of Cash Flows

(Direct Approach)Cash collected from customers $30,000Income taxes paid (13,300)Cash provided by operating activities $16,700

ContinuedContinued


Collazo CompanyStatement of Cash Flows

(Indirect Approach)Net income $18,000Decrease in income tax refund receivable (2,000)Decrease in income taxes payable (1,000)Increase in deferred tax liability 1,700Cash provided by operating activities $16,700

58International Accounting for Deferred Taxes

• No-Deferral Approach: Ignore the differences and report income tax expense equal to the amount of tax payable for the year.

• Comprehensive Recognition Approach: Deferred taxes are included in the computation of income tax expense and reported on the balance sheet.

• Partial Recognition Approach: A deferred tax liability is recorded only to the extent that the deferred taxes are actually expected to be paid in the future.

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The EndThe End

chapter 16

1 income taxes chapter chapter 16. 2 1. understand the concept of deferred taxes and the distinction...

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deferred income taxes

income tax system

income tax rate

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