2 ACCOUNTING FOR INCOME TAXES C H A P T E R 19ACCOUNTING FOR INCOME TAXESIntermediate Accounting13th EditionKieso, Weygandt, and Warfield
3 Fundamental Differences between Financial and Tax Reporting 4/5/2017Fundamental Differences between Financial and Tax Reporting
4 Background Deferral approach to tax allocation (APB Opinion 11) 4/5/2017BackgroundDeferral 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
5 4/5/2017BackgroundA 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 itemNet-of-Tax Approach
6 Asset/Liability Measurement Approach 4/5/2017BackgroundLiability 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
7 Fundamentals of Accounting for Income Taxes 4/5/2017Fundamentals of Accounting for Income TaxesFinancial StatementsTax ReturnIRSvs.ExchangesInvestors and CreditorsPretax Financial IncomeTaxable IncomeGAAPTax CodeIncome Tax ExpenseIncome Tax PayableLO 1 Identify differences between pretax financial income and taxable income.
8 Fundamentals of Accounting for Income Taxes Illustration: KRC, Inc. reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations. For tax purposes, KRC reported the same expenses to the IRS in each of the years. KRC reported taxable revenues of $100,000 in 2010, $150,000 in 2011, and $140,000 in What is the effect on the accounts of reporting different amounts of revenue for GAAP versus tax?LO 1 Identify differences between pretax financial income and taxable income.
9 Book vs. Tax Difference GAAP Reporting Tax Reporting 2010 2011 2012 Illustration 19-2GAAP Reporting201020112012TotalRevenues$130,000$130,000$130,000$390,000Expenses60,00060,00060,000180,000Pretax financial income$70,000$70,000$70,000$210,000Income tax expense (40%)$28,000$28,000$28,000$84,000Illustration 19-3Tax Reporting201020112012TotalRevenues$100,000$150,000$140,000$390,000Expenses60,00060,00060,000180,000Pretax financial income$40,000$90,000$80,000$210,000Income tax payable (40%)$16,000$36,000$32,000$84,000LO 1 Identify differences between pretax financial income and taxable income.
10 Book vs. Tax Difference Comparison Illustration 19-4Comparison201020112012TotalIncome tax expense (GAAP)$28,000$28,000$28,000$84,000Income tax payable (IRS)16,00036,00032,00084,000Difference$12,000$(8,000)$(4,000)$0Are the differences accounted for in the financial statements?YesYearReporting Requirement2010Deferred tax liability account increased to $12,0002011Deferred tax liability account reduced by $8,0002012Deferred tax liability account reduced by $4,000LO 1 Identify differences between pretax financial income and taxable income.
11 Financial Reporting for 2010 – Chelsea Inc. Balance SheetIncome Statement20102010Assets:Revenues:Expenses:Liabilities:Deferred taxes ,000Income tax payable 16,000Income tax expense 28,000Equity:Net income (loss)Where does the “deferred tax liability” get reported in the financial statements?LO 1 Identify differences between pretax financial income and taxable income.
12 Illustration 19-22 Examples of Temporary Differences 4/5/2017Temporary DifferencesA 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 AmountsFuture 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 Examples of Temporary DifferencesLO 2 Describe a temporary difference that results in future taxable amounts.
13 Future Taxable Amounts and Deferred Taxes Illustration: In Chelsea’s situation, the only difference between the book basis and tax basis of the assets and liabilities relates to accounts receivable that arose from revenue recognized for book purposes. Chelsea reports accounts receivable at $30,000 in the December 31, 2010, GAAP-basis balance sheet. However, the receivables have a zero tax basis.Illustration 19-5LO 2 Describe a temporary difference that results in future taxable amounts.
14 Future Taxable Amounts and Deferred Taxes Illustration: Reversal of Temporary Difference, Chelsea Inc.Illustration 19-6KRC assumes that it will collect the accounts receivable and report the $30,000 collection as taxable revenues in future tax returns. KRC does this by recording a deferred tax liability.LO 2 Describe a temporary difference that results in future taxable amounts.
15 Future Taxable Amounts and Deferred Taxes Deferred Tax Liability – Chelsea Inc.A deferred 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.Illustration 19-4201020112012TotalIncome tax expense (GAAP)$28,000$28,000$28,000$84,000Income tax payable (IRS)16,00036,00032,00084,000Difference$12,000$(8,000)$(4,000)$0LO 2 Describe a temporary difference that results in future taxable amounts.
16 Future Taxable Amounts and Deferred Taxes Deferred Tax Liability – Chelsea Inc.Illustration: Because it is the first year of operations for KRC, there is no deferred tax liability at the beginning of the year. KRC computes the income tax expense for 2010 as follows:Illustration 19-9LO 2 Describe a temporary difference that results in future taxable amounts.
17 Future Taxable Amounts and Deferred Taxes Deferred Tax LiabilityIllustration: Chelsea Inc. makes the following entry at the end of 2010 to record income taxes.Income Tax Expense 28,000Income Tax Payable 16,000Deferred Tax Liability 12,000LO 2 Describe a temporary difference that results in future taxable amounts.
18 Future Taxable Amounts and Deferred Taxes Deferred Tax Liability – Chelsea Inc.Illustration: Computation of Income Tax Expense for 2011.Illustration 19-10LO 2 Describe a temporary difference that results in future taxable amounts.
19 Future Taxable Amounts and Deferred Taxes Deferred Tax LiabilityIllustration: Chelsea Inc. makes the following entry at the end of 2011 to record income taxes.Income Tax Expense 28,000Deferred Tax Liability 8,000Income Tax Payable 36,000LO 2 Describe a temporary difference that results in future taxable amounts.
20 South Carolina Corporation 4/5/2017South Carolina CorporationE19-1 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 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.InstructionsCompute taxable income and income taxes payable for 2007.Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
21 South Carolina Corporation 4/5/2017South Carolina Corporationa.a.Blank for student version
22 South Carolina Corp. (Solution) 4/5/2017South Carolina Corp. (Solution)a.a.Leave this solution in student versionLO 2 Describe a temporary difference that results in future taxable amounts.
23 4/5/2017Columbia CorporationColumbia 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 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 Columbia expects to be profitable in the future.InstructionsCompute taxable income and income taxes payable for 2007.Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
24 4/5/2017Columbia Corporationa.a.BLANK ONLY FOR STUDENT VERSION
25 Income Statement Presentation Formula to Compute Income Tax ExpenseIllustration 19-20Income tax payable or refundableChange in deferred income taxIncome tax expense or benefit+-=In the income statement or in the notes to the financial statements, a company should disclose the significant components of income tax expense (current and deferred).LO 5 Describe the presentation of income tax expense in the income statement.
26 Income Statement Presentation Given the previous information related to KRC Inc., KRC reports its income statement as follows.Illustration 19-21LO 5 Describe the presentation of income tax expense in the income statement.
27 Temporary Differences (1) 4/5/2017Temporary Differences (1)Revenues and gains, recognized in financial income, are later taxed for income tax purposes.Installment salesExpenses and losses are deducted for income tax purposes before they are recognized in financial income.MACRS depreciationGoodwill deduction on tax returnTaxable temporary differencesRevenues or gains that are taxable after they are recognized on books:Installment method for tax returns, accrual method for financial accounting purposesCompleted contract method for tax returns, percentage of completion method for financial accounting purposes (now uncommon)Expenses or losses that are deductible before they are recognized on books:Accelerated depreciation for tax returns, straight-line for financial accounting purposesGoodwill, deductible on tax return but not an expense for GAAP. However, impairment of goodwill, if it occurs, would cause the write-down of goodwill and a loss on GAAP financial statementsBusiness combinations (goodwill): if assigned values of identifiable assets are higher than their tax basis, the difference is a taxable temporary difference and the related deferred tax liability would increase the goodwill to be recordedA reduction in the tax basis of depreciable assets because of tax credits (under 1982 law, it was possible to get a larger investment tax credit if the depreciable basis of the assets were reduced),; similar result if we capitalize interest for book purposes but deduct it on tax return as paid.Called “taxable temporary differences”
28 Temporary Differences (2) 4/5/2017Temporary Differences (2)Revenues and gains are taxed for income tax purposes before they are recognized in financial income.Subscription revenuePrepaid rentExpenses and losses, recognized in financial income, are later deducted for income tax purposes.Warranty expenseCalled “deductible temporary differences”
29 Summary of Temporary Differences 4/5/2017Summary of Temporary DifferencesTransactionWhen recordedin bookson tax returnDeferredtax effectRev or GainEarlierLaterLiabilityRev or GainLaterEarlierAssetExp or LossEarlierLaterAssetExp or LossLaterEarlierLiability
31 Permanent Differences: Examples 4/5/2017Permanent Differences: ExamplesItems, recognized for financial accounting purposes, but not for income tax purposes:Interest revenue on Municipal BondsLife insurance premiums and proceeds when corporation is beneficiaryFines and penaltiesItems, recognized for tax purposes, but not for financial accounting purposes:Dividend exclusionStatutory depletion
32 Deferred Tax Asset & Deferred Tax Liability: Sources 4/5/2017Deferred Tax Asset & Deferred Tax Liability: SourcesDeferred taxes may be a:Deferred tax liability, orDeferred tax assetDeferred tax liability arises due to net taxable amounts in the future.Deferred tax asset arises due to net deductible amounts in the future.
33 Valuation Allowance for Deferred Tax Assets 4/5/2017Valuation Allowance for Deferred Tax AssetsIf the deferred tax asset appears doubtful, a Valuation Allowance account is needed.Journal entry:Income Tax Expense $$Allowance to Reduce Deferred Tax Asset to Expected Realizable Value $$The entry records a potential future tax benefit that is not expected to be realized in the future.
34 4/5/2017What Tax Rate to ApplyBasic 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].
35 Let’s do an example Second Best Company 4/5/2017Let’s do an exampleSecond Best CompanyWorking paper style – working paper blank will be provided on Exam 2Do first two years and then stop and talk about NOL (next few slides) before going to year 3 where this is an NOL
37 Balance Sheet Presentation 4/5/2017Balance Sheet PresentationThe deferred tax classification relates to its underlying asset or liability.Classify the deferred tax amounts as current or non-current.Presentation isNET amount related to current itemsIf DR>CR, current deferred tax assetIf DR<CR, current deferred tax liabilityNET amount related to noncurrent itemsIf DR>CR, noncurrent deferred tax assetIf DR<CR, noncurrent deferred tax liability
38 Net Operating Loss (NOL) 4/5/2017Net Operating Loss (NOL)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.
39 NOL Rule (subject to change) 4/5/2017NOL 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 refundsCurrent rule: NOLs can be:carried back 2 years and carried forward 20 years (carryback option),or carried forward 20 years (carryforward only)
42 4/5/2017Zoop Inc. (NOL)Zoop Inc. incurred a net operating loss of $500,000 in Taxable income was $200,000 for 2005 and $200,000 for 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.LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
44 Zoop Inc. (NOL) - Solution 4/5/2017Zoop Inc. (NOL) - SolutionLeave in the student versionDeferred Tax Asset$160,000
45 Zoop Inc. (NOL) - Solution 4/5/2017Zoop Inc. (NOL) - SolutionZoop’s Journal Entries for 2007Leave in the student versionLO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
46 4/5/2017Zoop Inc. (Variation)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.LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
47 Zoop Inc. (Variation) - Solution 4/5/2017Zoop Inc. (Variation) - SolutionZoop Inc. - Journal Entries for 2007
48 Valuation Allowance Revisited 4/5/2017Valuation Allowance RevisitedWhether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period.Text Illustration Possible Sources of Taxable IncomeIf 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 Evidence to Consider in Evaluating the need for a Valuation Account
49 Valis Corporation (NOL) 4/5/2017Valis Corporation (NOL)Valis Corporation had the following tax information.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.LO 8 Apply procedures for a loss carryback and a loss carryforward.
50 Valis Corporation – Solution (NOL) 4/5/2017Valis Corporation – Solution (NOL)Student version (without solution)
51 Valis Corporation – Solution (NOL) 4/5/2017Valis Corporation – Solution (NOL)Valis Corp - Journal Entry for 2007
52 Example: Revision of Future Tax Rate 4/5/2017Example: Revision of Future Tax RateAt 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 millionDeferred tax liability: $1.2 millionRelated taxable amounts are expected to occur equally over 2003, 2004, and 2005.Provide the journal entry to reflect the change.
53 Example: Revision of Future Tax Rate 4/5/2017Example: Revision of Future Tax RateThe deferred tax liability end of 2005 is as follows:Future tax inc $1,000,000 1,000,000 1,000,000Tax rate % % %Deferred tax $400, , ,000liabilityEntry:Deferred Tax Liability $100, Income Tax Expense $100,000**$1,200,000 – $1,100,000
54 Intraperiod Tax Allocation 4/5/2017Intraperiod Tax AllocationIncome tax expense, is allocated to:Continuing operationsDiscontinued operationsExtraordinary itemsPrior period adjustmentsOther comprehensive incomeDisclose other significant components, such as:current tax expense,deferred tax expense/benefit, etc.} Income StatementIntraperiod Tax AllocationIncome StatementIncome tax expense or benefit for the year shall be allocated among continuing operations, discontinued operations, extraordinary items, other comprehensive income, and items charged or credited directly to shareholders' equity (paragraph 36).FAS109, Par. 35
55 Other Items Affected Comprehensive income items 4/5/2017Other Items AffectedComprehensive income itemsHolding gain/loss on AFS securitiesCertain gains/losses related to foreign currency and derivativesPension & post-retirement benefit amounts not yet recognized on income statementCorrection of error/change in accounting principle that affects beginning retained earningsExpenses for employee stock-based compensationExisting deferred amounts in quasi-reorganization
56 Special Reporting Issues Divide by weighted-average shares outstandingEPSLO 6
57 Review of the Asset-Liability Method Companies apply the following basic principles:Recognize a current tax liability or asset for the estimated taxes payable or refundable.Recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards using enacted tax rate.Base the measurement of current and deferred taxes on provisions of the enacted tax law. Do not anticipate future changes in tax laws.Reduce the measurement of deferred tax assets (create allowance account), if necessary, by the amount of any tax benefits that, companies do not expect to realize.
59 Which Tax Rate to Use Enacted or substantively enacted tax rat IFRSUS GAAPEnacted or substantively enacted tax ratEnacted tax rates
60 Deferred Tax AssetsIFRSUS GAAPDon’t recognize at all unless it is “more likely than not” to be usable in the futureUse an allowance account to reduce to net realizable valueUses same “more likely than not” criteria
61 Balance Sheet Presentation IFRSUS GAAPAlways is noncurrentPlans to revise to do it the FASB wayCurrent items nettedNoncurrent items netted
62 The classification of deferred taxes under iGAAP is always noncurrent. Under iGAAP, an affirmative judgment approach is used, by which a deferred tax asset is recognized up to the amount that is probable to be realized. U.S. GAAP uses an impairment approach.iGAAP uses the enacted tax rate or substantially enacted tax rate. (“Substantially enacted” means virtually certain.) For U.S. GAAP, the enacted tax rate must be used.
63 The tax effects related to certain items are reported in equity under iGAAP. That is not the case under U.S. GAAP, which charges or credits the tax effects to income.U.S. GAAP requires companies to assess the likelihood of uncertain tax positions being sustainable upon audit. Potential liabilities must be accrued and disclosed if the position is “more likely than not” to be disallowed. Under iGAAP, all potential liabilities must be recognized. With respect to measurement, iGAAP uses an expected-value approach to measure the tax liability, which differs from U.S. GAAP.
64 4/5/2017Essential KnowledgeBe able to tell a permanent difference from a temporary differenceKnow the impact of temporary differences:Is it a future deductible item?Is it a future taxable item?Textbook Illustrations & 19-24:If all else fails, memorize!I’ll also provide a “study guide” for Exam 2
65 Specific Differences Do the following generate: 4/5/2017Specific DifferencesDo the following generate:Future Deductible Amount = Deferred Tax AssetFuture Taxable Amount = Deferred Tax LiabilityA Permanent Difference1. 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.STUDENT VERSION3. Expenses are incurred in obtaining tax-exempt income.4. Costs of guarantees and warranties are estimated and accrued for financial reporting purposes.LO 6 Describe various temporary and permanent differences.
66 Specific Differences Do the following generate: 4/5/2017Specific DifferencesDo the following generate:Future Deductible Amount = Deferred Tax AssetFuture Taxable Amount = Deferred Tax LiabilityA Permanent Difference5. 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).STUDENT VERSION – DOES NOT HAVE THE ANSWER7. 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..LO 6 Describe various temporary and permanent differences.
67 First Place Example Go to Excel and work the problem 4/5/2017First Place ExampleGo to Excel and work the problemIdentify temporary and permanent differencesCompute tax payable (or refund)Compute change in deferred taxes and income tax expenseShow where deferred tax will be reported on the balance sheet
69 4/5/2017Review ProblemZurich Company reports pretax financial income of $70,000 for 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.
70 Review Problem – Abbreviated Working Paper 4/5/2017Review Problem – Abbreviated Working PaperClick to open Excel template