CHAPTER 19: Accounting for Income Taxes 1. Introduction: Chapter Objectives a. Fundamentals of accounting for IT i.

Identify differences between pretax financial income and taxable income ii. Describe a temporary difference that results in future taxable amounts iii. Describe a temporary difference that results in future deductible amounts iv. Explain the purpose of a deferred tax asset valuation allowance v. Describe the presentation of income tax expense in the income statement vi. Describe the various temporary and permanent differences vii. Explain the effect of various tax rates and tax rate changes on deferred income taxes b. Accounting for net operating losses i. Apply accounting procedures for a loss carryback and a loss carryforward. c. Describe the presentation of deferred income taxes in financial statements. d. Identify special issues related to deferred IT e. Indicate the basic principles of the asset-liability method 2. Deferred Income Taxes: An overview a. Two different income numbers exist i. Financial income: Income reported on financial statements GAAP basis ii. Taxable income: Income that is reported to taxing authorities in accordance with tax regulation serves as the basis for determining the IT liability of a given entity. b. Pretax financial income is often different from taxable income. 3. Deferred Tax Liability (DTL): A Simple Example In 2013, ABC Co. earned revenues of $30,000. ABC has no expenses other than income taxes. Assume that, in this case, the IT law specifies that income is taxed when received in cash and that ABC received $10,000 cash in 2013 and expects to receive $20,000 in 2014. The IT rate is 40%. What is the amount of total income tax liability in 2013?

Deferred Tax Liability is the expected IT on income earned but not taxed. It represents IT expected to be paid on future taxable amounts resulting from taxable temporary differences between financial and taxable income. Journal entry for 2013

4. Deferred Tax Assets: A Simple Example In 2013, its first year of operations, DEF Co. generated service revenues totaling $60,000, all taxable in 2006. DEF offers a warranty on its service. No warranty claims were made in 2013, but DEF estimates that in 2014 warranty costs of $10,000 will be incurred for warranty claims relating to 2013 service revenues. The $10,000 estimated warranty expense is reported in the 2013 financial statements as required by GAAP. For tax purposes, however, assume that the IRS does not allow any tax deduction until the actual warranty services are performed. Also assume that the IT rate is 40% and that there are no expenses in 2006 other than warranty costs and IT. Journal entry for 2013

Deferred tax asset: An expected benefit in the form of tax savings on future deductible amounts resulting from deductible temporary differences between financial and taxable income. 5. Accounting Pronouncements Pre-Codification a. APB 11 (1967): matching principle should be applied in recognizing IT expense. IT expense was based on PFI. Difference between IT expense and IT currently paid was treated as a deferred credit (debit). b. SFAS 96 (1987): focused on the asset-liability approach emphasized the reporting of future tax sacrifices or benefits attributable to temporary differences between the financial statement basis and tax basis of an asset or liability. c. SFAS 109 (1992) clarifies some controversies surrounding SFAS 96 and allows the recognition of more deferred tax assets. i. The objective of accounting for IT is to recognize a deferred tax liability or deferred tax asset for the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions and events that already have occurred. 6. Deferred Tax Liabilities: Annual Computation Year Depreciation Depreciation Pretax Taxable Income Financial Reporting Tax Financial Income 2013 25,000 40,000 22,000 2014 25,000 30,000 22,000 2015 25,000 25,000 22,000 2016 25,000 5,000 22,000 TOTAL 100,000 100,000 88,000 Assume enacted tax rates for 2013 and all future years is 40% IT Payable for 2013 = Taxable Income * Tax Rate = 60,000 * 40% = 24,000 Deferred Tax Liability at 12/31/2013 = 15,000 * 40% = $6,000 Journal Entry for 2013

Income statement presentation (2013) Income before income taxes Income tax expense: Current 24,000 Deferred 6,000 Net Income

75,000

30,000 45,000

DTL at the end of 2014 = 20,000 * 40% DTL at the end of 2013 Deferred tax expense for 2014 Current tax expense for 2014 IT expense (total) for 2007 Journal entry for 2014

= 8,000 = 6,000 = 2,000 =28,000 =30,000

2015: Dep. Expense for tax and financial reporting purposes are the same no adjustment to DTL account. Income for tax purposes = Income for FR Journal entry for 2015

DTL at the end of 2016 DTL at the end of 2015 = 20,000 * 40% Deferred tax expense (benefit) 2016 Current tax expense 2016 (95,000*40%) IT expense (total) for 2016 Journal Entry for 2016

= 0 = 8,000 = (8,000) =38,000 =30,000

7. Deferred Tax Assets: Annual Computation Year Warranty Expense Warranty Expense Financial Reporting Tax 2013 18,000 0 2014 0 6,000 2015 0 6,000 2016 0 6,000 TOTAL 18,000 18,000 2013 Journal entry

Pretax Financial Income 22,000 22,000 22,000 22,000 88,000

Taxable Income 40,000 16,000 16,000 16,000 88,000

*DTA = 18,000 X 0.4; 1/3 Current DTA; 2/3 Noncurrent DTA 2014 DTA end of 2014 DTA end of 2013 Deferred Tax Expense Current Tax Expense IT Expense Total 2014 Journal Entry

4,800 7,200 2,400 6,400 8,800 2015 Journal Entry 2016 Journal Entry

8. Nature of Deferred Tax Assets and Liabilities: Are deferred tax assets and liabilities true assets and liabilities? 9. Deferred Tax Asset Valuation Allowance a. A company should reduce a deferred tax asset by a valuation allowance if it is more likely than not that it will not realize some portion or all of the deferred tax asset. b. More likely than not likelihood of > 50% IT Expense xxxx Allowance for DTA xxxx c. Valuation allowance is a contra-asset account that reduces the asset to its expected realizable value. Current IT expense is increased as a result of reduced expectation of future tax savings. d. Valuation allowance is generally an issue when future profitability is in doubt. i. Some possible sources of taxable income to be considered in evaluating the realizable value of DTA 1. Future reversals of existing taxable temporary differences 2. Future taxable income exclusive of reversing temporary differences 3. Taxable income in prior (carryback) years ii. FASB stipulates that both positive and negative evidence be considered when determining whether deferred tax assets will be fully realized. Class Exercise for DTA Valuation Allowance: E19-14 Class Exercise for Reversal of DTA Valuation Allowance: E19-15 10. Financial Statement Presentation a. Income statement presentation: Current and deferred income tax expense b. Balance-Sheet Classification i. DTA and DTL are classified as either current or noncurrent depending upon how the related assets or liabilities are classified for financial reporting. ii. A DTA or DTL that is not related to a specific asset or liability should be classified according to when the underlying temporary difference is expected to reverse. iii. Several DTA and DTL amounts should not be reported separately, but combined into two amounts a net current amount and a net noncurrent amount are reported separately as either an asset or a liability. c. Valuation allowance for DTA should be allocated between the current and noncurrent amount in proportion to the amounts of DTA that are classified as current and noncurrent. d. Additional disclosures in notes. 11. Nature of Temporary Differences a. 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. i. Taxable temporary differences: Result in future taxable amounts, which are reported on the balance sheet as a DTL ii. Deductible temporary differences: Result in future deductible amounts. Expected benefit (tax savings) is reported in the balance sheet as DTA. iii. Original and reversing aspects of temporary differences. 12. Examples of Temporary Differences a. Differences that create DTL for future taxable amounts i. Revenues or gains are taxable after they are recognized for financial reporting purposes.

1. Installment sales method for tax purposes, but accrual method of recognizing sales revenue for FR. 2. Completed contract method for tax purposes vs. percentage of completion for FR. ii. Expenses or losses are deductible for tax purposes before they are recognized for FR purposes 1. MACRS for tax and straight line for FR b. Differences that create DTA for future deductible amounts i. Revenues or gains are taxable before they are recognized for financial reporting purposes 1. Rent revenue received in advance 2. Subscription revenue received in advance ii. Expenses or losses are deductible for tax after they are recognized for FR purposes. 1. Warranty expense 2. Bad debts, using allowance method 3. Other accruals, e.g., for litigation 13. Permanent Differences a. Permanent Differences: Nondeductible expenses or nontaxable revenues. Permanent differences are caused by items that (1) enter into pretax financial income but never into taxable income or (2) enter into taxable income but never into pretax financial income. i. Nontaxable revenues: 1. Proceeds from life insurance policies 2. Interest on municipal bonds ii. Nondeductible expenses 1. Fines on violations of law 2. Payment of life insurance premiums Class Exercise: E19-4 14. Future Tax Rate Considerations a. In determining tax rate to apply to temporary differences, a company must consider presently enacted changes in the tax rate that become effective for a particular future year(s) when the temporary difference is expected to reverse. b. FASB also requires that beginning DTA and DTL balances be adjusted as soon as a change in tax rate is enacted. Class Exercise: E19-13
2013 $70,000 X 30% $21,000 Future Years 2014 2015 $50,000 $40,000 X 30% $15,000 X 25% $10,000 2016 $20,000 X 25% $5,000 Total $180,000

Future taxable (deductible) amounts Enacted tax rate Deferred tax liability (asset)

$51,000

15. Net Operating Loss a. No income tax is payable if company experiences an operating loss. b. Internal Revenue Code provides carryback and carryforward provisions that permit a company to apply a NOL occurring in one year against income of other years. i. IRC 2-year carryback and 20-year carryforward. c. Carryback = NOL applied to income of 2 preceding years, earliest first. Amended IT returns filed. d. Unused NOL can be carried forward for up to 20 years. e. Company can also forgo carryback and carryforward NOL for 20 years Class Exercise NOL Carryback: BE19-12

Class Exercise NOL Carryforward: BE19-13

Class Exercise NOL with Valuation Allowance: BE19-14

16. Financial Statement Presentation and Disclosure a. Balance Sheet i. Report DTA and DTL as current or noncurrent ii. If DTA / DTL are related to specific assets/liabilities, classify in the same manner as the related asset or liability iii. If not related to a specific asset or liability (like DTA related to NOL c/f), classify according to expected reversal date iv. Determine net current amount by offsetting Current DTA with Current DTL and report as one current amount. v. Determine net noncurrent amount, and report in a similar manner. vi. Total of all DTA, DTL and valuation allowance along with changes in and major sources of DTA and DTL should be disclosed. vii. Income taxes payable is a current liability. b. Income Statement i. Companies should allocate income tax expense (or benefit) to continuing operations, discontinued operations, extraordinary items, and prior period adjustments Intraperiod tax allocation ii. Companies should disclose the significant components of income tax expense attributable to continuing operations (current tax expense, deferred tax expense, etc.), and amounts and expiration of NOL carryforwards. 17. Review of the Asset-Liability Method a. A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for the current year. b. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards. c. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated.

d. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized. 18. Evaluating the Asset-Liability Method a. Major Advantages of the Asset-Liability Method i. Deferred Tax 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. ii. It is a flexible approach that recognizes changes in circumstances and adjusts reported amounts accordingly. iii. Improves predictive value of financial statements. b. Disadvantages of the Asset-Liability Method i. Too complicated? ii. Ignores time value of money. 19. Why are Income Tax Disclosures Important? a. Assessment of earnings quality b. Better prediction of future cash flows c. Helpful in setting government policy 20. Accounting for Income Taxes: Comparing US GAAP and IFRS a. The classification of deferred taxes under IFRS is always non-current. GAAP allows both current and noncurrent classifications b. Under IFRS, an affirmative judgment approach is used, by which a deferred tax asset is recognized up to the amount that is probable to be realized. GAAP uses an impairment approach. In this approach, the deferred tax asset is recognized in full. It is then reduced by a valuation account if it is more likely than not that all or a portion of the deferred tax asset will not be realized. c. IFRS uses the enacted tax rate or substantially enacted tax rate. (Substantially enacted means virtually certain.) For GAAP, the enacted tax rate must be used. d. The tax effects related to certain items are reported in equity under IFRS. That is not the case under GAAP, which charges or credits the tax effects to income. e. 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 IFRS, all potential liabilities must be recognized. With respect to measurement, IFRS uses an expected-value approach to measure the tax liability, which differs from GAAP.