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Accounting for Income Taxes

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Deferred Tax Assets and Deferred Tax Liabilities


GAAP is the set of rules for preparing financial statements. Results in . . . The Internal Revenue Code is the set of rules for preparing tax returns. Usually. . . Results in . . .

Financial statement income tax expense.

IRS income taxes payable.

The objective of accounting for income taxes 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 or events that already have occurred.
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Temporary Differences
The difference in the rules for computing between pre-tax accounting income (according to GAAP) and taxable income (according to the IRS) often causes amounts to be reported in different years.

This results in temporary differences.


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Temporary Differences
Temporary differences will reverse in one or more future periods.

Accounting Income > Taxable Income Future Taxable Amounts

Accounting Income < Taxable Income Future Deductible Amounts

Deferred Tax Liability

Deferred Tax Asset

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Deferred Tax Liabilities

A temporary difference originates in one period and reverses, or turns around, in one or more subsequent periods.
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Deferred Tax Liabilities

Calculate income tax that is currently payable: $100 40% = $40 Calculate change in deferred tax liability: ($40 40%) = $16 Combine the two to get the income tax expense: $40 + $16 = $56

Income tax expense Income tax payable Deferred tax liability


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56 40 16

The FASBs Balance Sheet Approach

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Types of Temporary Differences

Deferred tax assets result in deductible amounts in the future.


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Deferred tax liabilities result in taxable amounts in the future.

Deferred Tax Liabilities

A temporary difference originates in one period and reverses, or turns around, in one or more subsequent periods.
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Deferred Tax Liabilities

Calculate income tax that is currently payable: $92 40% = $36.8 Calculate change in deferred tax liability: ($25 - $33) 40% = $3.2 Combine the two to get the income tax expense: $36.8 + $3.2 = $40

Journal entry at the end of 2011 Income tax expense Income tax payable Deferred tax liability
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40.0 36.8 3.2

Deferred Tax Liabilities

Calculate income tax that is currently payable: $81 40% = $32.4 Calculate change in deferred tax liability: (($25 - $44) 40%)) = $7.6 Combine the two to get the income tax expense: $32.4 + $7.6 = $40

Journal entry at the end of 2012 Income tax expense Income tax payable Deferred tax liability
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40.0 32.4 7.6

Deferred Tax Liabilities

Calculate income tax that is currently payable: $110 40% = $44 Calculate change in deferred tax liability: (($25 - $15) 40%)) = $4 Combine the two to get the income tax expense: $44 4 = $40

Journal entry at the end of 2013 Income tax expense Deferred tax liability Income tax payable
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40 4 44

Deferred Tax Liabilities


Journal entry at the end of 2014 Income tax expense Deferred tax liability Income tax payable

40.0 6.8
46.8

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Deferred Tax Assets


RDP Networking reported pretax accounting income in 2011, 2012, and 2013 of $70 million, $100 million, and $100 million, respectively. The 2011 income statement includes a $30 million warranty expense that is deducted for tax purposes when paid in 2012 ($15 million) and 2013 ($15 million). The income tax rate is 40% each year.

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Deferred Tax Assets

Calculate income tax that is currently payable: $100 40% = $40 Calculate change in deferred tax asset: $30 40% = $12 Combine the two to get the income tax expense: $40 12 = $28

Journal entry at the end of 2011 Income tax expense Deferred tax asset Income tax payable
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28 12 40

Deferred Tax Assets


Journal entry at the end of 2012 and 2013 Income tax expense Deferred tax asset Income tax payable 40

6 34

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Valuation Allowance
A valuation allowance account is needed if it is more likely than not that some portion of the deferred tax asset will not be realized. The deferred tax asset is then reported at its estimated net realizable value.
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Permanent Differences
Created when an income item is included in taxable income or accounting income but will never be included in the computation of the other.
Example: Interest on tax-free municipal bonds is included in accounting income but is never included in taxable income. Permanent differences are disregarded when determining both the tax payable currently and the deferred tax asset or liability.
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U.S. GAAP vs. IFRS


Despite the similar approaches for accounting for income taxes under IFRS and U.S. GAAP, differences in reported amounts for deferred taxes are among the most frequent between the two reporting approaches.

For example, U.S. GAAP requires a loss contingency be accrued if it is both probable and can be reasonably estimated. Accruing a loss contingency leads to a deferred tax asset.

For loss contingencies, IFRS uses a more likely than not threshold, which is lower than the U.S. probable requirement. As a result, under the lower threshold of IFRS, a loss contingency and a deferred tax asset sometimes is recorded for IFRS but not for U.S. GAAP.

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Tax Rate Considerations


Deferred tax assets and liabilities should be determined using the future tax rates, if known.

The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs.
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Multiple Temporary Differences


It would be unusual for any but a very small company to have only a single temporary difference in any given year. Categorize all temporary differences according to whether they create

Future taxable amounts


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Future deductible amounts

Net Operating Losses (NOL)


Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or subsequent periods.

When used to offset earlier taxable income: Called: operating loss carryback. Result: tax refund.
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When used to offset future taxable income: Called: operating loss carryforward. Result: reduced tax payable.

Net Operating Losses (NOL)

Carryback Period

Carryforward Period

-2

-1

Current Year

+1 +2 +3 +4 +5

. . . +20

The NOL may first be applied against taxable income from two previous years. Unused NOL may be carried forward for 20 years.

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Operating Loss Carryforward

Deferred tax asset Income tax benefit-operating loss


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50 50

Operating Loss Carryback

The carryback of the NOL must be applied to the earlier year first and then to the next year. Any remaining NOL may be carried forward.

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Operating Loss Carryback

Receivableincome tax refund Deferred tax asset Income tax benefit-operating loss
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29 20

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Balance Sheet Classification


Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability. A deferred tax asset that is not related to a specific asset or liability should be classified according to when the underlying temporary difference is expected to reverse.
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Deferred Tax Assets and Disclosure Notes Deferred Tax Liabilities Total of all deferred tax liabilities. Total of all deferred tax assets. Total valuation allowance recognized. Net change in valuation account. Income Tax Expense Current portion of the Approximate tax effect of each tax expense (or benefit). type of temporary difference Deferred portion of the (and carryforward). tax expense (or benefit) with separate disclosures of amounts Operating Loss Carryforwards attributable to several Amounts. specific items. Expiration dates.
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Coping with Uncertainty in Income Taxes


Two-step Decision Process Step 1. A tax benefit may be reflected in the financial statements only if it is more likely than not that the company will be able to sustain the tax return position, based on its technical merits. Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50 percent likely to be realized.
If the tax benefit is not more likely than not, then none of the tax benefit is allowed to be recorded.
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Intraperiod Tax Allocation


Income Statement: Income from continuing operations. Discontinued operations. Extraordinary items.

Other Comprehensive Income: Investments. Postretirement benefit plans. Derivatives. Foreign currency translation.
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U.S. GAAP vs. IFRS


The approach for accounting for intraperiod tax allocation is the same under IFRS and U.S. GAAP, but the categories used on the income statement are different.

GAAP separately reports both discontinued operations and extraordinary items on the income statement and each are shown net of tax.

IFRS does not separately report extraordinary items on the income statement. As a result, the only income statement item reported separately net of tax using IFRS is discontinued operations.

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End of Chapter 16

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