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Accounting for Income Taxes. Chapter 17. Chapter 17--Learning Objectives. 1. Contrast the objectives of income tax determination with the objectives of financial reporting. Income Taxes. Result from the earnings process Are not incurred to provide a product or service

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chapter 17 learning objectives
Chapter 17--Learning Objectives

1. Contrast the objectives of income tax determination with the objectives of financial reporting

income taxes
Income Taxes
  • Result from the earnings process
  • Are not incurred to provide a product or service
  • Are paid to many jurisdictions, including the U.S. government, state governments, and other national governments
  • Often require separate accounting records for each jurisdiction
u s federal income taxes
U.S. federal income taxes

Rules on taxes to be paid encompass:

1. Revenue items to be included in taxable income

2. Expense items permitted to be deducted

3. The rates applied to taxable income

4. Tax credits permitted as direct reductions to income tax liability

financial reporting and income tax assessment have different goals

Income

Statement

Tax

Return

Financial reporting and income tax assessment have different goals
  • Hence, the rules are different for financial reporting and for income tax calculation
  • Therefore, income for financial reporting purposes frequently differs from taxable income
chapter 17 learning objectives10
Chapter 17--Learning Objectives

2. Apply the liability approach to determine (a) temporary differences and carryforwards, (b) deferred income tax assets and liabilities, and (c) income tax expense

nature of income tax
Nature of Income Tax
  • Expense?
  • Distribution of profits to the government?
  • ARB 43
    • Income tax is an expense

IRS Agent

At your Service

accrual basis accounting
Accrual Basis Accounting
  • Matching principle
    • Allocates expenses to accounting periods
  • Income tax = An expense
    • Therefore, it too should be allocated among accounting periods
income tax allocation
Income Tax Allocation
  • Interperiod income tax allocation
    • Allocating income tax among accounting periods
  • Intraperiod income tax allocation
    • Allocating income tax among items reported within a given accounting period
      • Income from continuing operations
      • Discontinued operations
      • Extraordinary items
      • Prior period adjustments
      • Cumulative effect of accounting change
asset liability method
Asset/Liability Method
  • Future tax consequences of temporary differences between pretax accounting income (AI) & taxable income (TI) are deferred tax assets & deferred tax liabilities
  • Tax rates used:
    • Future tax rates
    • Based on currently enacted tax law
  • Tax expense = Current provision +/- changes in deferred tax assets & liabilities
differences between ai ti
Differences between AI & TI
  • Temporary differences
  • Permanent differences
permanent differences
Permanent Differences
  • Item in TI, never in AI
  • Item in AI, never in TI
items in ti never in ai
Items in TI, never in AI
  • Tax deductions that are not expenses under GAAP
    • Percentage depletion > Cost depletion
    • Dividend exclusion
items in ai never in ti
Items in AI, never in TI
  • Tax exempt revenues
    • Municipal bond interest
    • Life insurance proceeds paid to corporation on death of employee
  • Non-deductible expenses
    • Life insurance premiums on officers where corporation is beneficiary
    • Tax penalties
temporary differences
Temporary Differences
  • Differences between AI and TI caused by differences in when amounts are recognized
    • Timing differences
    • Assets & Liabilities have different bases
exercise
Exercise
  • Indicate whether each of the following is a temporary difference or a permanent difference between TI and AI
municipal bond interest
Municipal bond interest

Permanent

Temporary

double declining balance depreciation for tax straight line depreciation for books
Double declining balance depreciation for tax Straight-line depreciation for books

Permanent

Temporary

warranty expense is probable and can be reasonably estimated deduct when paid for tax
Warranty expense is probable and can be reasonably estimated. Deduct when paid for tax

Permanent

Temporary

use percentage of completion for books use completed contract method for tax
Use percentage of completion for books Use completed contract method for tax

Permanent

Temporary

tax penalties are incurred
Tax penalties are incurred

Permanent

Temporary

current period effect of temporary differences
Current Period Effect of Temporary Differences
  • Temporary difference ® Current TI > AI
  • Temporary difference ® Current TI < AI
current ti ai
Current TI > AI
  • Tax Consequence:
    • Future TI < AI
    • Called deductible amounts
    • Benefit = future tax reduction
    • Asset today
current ti ai examples
Current TI > AI - Examples
  • Revenues & Gains in TI before AI
    • Rent received in advance
  • Expenses & Losses in AI before TI
    • Contingent liabilities
current ti ai34
Current TI < AI
  • Tax consequence:
    • Future TI > AI
    • Called taxable amounts
    • Obligation to pay more tax in the future
    • Liability today
current ti ai examples35
Current TI < AI - Examples
  • Revenues & Gains in AI before TI
    • Installment sales method for tax
    • Point of sale revenue recognition for books
  • Expenses & Losses in TI before AI
    • Accelerated depreciation for tax
    • Straight line depreciation for books
exercise36
Exercise
  • For each temporary difference, determine:
    • The originating effect
    • The reversing effect
    • Whether there will be future taxable or deductible amounts
    • Whether there is a deferred tax asset or deferred tax liability
depreciation
Depreciation
  • DDB depreciation for tax
  • Straight-line depreciation for books

Originating Difference TI>AI or TI< AI

Reversal TI>AI or TI< AI

Reversal Taxable or Deductible amounts

Accounting Treatment D T Asset/ D T Liab

TI<AI

TI>AI

Taxable Amount

DTL

depreciation38
Depreciation
  • Life for tax < Life for books

Originating Difference TI>AI or TI< AI

Reversal TI>AI or TI< AI

Reversal Taxable or Deductible amounts

Accounting Treatment D T Asset/ D T Liab

TI<AI

TI>AI

Taxable Amount

DTL

sales
Sales
  • Record when made for books
  • Installment sales method for tax

Originating Difference TI>AI or TI< AI

Reversal TI>AI or TI< AI

Reversal Taxable or Deductible amounts

Accounting Treatment D T Asset/ D T Liab

TI<AI

TI>AI

Taxable Amount

DTL

warranty expense
Warranty Expense
  • Accrued for books
  • Deductible when paid for tax

Originating Difference TI>AI or TI< AI

Reversal TI>AI or TI< AI

Reversal Taxable or Deductible amounts

Accounting Treatment D T Asset/ D T Liab

TI>AI

TI<AI

Deductible Amount

DTA

rent received in advance
Rent Received in Advance
  • Deferred for books
  • Taxable upon receipt for tax

Originating Difference TI>AI or TI< AI

Reversal TI>AI or TI< AI

Reversal Taxable or Deductible amounts

Accounting Treatment D T Asset/ D T Liab

TI>AI

TI<AI

Deductible Amount

DTA

long term contract
Long-Term Contract
  • Percentage of completion for books
  • Completed contract method for tax

Originating Difference TI>AI or TI< AI

Reversal TI>AI or TI< AI

Reversal Taxable or Deductible amounts

Accounting Treatment D T Asset/ D T Liab

TI<AI

TI>AI

Taxable Amount

DTL

prepaid rent
Prepaid Rent
  • Defer for books
  • Deduct when paid for tax

Originating Difference TI>AI or TI< AI

Reversal TI>AI or TI< AI

Reversal Taxable or Deductible amounts

Accounting Treatment D T Asset/ D T Liab

TI<AI

TI>AI

Taxable Amount

DTL

steps accounting for deferred tax liabilities
Steps: Accounting for Deferred Tax Liabilities
  • Identify temporary differences
  • Identify future taxable amounts
  • Identify future taxable amounts from prior temporary differences
  • Calculate DTL
  • Calculate income tax payable
  • Income tax expense =
    • Income taxes payable + D in DTL
example deferred income tax liability
ExampleDeferred Income Tax Liability
  • Jan’s Cookies sells franchises
  • Price of franchise = $20,000
  • Franchisee pays equal installments over 4 years
  • Ignore time value of money
  • Recognize sale for books contract is signed
  • Cash basis for tax
year 1
Year 1
  • Sales $240,000
  • Pretax accounting income 200,000
  • Includes municipal bond interest of 10,000
  • Tax rate for 19x1 40%
  • Tax rate for all future years 30%
permanent difference
Permanent Difference?

Municipal bond interest $10,000

the temporary difference
Revenue in accounting income

Revenue in taxable income

Temporary difference

$ 240,000

60,000

$ 180,000

The Temporary Difference?
reversals
Reversals
  • Will future TI be greater than or less than AI?

TI > AI

  • Future Taxable or Deductible Amounts?

Taxable Amounts

  • Future Taxable Amounts will total?

$180,000

amount of dtl
Amount of DTL
  • 180,000 x 30% = 54,000

Yr 1

Yr 2 Yr 3 Yr 4

TD

180,000

TA 60,000 60,000 60,000

30% 30% 30%

18,000 18,000 18,000

54,000

taxable income
Pretax accounting income

Municipal bond interest

Temporary difference

Taxable income

$ 200,000

( 10,000)

(180,000)

$ 10,000

Taxable Income

Tax rate?

x 40%

Taxes payable

4,000

change in deferred tax liability
Change in Deferred Tax Liability

DTL

0 Beginning Balance

Credit

54,000 Increase

54,000 Ending Balance

income tax expense
Income tax payable

Increase in DTL

Income tax expense

$ 4,000

54,000

$ 58,000

Debit

Credit

Income Tax Expense

Income Tax Expense

58,000

54,000

Deferred Tax Liab

Income Tax Payable

4,000

balance sheet classification
Balance Sheet Classification
  • Classify as short term or long term
  • Based on related asset or liability balance
  • Report 1 long-term net asset or liability
  • Report 1 current net asset or liability
related asset or liability
Related Asset or Liability?
  • Accounts Receivable $180,000
  • Current asset?
  • If so, the DTL is a current liability
year 2
Year 2
  • Sales $360,000
  • Pretax accounting income 235,000
  • Includes municipal bond interest of $10,000
  • Includes $1,000 for tax penalties
  • Tax law change:
    • For all years subsequent to 2003
    • Tax rate = 35%
permanent differences58
Permanent Differences?
  • Municipal bond interest $10,000
  • Tax penalty $ 1,000
the amount of the temporary difference
Revenue in accounting income

Revenue in taxable income

Temporary difference

$ 360,000

90,000

$ 270,000

The amount of the Temporary Difference?
reversal in 2002
From 2001 Sales

Revenue in taxable income

Revenue in accounting income

Taxable amount

$ 60,000

none

$ 60,000

Reversal in 2002?
taxable income61
Pretax accounting income

Municipal bond interest

Tax penalty

Temporary difference

Reversal (taxable amount)

Taxable income

$ 235,000

( 10,000)

1,000

(270,000)

60,000

$ 16,000

Taxable Income

Tax rate?

x 30%

Taxes payable

4,800

year 2002
Year 2002

Revenue in TI

Revenue in AI

TI>AI or TI<AI

TD, TA or DA

Tax Rate

From 2001

60,000

0

TI>AI

TA

30%

From 2002

90,000

360,000

TI<AI

TD

year 2003
Year 2003

Revenue in TI

Revenue in AI

TI>AI or TI<AI

TD, TA or DA

Tax Rate

From 2001

60,000

0

TI>AI

TA

30%

From 2002

90,000

0

TI>AI

TA

year 2004
Year 2004

Revenue in TI

Revenue in AI

TI>AI or TI<AI

TD, TA or DA

Tax Rate

From 2001

60,000

0

TI>AI

TA

35%

From 2002

90,000

0

TI>AI

TA

year 2005
Year 2005

Revenue in TI

Revenue in AI

TI>AI or TI<AI

TD, TA or DA

Tax Rate

Nothing left from 2001

35%

From 2002

90,000

0

TI>AI

TA

amount of dtl66
Amount of DTL

Yr 2

Yr 3 Yr 4 Yr 5

TI

16,000

30%

4,800

TA 150,000 150,000 90,000

3 0% 35% 35%

45,000 52,500 31,500

Tx Payable

DTL 129,000

change in dtl
Change in DTL

DTL

54,000 Beginning Balance

Credit

75000 Increase

129,000 Ending Balance

income tax expense68
Income tax payable

Increase in DTL

Income tax expense

$ 4,800

75,000

$ 79,800

Debit

Credit

Income Tax Expense

Income Tax Expense

79,800

75,000

Deferred Tax Liab

Income Tax Payable

4,800

interperiod tax allocation

Interperiod Tax Allocation

Deferred Tax Asset

deferred tax assets
Deferred Tax Assets
  • Future tax consequences = benefit
  • Result from temporary differences associated with future deductible amounts
  • Result from net operating loss carryovers
net operating losses nol
Net Operating Losses (NOL)
  • When deductions and losses on a tax return exceed taxable revenues and gains
  • Can carry back 3 years
  • Can carry over 15 years
accounting for dtas additional steps
Accounting for DTAsAdditional Steps
  • Identify future deductible amounts
    • Including NOL carryovers
  • Calculate DTA
  • If more likely than not that NRV<DTA
    • Calculate allowance to reduce net DTA to NRV
  • Income Tax Expense =
    • Income Taxes Payable +
      • D in DTL
      • D in DTA
      • D in allowance
dtl dta example
DTL & DTA Example
  • 7/1/x1 - Purchased depreciable asset
  • Cost $30,000
  • Ignore salvage value
  • Useful life 6 years
  • Tax life 4 years
  • Straight-line depreciation - book & tax
  • Pretax accounting income $10,000
  • Tax rate 40% 2001

35% after 2003

dtl dta example74
DTL & DTA Example
  • Let TD = temporary difference
  • Let TA = taxable amount
  • Let DA = deductible amount
slide75

Depr in TI

Depr in AI

TI>AI TI<AI

TD/TA/DA

Tax Rate

Yr

1

3,750

2,500

TI<AI

TD=1,250

40%

2

7,500

5,000

TI<AI

TD=2,500

40%

3

7,500

5,000

TI<AI

TD=2,500

40%

Equal

4

7,500

5,000

TI<AI

TD=2,500

35%

5

3,750

5,000

TI>AI

TA=1,250

35%

6

-

5,000

TI>AI

TA=5,000

35%

7

-

2,500

TI>AI

TA=2,500

35%

taxable income for 2001
Accounting income

Temporary difference

Taxable income

$ 10,000

( 1,250)

$ 8,750

Taxable Income for 2001?

Tax rate?

x 40%

Taxes payable

$ 3,500

for 2001
Depreciation in TI

Depreciation in AI

Temporary difference

$ 3,750

2,500

$ 1,250

For 2001

Will reverse in what year?

$ 3,500

reversal will be a
Reversal will be a

Taxable Amount

Deductible Amount

The tax consequence is a

DTA or DTL

schedule tax consequences
Schedule Tax Consequences

Description

2001

Description

2005

Taxable Income

Taxable Amount

1,250

8,750

Tax Rate

x 40%

Tax Rate

x 35%

Taxes Payable

Tax Consequence

3,500

437.50

DTL

change in deferred tax liability80
Change in Deferred Tax Liability

DTL

0 Beginning Balance

Credit

437.50 Increase

437.50 Ending Balance

2001 income tax expense
Income tax payable

Increase in DTL

Income tax expense

$ 3,500.00

437.50

$ 3,937.50

Debit

Credit

2001 Income Tax Expense

Income Tax Expense

3,937.50

437.50

Deferred Tax Liab

Income Tax Payable

3,500.00

assumption 2001 ai 8 000
Taxable income?

Accounting income

Temporary difference

NOL

(8,000)

(2,500)

(10,500)

Assumption: 2001 AI = (8,000)
amount of tax refund
Amount of Tax Refund?
  • $ 3,500
  • Income Tax Refund Receivable
  • Classified as a?
    • Current asset

TI Tax Paid Year 1 8,750 3,500

Year 2 (10,500) NOL

2002 cumulative td
2002- Cumulative TD?

2002 Depreciation in TI

7,500

2002 Depreciation in AI

5,000

2002 Temporary difference

2006

2,500

2001Temporary difference

1,250

2005

Cumulative TD

3,750

In what year(s) will cumulative TD reverse?

schedule tax consequences85
Schedule Tax Consequences

2001

2002

2005

2006

TI (NOL)

8,750

(10,500)

TA

1,250

2,500

Tax Rate

x 40%

Tax Rate

x 35%

x 35%

Taxes Payable

Tax Consequence

437.50

875.00

3,500

1,312.50

NOL CB

8,750

Tax Rate

x 40%

Tax Refund

DTL

3,500

nol carryover
NOL Carryover
  • 2002 NOL 10,500
  • Carried back to 2001 8,750
  • NOL carryover 1,750

A future benefit

future tax consequence nol
Future Tax Consequence - NOL?
  • What tax rate to choose?
  • We will use 35%
  • Tax consequence
    • 1,750 x 35% = 612.50
t account89
T Account

DTL

437.50

875.00

1,312.50

t account91
T Account

DTA

0

612.50

612.50

journal entry 2002
Journal Entry - 2002
  • Income Tax Refund Receivable 3,500.00

DTA 612.50

DTL 875.00

Income Tax Benefit 3,237.50

slide93
2003
  • Accounting income = (10,000)
  • Tax law change:
    • Tax rate for current & future years
    • Changed to 30%
calculate loss carryover
Calculate Loss Carryover

Accounting Loss

(10,000)

Depreciation in TI

7,500

(2,500)

Depreciation in AI

5,000

2003 NOL

(12,500)

NOL Carryover to 2003

(1,750)

NOL Carryover to 2004

(14,250)

2003 temporary difference
2003 Temporary Difference?
  • $ 2,500

Cumulative temporary difference?

  • From 2001 1,250
  • From 2002 2,500
  • From 2003 2,500
  • Cumulative TD 6,250
schedule tax consequences96
Schedule Tax Consequences

2002

2003

2005

2006

TI (NOL)

(10,500)

(12,500)

TA

1,250

5,000

NOL CB

8,750

Tax Rate

x 30%

x 30%

Tax Consequence

375

1,500

NOL CO

1,750

(14,250)

1,875

DTL

future tax consequences nol carryover
Amount of NOL Carryover

Tax rate

Future tax consequence

What is it?

$ 14,250

30%

$ 4,275

DTA

Future Tax ConsequencesNOL Carryover
assumption
Assumption
  • More likely than not
  • No future taxable income
  • How much of the DTA is realizeable?
  • The amount of the DTL
  • $ 1,875
the valuation allowance
DTA

Realizeable

Valuation allowance

4,275

1,875

2,400

The Valuation Allowance?
balance sheet
Balance Sheet?
  • DTA $ 4,275
  • Allowance ( 2,400)
  • Net Asset $ 1,875
  • DTL ( 1,875)
  • Net amount none
t account102
T Account

DTL

1,312.50

562.50

1,875.00

t account104
T Account

DTA

612.50

3,662.50

4,275.00

t account105
T Account

DTA-Valuation Allowance

t account106
T Account

DTA-Valuation Allowance

0

2,400

2,400

journal entry 2003
Journal Entry - 2003
  • DTA 3,662.50

Valuation Allow 2,400.00

DTL 562.50

Income Tax Benefit 700.00

assumptions 2004
Assumptions - 2004
  • Accounting income = $4,000
  • Includes accrual of $8,000
    • Expected loss on lawsuit
    • Expected to be settled in 2006
calculate loss carryover109
Calculate Loss Carryover

Accounting Income

4,000

Depreciation in TI

7,500

Depreciation in AI

5,000

TD due to depreciation

(2,500)

TD due to law suit

8,000

TI before special deductions

9,500

NOL Carryover to 2004

(14,250)

NOL Carryover to 2005

(4,750)

cumulative td for depr
Cumulative TD for Depr?
  • 2001 $ 1,250
  • 2002 2,500
  • 2003 2,500
  • 2004 2,500
  • Cumulative TD $ 8,750

Taxable Amount

or

Deductible Amount

td from lawsuit
TD from Lawsuit?
  • $ 8,000

Taxable Amount

or

Deductible Amount

schedule current tax consequences
Schedule Current Tax Consequences

Description

2002

2003

2004

Taxable Inc (Loss)

(10,500)

9,500

(12,500)

NOL CB

8,750

n/a

n/a

NOL CO

1,750

4,750

14,250

Deductible Amount

schedule future tax consequences
Schedule Future Tax Consequences

Description

2005

2006

2007

Taxable Amount

2,500

1,250

5,000

Tax Rate

x 30%

x 30%

x 30%

Taxes Consequence

375

1,500

750

2,625

DTL

deferred tax asset
Deferred Tax Asset?
  • 3,825
    • NOL 4,750
    • Deductible Amount 8,000
    • Total 12,750
    • Tax Rate 30%
    • DTA 3,825
valuation allowance
Valuation Allowance?
  • ZERO
  • No Evidence to indicate that it is more likely than not that the DTA will not be realized
t account117
T Account

DTL

1,875

750

2,625

t account119
T Account

DTA

4,275

450

3,825

t account120
T Account

DTA-Valuation Allowance

t account121
T Account

DTA-Valuation Allowance

2,400

2,400

0

journal entry 2004
Journal Entry - 2004
  • Valuation Allowance 2,400

DTA 450

DTL 750

Income Tax Benefit 1,200

chapter 17 learning objectives123
Chapter 17--Learning Objectives

3. Interpret the major issues central to the historical development of accounting for income taxes

interperiod income tax allocation theories
Interperiod Income Tax Allocation Theories
  • No income tax allocation
  • Partial income tax allocation
  • Comprehensive income tax allocation
no income tax allocation
No Income Tax Allocation
  • Income tax expense = Income tax paid
  • Rationale
    • No income tax liability until a tax return is filed
      • No future tax consequences yet
    • Deferred income tax liabilities are never paid
      • Continuous replacement
      • Never write the check
comprehensive allocation
Comprehensive Allocation
  • Report all future tax consequences associated with items reported in the income statement
  • APB & FASB take this position
arguments in favor of interperiod income tax allocation
Arguments in Favor of Interperiod Income Tax Allocation
  • Matches
    • Items reported in earnings
    • with their future tax consequences
  • Reports the anticipated future tax consequences as
    • Assets & Liabilities
methods of incometax allocation
Methods of IncomeTax Allocation
  • Deferred method
    • Was required under APB 11
  • Asset/Liability method
    • Is required under SFAS 109
criticism of deferred method
Criticism of Deferred Method
  • Measurement based on current tax rate
  • Does not measure future tax consequence
  • Because the tax is deferred, the tax consequence occurs in the future.
  • Measurement should be based on expected future rates
  • Tax expense should be based on the change in asset & liability measures
net of tax presentation
Net-of-tax presentation
  • Refers to offsetting a deferred tax amount against a related asset or liability
  • Was used briefly in certain business combination situations
  • Is no longer acceptable under GAAP
discounting to present value
Discounting to Present Value
  • Is a subject under continuing debate
  • Is not used for deferred tax items under current GAAP
  • Yet, anticipated future cash flows for other assets and liabilities are discounted
chapter 17 learning objectives132
Chapter 17--Learning Objectives

4. Analyze the financial reporting of income tax information disclosed in notes to financial statements

income statement
Income Statement

Items are classified in four categories

1. Continuing operations

2. Discontinued operations

3. Extraordinary items

4. Changes in accounting principles

Income tax expense is allocated among these categories

required disclosure notes for balance sheet items include
Required disclosure notesfor balance sheet items include
  • Changes in deferred tax valuation allowances
  • Types of temporary differences and carry-forwards that involve significant deferred tax assets or liabilities with amounts and uncertainties
  • Exceptions involving deferred taxes
required disclosure notes for income statement items
Required disclosure notesfor income statement items
  • Significant components of income tax expense for continuing operations
  • Amounts of tax expense allocated to other than continuing operations
  • Nature of differences due to state taxes, nondeductible items, tax credits, etc.
  • Nature of items affecting comparability between periods
  • Amounts and dates for any carryforwards
chapter 17 learning objectives136
Chapter 17--Learning Objectives

5. Interpret the impact income tax accounting principles can have on analyzing a company’s financial position, results of operations, and growth potential

tax items which can cause special concern in financial analysis
Tax items which can cause special concern in financial analysis
  • Effects of tax-exempt income
  • Effects of tax credits and depreciation
  • Contrast of tax rates and tax credits
  • Valuation allowances
  • Actual examples of the above situations are presented in the text.
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