Accounting for Income Taxes

1. Accounting for Income Taxes Chapter 17

2. Chapter 17--Learning Objectives 1. Contrast the objectives of income tax determination with the objectives of financial reporting

3. 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

4. U.S. corporationsare subject to federal income taxes

5. They may also be subject to a number of state income taxes

6. And increasingly to foreign income taxes as well

7. Our focus is primarily on U.S.federal income taxes

8. 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

9. 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

10. 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

11. Nature of Income Tax • Expense? • Distribution of profits to the government? • ARB 43 • Income tax is an expense IRS Agent At your Service

12. Accrual Basis Accounting • Matching principle • Allocates expenses to accounting periods • Income tax = An expense • Therefore, it too should be allocated among accounting periods

13. 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

14. 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

15. Differences between AI & TI • Temporary differences • Permanent differences

16. Permanent Differences • Item in TI, never in AI • Item in AI, never in TI

17. Items in TI, never in AI • Tax deductions that are not expenses under GAAP • Percentage depletion > Cost depletion • Dividend exclusion

18. 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

19. Temporary Differences • Differences between AI and TI caused by differences in when amounts are recognized • Timing differences • Assets & Liabilities have different bases

20. Exercise • Indicate whether each of the following is a temporary difference or a permanent difference between TI and AI

21. Municipal bond interest Permanent Temporary

22. Double declining balance depreciation for tax Straight-line depreciation for books Permanent Temporary

23. Depreciable life for tax < Depreciable life for books Permanent Temporary

24. Recognize sales when made for books Use installment sales method for tax Permanent Temporary

25. Warranty expense is probable and can be reasonably estimated. Deduct when paid for tax Permanent Temporary

26. Defer rent received in advance for books Rent is taxed upon receipt Permanent Temporary

27. Use percentage of completion for books Use completed contract method for tax Permanent Temporary

28. Tax penalties are incurred Permanent Temporary

29. Prepaid rent for 2 years in advance. The rent deductible when paid for tax Permanent Temporary

30. Statutory depletion exceeds full cost depletion recognized for books Permanent Temporary

31. Current Period Effect of Temporary Differences • Temporary difference ® Current TI > AI • Temporary difference ® Current TI < AI

32. Current TI > AI • Tax Consequence: • Future TI < AI • Called deductible amounts • Benefit = future tax reduction • Asset today

33. Current TI > AI - Examples • Revenues & Gains in TI before AI • Rent received in advance • Expenses & Losses in AI before TI • Contingent liabilities

34. Current TI < AI • Tax consequence: • Future TI > AI • Called taxable amounts • Obligation to pay more tax in the future • Liability today

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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%

47. Permanent Difference? Municipal bond interest $10,000

48. Revenue in accounting income Revenue in taxable income Temporary difference $ 240,000 60,000 $ 180,000 The Temporary Difference?

49. 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

50. The Balance Sheet will report DTA or DTL