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Part Six : Accounting for Enterprise Income Taxes. Key Issues. Book (financial statement) vs. taxable income Permanent differences Effective vs. statutory tax rates Temporary (timing) differences Deferred taxes: Assets, Liabilities, Expense Possible cases and examples

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Presentation Transcript
key issues
Key Issues
  • Book (financial statement) vs. taxable income
  • Permanent differences
  • Effective vs. statutory tax rates
  • Temporary (timing) differences
  • Deferred taxes: Assets, Liabilities, Expense
  • Possible cases and examples
  • Components of income tax expense (current vs deferred)
  • Tax journal entries
  • Originating vs reversing differences
  • Asset, Liability (B/S) method vs I/S method
  • NOL carryback and carryforward
  • Deferred tax asset valuation allowance
  • Footnote disclosures:

Paul Zarowin

3 parts of tax disclosure
3 Parts of Tax Disclosure
  • Current vs. deferred expense
  • Reconciliation between statuary vs. effective tax rates
  • Changes in Deferred Tax (DT) assets/liabilities and/or components of DT expense.

Paul Zarowin

key identity
Key Identity

Pre-tax book (accounting) income

± Permanent differences

± Temporary differences

= pre-tax taxable income

Paul Zarowin

permanent differences
Permanent Differences

Definition:

Items of revenue or expense that are in book (or taxable) income of a period, but never part of taxable (or book) income.

2 types:

  • non-taxable revenues
  • non-deductible expenses (ex. GW amortization)

(ex. interest income on municipal bonds)

Paul Zarowin

importance of permanent differences effective vs statutory tax rate
Importance of Permanent Differences:Effective vs. Statutory Tax Rate

def:effective tax rate (ETR) =

def:statutory tax rate (STR) = rate set by government

  • permanent diffs cause ETR  STR
  • non-taxable revenues lower the ETR
  • non-deductible expenses raise the ETR

ex. E13-7, E13-8 (Kent)

Paul Zarowin

temporary timing differences
Temporary (Timing) Differences

Temp. diff. cause deferred tax assets, liabilities, expense

Definitions:

  • Temp diff: item of revenue or expense that are part of book and taxable income, in different periods
  • Deferred tax asset:future tax deductible due to current timing difference
  • Deferred tax liability:future tax payable due to current timing difference

Q: What is sum of temporary differences over firm’s life?

Paul Zarowin

ex 1 accrued asset receivable
Ex. 1. accrued asset, receivable

Books = accrual accountingTaxes = cash accounting

DRCRDRCR A/R 100 Rev 100 N/A

DRCRDRCR

Cash 100 A/R 100 Cash 100 Rev 100

Note: total revenue is the same, just timing differs

period 1:

period 2:

Paul Zarowin

ex 2 unearned revenue
Ex. 2. unearned revenue

Books = accrual accountingTaxes = cash accounting

DRCRDRCR Cash 100 Liab 100 Cash 100 Rev 100

DRCRDRCR

Liab 100 Rev 100 N/A

Note: total revenue is the same, just timing differs

period 1:

period 2:

Paul Zarowin

ex 3 accrued liability payable
Ex. 3. accrued liability, payable

Books = accrual accountingTaxes = cash accounting

DRCRDRCR Exp 100 Liab 100 N/A

DRCRDRCR

Liab 100 Cash 100 Exp 100 Cash 100

Note: total expense is the same, just timing differs

period 1:

period 2:

Paul Zarowin

ex 4 prepaid expense
Ex. 4. prepaid expense

Books = accrual accountingTaxes = cash accounting

DRCRDRCR Asset 100 Cash 100 Exp 100 Cash 100

DRCRDRCR

Exp 100 Asset 100 N/A

Note: total expense is the same, just timing differs

period 1:

period 2:

Paul Zarowin

components of tax expense and tax je
Components of Tax Expense and Tax JE

1. current (pay now); and

Components of tax expense:

  • DRcurrent tax expensea

CR Cash or taxes payable

a)Current tax expense = taxable inc.*current statutory tax rate

  • DR deferred tax expenseb

CR Deferred tax asset/liability

b)Deferred tax expense =

net  in deferred tax asset/liability

2. deferred (paid before or after)

Assumes positive taxable income

can DR or CR deferred tax expense, depending on net  deferred tax asset/liability

Paul Zarowin

components of tax expense cont d
Components of Tax Expense (cont’d)

Alternatively,

  • DRtotal tax expensec

CR Deferred tax asset/liability

CR Cash

c)Total tax expense = current + deferred

Paul Zarowin

deferred tax accounting inter period tax allocation
Deferred Tax Accounting = Inter-period Tax Allocation

Total income tax expense =

Current (paid now)

+ Deferred (paid both before or after)

Paul Zarowin

originating vs reversing timing diff
Originating vs. Reversing Timing Diff.
  • Originating differences create deferred tax assets (DR); and liabilities (CR)
  • Reversing differences reduce deferred tax assets (CR) and liabilities (DR)

Paul Zarowin

examples of deferred tax assets liab
Examples of Deferred Tax Assets/Liab
  • Installment sale; revenue is recognized up front for financial reporting, but is recognized for tax purposes later, when cash is received each period.
  • Prepayment; revenue is recognized for tax purposes up front as cash is received , while accrual accounting delays revenue recognition until revenue is earned later.
  • Bad debts expense. The allowance method for books recognizes the expense in the period of sale by the adjusting entry (matching principle), while the direct write-off method recognizes the expense in a later period, when the receivable is actually written off.

Paul Zarowin

examples of deferred tax assets liab cont d
Examples of Deferred Tax Assets/ Liab (cont’d)
  • depreciation expense; firms use an accelerated method for taxes and SL for books. This combination recognizes some depreciation for taxes first and for books later.
  • RCJ give additional examples of revenues and expenses that produce deferred tax assets and liabilities in Exhibit 13.1, Pg. 689-90.

Paul Zarowin

calculation of deferred tax expense asset liability b s method
Calculation of Deferred Tax Expense, Asset, Liability: B/S Method
  • deferred tax asset/liability = cumulative timing difference * STR
  • deferred tax expense = net  in deferred tax asset/liability

B/S method (also called asset/liability method)

  • use STR expected to be in effect when timing difference reverses
  • so, if STR changes, calculate deferred tax asset/liability as per (2), and calculate deferred tax expense =  deferred tax asset/liability

I/S method

  • for constant STR only,

deferred tax expense = current year’s timing difference * STR

  • B/S method is or constant or changing STR

Paul Zarowin

deferred tax asset liability and expense depend on tax rate
Deferred Tax Asset, Liability and Expense Depend on Tax Rate

Key point:

Deferred tax asset, deferred tax liability and deferred tax expense depend on the tax rate.

Paul Zarowin

intuition
Intuition
  • Deferred tax asset =

$ amount of future tax deduction (or tax saving)=

$ timing difference * STR

  • Deferred tax liability =

$ amount of future tax payable =

$ timing difference * STR

Paul Zarowin

net operating loss nol
Net Operating Loss (NOL)

NOL = negative taxable income

  • Book income may be either positive or negative

NOL can be carried back or forward

NOL carryback:

Get a refund of past taxes paid:

DR cash or tax refund receivable CR (current) income tax expense

  • The maximum carryback period is 2 years (offset the earlier year first, as in FIFO)

Paul Zarowin

net operating loss cont d
Net Operating Loss (cont’d)

NOL carryforward:

Offset future income (also FIFO), reducing future taxes payable:

DR deferred tax asset

CR (deferred) income tax expense

This is another reason for deferred tax asset in addition to timing differences.

  • A firm can carryforward an NOL for up to 20 years.

Paul Zarowin

incentives for carryback vs carryforward
Incentives for Carryback vs. Carryforward
  • Can’t carryback because of 2 years of losses
  • Time value of money: get the cash ASAP  carryback
  • If tax rates are expected to rise, a dollar of deduction will be worth more  carryforward

Paul Zarowin

deferred tax asset valuation allowance
Deferred Tax Asset Valuation Allowance

Contra-asset account (CR balance on the B/S ; eg, acc’d depreciation or AUA) that reduces the deferred tax asset to its expected realizable value

  • Record the deferred tax asset in the usual way (as if there were no valuation allowance)
  • Make an additional entry:

DR (deferred) income tax expense

CR deferred tax asset valuation allowance

  • increasing (decreasing) the allowance increases (decreases) deferred income tax expense
  • allowance’s existence and magnitude reveals management’s expectation of future earnings.
  • management can use changes in the allowance to manipulate NI, by affecting income tax expense.

Paul Zarowin

financial statement disclosures
Financial Statement Disclosures

I/S : total income tax expense

B/S: net current and net non-current deferred tax asset or liability

Footnote disclosure:

  • Current and deferred components of total income tax expense (from Income From Continuing Operations, because the below the line components are shown net of tax).
  • Reconciliation between the federal statutory and effective tax rates (in $ and/or %).

C13-1, 2, 3, 5, 6

Paul Zarowin

financial statement disclosures cont d
Financial Statement Disclosures (cont’d)

3a. components of deferred tax assets and liabilities

and/or

3b. Components of deferred tax expense

(e.g., revenue and expense items that cause the deferred tax expense, assets, liabilities, such as depreciation, bad debts, installment sales, etc.)

Paul Zarowin

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