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Income Taxes. RCJ Chapter 13. 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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Income taxes l.jpg

Income Taxes

RCJ Chapter 13


Key issues l.jpg
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


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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


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Key Identity

Pre-tax book (accounting) income

± Permanent differences

± Temporary differences

= pre-tax taxable income

ex. E13-7, E13-8 (Kent), P13-4 (Joy)

Paul Zarowin


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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. E13-7 Exhibit 13.2, Pg. 690

(ex. interest income on municipal bonds)

Paul Zarowin


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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


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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?

    ex. E13-7

Paul Zarowin



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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


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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


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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


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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


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Timing Differences: Relation to Deferred Tax Assets, Liab.

Paul Zarowin


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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


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Components of Tax Expense (cont’d)

Alternatively,

  • DRtotal tax expensec

    CR Deferred tax asset/liability

    CR Cash

    c)Total tax expense = current + deferred

    ex. E13-7

Paul Zarowin


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Deferred Tax Accounting = Inter-period Tax Allocation

Total income tax expense =

Current (paid now)

+ Deferred (paid both before or after)

Paul Zarowin


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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


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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


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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


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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

    ex. E13-3 different rates over time, vs.

    E13-2 change in rates

Paul Zarowin


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Deferred Tax Asset, Liability and Expense Depend on Tax Rate Method

Key point:

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

Ex. E13-8, E13-9, E13-10

Paul Zarowin


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Intuition Method

  • 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


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Net Operating Loss (NOL) Method

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


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Net Operating Loss (cont Method’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.

    EX. E13-13, 14, 16

Paul Zarowin


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Incentives for Carryback vs. Carryforward Method

  • 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

    ex. P13-7

Paul Zarowin


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Deferred Tax Asset Valuation Allowance Method

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.

    ex. E13-17

Paul Zarowin


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Financial Statement Disclosures Method

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


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Financial Statement Disclosures (cont Method’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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