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Income Taxes. Learning Objectives. Understand the concept of deferred taxes and the distinction between permanent and temporary differences. Compute the amount of deferred tax liabilities and assets.

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Learning objectives
Learning Objectives

  • Understand the concept of deferred taxes and the distinction between permanent and temporary differences.

  • Compute the amount of deferred tax liabilities and assets.

  • Explain the provisions of tax loss carrybacks and carryforwards, and be able to account for these provisions.


Learning Objectives

  • Schedule future tax rates, and determine the effect on tax assets and liabilities.

  • Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities.

  • Comply with income tax disclosure requirements associated with the statement of cash flows.


Learning objectives1
Learning Objectives

  • Describe how, with respect to deferred income taxes, international accounting standards have converged toward the U.S. treatment.

EXPANDED MATERIALS

  • Perform intraperiod tax allocation.


Deferred Tax Liabilities

Defined: Income taxes expected to be paid on future taxable amounts resulting from temporary differences between financial and taxable income.


Deferred tax liabilities
Deferred Tax Liabilities

  • Examples

    • Revenues (or gains) taxable after they are recognized for financial reporting, such as receivables from installment sales.

    • Expenses (or losses) deductible for tax purposes before they are recognized for financial reporting purposes, such as accelerated tax depreciation.


Deferred tax assets
Deferred Tax Assets

Defined: An expected benefit in the form of tax savings on future deductible amounts resulting from deductible temporary differences between financial and taxable income.


Deferred Tax Assets

  • Examples

    • Expenses (or losses) that are deductible for tax purposes after they are recognized for financial reporting purposes, such as warranty expenses.

    • Revenues (or gains) that are taxable before they are recognized for financial reporting purposes, such as subscriptions received in advance.


Permanent and temporary differences
Permanent and Temporary Differences

  • Permanent Differences: Nondeductible expenses or nontaxable revenues that are recognized for financial reporting purposes but are never part of taxable income.

  • Temporary Differences: Differences between pretax financial income and taxable income arising from business events that are recognized for both financial and tax purposes, but in different time periods.


Illustration of permanent and temporary differences
Illustration of Permanent and Temporary Differences

For the year ended December 31, 2002, Monroe Corporation reported net income before taxes of $420,000. This amount includes $20,000 of nontaxable revenues and $5,000 of nondeductible expenses. The depreciation method used for tax purposes allowed a deduction that exceeded the book approach by $30,000.


Illustration of Permanent and Temporary Differences

Pretax income from income statement $420,000

Add (deduct) permanent differences:

Nontaxable revenues $(20,000)

Nondeductible expenses 5,000 (15,000)

Financial income subject to tax $405,000

Add (deduct) temporary differences:

Excess of tax depreciation over

book depreciation (30,000)

Taxable income $375,000

Tax on taxable income (income

taxes payable): $375,000 x .35 $131,250


Advantages of the asset and liability method
Advantages of the Asset and Liability Method

  • Because the assets and liabilities recorded under this method are in agreement with the FASB definitions of financial statement elements, the method is conceptually consistent with other standards.


Advantages of the Asset and Liability Method

  • The asset and liability method is a flexible method that recognizes changes in circumstances and adjusts the reported amounts accordingly. This flexibility may improve the predictive value of the financial statements.


Annual computation of deferred tax liabilities and assets
Annual Computation of Deferred Tax Liabilities and Assets

Measure the deferred tax liability for taxable temporary differences (use enacted rates).

Measure the deferred tax asset for deductible temporary differences (use enacted rates).

Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized.

Identify type and amounts of existing temporary differences.


Example: Computation of Deferred Tax Liabilities and Assets

  • Rodney’s Burger Barn had GAAP income of $4,200. Rodney identified the following possible differences between GAAP and Taxable income:

    • Interest from municipal bonds $ 100

    • Premium for Life Insurance on Joe $ 50

    • Straight-Line Depreciation $ 100

    • MACRS Depreciation $ 200

    • Franchising Fees Earned $ 500

    • Cash Franchising Fees Received $ 800

  • Rodney’s enacted tax rate is 40%.


Annual computation of deferred tax liabilities and assets1
Annual Computation of Deferred Tax Liabilities and Assets

Identify type and amounts of existing temporary differences.

Measure the deferred tax liability for taxable temporary differences (use enacted rates).

Measure the deferred tax asset for deductible temporary differences (use enacted rates).

Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized.


Example identifying type s of differences for rodney s
Example: Identifying Type(s)of Differences for Rodney’s

Temporary/

Difference

Type

Permanent

Reduction in

Interest on bonds

Permanent

Taxable Income

Increase in

Life Insurance

Permanent

Taxable Income

Net

Deferred Tax

Temporary

Depreciation

Liability

Net Franchising

Deferred Tax

Temporary

Fees

Asset


Example identifying amount of differences for rodney s
Example: Identifying Amountof Differences for Rodney’s

Pretax income $4,200

Add (deduct) permanent differences:

Interest on municipal bonds $(100)

Life insurance 50 (50)

Income subject to tax $4,150

Add (deduct) temporary differences:

Net depreciation ($100 - $200) $(100)

Net fran. revenue ($800 - $500)300 200

Taxable income $4,350


Annual computation of deferred tax liabilities and assets2
Annual Computation of Deferred Tax Liabilities and Assets

Measure the deferred tax liability for taxable temporary differences (use enacted rates).

Measure the deferred tax asset for deductible temporary differences (use enacted rates).

Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized.

Identify type and amounts of existing temporary differences.


Example measure deferred tax liabilities for rodney s
Example: Measure DeferredTax Liabilities for Rodney’s

Depreciation for financial income $100

Depreciation for taxable income 200

Net deferred amount $100

Tax rate x 40%

Deferred tax liability $ 40


Annual Computation of Deferred Tax Liabilities and Assets

Identify type and amounts of existing temporary differences.

Measure the deferred tax liability for taxable temporary differences (use enacted rates).

Measure the deferred tax asset for deductible temporary differences (use enacted rates).

Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized.


Example measure deferred tax assets for rodney s
Example: Measure DeferredTax Assets for Rodney’s

Franchising revenue for

financial revenue $(500)

Franchising revenue for taxable

revenue 800

Net deferred amount $ 300

Tax rate x 40%

Deferred tax asset $ 120


Deferred tax asset
Deferred Tax Asset

Some possible sources of taxable income to be considered in evaluating the realistic value of a deferred tax asset are:

  • Future reversals of existing taxable temporary differences.

  • Future taxable income exclusive of reversing temporary differences.

  • Taxable income in prior (carryback) years.


Deferred Tax Asset

A typical journal entry to record the deferred portion of income tax expense is:

Deferred Tax Asset--Current xxx

Deferred Tax Asset--Noncurrent xxx

Allowance to Reduce Deferred

Tax Asset to Realizable Value--

Current xxx

Allowance to Reduce Deferred

Tax Asset to Realizable Value--

Noncurrent xxx

Deferred Tax Liability--Noncurrent xxx


Taxable income
Taxable Income

Commonly Confused Relationships:

Income Statement

Pretax financial income

+/- Permanent differences

= Financial income subject to tax

+/- Temporary differences

= Taxable income


Net operating losses nol alternative elections
Net Operating Losses (NOL)--Alternative Elections

Carryback Election

Year

-2

Year

+20

Loss

Year

Carryforward Election


Accounting for nol carryback
Accounting for NOL Carryback

Income

(Loss)

Income

Year

Tax Rate

Tax

2001 $10,000 35% $3,500

2002 14,000 30% 4,200

2003 (19,000) 30% 0

Journal Entry in 2003:

Income Tax Refund Receivable 6,200

Income Tax Benefit From NOL Carryback 6,200

[$3,500 + (30% x $9,000)]


Accounting for nol carryforward
Accounting for NOL Carryforward

The only loss remaining against which operating income can be applied is $5,000 from 2002. This leaves $30,000 to be carried forward from 2004 as a future tax benefit of $9,000 ($30,000 x .30).

Income

(Loss)

Income

Year

Tax Rate

Tax

2003 $(19,000) 30% $0

2004 (35,000) 30% 0


Accounting for NOL Carryforward

The journal entry recorded at the end of 2004 indicates that is more likely than not that the carryforward benefit will be realized in full.

Journal Entry:

Deferred Tax Asset--NOL Carryforward 9,000

Income Tax Benefit From NOL

Carryforward 9,000


Accounting for NOL Carryforward

The firm reports a taxable income of $50,000 in 2005. The tax carryforward allows management to deduct the carryforward from the $15,000 tax ($50,000 x .30) that would be due without the carryforward.

Journal Entry:

Income Tax Expense 15,000 Income Taxes Payable 6,000

Deferred Tax Asset--NOL

Carryforward 9,000


Accounting for NOL Carryforward

What if, due to a declining market, management believes that losses will continue in the future and the tax benefit will not be realized?


Accounting for NOL Carryforward

Journal Entry:

Deferred Tax Asset--NOL Carryforward 9,000

Allowance to Reduce Deferred Tax

Assets to Realizable Value--NOL

Carryforward 9,000

As a result of this entry, the deferred tax asset is zero--the expected realizable value.


Presentation in financial statements
Presentation inFinancial Statements

Income Statement

Report current tax

expense (benefit)

and deferred tax

expense (benefit) and

total income tax

expense (benefit).

Balance Sheet

Classify deferred

taxes as current or

noncurrent based on

asset or liability to

which they relate.

Report a net current

and a net noncurrent

amount.


Financial statement presentation and disclosure
Financial StatementPresentation and Disclosure

The following items must appear in the income statement or an accompanying note:

  • Current tax expense or benefit

  • Deferred tax expense or benefit

  • Investment tax credits

  • Government grants recognized as tax reductions

Continued


Financial StatementPresentation and Disclosure

The following items must appear in the income statement or an accompanying note:

  • Benefits of NOL carryforwards

  • Adjustments of a deferred tax liability or asset (for enacted laws or rate changes)

  • Adjustments in beginning-of-the-year valuation allowance (for a change in circumstances)


Approaches to deferred tax accounting
Approaches to Deferred Tax Accounting

  • No-Deferral Approach: Ignore the differences and report income tax expense equal to the amount of tax payable for the year.

  • Comprehensive Recognition Approach: Deferred taxes are included in the computation of income tax expense and reported on the balance sheet.

  • Partial Recognition Approach: A deferred tax liability is recorded only to the extent that the deferred taxes are actually expected to be paid in the future.


Intraperiod tax allocation
Intraperiod Tax Allocation

Using interperiod tax allocation, the income tax effect of each special item is reported with the individual item rather than being included with income tax expense related to current operations.



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