Accounting for Income Taxes Chapter 19 Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Prepared by Coby Harmon, University of California, Santa Barbara
Background • Deferral approach to tax allocation (APB Opinion 11) • Income tax expense = amount of taxes that would be paid if income statement numbers appeared on the current year's tax return. • Deferred taxes was the plug figure (difference between taxes payable and tax expense). • The effect of subsequent changes in tax rates on deferred tax account were essentially ignored. Matching Approach
Background • A method that was proposed theoretically (but has never been GAAP in US) • Assets and liabilities would be recorded NET of any deferred tax related to the item Net-of-Tax Approach
Background • Liability approach to tax allocation (FASB 96, 109) • Income tax expense = taxes currently payable plus change in deferred taxes. • If tax rates change, the effect on deferred tax amounts affect income tax expense in the year the change is enacted. • If there are no changes in tax rates, income tax expense should be approximately the same as under APB Opinion 11. Asset/Liability Measurement Approach
Fundamentals of Accounting for Income Taxes Financial Statements Tax Return IRS vs. Exchanges Investors and Creditors Pretax Financial Income Taxable Income GAAP Tax Code Income Tax Expense Income Tax Payable LO 1 Identify differences between pretax financial income and taxable income.
Temporary Differences A Temporary Difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years. Future Taxable Amounts Future Deductible Amounts Deferred Tax Liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year. Deferred Tax Asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year. Illustration 19-22Examples of Temporary Differences LO 2 Describe a temporary difference that results in future taxable amounts.
Example – Deferred Tax Liability • Assume that Sales Company recognizes $15,000 gross profit from installment sales for financial accounting in 2006. The gross profit will be taxable at $3,000 each year for the next five years. The company earns $10,000 additional income each year and the tax rate is 40%. The following schedule shows taxable income, income tax payable, financial income, and income tax expense for the five year period.
Solution – Sales Company For tax purposes, we are postponing recognition of revenue until later years. This revenue will be reported on future tax returns and the taxes will be paid at that time (rather than immediately)
Example – Deferred Tax Asset Financial Magazine Company received $15,000 of subscriptions in advance for 2006. Subscription revenue will be recognized equally in 2007, 2008, and 2009, for financial accounting purposes but all of the $15,000 will be recognized in 2006 for tax purposes. There is additional income of $50,000 each year and the tax rate is 40%.
South Carolina Corporation • E19-1South Carolina Corporation has one temporary difference at the end of 2007 that will reverse and cause taxable amounts of $55,000 in 2008, $60,000 in 2009, and $65,000 in 2010. South Carolina’s pretax financial income for 2007 is $300,000, and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2007. • Instructions • Compute taxable income and income taxes payable for 2007. • Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
South Carolina Corp. (Solution) a. a. LO 2 Describe a temporary difference that results in future taxable amounts.
Columbia Corporation • Columbia Corporation has one temporary difference at the end of 2007 that will reverse and cause deductible amounts of $50,000 in 2008, $65,000 in 2009, and $40,000 in 2010. Columbia’s pretax financial income for 2007 is $200,000 and the tax rate is 34% for all years. There are no deferred taxes at the beginning of 2007. Columbia expects to be profitable in the future. • Instructions • Compute taxable income and income taxes payable for 2007. • Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.
Columbia Corporation a. a.
Temporary Differences (1) • Revenues and gains, recognized in financial income, are later taxed for income tax purposes. • Installment sales • Expenses and losses are deducted for income tax purposes before they are recognized in financial income. • MACRS depreciation • Goodwill deduction on tax return Called “taxable temporary differences”
Temporary Differences (2) • Revenues and gains are taxed for income tax purposes beforethey are recognized in financial income. • Subscription revenue • Prepaid rent • Expenses and losses, recognized in financial income, are later deducted for income tax purposes. • Warranty expense Called “deductible temporary differences”
Transaction When recorded in books When recorded on tax return Deferred tax effect Rev or Gain Earlier Later Liability Rev or Gain Later Earlier Asset Exp or Loss Earlier Later Asset Exp or Loss Later Earlier Liability Summary of Temporary Differences
Some items are recorded in Books but NEVER on tax return Other items are NEVER recorded in books but recorded on tax return Permanent Differences Sources of Permanent Differences No deferred tax effects for permanent differences
Permanent Differences: Examples • Items, recognized for financial accounting purposes, but not for income tax purposes: • Interest revenue on Municipal Bonds • Life insurance premiums and proceeds when corporation is beneficiary • Fines and penalties • Items, recognized for tax purposes, but not for financial accounting purposes: • Dividend exclusion • Statutory depletion
Deferred Tax Asset & Deferred Tax Liability: Sources • Deferred taxes may be a: • Deferred tax liability, or • Deferred tax asset • Deferred tax liability arises due to net taxable amounts in the future. • Deferred tax asset arises due to net deductible amounts in the future.
Valuation Allowance for Deferred Tax Assets If the deferred tax asset appears doubtful, a Valuation Allowance account is needed. Journal entry: Income Tax Expense $$ Allowance to Reduce Deferred Tax Asset to Expected Realizable Value$$ The entry records a potential future taxbenefit that is notexpected to be realized in the future.
Balance Sheet Presentation • The deferred tax classification relates to its underlying asset or liability. • Classify the deferred tax amounts as currentor non-current. • Presentation is • NET amount related to current items • If DR>CR, current deferred tax asset • If DR<CR, current deferred tax liability • NET amount related to noncurrent items • If DR>CR, noncurrent deferred tax asset • If DR<CR, noncurrent deferred tax liability
What Tax Rate to Apply • Basic Rule: Apply the yearly tax rate to calculate deferred tax effects. • If future tax rates change: use the enacted tax rate expected to apply in the future year. • If new rates are not yet enacted into law for future years, the current rate should be used. • The appropriate enacted rate for a year is the average tax rate [based on graduated tax brackets].
Let’s do an example • Second Best Company • Working paper style – working paper blank will be provided on Exam 2
Net Operating Loss (NOL) Net operating loss is tax terminology. A net operating loss occurs when tax deductions for a year exceed taxable revenues. Net loss or operating loss is a financial accounting term.
NOL Rule (subject to change) • NOL for each tax year is computed. • The NOL of one year can be applied to offset taxable income of other years, possibly resulting in tax refunds • Current rule: NOLs can be: • carried back 2 years and carried forward 20 years (carryback option), • or carried forward 20 years (carryforward only)
next Apply first Loss carryforward 20 years forward Expect tax refund here Expect tax shield here Record all tax effects here NOL Carryback Tax years 2001 2002 2003 2004 2005 2006 2007 NOL 2004
Loss carryforward 20 years forward Expect tax shield here Record all tax effects here NOL Carryforward Tax years 2001 2002 2003 2004 2053 2006 2007 NOL 2004 Forgo 2 year rule
Zoop Inc. (NOL) Zoop Inc. incurred a net operating loss of $500,000 in 2007. Taxable income was $200,000 for 2005 and $200,000 for 2006. The tax rate for all years is 40%. Zoop elects the carryback option. Prepare the journal entries to record the benefits of the loss carryback and the loss carryforward. LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
Zoop Inc. (NOL) - Solution Deferred Tax Asset $160,000
Zoop Inc. (NOL) - Solution Zoop’s Journal Entries for 2007 LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
Zoop Inc. (Variation) Now assume that it is more likely than not that the entire net operating loss carryforward will not be realized by Zoop Inc. in future years. Prepare all the journal entries necessary at the end of 2007. LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.
Zoop Inc. (Variation) - Solution Zoop Inc. - Journal Entries for 2007
Valuation Allowance Revisited Whether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period. Text Illustration 19-37 Possible Sources of Taxable Income If any one of these sources is sufficient to support a conclusion that a valuation allowance is unnecessary, a company need not consider other sources. Text Illustration 19-38 Evidence to Consider in Evaluating the need for a Valuation Account
Valis Corporation (NOL) Valis Corporation had the following tax information. In 2007 Valis suffered a net operating loss of $450,000, which it elected to carry back. The 2007 enacted tax rate is 29%. Prepare Valis’s entry to record the effect of the loss carryback. LO 8 Apply procedures for a loss carryback and a loss carryforward.
Valis Corporation – Solution (NOL) Valis Corp - Journal Entry for 2007
Example: Revision of Future Tax Rate At the end of 2002, the corporate tax rate is changed from 40% to 35%. The new rate is effective January 1, 2004. The deferred tax account (1/1/2002) is as follows: Excess tax depreciation: $3 million Deferred tax liability: $1.2 million Related taxable amounts are expected to occur equally over 2003, 2004, and 2005. Provide the journal entry to reflect the change.
Example: Revision of Future Tax Rate The deferred tax liability end of 2005 is as follows: 200320042005 Future tax inc $1,000,000 1,000,000 1,000,000 Tax rate 40% 35% 35% Deferred tax $400,000 350,000 350,000 liability Entry: Deferred Tax Liability $100,000 Income Tax Expense $100,000* *$1,200,000 – $1,100,000
Let’s return to Second Best • In the third year: • A change in enacted tax rates • A net operating loss
Intraperiod Tax Allocation Income tax expense, is allocated to: • Continuing operations • Discontinued operations • Extraordinary items • Cumulative effect of an accounting change,– we won’t see this one any more after FAS154 • Prior period adjustments Disclose other significant components, such as: • current tax expense, • deferred tax expense/benefit, etc.
Other Items Affected • Comprehensive income items • Holding gain/loss on AFS securities • Certain gains/losses related to foreign currency and derivatives • Pension & post-retirement benefit amounts not yet recognized on income statement • Correction of error/change in accounting principle that affects beginning retained earnings • Expenses for employee stock-based compensation • Existing deferred amounts in quasi-reorganization
First Place Example • Go to Excel and work the problem • Identify temporary and permanent differences • Compute tax payable (or refund) • Compute change in deferred taxes and income tax expense • Show where deferred tax will be reported on the balance sheet