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C H A P T E R 19

C H A P T E R 19. ACCOUNTING FOR INCOME TAXES. Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield. Fundamental Differences between Financial and Tax Reporting. Background. Deferral approach to tax allocation (APB Opinion 11)

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C H A P T E R 19

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  1. C H A P T E R 19 ACCOUNTING FOR INCOME TAXES Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

  2. Fundamental Differences between Financial and Tax Reporting

  3. 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

  4. 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

  5. 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

  6. 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.

  7. Fundamentals of Accounting for Income Taxes Illustration: KRC, Inc. reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations. For tax purposes, KRC reported the same expenses to the IRS in each of the years. KRC reported taxable revenues of $100,000 in 2010, $150,000 in 2011, and $140,000 in 2012. What is the effect on the accounts of reporting different amounts of revenue for GAAP versus tax? LO 1 Identify differences between pretax financial income and taxable income.

  8. Book vs. Tax Difference Illustration 19-2 GAAP Reporting 2010 2011 2012 Total Revenues $130,000 $130,000 $130,000 $390,000 Expenses 60,000 60,000 60,000 180,000 Pretax financial income $70,000 $70,000 $70,000 $210,000 Income tax expense (40%) $28,000 $28,000 $28,000 $84,000 Illustration 19-3 Tax Reporting 2010 2011 2012 Total Revenues $100,000 $150,000 $140,000 $390,000 Expenses 60,000 60,000 60,000 180,000 Pretax financial income $40,000 $90,000 $80,000 $210,000 Income tax payable (40%) $16,000 $36,000 $32,000 $84,000 LO 1 Identify differences between pretax financial income and taxable income.

  9. Book vs. Tax Difference Illustration 19-4 Comparison 2010 2011 2012 Total Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000 Income tax payable (IRS) 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) $0 Are the differences accounted for in the financial statements? Yes Year Reporting Requirement 2010 Deferred tax liability account increased to $12,000 2011 Deferred tax liability account reduced by $8,000 2012 Deferred tax liability account reduced by $4,000 LO 1 Identify differences between pretax financial income and taxable income.

  10. Financial Reporting for 2010 – Chelsea Inc. Balance Sheet Income Statement 2010 2010 Assets: Revenues: Expenses: Liabilities: Deferredtaxes 12,000 Income tax payable 16,000 Income tax expense 28,000 Equity: Net income (loss) Where does the “deferred tax liability” get reported in the financial statements? LO 1 Identify differences between pretax financial income and taxable income.

  11. 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.

  12. Future Taxable Amounts and Deferred Taxes Illustration: In Chelsea’s situation, the only difference between the book basis and tax basis of the assets and liabilities relates to accounts receivable that arose from revenue recognized for book purposes. Chelsea reports accounts receivable at $30,000 in the December 31, 2010, GAAP-basis balance sheet. However, the receivables have a zero tax basis. Illustration 19-5 LO 2 Describe a temporary difference that results in future taxable amounts.

  13. Future Taxable Amounts and Deferred Taxes Illustration: Reversal of Temporary Difference, Chelsea Inc. Illustration 19-6 KRC assumes that it will collect the accounts receivable and report the $30,000 collection as taxable revenues in future tax returns. KRC does this by recording a deferred tax liability. LO 2 Describe a temporary difference that results in future taxable amounts.

  14. Future Taxable Amounts and Deferred Taxes Deferred Tax Liability – Chelsea Inc. A 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. Illustration 19-4 2010 2011 2012 Total Income tax expense (GAAP) $28,000 $28,000 $28,000 $84,000 Income tax payable (IRS) 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) $0 LO 2 Describe a temporary difference that results in future taxable amounts.

  15. Future Taxable Amounts and Deferred Taxes Deferred Tax Liability – Chelsea Inc. Illustration: Because it is the first year of operations for KRC, there is no deferred tax liability at the beginning of the year. KRC computes the income tax expense for 2010 as follows: Illustration 19-9 LO 2 Describe a temporary difference that results in future taxable amounts.

  16. Future Taxable Amounts and Deferred Taxes Deferred Tax Liability Illustration: Chelsea Inc. makes the following entry at the end of 2010 to record income taxes. Income Tax Expense 28,000 Income Tax Payable 16,000 Deferred Tax Liability 12,000 LO 2 Describe a temporary difference that results in future taxable amounts.

  17. Future Taxable Amounts and Deferred Taxes Deferred Tax Liability – Chelsea Inc. Illustration: Computation of Income Tax Expense for 2011. Illustration 19-10 LO 2 Describe a temporary difference that results in future taxable amounts.

  18. Future Taxable Amounts and Deferred Taxes Deferred Tax Liability Illustration: Chelsea Inc. makes the following entry at the end of 2011 to record income taxes. Income Tax Expense 28,000 Deferred Tax Liability 8,000 Income Tax Payable 36,000 LO 2 Describe a temporary difference that results in future taxable amounts.

  19. 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.

  20. South Carolina Corporation a. a.

  21. South Carolina Corp. (Solution) a. a. LO 2 Describe a temporary difference that results in future taxable amounts.

  22. 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.

  23. Columbia Corporation a. a.

  24. Income Statement Presentation Formula to Compute Income Tax Expense Illustration 19-20 Income taxexpense or benefit Income tax payable or refundable Change in deferred income tax +- = In the income statement or in the notes to the financial statements, a company should disclose the significant components of income tax expense (current and deferred). LO 5 Describe the presentation of income tax expense in the income statement.

  25. Income Statement Presentation Given the previous information related to KRC Inc., KRC reports its income statement as follows. Illustration 19-21 LO 5 Describe the presentation of income tax expense in the income statement.

  26. 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”

  27. 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”

  28. 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

  29. 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

  30. 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

  31. 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.

  32. 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.

  33. 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].

  34. Let’s do an example • Second Best Company • Working paper style – working paper blank will be provided on Exam 2

  35. 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

  36. 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.

  37. 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)

  38. 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

  39. 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

  40. 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.

  41. Zoop Inc. (NOL)

  42. Zoop Inc. (NOL) - Solution Deferred Tax Asset $160,000

  43. Zoop Inc. (NOL) - Solution Zoop’s Journal Entries for 2007 LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.

  44. 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.

  45. Zoop Inc. (Variation) - Solution Zoop Inc. - Journal Entries for 2007

  46. 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

  47. 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.

  48. Valis Corporation – Solution (NOL)

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