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Accounting for Income Taxes

Accounting for Income Taxes

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Accounting for Income Taxes

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    1. Accounting for Income Taxes Chapter 17

    2. Chapter 17--Learning Objectives 1. Contrast the objectives of income tax determination with the objectives of financial reporting

    3. Income Taxes Result from the earnings process Are not incurred to provide a product or service Are paid to many jurisdictions, including the U.S. government, state governments, and other national governments Often require separate accounting records for each jurisdiction

    4. U.S. corporations are subject to federal income taxes

    5. They may also be subject to a number of state income taxes

    6. And increasingly to foreign income taxes as well

    7. Our focus is primarily on U.S. federal income taxes

    8. U.S. federal income taxes Rules on taxes to be paid encompass: 1. Revenue items to be included in taxable income 2. Expense items permitted to be deducted 3. The rates applied to taxable income 4. Tax credits permitted as direct reductions to income tax liability

    9. Financial reporting and income tax assessment have different goals Hence, the rules are different for financial reporting and for income tax calculation Therefore, income for financial reporting purposes frequently differs from taxable income

    10. Chapter 17--Learning Objectives 2. Apply the liability approach to determine (a) temporary differences and carryforwards, (b) deferred income tax assets and liabilities, and (c) income tax expense

    11. Nature of Income Tax Expense? Distribution of profits to the government? ARB 43 Income tax is an expense

    12. Accrual Basis Accounting Matching principle Allocates expenses to accounting periods Income tax = An expense Therefore, it too should be allocated among accounting periods

    13. Income Tax Allocation Interperiod income tax allocation Allocating income tax among accounting periods Intraperiod income tax allocation Allocating income tax among items reported within a given accounting period Income from continuing operations Discontinued operations Extraordinary items Prior period adjustments Cumulative effect of accounting change

    14. Asset/Liability Method Future tax consequences of temporary differences between pretax accounting income (AI) & taxable income (TI) are deferred tax assets & deferred tax liabilities Tax rates used: Future tax rates Based on currently enacted tax law Tax expense = Current provision +/- changes in deferred tax assets & liabilities

    15. Differences between AI & TI Temporary differences Permanent differences

    16. Permanent Differences Item in TI, never in AI Item in AI, never in TI

    17. Items in TI, never in AI Tax deductions that are not expenses under GAAP Percentage depletion > Cost depletion Dividend exclusion

    18. Items in AI, never in TI Tax exempt revenues Municipal bond interest Life insurance proceeds paid to corporation on death of employee Non-deductible expenses Life insurance premiums on officers where corporation is beneficiary Tax penalties

    19. Temporary Differences Differences between AI and TI caused by differences in when amounts are recognized Timing differences Assets & Liabilities have different bases

    20. Exercise Indicate whether each of the following is a temporary difference or a permanent difference between TI and AI

    21. Municipal bond interest

    22. Double declining balance depreciation for tax Straight-line depreciation for books

    23. Depreciable life for tax < Depreciable life for books

    24. Recognize sales when made for books Use installment sales method for tax

    25. Warranty expense is probable and can be reasonably estimated. Deduct when paid for tax

    26. Defer rent received in advance for books Rent is taxed upon receipt

    27. Use percentage of completion for books Use completed contract method for tax

    28. Tax penalties are incurred

    29. Prepaid rent for 2 years in advance. The rent deductible when paid for tax

    30. Statutory depletion exceeds full cost depletion recognized for books

    31. Current Period Effect of Temporary Differences Temporary difference Current TI > AI Temporary difference Current TI < AI

    32. Current TI > AI Tax Consequence: Future TI < AI Called deductible amounts Benefit = future tax reduction Asset today

    33. Current TI > AI - Examples Revenues & Gains in TI before AI Rent received in advance Expenses & Losses in AI before TI Contingent liabilities

    34. Current TI < AI Tax consequence: Future TI > AI Called taxable amounts Obligation to pay more tax in the future Liability today

    35. Current TI < AI - Examples Revenues & Gains in AI before TI Installment sales method for tax Point of sale revenue recognition for books Expenses & Losses in TI before AI Accelerated depreciation for tax Straight line depreciation for books

    36. Exercise For each temporary difference, determine: The originating effect The reversing effect Whether there will be future taxable or deductible amounts Whether there is a deferred tax asset or deferred tax liability

    37. Depreciation DDB depreciation for tax Straight-line depreciation for books

    38. Depreciation Life for tax < Life for books

    39. Sales Record when made for books Installment sales method for tax

    40. Warranty Expense Accrued for books Deductible when paid for tax

    41. Rent Received in Advance Deferred for books Taxable upon receipt for tax

    42. Long-Term Contract Percentage of completion for books Completed contract method for tax

    43. Prepaid Rent Defer for books Deduct when paid for tax

    44. Steps: Accounting for Deferred Tax Liabilities Identify temporary differences Identify future taxable amounts Identify future taxable amounts from prior temporary differences Calculate DTL Calculate income tax payable Income tax expense = Income taxes payable + D in DTL

    45. Example Deferred Income Tax Liability Jans Cookies sells franchises Price of franchise = $20,000 Franchisee pays equal installments over 4 years Ignore time value of money Recognize sale for books contract is signed Cash basis for tax

    46. Year 1 Sales $240,000 Pretax accounting income 200,000 Includes municipal bond interest of 10,000 Tax rate for 19x1 40% Tax rate for all future years 30%

    47. Permanent Difference? Municipal bond interest $10,000

    48. The Temporary Difference? Revenue in accounting income Revenue in taxable income Temporary difference $ 240,000 60,000 $ 180,000

    49. Reversals Will future TI be greater than or less than AI? TI > AI Future Taxable or Deductible Amounts? Taxable Amounts Future Taxable Amounts will total? $180,000

    50. The Balance Sheet will report

    51. Amount of DTL 180,000 x 30% = 54,000

    52. Taxable Income Pretax accounting income Municipal bond interest Temporary difference Taxable income $ 200,000 ( 10,000) (180,000) $ 10,000

    53. Change in Deferred Tax Liability

    54. Income Tax Expense Income tax payable Increase in DTL Income tax expense $ 4,000 54,000 $ 58,000

    55. Balance Sheet Classification Classify as short term or long term Based on related asset or liability balance Report 1 long-term net asset or liability Report 1 current net asset or liability

    56. Related Asset or Liability? Accounts Receivable $180,000 Current asset? If so, the DTL is a current liability

    57. Year 2 Sales $360,000 Pretax accounting income 235,000 Includes municipal bond interest of $10,000 Includes $1,000 for tax penalties Tax law change: For all years subsequent to 2003 Tax rate = 35%

    58. Permanent Differences? Municipal bond interest $10,000 Tax penalty $ 1,000

    59. The amount of the Temporary Difference? Revenue in accounting income Revenue in taxable income Temporary difference $ 360,000 90,000 $ 270,000

    60. Reversal in 2002? From 2001 Sales Revenue in taxable income Revenue in accounting income Taxable amount $ 60,000 none $ 60,000

    61. Taxable Income Pretax accounting income Municipal bond interest Tax penalty Temporary difference Reversal (taxable amount) Taxable income $ 235,000 ( 10,000) 1,000 (270,000) 60,000 $ 16,000

    62. Year 2002

    63. Year 2003

    64. Year 2004

    65. Year 2005

    66. Amount of DTL

    67. Change in DTL

    68. Income Tax Expense Income tax payable Increase in DTL Income tax expense $ 4,800 75,000 $ 79,800

    69. Interperiod Tax Allocation Deferred Tax Asset

    70. Deferred Tax Assets Future tax consequences = benefit Result from temporary differences associated with future deductible amounts Result from net operating loss carryovers

    71. Net Operating Losses (NOL) When deductions and losses on a tax return exceed taxable revenues and gains Can carry back 3 years Can carry over 15 years

    72. Accounting for DTAs Additional Steps Identify future deductible amounts Including NOL carryovers Calculate DTA If more likely than not that NRV<DTA Calculate allowance to reduce net DTA to NRV Income Tax Expense = Income Taxes Payable + D in DTL D in DTA D in allowance

    73. DTL & DTA Example 7/1/x1 - Purchased depreciable asset Cost $30,000 Ignore salvage value Useful life 6 years Tax life 4 years Straight-line depreciation - book & tax Pretax accounting income $10,000 Tax rate 40% 2001 35% after 2003

    74. DTL & DTA Example Let TD = temporary difference Let TA = taxable amount Let DA = deductible amount

    76. Taxable Income for 2001? Accounting income Temporary difference Taxable income $ 10,000 ( 1,250) $ 8,750

    77. For 2001 Depreciation in TI Depreciation in AI Temporary difference $ 3,750 2,500 $ 1,250

    78. Reversal will be a

    79. Schedule Tax Consequences

    80. Change in Deferred Tax Liability

    81. 2001 Income Tax Expense Income tax payable Increase in DTL Income tax expense $ 3,500.00 437.50 $ 3,937.50

    82. Assumption: 2001 AI = (8,000) Taxable income? Accounting income Temporary difference NOL (8,000) (2,500) (10,500)

    83. Amount of Tax Refund? $ 3,500 Income Tax Refund Receivable Classified as a? Current asset

    84. 2002- Cumulative TD?

    85. Schedule Tax Consequences

    86. NOL Carryover 2002 NOL 10,500 Carried back to 2001 8,750 NOL carryover 1,750

    87. Future Tax Consequence - NOL? What tax rate to choose? We will use 35% Tax consequence 1,750 x 35% = 612.50

    88. T Account DTL

    89. T Account DTL

    90. T Account DTA

    91. T Account DTA

    92. Journal Entry - 2002 Income Tax Refund Receivable 3,500.00 DTA 612.50 DTL 875.00 Income Tax Benefit 3,237.50

    93. 2003 Accounting income = (10,000) Tax law change: Tax rate for current & future years Changed to 30%

    94. Calculate Loss Carryover

    95. 2003 Temporary Difference? $ 2,500

    96. Schedule Tax Consequences

    97. Future Tax Consequences NOL Carryover Amount of NOL Carryover Tax rate Future tax consequence What is it? $ 14,250 30% $ 4,275 DTA

    98. Assumption More likely than not No future taxable income How much of the DTA is realizeable? The amount of the DTL $ 1,875

    99. The Valuation Allowance? DTA Realizeable Valuation allowance 4,275 1,875 2,400

    100. Balance Sheet? DTA $ 4,275 Allowance ( 2,400) Net Asset $ 1,875 DTL ( 1,875) Net amount none

    101. T Account DTL

    102. T Account DTL

    103. T Account DTA

    104. T Account DTA

    105. T Account DTA-Valuation Allowance

    106. T Account DTA-Valuation Allowance

    107. Journal Entry - 2003 DTA 3,662.50 Valuation Allow 2,400.00 DTL 562.50 Income Tax Benefit 700.00

    108. Assumptions - 2004 Accounting income = $4,000 Includes accrual of $8,000 Expected loss on lawsuit Expected to be settled in 2006

    109. Calculate Loss Carryover

    110. Cumulative TD for Depr? 2001 $ 1,250 2002 2,500 2003 2,500 2004 2,500 Cumulative TD $ 8,750

    111. TD from Lawsuit? $ 8,000

    112. Schedule Current Tax Consequences

    113. Schedule Future Tax Consequences

    114. Deferred Tax Asset? 3,825 NOL 4,750 Deductible Amount 8,000 Total 12,750 Tax Rate 30% DTA 3,825

    115. Valuation Allowance? ZERO No Evidence to indicate that it is more likely than not that the DTA will not be realized

    116. T Account DTL

    117. T Account DTL

    118. T Account DTA

    119. T Account DTA

    120. T Account DTA-Valuation Allowance

    121. T Account DTA-Valuation Allowance

    122. Journal Entry - 2004 Valuation Allowance 2,400 DTA 450 DTL 750 Income Tax Benefit 1,200

    123. Chapter 17--Learning Objectives 3. Interpret the major issues central to the historical development of accounting for income taxes

    124. Interperiod Income Tax Allocation Theories No income tax allocation Partial income tax allocation Comprehensive income tax allocation

    125. No Income Tax Allocation Income tax expense = Income tax paid Rationale No income tax liability until a tax return is filed No future tax consequences yet Deferred income tax liabilities are never paid Continuous replacement Never write the check

    126. Comprehensive Allocation Report all future tax consequences associated with items reported in the income statement APB & FASB take this position

    127. Arguments in Favor of Interperiod Income Tax Allocation Matches Items reported in earnings with their future tax consequences Reports the anticipated future tax consequences as Assets & Liabilities

    128. Methods of IncomeTax Allocation Deferred method Was required under APB 11 Asset/Liability method Is required under SFAS 109

    129. Criticism of Deferred Method Measurement based on current tax rate Does not measure future tax consequence Because the tax is deferred, the tax consequence occurs in the future. Measurement should be based on expected future rates Tax expense should be based on the change in asset & liability measures

    130. Net-of-tax presentation Refers to offsetting a deferred tax amount against a related asset or liability Was used briefly in certain business combination situations Is no longer acceptable under GAAP

    131. Discounting to Present Value Is a subject under continuing debate Is not used for deferred tax items under current GAAP Yet, anticipated future cash flows for other assets and liabilities are discounted

    132. Chapter 17--Learning Objectives 4. Analyze the financial reporting of income tax information disclosed in notes to financial statements

    133. Income Statement Items are classified in four categories 1. Continuing operations 2. Discontinued operations 3. Extraordinary items 4. Changes in accounting principles Income tax expense is allocated among these categories

    134. Required disclosure notes for balance sheet items include Changes in deferred tax valuation allowances Types of temporary differences and carry-forwards that involve significant deferred tax assets or liabilities with amounts and uncertainties Exceptions involving deferred taxes

    135. Required disclosure notes for income statement items Significant components of income tax expense for continuing operations Amounts of tax expense allocated to other than continuing operations Nature of differences due to state taxes, nondeductible items, tax credits, etc. Nature of items affecting comparability between periods Amounts and dates for any carryforwards

    136. Chapter 17--Learning Objectives 5. Interpret the impact income tax accounting principles can have on analyzing a companys financial position, results of operations, and growth potential

    137. Tax items which can cause special concern in financial analysis Effects of tax-exempt income Effects of tax credits and depreciation Contrast of tax rates and tax credits Valuation allowances Actual examples of the above situations are presented in the text.