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  1. Welcome TEI – Introduction to Financial Reporting for Taxes

  2. Agenda Welcome and Introduction 8:30 - 8:45 Financial Accounting Framework 8:45 - 9:15 Basics of the Liability Method 9:15 - 10:45 Break 10:45 - 11:00 Valuation Allowances 11:00 - 11:30 Uncertain Tax Positions 11:30 - 12:00 Lunch 12:00 - 1:00 Preparing a Tax Provision 1:00 - 1:30 Interim Reporting 1:30 - 2:00 State and Local Income Tax 2:00 - 2:30 Break 2:30 - 2:45 International Tax 2:45 - 4:00 Disclosures 4:00 - 4:30

  3. Your teachers • John Basseer • Partner, Ernst & Young San Francisco • 415 894 8614 • john.basseer@ey.com • John Gunn • Senior Manager, Ernst & Young San Francisco • 415 894 8286 • john.gunn1@ey.com • Helen Wilcenski • Senior Manager, Ernst & Young San Francisco • 415 894 8029 • helen.wilcenski@ey.com

  4. Your teachers • Tyler Caldwell • Senior Manager, Ernst & Young San Francisco • 415 894 8065 • tyler.caldwell@ey.com • Beth Wutzke • Senior Manager, Ernst & Young San Francisco • 415 894 8480 • elizabeth.wutzke@ey.com

  5. Circular 230 Disclosure - Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

  6. Introduction to tax accounting TEI – Introduction to Financial Reporting for Taxes

  7. Why are you here? • Tax accounting needs > supply! • Industry needs more people with knowledge of: • Tax • Accounting for income taxes • Tax auditing • Tax controls and process

  8. Regulatory environment • Sarbanes-Oxley • New “SOX-like” regulations globally • SEC and PCAOB focus • New accounting pronouncements from FASB • Enhanced IRS focus

  9. Changed market environment • Strong, engaged audit committees • Focus on risk mitigation • Impact on company brand value/reputation • Media factor • Intense scrutiny by investors, analysts, regulators, Congress, state and local governments

  10. Complex rules under tax laws and accounting Significant use of estimates and judgment Financial reporting systems often based on management reporting, not legal-entity basis Lack of control over data inputs Lack of communication among tax, financial accounting and budgeting Lack of accountants trained in ASC 740 , particularly in foreign locations True-up in following year Increasing focus as move to risk-based approach Conflicting objectives of regulators Why is tax a high risk area?

  11. And the result • Tax financial reporting under the microscope • More pressure than ever on tax departments

  12. What you will learn today • Accounting for income taxes: • Technical tax accounting topics (ASC 740 , ASC 740-10, etc.) • How to calculate a provision, including deferred taxes • Financial statement disclosures • Working with your auditor • SOX 404/Internal controls - tax accounts

  13. Questions?

  14. Financial accounting framework TEI – Introduction to Financial Reporting for Taxes

  15. Objectives • Identify where tax items are disclosed on financial statements • Explain how tax affects other items on the balance sheet and income statement

  16. Discussion activity • Keep the Caterpillar financial statements handy, your instructors will point out the tax items in the financial statements and footnotes for reference purposes

  17. Financial information sources • Information about publicly traded companies comes in many forms and may be found in many places: • Annual reports • Securities and Exchange Commission (SEC) filings and databases • Company press releases • Articles that appear in the financial press

  18. Financial information reporting • The annual report is important to investors because it is complete and reliable, having been audited by an independent auditor. It includes: • Financial statements • Footnotes to the financial statements • A summary of accounting principles used • Management’s discussion and analysis of the financial results • The auditor’s report • Comparative financial data for a series of years • Narrative information about the company

  19. Financial information reporting (cont.) • Publicly traded companies also must prepare reports for government agencies, e.g., the SEC: • Form 10-K – presents financial statement data in greater detail than the financial statements in annual reports • Form 10-Q – includes quarterly financial statements that provide more timely but less complete information than annual reports

  20. Financial statement analysis • Financial statement analysis – applying analytical techniques to financial statements and other relevant data to produce information useful for decision-making • It is not simply probing for more detail, but rather a process of: • Summarization • Study of relationships • Comparative analyses

  21. Financial statement analysis (cont.) • Although different investors demand different returns, they all use financial statement analysis for common reasons: • To predict their expected returns • To assess risk • Financial statement analysis focuses on past performance to predict future performance

  22. Basic financial statements • Income statement: • Statement of profit and loss which reports business results over a specified operating period • Focus on revenues and expenses (includes EPS) • Tax provision = income tax expense (shown “below the line”)

  23. Basic financial statements (cont.) • General presentation: • Income from continuing operations before income taxes • Less: income taxes = • Income from continuing operations • Less: discontinued operations (net of tax) = • Income before extraordinary items • Less: extraordinary items (net of tax) = • Income before cumulative effect of an accounting change • Less: cumulative effect of an accounting change (net of tax) = • Net income

  24. Basic financial statements (cont.) • Balance sheet: • Statement of financial position at a specific point in time • Changes in the balance sheet accounts from period-to-period drive the profit and loss activity within the income statement • Current taxes payable (including liabilities for tax exposure items) • Deferred tax assets and liabilities • Basic accounting equation: • Assets = liabilities + shareholders’ equity • Statement of retained earnings: • Shows how much of the company’s total earnings have been retained within the business for purposes of future growth vs. how much has been distributed to stakeholders • Ending RE Balance (appears on B/S): Prior period RE + current earnings - dividends

  25. Basic financial statements (cont.) • Statement of cash flows: • Shows cash receipts and disbursements for a period of time • Organized by three major business functions: • Operating • Investing • Financing • Income taxes paid and refunds received • Ending balance of statement should match cash balance on the balance sheet

  26. Summary • It is vitally important to “get the numbers right” for tax purposes to provide accurate financial statements and to provide shareholders with accurate information about the financial condition of the company

  27. Questions?

  28. Basics of the liability method TEI – Introduction to Financial Reporting for Taxes

  29. Objective • Identify and apply the basic principles of the liability method of accounting for income taxes under ASC 740

  30. Accounting for income taxes ASC 740 (Dec. 2009) APB 11 (Dec. 1967) FAS 96 (Dec. 1987) ASC 740 (Dec. 1992) Superseded Codification

  31. ASC 740 – Introduction • ASC 740 addresses financial accounting and reporting for the effects of income taxes that result from an enterprise’s activities during the current and preceding years

  32. Application of ASC 740 • Domestic federal (national) income taxes and foreign, state, and local (including franchise) taxes based on income • An enterprise’s domestic and foreign operations that are consolidated, combined or accounted for by the equity method • Foreign enterprises in preparing financial statements in accordance with US generally accepted accounting principles (US GAAP)

  33. ASC 740 – Scope • ASC 740 establishes standards of financial accounting and reporting for income taxes that are currently payable and for the tax consequences of: • Revenues, expenses, gains or losses that are included in taxable income of an earlier or later year than the year in which they are recognized • Other events that create differences between the book and tax bases of assets and liabilities • Operating loss or tax credit carrybacks for refunds of income taxes paid in prior years and carryforwards to reduce future taxes payable

  34. Key terms and concepts • Taxable income • Total tax expense/(benefit): • Current tax expense/(benefit) • Deferred tax expense/(benefit) • Permanent differences • Temporary differences: • Deferred tax liabilities (DTLs) • Deferred tax assets (DTAs) • Valuation allowance

  35. Taxable income – The excess of taxable revenues over tax-deductible expenses and exemptions for the year, as defined by the governmental taxing authority Current tax expense/(benefit) – The amount of income taxes paid or payable (or refundable) for a year, as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues Deferred tax expense/(benefit) – The change during the year in an enterprise’s deferred tax liabilities and assets Permanent differences – Not specifically defined in ASC 740 In general, book-tax differences that increase or decrease current tax liabilities without any future tax implications affecting tax expense ASC 740 – Definitions

  36. Temporary differences – A difference between the book and tax base of an asset or liability that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled DTL (deferred tax liability) – Recognizes the deferred tax consequences attributable to taxable temporary differences DTA (deferred tax asset)– Recognizes the deferred tax consequences attributable to deductible temporary differences and carryforwards Valuation allowance – The portion of a DTA for which it is more-likely-than-not that a tax benefit will not be realized ASC 740 – Definitions (cont.)

  37. ASC 740 – Definitions (cont.) • Carrybacks – Deductions or credits that cannot be used on the tax return during a year that may be carried back to reduce taxable income or taxes payable in a prior year • Carryforwards – Deductions or credits that cannot be used on the tax return during a year that may be carried forward to reduce taxable income or taxes payable in a future year

  38. Examples of permanent differences • Book revenues/gains that will never be taxable due to statutory exclusion, for example: • Municipal bond interest • Book expenses/losses that will never be deductible for income tax purposes, for example: • Fines, nondeductible meals and entertainment (M&E), officer’s life insurance expense • Items taxable or deductible for tax purposes but not included in financial statements, for example: • Stock option deduction, transfer pricing adjustments

  39. Liability method basic principles • Focus: balance sheet • Objective: measure taxes payable/refundable based on difference between book basis and tax basis of assets and liabilities • Deferred tax assets are recognized subject to valuation allowance considerations • A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year • A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards

  40. How DTAs arise • Expenses currently recognized for book purposes but not for tax purposes • Revenues currently recognized for tax purposes but not for book purposes Book income Taxable income > Future(as items reverse)

  41. Examples of DTAs • Expense items: • Allowance for bad debts • Compensation accruals (vacation, bonus, commission) • Contingency reserve accruals (legal, environmental) • Revenue items: • Advance receipts for goods (revenue deferred for book but not tax) • Tax carryforward items: • Foreign tax credits in worldwide taxation regimes that allow credits for foreign taxes paid • Net operating losses

  42. Examples of DTLs • Expense items: • Fixed assets (tax depreciation > book depreciation) • Intangible assets (tax goodwill amortization > book goodwill impairment) • Revenue items: • Installment sale receivable (revenue deferred for tax but not book) • Completed contract tax accounting method

  43. Liability method basic principles:measurement • Measurement of current and deferred tax liabilities and assets is based on provisions of enacted tax law; effects of future changes in tax laws or rates are not anticipated • Measurement of DTAs is reduced by the amount of any tax benefits that are not expected to be realized (i.e., a valuation allowance)

  44. 2. Measure total deferred tax liability for taxable temporary differences using applicable enacted tax rate. Measurement of DTAs and DTLs 1. Identify types and amounts of cumulative temporary differences and carryforwards. 3. Measure total deferred tax asset for deductible temporary differences and loss carryforwards using applicable enacted tax rate, plus tax credit carryforwards. 4. Reduce the deferred tax asset by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.

  45. Temporary differences – Book vs. tax basis

  46. Temporary differences summary

  47. Computation of tax expense • Current tax expense = • Current taxes payable (generally, includes changes in income tax contingency reserves) • Deferred tax expense = • Net change in deferred tax liabilities and assets (adjusted for special items) • Total tax expense = • Current tax expense + deferred tax expense • Consider other items: • Prior-year provision-to-return reconciliation items (both permanent and temporary) • Previously unrecognized benefits of NOL carryforwards or other DTAs (adjustments to valuation allowance)

  48. Why bother with deferred taxes? • Matching of tax expense with economic income earned by the entity • When an “event” is recognized in the financial statements, the eventual tax consequences of the event should also be recognized (e.g., “match” the tax to the same financial statement period that includes the gain or loss) • Economic results are the focus, not the timing of tax payments

  49. Deferred taxes exercise:“with and without” example • Company earns $100 of interest income in both year 1 and year 2 • Company sells a product in year 1 and recognizes $100 of book income • Due to their tax method of accounting, the $100 gain on the sale will be taxable in year 2

  50. Computation of tax expense without deferred taxes