11

Accounting for Income Taxes

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Accounting for Income Accounting for Income TaxesTaxes

After studying this, you should be able to:After studying this, you should be able to:Identify differences between pretax financial Identify differences between pretax financial

income and taxable income.income and taxable income.Describe a temporary difference that results Describe a temporary difference that results

in future taxable amounts.in future taxable amounts.Describe a temporary difference that results Describe a temporary difference that results

in future deductible amounts.in future deductible amounts.Explain the purpose of a deferred tax asset Explain the purpose of a deferred tax asset

valuation allowance.valuation allowance.Describe the presentation of income tax Describe the presentation of income tax

expense in the income statement.expense in the income statement.

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2

3

4

5

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Accounting for Income TaxAccounting for Income TaxAfter studying this, you should be able to:After studying this, you should be able to:Describe the various temporary and Describe the various temporary and

permanent differences.permanent differences.Explain the effect of various tax rates and tax Explain the effect of various tax rates and tax

rate changes on deferred income taxes.rate changes on deferred income taxes.Apply accounting procedures for a loss Apply accounting procedures for a loss

carryback and a loss carryforward.carryback and a loss carryforward.Describe the presentation of deferred income Describe the presentation of deferred income

taxes in financial statements.taxes in financial statements.Indicate the basic principles of the asset-Indicate the basic principles of the asset-

liability method.liability method.

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Deferred Taxes: BasicsDeferred Taxes: Basics

Deferred taxes arise when income tax Deferred taxes arise when income tax expenseexpense differs from income tax differs from income tax liabilityliability

The tax The tax expenseexpense is determined under is determined under GAAPGAAP The income tax The income tax liabilityliability is determined under the is determined under the

Internal Revenue CodeInternal Revenue Code Some of these differences are Some of these differences are temporarytemporary and and

reverse over timereverse over time Others are Others are permanentpermanent and do not reverse and do not reverse

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Temporary Differences: ExamplesTemporary Differences: Examples Revenues and Gains, recognized in financial Revenues and Gains, recognized in financial

income, are income, are later taxedlater taxed for income tax purposes for income tax purposes Expenses and losses, recognized in financial Expenses and losses, recognized in financial

income, are income, are later deductedlater deducted for income tax for income tax purposespurposes

Revenues and gains are taxed for income tax Revenues and gains are taxed for income tax purposes purposes beforebefore they are recognized in financial they are recognized in financial incomeincome

Expenses and losses are deducted for income Expenses and losses are deducted for income tax purposes tax purposes beforebefore they are recognized in they are recognized in financial income financial income

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Summary of Temporary DifferencesSummary of Temporary Differences

Transaction When recordedin books

When recordedon tax return

Deferredtax 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

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Permanent Differences: ExamplesPermanent Differences: Examples Items, Items, recognized for financial accounting recognized for financial accounting

purposespurposes, but not for income tax purposes:, but not for income tax purposes: interest income received on tax exempt securitiesinterest income received on tax exempt securities fines and expenses resulting from violations of lawfines and expenses resulting from violations of law Premiums paid for life insurance on key Premiums paid for life insurance on key

officers/employeesofficers/employees Items, Items, recognized for tax purposesrecognized for tax purposes, but not for , but not for

financial accounting purposes:financial accounting purposes: the dividends received deduction under the Codethe dividends received deduction under the Code percentage depletion of natural resources in percentage depletion of natural resources in

excess of their cost excess of their cost

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Summary of Permanent Summary of Permanent DifferencesDifferences

Sources of PERMANENT DIFFERENCES

No deferred tax effectsfor permanent differences

Some items are recordedin Books

but NEVERon tax return

Other items are NEVERrecorded in books

but recordedon tax return

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Deferred Tax Asset & Deferred Tax Liability: Deferred Tax Asset & Deferred Tax Liability: SourcesSources

Deferred taxes may be a: Deferred taxes may be a: Deferred tax Deferred tax liability, liability, oror Deferred tax Deferred tax assetasset Deferred tax Deferred tax liabilityliability arises due to arises due to

net net taxable amountstaxable amounts in the future. in the future. Deferred tax Deferred tax asset asset arises due to arises due to net net

deductible amountsdeductible amounts in the future. in the future.

1010

Recording a Valuation AllowanceRecording a Valuation Allowancefor Doubtful Deferred Tax Assets for Doubtful Deferred Tax Assets

If the deferred tax asset appears If the deferred tax asset appears doubtful, doubtful, a a Valuation Allowance account is neededValuation Allowance account is needed..

Journal entryJournal entry::Income Tax Expense Income Tax Expense $$ $$

Allowance to ReduceAllowance to Reduce Deferred Tax Asset to Deferred Tax Asset to

ExpectedExpected Realizable Value Realizable Value $$ $$

The entry records a potential future tax benefit The entry records a potential future tax benefit that is that is not not expected to be realized in the future.expected to be realized in the future.

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Deferred Taxes:Deferred Taxes:Applying Tax RatesApplying Tax Rates

Basic RuleBasic Rule: : Apply the yearly tax rate to calculate deferred Apply the yearly tax rate to calculate deferred taxtax effects.effects.

If future tax rates changeIf future tax rates change:: use the enacted tax rate expected to use the enacted tax rate expected to

apply in theapply in the future year future year If new rates are If new rates are not yet enactednot yet enacted into law for into law for

future years, the current rate should be used future years, the current rate should be used The appropriate enacted rate for a year is the The appropriate enacted rate for a year is the

average tax rate [based on graduated tax average tax rate [based on graduated tax brackets].brackets].

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Revision of Future Tax RatesRevision of Future Tax Rates

When a change in tax rate is enacted, its When a change in tax rate is enacted, its effect should be recorded immediatelyeffect should be recorded immediately

The effect is reported as an adjustment to The effect is reported as an adjustment to tax expense in the period of changetax expense in the period of change

Changes in tax rates are treated just like Changes in tax rates are treated just like any other change in estimate, any other change in estimate, prospectivelyprospectively

See example following slideSee example following slide

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Revision of Future Tax Rates: ExampleRevision of Future Tax Rates: Example

End of 2002, corporate tax rate is changed from End of 2002, corporate tax rate is changed from 40% to 35%40% to 35%

The new rate is effective January 1, 2004The new rate is effective January 1, 2004 The deferred tax account (1/1/2002) is as The deferred tax account (1/1/2002) is as

followsfollows:: Excess tax depreciation:Excess tax depreciation: $3 million$3 million Deferred tax liability:Deferred tax liability: $1.2 million.$1.2 million. Related taxable amounts are expected to occur Related taxable amounts are expected to occur

equally over 2003, 2004, and 2005.equally over 2003, 2004, and 2005. Provide the journal entry to reflect the changeProvide the journal entry to reflect the change. .

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Revision of Future Tax Rates: ExampleRevision of Future Tax Rates: Example

The deferred tax liability end of 2005 is as followsThe deferred tax liability end of 2005 is as follows:: 20032003 20042004 20052005 Future tax incFuture tax inc $1,000,000$1,000,000 1,000,0001,000,000 1,000,0001,000,000 Tax rateTax rate 40%40% 35%35% 35%35% Deferred tax Deferred tax liabilityliability $$400,000400,000 350,000350,000

350,000350,000 EntryEntry:: Deferred Tax LiabilityDeferred Tax Liability $100,000 $100,000

Income Tax ExpenseIncome Tax Expense $100,000* $100,000*

*$1,200,000 - $1,100,000

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Financial Statement PresentationFinancial Statement Presentation

Balance Sheet PresentationBalance Sheet Presentation:: The deferred tax classification relates to The deferred tax classification relates to

its underlying asset or liabilityits underlying asset or liability Classify the deferred tax amounts as Classify the deferred tax amounts as

currencurrentt or noncurrentor noncurrent Sum the various deferred tax assets and Sum the various deferred tax assets and

liabilities classified as liabilities classified as currentcurrent Sum the various deferred tax assets and Sum the various deferred tax assets and

liabilities classified as liabilities classified as noncurrent noncurrent

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Financial Statement PresentationFinancial Statement Presentation

Balance Sheet PresentationBalance Sheet Presentation:: Sum the various deferred tax assets and liabilities Sum the various deferred tax assets and liabilities

classified as classified as current:current: If net result is an asset, report as current assetIf net result is an asset, report as current asset If net result is a liability, report as current liabilityIf net result is a liability, report as current liability Sum the various deferred tax assets and liabilities Sum the various deferred tax assets and liabilities

classified as classified as noncurrentnoncurrent If net result is an asset, report as long-term assetIf net result is an asset, report as long-term asset If net result is a liability, report as long-term liabilityIf net result is a liability, report as long-term liability

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Income Statement PresentationIncome Statement Presentation

Income tax expense, as allocated toIncome tax expense, as allocated to::1.1. Continuing operationsContinuing operations2.2. Discontinued operationsDiscontinued operations3.3. Extraordinary itemsExtraordinary items4.4. Cumulative effect of an accounting change, Cumulative effect of an accounting change,

andand5.5. Prior period adjustmentsPrior period adjustments Disclose other significant componentsDisclose other significant components, such as:, such as: current tax expense, current tax expense,

deferred tax expense/benefit,etcdeferred tax expense/benefit,etc..

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Net Operating Losses [NOLs]:Net Operating Losses [NOLs]:Basic TerminologyBasic Terminology

Net operating loss is a tax terminologyNet operating loss is a tax terminology A net operating loss occurs when A net operating loss occurs when taxtax

deductions for a year exceed deductions for a year exceed taxabletaxable revenuesrevenues

Net loss or operating loss is a financial Net loss or operating loss is a financial accounting term accounting term

NOL can be derived from net loss: but NOL can be derived from net loss: but these two amounts must be kept these two amounts must be kept separatelyseparately

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NOLs: Rules of Application NOLs: Rules of Application NOL for each tax year is computedNOL for each tax year is computed The NOL of one year can be applied to The NOL of one year can be applied to

offset offset taxable income of other years, taxable income of other years, possibly resulting possibly resulting tax refundstax refunds

NOLs can be:NOLs can be: carried back carried back 2 years2 years and carried and carried

forward forward 20 years20 years (carryback option), or(carryback option), or carried forward carried forward 20 years20 years (carryforward (carryforward

only)only)

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Net Operating Loss: Carryback rules.Net Operating Loss: Carryback rules.

If NOLs are carried back 2 years and If NOLs are carried back 2 years and carried forward 20 years:carried forward 20 years:

NOL is applied to the NOL is applied to the earlierearlier of the 2 year of the 2 year period, then to the immediately period, then to the immediately preceding year etcpreceding year etc

Remaining NOLs are applied to the Remaining NOLs are applied to the following 20 year periodfollowing 20 year period

Any tax refunds are reported in the year Any tax refunds are reported in the year of the of the originaloriginal net operating loss net operating loss

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NOL Carryback Rules: NOL Carryback Rules: continuedcontinued

2001 2002 2003 2004 2005 2006 2007 2024

NOL2004

Tax years

Apply first

next

Loss carryforward20 years forward

Expect tax refund

hereRecord all

tax effects here

Expecttax

shieldhere

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NOL Carryforward Rules NOL Carryforward Rules

2001 2002 2003 2004 2053 2006 2007 2024

NOL2004

Tax years

Loss carryforward20 years forward

Record alltax effects here

Expecttax

shieldhere

Forgo 2year rule

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Basic Principles of Asset-Liability Basic Principles of Asset-Liability MethodMethod

A current tax liability or asset is recognized for the A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax estimated taxes payable or refundable on the tax return for current yearreturn for current year

A deferred tax liability or asset is recognized for the A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary estimated future tax effects attributable to temporary differences and carryforwardsdifferences and carryforwards

The measurement of current and deferred tax The measurement of current and deferred tax liabilities and assets is based on provisions of liabilities and assets is based on provisions of enacted tax law, effects of future changes in tax law enacted tax law, effects of future changes in tax law or rates are not anticipatedor rates are not anticipated

The measurement of deferred tax assets is reduced, The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that if necessary, by the amount of any tax benefits that are not expected to be realizedare not expected to be realized

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