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Section 19 – Accounting for Income Taxes
(Deferred Taxes)
Financial Statements are governed by GAAP,
while income taxes are governed by the
Internal Revenue Code. Their recognition and
measurement are different. Thus, the amount
of “Income tax expense” & the amount of
“income tax payable” are often different.
Intraperiod Income Tax Allocation (GAAP)
Income Tax Expense must be associated with
each component of income that causes it.
Show “Income Tax Expense”
related to Income from
Continuing Operations as a
“separate line item".
Report effects of
Discontinued Operations and
Extraordinary Items net of
related income tax effect.
Deferred Tax Assets & Deferred Tax Liabilities
Tax Returns: The Internal
Revenue Code is the set
of rules for preparing.
Financial Statements:
GAAP is the set of rules
for preparing.
Results in . . .
Results in . . .
Financial statement
income tax expense.
Usually
IRS income taxes payable.
The objective of accounting for income taxes is to recognize a
deferred tax liability (pay me later per IRS; future taxable; book
income > IRS Taxable income) or deferred tax asset (pay me now
per IRS; future deductible) for the tax consequences of amounts
that will become taxable or deductible in future years as a result
of transactions or events that already have occurred.
Deferred Tax Assets are similar with Deferred Charges:
Deferred Charges:
An expenditure that is expected to yield benefits for several
Accounting periods. It should be amortized over its estimated useful life.
Examples: start up costs, bond issuance costs, plant arrangement
& moving costs.
Deferred charges and intangible costs (patents, copy rights…) both
Represent “bundles of services” in the form of long-term prepayments
(i.e., expenses paid in advance).
Temporary Differences
The difference in the rules for computing between
pretax accounting income (according to GAAP) and
taxable income (according to the IRS) often causes
amounts to be reported in different years.
This results in
temporary
differences.
Temporary Differences
Temporary differences will reverse in
one or more future periods.
Accounting Income > Taxable Income
Accounting Income < Taxable Income
Future Taxable Amounts
Future Deductible Amounts
Deferred Tax Liability
Deferred Tax Asset
Pay me later per IRS,
Future Taxable
Pay me now per IRS,
Future Deductible
Deferred Tax Liabilities
– Installment Sale (Pay Me Later Per IRS) Example 1
Kent Land Management reported pretax accounting income in each 2013, 2014, and 2015
of $100 million, plus additional 2013 income of $40 million from installment sales of
property. However, the installment sales income is reported on the tax return when
collected, in 2014 ($10 million) and 2015 ($30 million). The enacted tax rate is 40% each
year.
Temporary difference: originates in one period and reverses, or turns
around, in one or more subsequent periods. Installment sales incur:
Dr. Accounts Receivable, Cr. Revenue (assuming no cash collected in
2013)
Deferred Tax Liabilities – Example 1
(Cont’d)
Calculate income tax that is currently payable: $100 × 40% = $40
Calculate change in deferred tax liability: ($40 × 40%) = $16
Combine the two to get the income tax expense: $40 + $16 = $56
Income tax expense (pretax acctg income)
Income tax payable (100 x .4 per IRS)
Deferred tax liability
56
40
16
The FASB’s Balance Sheet Approach
- Example 1
$(10)
X 40%
$(4)
Total amount reversed $16 (ie., 4+12)
Types of Temporary Differences
Deferred tax assets result in
deductible amounts in the
future.
Deferred tax liabilities result
in taxable amounts in the
future.
Deferred Tax Liabilities –
Depreciation Expense (Pay Me Later Per IRS) Example 2
Courts Temporary Services reported pretax accounting income in 2013, 2014,
2015, and 2016 of $100 million. In 2013, an asset was acquired for $100 million.
The asset is depreciated for financial reporting purposes over 4 years on a
straight-line basis (no residual value). For tax purposes the asset’s cost is
deducted (by MACRS) over 2013–2016 as follows: $33 million, $44 million, $15
million, and $8 million. No other depreciable assets were acquired. The enacted
tax rate is 40% each year.
92=(100+25)-33
Deferred Tax Liabilities - Example 2
(Cont’d)
Calculate income tax that is currently payable: $92 × 40% = $36.8 (125-33=92)
Calculate change in deferred tax liability: ($25 - $33) × 40% = $3.2
Combine the two to get the income tax expense: $36.8 + $3.2 = $40
Journal entry at the end of 2013
Income tax expense (on pretax acctg income) 40.0
Income tax payable (by taxable income)
Deferred tax liability
36.8
3.2
Deferred Tax Liabilities - Example 2
(Cont’d)
Calculate income tax that is currently payable: $81 × 40% = $32.4
Calculate change in deferred tax liability: (($25 - $44) × 40%)) = $7.6
Combine the two to get the income tax expense: $32.4 + $7.6 = $40
Journal entry at the end of 2014
Income tax expense
Income tax payable
Deferred tax liability
40.0
32.4
7.6
Deferred Tax Liabilities - Example 2
(Cont’d)
Calculate income tax that is currently payable: $110 × 40% = $44
Calculate change in deferred tax liability: (($25 - $15) × 40%)) = $4
Combine the two to get the income tax expense: $44 – 4 = $40
Journal entry at the end of 2015
Income tax expense (pretax acctg income)
Deferred tax liability
Income tax payable
40
4
44
Deferred Tax Liabilities - Example 2
(Cont’d)
Journal entry at the end of 2016
Income tax expense (plug)
Deferred tax liability ((25-8)=17M x .4)
Income tax payable
40.0
6.8
46.8
Note: Income tax expense is calculated based on pre-tax accounting income,
thus it is always the same amount of $40.
Deferred Tax Assets
– Warranty Expense (Pay Me Now Per IRS) Example 3
Deferred Tax Assets
– Warranty Expense (Pay Me Now Per IRS) Example 3
Calculate income tax that is currently payable: $100 × 40% = $40
Calculate change in deferred tax asset: $30 × 40% = $12
Combine the two to get the income tax expense: $40 – 12 = $28
Journal entry at the end of 2013
Income tax expense
Deferred tax asset (future deductible)
Income tax payable
28
12
40
Deferred Tax Assets
– Warranty Expense (Pay Me Now Per IRS) Example 3
Journal entry at the end of 2014 and 2015
Income tax expense
Deferred tax asset
Income tax payable
0
40
6
34
Valuation Allowance
• A valuation allowance account is needed if it is
more likely than not that some portion of the
deferred tax asset will not be realized; it reduces a
deferred tax asset, i.e., no longer a future
deductible.
Income tax expense xxx
Deferred Tax Asset - Valuation Allowance xxx
• The deferred tax asset is then reported at its
estimated net realizable value.
Permanent Differences
Created when an income item is included in taxable
income or accounting income but will never be
included in the computation of IRS taxes.
Example: Interest on tax-free municipal bonds is included in
accounting income but is never included in taxable income.
Proceeds received from a life insurance company because of
the death of a key officer is not taxable (the company carries a
policy on key officers).
Permanent differences are disregarded when
determining both the tax payable currently and the
deferred tax asset or liability.
U.S. GAAP vs. IFRS
Despite the similar approaches for accounting for income taxes
under IFRS and U.S. GAAP, differences in reported amounts for
deferred taxes are among the most frequent between the two
reporting approaches.
• For example, U.S. GAAP requires
a loss contingency be accrued if it
is both probable and can be
reasonably estimated. Accruing a
loss contingency leads to a
deferred tax asset, because the
accrued loss causes Book Income
< Taxable Income; a future
deductible.
• For loss contingencies, IFRS uses
a “more likely than not”
threshold, which is lower than
the U.S. “probable” requirement.
As a result, under the lower
threshold of IFRS, a loss
contingency and a deferred tax
asset sometimes is recorded for
IFRS but not for U.S. GAAP.
Tax Rate Considerations
• Deferred tax assets & liabilities
should be determined using the
future tax rates, if known.
• The deferred tax asset or liability
must be adjusted if an enacted
changes in a tax law or rates
occurs.
Enacted Tax Rate Changed
Deferred Tax Liabilities – Example 1
Calculate income tax for 2013 that is currently payable: $100 × 40% =
$40
Calculate change in deferred tax liability: ($40 × 40%) = $16
Combine the two to get the income tax expense: $40 + $16 = $56
Income tax expense
Income tax payable (100 x .4 per IRS)
Deferred tax liability
56
40
16
Enacted Tax Rate Changed
The FASB’s Balance Sheet Approach
- Example 1
(10)
X 40%
$(4)
Total amount reversed $16 (4+12)
Enacted Tax Rate Changed – Example 1
(Data from Slide 23)
In 2014 IRS Announced that Tax Rate for 2015
Is Changed from 40% to 30%
Pretax accounting income
Temporaty difference:
Installment income
Taxable income
Enacted tax rate
Tax Payable currently
Current
Yr
2013
2014
140
100
(40)
100
10
110
40%
44
Deferred tax liability (30 x .30)
Deferred Tax Liability
Ending balance
Less: Beginning balance
Change in balance
2015
100
30
130
30%
9
9
(16) (10x.4: 2014 + 30x.4: 2015 at 40% rate)
(7.00)
JE at 12/31/14 when company was informed that enacted tax rate for 2015
will be changed to 30%:
Income tax Expense (to balance)
Deferred tax liability (from above)
Income tax payable (determined above)
9
37
7
44
T account
Deferred Tax Liability
12/31/2013
12/31/2014
12/31/2015 if still 40%
16
7
4
9
12
0
Note:
Instead of reversing $12 at12/31/15, it can only reverse $9 at 30% (rather than $12), thus it
is short of $3;
Add the $3 to 12/31/14's reversal amount, 4+3 = 7(plug), so 7 + 9 would = 16, total amount need to be reversed.
Multiple Temporary Differences
It would be unusual for any company (except very small
co.) to have only a single temporary difference in any
given year.
Categorize all temporary
differences according to
whether they create …
Future taxable
amounts
(Pay me later)
Future deductible
amounts
(Pay me now)
Net Operating Losses (NOL)
Tax laws often allow a company to use tax NOLs to
offset taxable income in earlier or subsequent
periods.
When used to offset earlier
taxable income:
 Called: operating loss
carryback.
 Result: tax refund.
When used to offset future taxable
income:
 Called: operating loss carry
forward.
 Result: reduced tax payable.
Net Operating Losses (NOL)
Carryback
Period
-2
-1
Carryforward
Period
+1 +2 +3 +4 +5
Current
Year
. . . +20
The NOL may first be applied against taxable income from
two previous years.
Unused NOL may be carried forward for 20 years.
Operating Loss Carryforward - Example
A carryforward is a future deductible amount (a tax benefit)
Journal entry at the end of 2013
Deferred tax asset
50
Income tax benefit-operating loss
50
NOL carried forward reduces tax payable (deduct later); thus it
is a DTA
Operating Loss Carryback - Example
The carryback of the NOL must be applied to the
earlier (oldest) year first and then to the next year.
Any remaining NOL may be carried forward.
Operating Loss Carryback - Example
Journal entry at the end of 2013
Receivable—income tax refund
Deferred tax asset
Income tax benefit-operating loss
29
20 (50x.4)
49
Coping with Uncertainty in Income Taxes
Two-step Decision Process
Step 1. A tax benefit (reduction in tax expense or
taking the deduction) may be reflected in the financial
statements only if it is “more likely than not” that the
company will be able to sustain the tax return position,
based on its technical merits.
Step 2. A tax benefit should be measured as the
largest amount of benefit that is cumulatively greater
than 50 percent likely to be realized.
If the tax benefit is not “more likely than not,” then
none of the tax benefit is allowed to be recorded,
instead, a “Liability – projected additional tax” should
be recorded.
Disclosure Notes
Deferred Tax Assets and Deferred Tax
Liabilities
• Total of all deferred tax liabilities.
• Total of all deferred tax assets.
Income Tax Expense
• Total valuation allowance
• Current portion of the tax
recognized.
expense (or benefit).
• Net change in valuation account.
• Deferred portion of the tax
• Approximate tax effect of each type
expense (or benefit) with
of temporary difference (and
separate disclosures of
carryforward).
amounts attributable to
several specific items.
Operating Loss Carryforwards
• Amounts.
• Expiration dates.
Balance Sheet Classification
Deferred tax assets/liabilities:
Classified as current or noncurrent (net amount)
based on how the related asset or liability is
classified for financial reporting.
When a deferred tax asset or a deferred tax liability
cannot be related to a specific asset or liability, it
should be classified according to when the
underlying temporary difference is expected to
reverse.
Income Statement Presentation
Companies should allocate income tax expense (or benefit)
to continuing operations, discontinued operations,
extraordinary items, and prior period adjustments.
Companies should disclose the significant components of
income tax expense attributable to continuing operations
(current tax expense, deferred tax expense, etc., see next
slide).
Income Statement Presentation - Example
Given the previous information related to Chelsea Inc.,
Chelsea reports its income statement as follows.
Intraperiod Tax Allocation
Income Statement:
• Income from continuing operations.
• Discontinued operations.
• Extraordinary items.
Other Comprehensive Income:
• Investments.
• Postretirement benefit plans.
• Derivatives.
• Foreign currency translation.
U.S. GAAP vs. IFRS
The approach for accounting for intraperiod tax allocation is the
same under IFRS and U.S. GAAP, but the categories used on the
income statement are different.
• GAAP separately reports both
discontinued operations and
extraordinary items on the
income statement and each are
shown net of tax.
• IFRS does not separately report
extraordinary items on the
income statement. As a result,
the only income statement item
reported separately net of tax
using IFRS is discontinued
operations.
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