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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.