|
Slide 76 -
|
Accounting for Income Taxes C hapter 19 An electronic presentation
by Norman Sunderman
Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition
Nikolai Bazley Jones 2 Understand permanent and temporary differences.
Explain the conceptual issues regarding interperiod tax allocation.
Record and report deferred tax liabilities.
Record and report deferred tax assets.
Explain an operating loss carryback and carryforward. Objectives 3 Account for an operating loss carryback.
Account for an operating loss carryforward.
Apply intraperiod tax allocation.
Classify deferred tax liabilities and assets. Objectives 4 Because there are differences between when an event is recognized for tax purposes and when it is recognized for financial purposes, there will be differences between tax expense on the income statement and taxes actually paid.
The objective of accounting for income taxes on the accrual basis is to recognize the amount of current and deferred taxes payable or refundable at the date of the financial statements. Continued Differences Between Taxable and Financial Income 5 These differences require the use of Deferred Income Tax accounts to reflect the tax consequences of events recognized in different periods for financial and tax reporting.
Recognition of deferred tax liabilities and deferred tax assets is required for domestic federal income taxes, and foreign, state, and local (including franchise) taxes based on income. Differences Between Taxable and Financial Income 6 The objective of financial reporting is to provide useful information about companies to decision makers. Overview and Definitions 7 Overview and Definitions 8 Overview and Definitions 9 Permanent differences.
Temporary differences.
Operating loss carrybacks and carryforwards.
Tax credits.
Intraperiod tax allocations. Causes of Differences 10 Should corporations be required to make interperiod income tax allocations for temporary differences, or should there be no interperiod tax allocation?
If interperiod tax allocation is required, should it be based on a comprehensive approach for all temporary differences or on a partial approach for certain temporary differences?
Should interperiod tax allocation be applied using the asset/liability method or the deferred method? Conceptual Issues 11 The FASB concluded that-- Interperiod income tax allocation of temporary differences is appropriate.
The comprehensive allocation approach is to be applied.
The asset/liability method of income tax allocation is to be used. Conceptual Issues 12 Some items of revenue and expense that a corporation reports for financial accounting purposes are never reported for income tax purposes. These permanent differences never reverse in a later accounting period. Permanent Differences 13 Permanent Differences 14 Revenues that are recognized for financial reporting purposes but are never taxable
Interest on state and local government bonds
Life insurance proceeds payable to a corporation upon death of insured Continued Permanent Differences 15 Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes
Life insurance premiums on officers
Fines resulting from a violation of the law
Expenses incurred in obtaining tax-exempt income Continued Permanent Differences 16 Deductions that are allowed for income tax purposes but do not qualify as expenses under generally accepted accounting principles
Percentage depletion in excess of cost depletion
Dividend received deduction Permanent differences affect either a corporation’s reported pretax financial income or its taxable income, but not both. Permanent Differences 17 Corporations receive a 70% deduction for dividends received if less than 20% of a U.S. corporation is owned, an 80% deduction for dividends received if 80% or less of a U.S. corporation is owned, and a 100% deduction for dividends received if more than 80% of a U.S. corporation is owned. Dividend Received Deduction 18 A temporary difference causes a difference between a corporation’s pretax financial income and taxable income that “originates” in one or more years and “reverses” in later years. Temporary Differences 19 For example, a depreciable asset may be depreciated using MACRS over the prescribed tax life for income purposes, but using straight-line depreciation over a longer life for financial reporting purposes. Future Taxable Income Will Be Higher Than Future Pretax Financial Income Continued Temporary Differences- Future Taxable Amounts T
Over F = Taxable 20 Gross profit on installment sales normally is recognized at the point of sale for financial reporting purposes, but for income tax purposes, in certain situations it is recognized as cash is collected. Future Taxable Income Will Be Higher Than Future Pretax Financial Income Continued Temporary Differences- Future Taxable Amounts T
Over F = Taxable 21 It is assumed that investment income reported under the equity method for financial purposes, but not received as a dividend, will eventually be received as dividends or as a gain when the stock is sold. Future Taxable Income Will Be Higher Than Future Pretax Financial Income Continued Temporary Differences- Future Taxable Amounts T
Over F = Taxable 22 Prepaid expenses are deductible when paid for tax purposes, but are not recorded as expenses under used for financial purposes.
Unrealized gains on trading securities are not taxable until realized. Future Taxable Income Will Be Higher Than Future Pretax Financial Income Continued Temporary Differences- Future Taxable Amounts T
Over F = Taxable 23 Profit recognized, but not realized, under the percentage of completion method for financial reporting that will not be taxable until a later year. Future Taxable Income Will Be Higher Than Future Pretax Financial Income Continued Temporary Differences- Future Taxable Amounts T
Over F = Taxable 24 For example, items such as rent, interest, and royalties received in advance are taxable when received but are not reported for financial reporting purposes until the service actually has been provided. Future Pretax Financial Income Higher Than Future Taxable Income Continued Temporary Differences- Future Deductible Amounts F
Over T = Deductible 25 Product warranty costs may be estimated and recorded as expenses in the current year for financial reporting purposes but deducted, as actually incurred, for the determination of taxable income. Future Pretax Financial Income Higher Than Future Taxable Income Continued Temporary Differences- Future Deductible Amounts F
Over T = Deductible 26 Bad debts expense estimated for financial reporting, but not deductible until the receivable is written off for tax purposes.
Portion of depreciation capitalized for tax purposes into inventory. Future Pretax Financial Income Higher Than Future Taxable Income Continued Temporary Differences- Future Deductible Amounts F
Over T = Deductible 27 Accrued litigation losses for financial reporting, but not deducted until paid for tax purposes.
Losses on investments classified as trading securities.
Unrealized profit on sale and leaseback for financial reporting and a profit on the sale for tax purposes. Future Pretax Financial Income Higher Than Future Taxable Income Temporary Differences- Future Deductible Amounts F
Over T = Deductible 28 The FASB established four basic principles that a corporation is to apply in accounting for its income taxes at the date of its financial statements. Conceptual Issues 29 A current tax liability or asset is recognized for the estimated income tax obligation or refund on its income tax return for the current year.
A deferred tax liability or asset is recognized for the estimated future tax effects of each temporary difference. Continued Conceptual Issues 30 The measurement of deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax law or rates are not anticipated.
The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized. Conceptual Issues 31 The applicable income tax rates.
Whether a valuation allowance should be established for deferred tax assets. The FASB addressed two issues regarding the measurement of deferred tax liabilities or deferred tax asset in its financial statements. Measurement 32 Step 1. Measure the income tax obligation by applying the applicable tax rate to the current taxable income.
Step 2. Identify the existing temporary differences and classify each as either“taxable” or “deductible.”
Step 3. Measure the deferred tax liability for each taxable temporary difference using the applicable tax rate. Continued Steps in Recording and Reporting of Current and Deferred Taxes 33 Step 4. Measure the deferred tax asset for each deductible temporary difference using the applicable tax rate.
Step 5. Reduce deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
Step 6. Record the income tax obligation, change in deferred tax liabilities and/or deferred tax assets, change in valuation allowance (if any), and plug income tax expense. Steps in Recording and Reporting of Current and Deferred Taxes 34 In 2007, Track Company purchased an asset at a cost of $6,000. For financial reporting purposes, the asset has a 4-year life, no residual value, and is depreciated by the units-of-output method over 6,000 units (2007: 1,600 units). For income tax purposes the asset is depreciated under MACRS using the 3-year life (33.33% for 2007). The taxable income is $7,500 and the income tax rate for 2007 is 30%. Basic Entries This button will be used later 35 In the future taxable income will be higher than financial income, so the taxable amount times the tax rate is the deferred tax liability. Deferred Tax Liability 36 Step 1. $7,500 (taxable income) x 30%
Step 2. The depreciation difference is identified as the only taxable temporary difference.
Step 3. The $120 total deferred tax liability is calculated by multiplying the total taxable temporary difference ($400) times the future tax rate (30%).
Steps 4 and 5. No deferred tax asset, so not required.
Step 6. A journal entry is made. Continued Basic Entries 37 Income Tax Expense (plug) 2,370
Income Taxes Payable 2,250
Deferred Tax Liability 120 Basic Entries 38 When future enacted tax rates change, reversals are calculated at the future tax rates. Future Tax Rates Differ 39 Assume the same facts as in Slide 34, except that the income tax rate for 2007 for 40%, but Congress has enacted tax rates of 35% for 2008, 33% for 2009, and 30% for 2010 and beyond. Click here to review Slide 34, then click the button on Slide 34 to return. Example 2-Multiple Rates 40 2007 2008 2009 Deferred Tax Liability Financial depreciation $2,800 $1,100 $500
Income tax depreciation (2,667 ) (889 ) (444 )
Taxable amount $ 133 $ 211 $ 56 = $400
Income tax rate 0.35 0.33 0.30
Deferred tax liability $ 47 $ 70 $ 17 = $134 Income Tax Expense (plug) 3,134
Deferred Tax Liability 134
Income Taxes Payable 3,000 Example 2-Multiple Rates 41 Klemper Company sells a product on which it provides a 3-year warranty. For financial reporting purposes, the company estimates its future warranty costs and records a warranty expense/liability at year-end. For income tax purposes, the company deducts its warranty costs when paid. Deferred Tax Asset 42 At the beginning of 2007, the company had a deferred tax asset of $330 related to its warranty plan. At the end of 2007, the company estimates that its ending warranty liability is $1,400. In 2007, the company has taxable income of $5,000 and a tax rate of 30%. The ending Deferred Asset should be $1,400 X 30%, or $420. Income Tax Expense (plug) $1,410
Deferred Tax Asset ($420 - $330) 90
Income Taxes Payable ($5,000 x 30%) 1,500
Deferred Tax Asset 43 Deferred Tax Asset and Valuation Allowance If it is “more likely than not” that a deferred tax asset will not be realized, a valuation allowance must be established. 44 Negative Evidence Negative evidence indicating the need for a valuation allowance include:
A history of operating loss or tax credit carryforwards expiring unused.
Losses expected in early future years (by a presently profitable entity).
Unrecognized loss contingencies that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years.
A carryback, carryforward period that is so brief that it would limit realization of tax benefits. 45 Positive Evidence Positive evidence as to whether existing net deductible temporary differences and loss carryforwards will be realized include:
Existing contracts or firm sales backlog will produce more than enough future taxable income to realize the deferred tax asset based on existing sales prices and cost structures.
Income in carryback years prior to the present year.
Feasible and presently available tax strategies would result in more than enough taxable income to realize the deferred tax asset.
Appreciation of assets is sufficient to realize the deferred tax asset.
A strong earnings history exclusive of the charge to income that created the future deductible amount coupled with evidence indicating the transaction or event that created the charge to income (i.e. extraordinary item) is an aberration rather than a continuing condition.
46 Deferred Tax Assets and Valuation Allowance At the end of 2007, Klemper Corporation decides that it is “more likely than not” that $600 of the ending temporary difference will not be realized. (30% tax rate) Income Tax Expense 180
Allowance to Reduce Deferred
Tax Asset to Realizable Value 180 47 PPretax financial income XX Add: Deductible temporary items XX Fines XX Excess charitable contributions XX Expenses to earn tax exempt income XX Excess of bad debts expense over write-offs (deductible item) XX XX XX Less: Taxable temporary items XX Tax exempt interest XX Proceeds of life insurance XX Excess of percentage depletion over cost depletion XX Equity income not received as dividends (taxable item) XX Dividends received deduction XX XX Taxable income XX Determining Taxable Income Both permanent and temporary differences are considered when determining taxable income. 48 Example 5-Pages 959 & 960 Assume the following for Sand Company for 2007:
Interest on municipal bonds $1,500
Gross profit on installment sales-financial 10,000
Gross profit on installment sales-taxable 2,000
Rent revenue-financial 3,000
Rent revenue-taxable 9,000
Pre-tax financial income 75,500
Deferred tax liability-Jan. 1, 2007 300
Deferred gross profit-installment sales-2006 1,000
Make the journal entry for 2007. 49 PPretax financial income $75,500 Add: Rent revenue collected in advance 6,000 $81,500 Less: Tax exempt interest $1,500 Difference in gross profit on installment sales 8,000 9,500 Taxable income $72,000 Determining Taxable Income Both permanent and temporary differences are considered when determining taxable income. 50 Deferred Tax Assets and Liabilities Income Tax Expense (plug) 22,200
Deferred Tax Asset 1,800
Deferred Tax Liability 2,400
Taxes Payable 21,600 51 Conceptual Issues 52 A corporation must recognize the tax benefit of an operating loss carryback in the period of the loss as an asset on its balance sheet and as a reduction of the operating loss on its income statement.
A corporation must recognize the tax benefit of an operating loss carryforward in the period of the loss as a deferred tax asset. However, it must reduce the deferred tax asset by a valuation allowance if it is more likely than not that the corporation will not realize some or all of the deferred tax asset. Conceptual Issues 53 Operating Loss Carrybacks and Carryforwards 54 Monk Company reports a pretax operating loss of $90,000 in 2007 for both financial reporting and income tax purposes, and that reported pretax financial income and taxable income for the previous 2 years had been: 2005--$40,000 (tax rate 25%); and 2006--$70,000 (tax rate 30%). Income Tax Refund Receivable 25,000
Income Tax Benefit From
Operating Loss Carryback 25,000 Operating Loss Carryback Continued 55 Income Statement An operating loss is reduced by the benefit, not by the total carryback.
Pretax operating loss $(90,000)
Less: Income tax benefit from operating loss carryback $40,000 x 25% + $50,000 x 30% 25,000
Net loss $(65,000) 56 Lake Company reports a pretax operating loss of $60,000 in 2007 for both financial reporting and income tax purposes. The income tax rate is 30% and no change in the tax rate has been enacted for future years. The deferred tax asset is calculated to be $18,000 ($60,000 x 0.30). Deferred Tax Asset 18,000
Income Tax Benefit From
Operating Loss Carryforward 18,000 Continued Operating Loss Carryforward 57 If the company establishes a valuation allowance for the entire amount of the deferred tax asset, it also makes the following journal entry at the end of 2007. Income Tax Benefit From Operating
Loss Carryforward 18,000
Allowance to Reduce Deferred Tax
Asset to Realizable Value 18,000 Operating Loss Carryforward Continued 58 In 2008, Lake Company operates successfully and earns pretax operating income of $100,000 for both financial reporting and tax purposes. Income Tax Expense 12,000
Allowance to Reduce Deferred Tax
Asset to Realizable Value 18,000
Income Taxes Payable 12,000
Deferred Tax Asset 18,000 Operating Loss Carryforward $40,000 x 0.30 59 Intraperiod Tax Allocation 60 Intraperiod Tax Allocation Income tax may appear in five different places in the financial statements for a period.
Income from continuing operations
Discontinued operations
Extraordinary items
Prior period and retrospective adjustments
Other comprehensive income 61 Income from continuing operations
[$270,000 (revenues) – $190,000 (expenses)] $80,000
Gain on disposal of discontinued Segment X 18,000
Loss from operations of discontinued Segment X (5,000 )
Extraordinary loss on bond redemption (10,000 )
Cumulative effect of change in accounting
principle (accelerated depreciation to S/L) 15,000
Prior period adjustment (error) (8,000 )
Amount subject to income taxes $90,000
Continued Intraperiod Tax Allocation Kalloway Company reports the following items of pretax financial and taxable income for 2007: 62 Kalloway Company is subject to income tax rates of 20% on the first $50,000 of income and 30% on all income in excess of $50,000. Let’s take a look at Kalloway Company’s income statement for 2007. Continued Intraperiod Tax Allocation 63 Pretax Amount Income Tax Rate Income Tax Expense (Cr.) Component (Pretax) Income from continuing
operations $50,000 0.20 $10,000
30,000 0.30 9,000
Gain on disposal of
discontinued Division X 18,000 0.30 5,400
Extraordinary loss from tornado (5,000) 0.30 (1,500 ) x = Continued Intraperiod Tax Allocation 64 Pretax Amount Income Tax Rate Income Tax Expense (Cr.) Component (Pretax) Cumulative effect of change in
accounting principle on prior
year’s income $15,000 0.20 $ 4,300
Prior period adjustment (8,000) 0.30 (2,400)
Total income tax expense $22,000 x = Intraperiod Tax Allocation 65 Now, let’s examine Kalloway Company’s income statement for 2007. Intraperiod Tax Allcoation 66 Kalloway Company
Income Statement
for Year Ended December 31, 2007 Revenues (listed separately) $270,000
Expenses (listed separately) (190,000)
Pretax income from continuing operations$ 80,000
Income tax expense (19,000) Intraperiod Tax Allocation 67 Kalloway Company
Income Statement
for Year Ended December 31, 2007 Revenues (listed separately) $270,000
Expenses (listed separately) (190,000)
Pretax income from continuing operations $ 80,000
Income tax expense (19,000)
Income from continuing operations $ 61,000
Results of discontinued operations:
Gain on disposal of discontinued
Segment X (net of $5,400 tax) $12,600
Loss from operations of discontinued
Segment X (net of $1,500 tax credit) (3,500) 9,100
Income before extraordinary item $ 70,100
Statement Continued $18,000 x 0.30 ($5,000) X .30 68 Income before extraordinary item $70,100
Extraordinary loss from tornado
(net of $3,000 income tax credit) (7,000)
Net Income $63,100 ($10,000) x 0.30 69 A corporation must report its deferred tax liabilities and assets in two classifications... …a net current amount and a net noncurrent amount. Balance Sheet Presentation 70 Deferred tax liabilities and assets are classified as current or noncurrent based upon their related assets or liabilities for financial reporting. Balance Sheet Presentation 71 Any deferred tax liability or asset not related to an asset or liability is classified according to the expected reversal date of the temporary difference. Balance Sheet Presentation 72 Current and Noncurrent Related
Asset or
Liability Classification
Installment sales Accounts Receivable Current
Inventory differences Inventory Current
Allowance for Doubtful Accounts Receivable Current
Depreciation differences Plant Assets Noncurrent
Estimated Reversals
Accrued Pension Expense Probably noncurrent
Warranty Liability Probably current
Unearned Revenue
NOL 73 Account Related Balance
Deferred Tax Accounts Balance Sheet Account Deferred Tax Liabilities
Installment sales $ 6,000 credit Accounts receivable
Depreciation $12,000 credit Property, plant, and equipment
Deferred Tax Assets
Warranty costs $ 3,400 debit Warranty liability
Rent revenue $ 2,500 debit Unearned revenue Balance Sheet Presentation Current Current Noncurrent Noncurrent 74 The next slide presents an illustration that includes several temporary differences. Assume taxable income of $700,000 at a 30% tax rate. 75 Comprehensive Illustration Deferred Tax Asset 25,500
Income Tax Expense (plug) 194,500
Deferred Tax Liability 10,000
Taxes Payable 210,000 Continued 76 Current and Deferred Amounts on INCOME STATEMENT Taxes Payable (current) $210,000
Deferred Tax Asset (net)
($25,500 asset - $10,000 liability) 15,500
Income Tax Expense $194,500
|