C H A P T E R 19

C H A P T E R C H A P T E R 1919

ACCOUNTING FOR INCOME TAXESACCOUNTING FOR INCOME TAXES

Intermediate Accounting13th EditionKieso, Weygandt, and Warfield

Fundamental Differences between Financial and Tax

Reporting

4

Background• Deferral approach to tax allocation

(APB Opinion 11)– Income tax expense = amount of taxes that

would be paid if income statement numbers appeared on the current year's tax return.

• Deferred taxes was the plug figure (difference between taxes payable and tax expense).

• The effect of subsequent changes in tax rates on deferred tax account were essentially ignored.

Matching Approach

5

Background

• A method that was proposed theoretically (but has never been GAAP in US)– Assets and liabilities would be recorded NET of

any deferred tax related to the item

Net-of-Tax Approach

6

Background

• Liability approach to tax allocation (FASB 96, 109)– Income tax expense = taxes currently payable

plus change in deferred taxes. • If tax rates change, the effect on deferred tax

amounts affect income tax expense in the year the change is enacted.

• If there are no changes in tax rates, income tax expense should be approximately the same as under APB Opinion 11. Asset/Liability

Measurement Approach

7

Tax Code

Exchanges

Investors and Creditors

Financial Statements

Pretax Financial Income

GAAPIncome Tax Expense

Taxable Income

Income Tax Payable

Tax Return

vs.

Fundamentals of Accounting for Income Taxes

LO 1 Identify differences between pretax financial income and taxable income.

Illustration: KRC, Inc. reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations. For tax purposes, KRC reported the same expenses to the IRS in each of the years. KRC reported taxable revenues of $100,000 in 2010, $150,000 in 2011, and $140,000 in 2012. What is the effect on the accounts of reporting different amounts of revenue for GAAP versus tax?


Fundamentals of Accounting for Income Fundamentals of Accounting for Income TaxesTaxes

RevenuesExpensesPretax financial income

Income tax expense (40%)

$130,00060,000

$70,000

$28,000

$130,000

2011

60,000$70,000

$28,000

$130,000

2012

60,000$70,000

$28,000

$390,000

Total

180,000$210,000

$84,000

GAAP ReportingGAAP Reporting

RevenuesExpensesPretax financial income

Income tax payable (40%)

$100,0002010

60,000$40,000

$16,000

$150,0002011

60,000$90,000

$36,000

$140,0002012

60,000$80,000

$32,000

$390,000Total

180,000$210,000

$84,000

Tax Reporting

2010


Book vs. Tax DifferenceBook vs. Tax DifferenceIllustration 19-2

Illustration 19-3

Income tax expense (GAAP)Income tax payable (IRS)Difference

$28,00016,000

$12,000

$28,000

2011

36,000$(8,000)

$28,000

2012

32,000$(4,000)

$84,000

Total

84,000$0

ComparisonComparison 2010

Are the differences accounted for in the financial statements?Year Reporting Requirement201020112012

Deferred tax liability account increased to $12,000Deferred tax liability account reduced by $8,000Deferred tax liability account reduced by $4,000

YesYes


Book vs. Tax DifferenceBook vs. Tax DifferenceIllustration 19-4

Balance Sheet

Assets:

Liabilities:

Equity:Income tax expense Income tax expense 28,00028,000

Income Statement

Revenues:

Expenses:

Net income (loss)

2010 2010

DeferredDeferred taxes taxes 12,00012,000

Where does the “deferred tax liability” get reported in the financial statements?

Income tax payable Income tax payable 16,00016,000


Financial Reporting for 2010 – Chelsea Financial Reporting for 2010 – Chelsea Inc.Inc.

12

A Temporary Difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years.

Future Taxable Amounts

Future Deductible AmountsDeferred Tax Liability

represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year.

Deferred Tax Asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year.

Illustration 19-22 Examples of Temporary Differences

LO 2 Describe a temporary difference that results in future taxable amounts.

Temporary Differences


Future Taxable Amounts and Deferred Future Taxable Amounts and Deferred TaxesTaxes

Illustration: In Chelsea’s situation, the only difference between the book basis and tax basis of the assets and liabilities relates to accounts receivable that arose from revenue recognized for book purposes. Chelsea reports accounts receivable at $30,000 in the December 31, 2010, GAAP-basis balance sheet. However, the receivables have a zero tax basis.

Illustration 19-5



KRC assumes that it will collect the accounts receivable and report the $30,000 collection as taxable revenues in future tax returns. KRC does this by recording a deferred tax liability.

Illustration 19-6

Illustration: Reversal of Temporary Difference, Chelsea Inc.



A deferred tax liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year.

Deferred Tax Liability – Chelsea Inc.

Income tax expense (GAAP)Income tax payable (IRS)Difference

$28,00016,000

$12,000

$28,000

2011

36,000$(8,000)

$28,000

2012

32,000$(4,000)

$84,000

Total

84,000$0

2010Illustration 19-4



Illustration: Because it is the first year of operations for KRC, there is no deferred tax liability at the beginning of the year. KRC computes the income tax expense for 2010 as follows:


Illustration 19-9



Illustration: Chelsea Inc. makes the following entry at the end of 2010 to record income taxes.

Deferred Tax Liability

Income Tax Expense 28,000Income Tax Payable

16,000Deferred Tax Liability

12,000



Illustration: Computation of Income Tax Expense for 2011.


Illustration 19-10



Illustration: Chelsea Inc. makes the following entry at the end of 2011 to record income taxes.

Deferred Tax Liability

Income Tax Expense 28,000Deferred Tax Liability 8,000

Income Tax Payable 36,000

20

E19-1 South Carolina Corporation has one temporary difference at the end of 2007 that will reverse and cause taxable amounts of $55,000 in 2008, $60,000 in 2009, and $65,000 in 2010. South Carolina’s pretax financial income for 2007 is $300,000, and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2007.

Instructionsa) Compute taxable income and income taxes payable for

2007.b) Prepare the journal entry to record income tax expense,

deferred income taxes, and income taxes payable for 2007.

South Carolina Corporation

21

South Carolina CorporationEx. 19- 1 Current Yr.INCOME: 2007 2008 2009 2010Financial income (GAAP)Temporary Diff .Taxable income (IRS)

Tax rateIncome tax

b. Income tax expense (plug)Income tax payableDeferred tax liability

a.a.

a.a.

22LO 2 Describe a temporary difference that results in future taxable amounts.

South Carolina Corp. (Solution)Ex. 19- 1 Current Yr.I NCOME: 2007 2008 2009 2010Financial income (GAAP) 300,000 Temporary Diff . (180,000) 55,000 60,000 65,000 Taxable income (I RS) 120,000 55,000 60,000 65,000

Tax rate 30% 30% 30% 30%I ncome tax 36,000 16,500 18,000 19,500

b. I ncome tax expense (plug) 90,000 I ncome tax payable 36,000 Deferred tax liability 54,000

a.a.

a.a.

23

Columbia Corporation has one temporary difference at the end of 2007 that will reverse and cause deductible amounts of $50,000 in 2008, $65,000 in 2009, and $40,000 in 2010. Columbia’s pretax financial income for 2007 is $200,000 and the tax rate is 34% for all years. There are no deferred taxes at the beginning of 2007. Columbia expects to be profitable in the future. Instructions

a) Compute taxable income and income taxes payable for 2007.

b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.

Columbia Corporation

24

Columbia Corp. Current Yr.INCOME: 2007 2008 2009 2010Financial income (GAAP)Temporary Diff .Taxable income (IRS)

Tax rateIncome tax

b. Income tax expenseIncome tax payableDeferred tax asset

Columbia Corporation

a.a.

a.a.

Income tax payable or refundable

LO 5 Describe the presentation of income tax expense in the income statement.

Income Statement PresentationIncome Statement Presentation

Change in deferred income tax

Income tax expense or benefit

++-- ==

In the income statement or in the notes to the financial statements, a company should disclose the significant components of income tax expense (current and deferred).

Formula to Compute Income Tax Expense Illustration 19-20

LO 5 Describe the presentation of income tax expense in the income statement.

Income Statement PresentationIncome Statement Presentation

Given the previous information related to KRC Inc., KRC reports its income statement as follows.

Illustration 19-21

Temporary Differences (1)• Revenues and gains, recognized in

financial income, are later taxed for income tax purposes.– Installment sales

• Expenses and losses are deducted for income tax purposes before they are recognized in financial income.– MACRS depreciation– Goodwill deduction on tax return

Called “taxable temporary differences”

• Revenues and gains are taxed for income tax purposes before they are recognized in financial income.– Subscription revenue – Prepaid rent

• Expenses and losses, recognized in financial income, are later deducted for income tax purposes.– Warranty expense

Called “deductible temporary differences”

Temporary Differences (2)

TransactionWhen 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

Summary of Temporary Differences

30

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

Permanent DifferencesPermanent Differences

31

Permanent Differences: Examples

• Items, recognized for financial accounting purposes, but not for income tax purposes:– Interest revenue on Municipal Bonds– Life insurance premiums and proceeds when corporation is

beneficiary– Fines and penalties

• Items, recognized for tax purposes, but not for financial accounting purposes:– Dividend exclusion– Statutory depletion

Deferred Tax Asset & Deferred Tax Liability:

Sources• Deferred taxes may be a:

– Deferred tax liability, or– Deferred tax asset

• Deferred tax liability arises due to net taxable amounts in the future.

• Deferred tax asset arises due to net deductible amounts in the future.

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

Journal entry: Income Tax Expense $$

Allowance to ReduceDeferred Tax Asset toExpected Realizable Value $$

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

Valuation Allowance for Deferred Tax Assets

• Basic Rule: Apply the yearly tax rate to calculate deferred tax effects.– If future tax rates change: use the enacted tax rate

expected to apply in the future year.– If new rates are not yet enacted into law for future

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

average tax rate [based on graduated tax brackets].

What Tax Rate to Apply

Let’s do an example• Second Best Company

– Working paper style – working paper blank will be provided on Exam 2

35

• The deferred tax classification relates to its underlying asset or liability.– Classify the deferred tax amounts as current or

non-current.• Presentation is

– NET amount related to current items• If DR>CR, current deferred tax asset• If DR<CR, current deferred tax liability

– NET amount related to noncurrent items • If DR>CR, noncurrent deferred tax asset• If DR<CR, noncurrent deferred tax liability

Balance Sheet Presentation

38

Net operating loss is tax terminology.A net operating loss occurs when tax deductions for a year exceed taxable revenues.

Net loss or operating loss is a financial accounting term.

Net Operating Loss (NOL)

39

NOL Rule (subject to change)

• NOL for each tax year is computed.• The NOL of one year can be applied to

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

• Current rule: NOLs can be:– carried back 2 years and carried forward

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

only)

40

2001 2002 2003 2004 2005 2006 2007

NOL2004

Tax years

Apply first

next

Loss carryforward20 years forward

Expect tax refund

hereRecord all

tax effects here

Expecttax

shieldhere

NOL Carryback

41

2001 2002 2003 2004 2053 2006 2007

NOL2004

Tax years

Loss carryforward20 years forward

Record alltax effects here

Expecttax

shieldhere

Forgo 2year rule

NOL Carryforward

42

Zoop Inc. incurred a net operating loss of $500,000 in 2007. Taxable income was $200,000 for 2005 and $200,000 for 2006. The tax rate for all years is 40%. Zoop elects the carryback option. Prepare the journal entries to record the benefits of the loss carryback and the loss carryforward.

Zoop Inc. (NOL)

LO 8 Apply accounting procedures for a loss carryback and a loss carryforward.

43

Zoop Inc. (NOL)Zoop Inc. 2005 2006 2007 2008Financial incomeDiff erenceTaxable income (loss)RateIncome tax

NOL ScheduleTaxable incomeCarryback from 2007Taxable income RateIncome tax (revised)

Refund

44

Zoop Inc. (NOL) - SolutionZoop Inc. 2005 2006 2007 2008Financial income 200,000$ 200,000$ Diff erenceTaxable income (loss) 200,000 200,000 (500,000) Rate 40% 40% 40%Income tax 80,000$ 80,000$

NOL ScheduleTaxable income 200,000$ 200,000$ (500,000) Carryback from 2007 (200,000) (200,000) 400,000 Taxable income - - (100,000) Rate 40% 40% 40%Income tax (revised) -$ -$ (40,000)

Refund 80,000$ 80,000$

$160,000$160,000 Deferred Tax AssetDeferred Tax Asset

45

Zoop’s Journal Entries for 2007I ncome tax refund receivable 160,000

Benefit due to loss carryback 160,000

Deferred tax asset 40,000 Benefit due to loss carryforward 40,000

Zoop Inc. (NOL) - Solution


46

Now assume that it is more likely than not that the entire net operating loss carryforward will not be realized by Zoop Inc. in future years. Prepare all the journal entries necessary at the end of 2007.

Zoop Inc. (Variation)


47

Zoop Inc. - Journal Entries for 2007I ncome tax refund receivable 160,000


Deferred tax asset 40,000 Benefit due to loss carryforward 40,000

Benefit due to loss carryforward 40,000 Allowance for deferred tax asset 40,000

Zoop Inc. (Variation) - Solution

48

Whether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period.

Valuation Allowance Revisited

Text Illustration 19-37 Possible Sources of Taxable Income

If any one of these sources is sufficient to support a conclusion that a valuation allowance is unnecessary, a company need not consider other sources.Text Illustration 19-38 Evidence to Consider in Evaluating the need for a Valuation Account

49

Valis Corporation had the following tax information.

Valis Corporation (NOL)

LO 8 Apply procedures for a loss carryback and a loss carryforward.

Taxable Tax TaxesYear I ncome Rate Paid2004 300,000$ 35% 105,000$ 2005 325,000 30% 97,500 2006 400,000 30% 120,000

In 2007 Valis suffered a net operating loss of $450,000, which it elected to carry back. The 2007 enacted tax rate is 29%. Prepare Valis’s entry to record the effect of the loss carryback.

50

Valis Corporation – Solution (NOL)

Valis Corp. 2004 2005 2006 2007Financial incomeDiff erenceTaxable income (loss)RateIncome tax

NOL ScheduleTaxable incomeCarryback from 2007Taxable income RateIncome tax (revised)

Refund

51

Valis Corp - Journal Entry for 2007I ncome tax refund receivable 135,000


Valis Corporation – Solution (NOL)

At the end of 2002, the corporate tax rate is changed from 40% to 35%. The new rate is effective January 1, 2004.The deferred tax account (1/1/2002) is as follows:

Excess tax depreciation: $3 million Deferred tax liability: $1.2 million

Related taxable amounts are expected to occur equally over 2003, 2004, and 2005.

Provide the journal entry to reflect the change.

Example: Revision of Future Tax Rate

The deferred tax liability end of 2005 is as follows: 2003 2004 2005Future tax inc $1,000,000 1,000,000 1,000,000Tax rate 40% 35% 35%Deferred tax $400,000 350,000 350,000liability Entry:

Deferred Tax Liability $100,000 Income Tax Expense $100,000*

*$1,200,000 – $1,100,000

Example: Revision of Future Tax Rate

Income tax expense, is allocated to:• Continuing operations• Discontinued operations• Extraordinary items• Prior period adjustments• Other comprehensive income

Disclose other significant components, such as:

• current tax expense, • deferred tax expense/benefit, etc.

Intraperiod Tax Allocation

} Income Statement

55

Other Items Affected• Comprehensive income items

– Holding gain/loss on AFS securities– Certain gains/losses related to foreign currency

and derivatives– Pension & post-retirement benefit amounts not yet

recognized on income statement• Correction of error/change in accounting

principle that affects beginning retained earnings

• Expenses for employee stock-based compensation

• Existing deferred amounts in quasi-reorganization

Special Reporting Issues

LO LO 66

EPS

Divide by weighted-average shares outstanding

ReviewReview of the Asset-Liability of the Asset-Liability MethodMethodCompanies apply the following basic principles:

(1) Recognize a current tax liability or asset for the estimated taxes payable or refundable.

(2) Recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards using enacted tax rate.

(3) Base the measurement of current and deferred taxes on provisions of the enacted tax law. Do not anticipate future changes in tax laws.

(4) Reduce the measurement of deferred tax assets (create allowance account), if necessary, by the amount of any tax benefits that, companies do not expect to realize.

Deferred Taxes

IAS 12 vs FAS 109

versus

US GAAP

• Enacted tax rates

Which Tax Rate to Use

• Enacted or substantively enacted tax rat

IFRS

US GAAP

• Use an allowance account to reduce to net realizable value

• Uses same “more likely than not” criteria

Deferred Tax Assets

• Don’t recognize at all unless it is “more likely than not” to be usable in the future

IFRS

US GAAP

• Current items netted

• Noncurrent items netted

Balance Sheet Presentation

• Always is noncurrent

• Plans to revise to do it the FASB way

IFRS

The classification of deferred taxes under iGAAP is always noncurrent.

Under iGAAP, an affirmative judgment approach is used, by which a deferred tax asset is recognized up to the amount that is probable to be realized. U.S. GAAP uses an impairment approach.

iGAAP uses the enacted tax rate or substantially enacted tax rate. (“Substantially enacted” means virtually certain.) For U.S. GAAP, the enacted tax rate must be used.

The tax effects related to certain items are reported in equity under iGAAP. That is not the case under U.S. GAAP, which charges or credits the tax effects to income.

U.S. GAAP requires companies to assess the likelihood of uncertain tax positions being sustainable upon audit. Potential liabilities must be accrued and disclosed if the position is “more likely than not” to be disallowed. Under iGAAP, all potential liabilities must be recognized. With respect to measurement, iGAAP uses an expected-value approach to measure the tax liability, which differs from U.S. GAAP.

Essential Knowledge• Be able to tell a permanent difference from

a temporary difference• Know the impact of temporary differences:

– Is it a future deductible item?– Is it a future taxable item?

• Textbook Illustrations 19-22 & 19-24:– If all else fails, memorize!– I’ll also provide a “study guide” for Exam 2

64

65

Do the following generate: • Future Deductible Amount = Deferred Tax Asset• Future Taxable Amount = Deferred Tax Liability• A Permanent Difference

1. The MACRS depreciation system is used for tax purposes, and the straight-line depreciation method is used for financial reporting purposes.2. A landlord collects some rents in advance. Rents received are taxable in the period when they are received.

3. Expenses are incurred in obtaining tax-exempt income.

4. Costs of guarantees and warranties are estimated and accrued for financial reporting purposes.

Specific Differences

LO 6 Describe various temporary and permanent differences.

66

Do the following generate: • Future Deductible Amount = Deferred Tax Asset• Future Taxable Amount = Deferred Tax Liability• A Permanent Difference

5. Sales of investments are accounted for by the accrual method for financial reporting purposes and the installment method for tax purposes.6. Proceeds are received from a life insurance company because of the death of a key officer (the company carries a policy on key officers).

7. Estimated losses on pending lawsuits and claims are accrued for books. These losses are tax deductible in the period(s) when the related liabilities are settled..

Specific Differences

LO 6 Describe various temporary and permanent differences.

67

First Place Example• Go to Excel and work the problem

– Identify temporary and permanent differences

– Compute tax payable (or refund)– Compute change in deferred taxes and

income tax expense– Show where deferred tax will be reported

on the balance sheet

69

Zurich Company reports pretax financial income of $70,000 for 2007. The following items cause taxable income to be different than pretax financial income. (1) Depreciation on the tax return is greater than depreciation on the income statement by $16,000. (2) Rent collected on the tax return is greater than rent earned on the income statement by $22,000. (3) Fines for pollution appear as an expense of $11,000 on the income statement.

Zurich’s tax rate is 30% for all years, and the company expects to report taxable income in all future years. There are no deferred taxes at the beginning of 2007.

Instructions Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2007.

Review Problem

70

Review Problem – Abbreviated Working Paper

Current Yr. Deferred DeferredINCOME: 2007 Asset LiabilityFinancial income (GAAP)Permanent diffBook TITemp diffTemp diffTaxable income (IRS)

Tax rateIncome tax

Income tax expenseDeferred tax asset

Deferred tax liabilityIncome tax payable

C H A P T E R 19

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