Accounting for Income Taxes Chapter 16 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Deferred Tax Assets and Deferred Tax Liabilities GAAP is the set of rules for preparing financial statements. Results in . . . Financial statement income tax expense. 16-2 The Internal Revenue Code is the set of rules for preparing tax returns. Results in . . . Usually. . . IRS income taxes payable. The objective of accounting for income taxes is to recognize a deferred tax liability or deferred tax asset 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. 16-3 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. 16-4 Deferred Tax Liabilities 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 Income tax payable Deferred tax liability 56 40 16 16-5 The FASB’s Balance Sheet Approach 16-6 Types of Temporary Differences Deferred tax assets result in deductible amounts in the future. Deferred tax liabilities result in taxable amounts in the future. 16-7 Deferred Tax Liabilities Calculate income tax that is currently payable: $92 × 40% = $36.8 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 Income tax payable Deferred tax liability 40.0 36.8 3.2 16-8 Deferred Tax Liabilities 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 16-9 Deferred Tax Liabilities Journal entry at the end of 2016 Income tax expense Deferred tax liability Income tax payable 40.0 6.8 46.8 16-10 Deferred Tax Assets 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 Income tax payable 28 12 40 16-11 Deferred Tax Assets Journal entry at the end of 2014 and 2015 Income tax expense Deferred tax asset Income tax payable 40 6 34 16-12 Permanent Differences Created when an income item is included in taxable income or accounting income but will never be included in the computation of the other. Example: Interest on tax-free municipal bonds is included in accounting income but is never included in taxable income. Permanent differences are disregarded when determining both the tax payable currently and the deferred tax asset or liability. 16-13 Tax Rate Considerations Deferred tax assets and liabilities should be determined using the future tax rates, if known. The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs. 16-14 Multiple Temporary Differences It would be unusual for any but a very small company to have only a single temporary difference in any given year. Categorize all temporary differences according to whether they create … Future taxable amounts Future deductible amounts 16-15 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 carryforward. Result: reduced tax payable. 16-16 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. 16-17 Operating Loss Carryforward Journal entry at the end of 2013 Deferred tax asset Income tax benefit-operating loss 50 50 16-18 Operating Loss Carryback The carryback of the NOL must be applied to the earlier year first and then to the next year. Any remaining NOL may be carried forward. 16-19 Operating Loss Carryback Journal entry at the end of 2013 Receivable—income tax refund Deferred tax asset Income tax benefit-operating loss 29 20 49 16-20 Balance Sheet Classification Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability. A deferred tax asset that is not related to a specific asset or liability should be classified according to when the underlying temporary difference is expected to reverse. 16-21 Disclosure Notes Deferred Tax Assets and Deferred Tax Liabilities • Total of all deferred tax liabilities. • Total of all deferred tax assets. • Total valuation allowance Income Tax Expense recognized. • Current portion of the tax • Net change in valuation account. expense (or benefit). • Approximate tax effect of each type • Deferred portion of the of temporary difference (and tax expense (or benefit) carryforward). with separate disclosures of amounts attributable to Operating Loss Carryforwards several specific items. • Amounts. • Expiration dates. Coping with Uncertainty in Income Taxes Two-step Decision Process Step 1. A tax benefit 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. 16-22 16-23 Intraperiod Tax Allocation Income Statement: • Income from continuing operations. • Discontinued operations. • Extraordinary items. Other Comprehensive Income: • Investments. • Postretirement benefit plans. • Derivatives. • Foreign currency translation. 16-24 End of Chapter 16