Intermediate Accounting
Thomas H. Beechy
Schulich School of Business,
York University
Joan E. D. Conrod
Faculty of Management,
Dalhousie University
PowerPoint slides by:
Bruce W. MacLean,
Faculty of Management,
Dalhousie University
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16
Chapter 16
Accounting for Corporate
Income Taxes
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16
■
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Introduction
The amount of taxable income often
differs from the amount of pre-tax
net income reported for accounting purposes.
Intraperiod income tax allocation Disaggregate the single net
income tax amount and report it in the appropriate sections of
the financial statements with related gains and losses.
Interperiod tax allocation The accounting carrying values of
assets and liabilities may be different than from their tax
bases. Recognize these differences by basing income
expense on the accounting values. Future income tax assets
or liabilities may result from temporary timing differences.
Accounting for loss carry forward or back.
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16
Provision Or Expense?
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■
In the income statement, we always are reporting the expense for
income taxes. However, it is very common in practice for
companies to label the income tax expense in the income
statement as Provision for Income Taxes.
Taxes This is a somewhat
confusing label because a provision usually is used for an
estimated liability, such as ‘Provision for Warranty Costs’ in the
liabilities section of a balance sheet.
The reason that companies use provision for the income tax
expense is that when the company has a loss for tax purposes, the
income statement entry for income taxes may be a credit rather
than a debit. Rather than switch the income statement label from
“expense” to “benefit”, companies use the vague term provision
to fit all circumstances.
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16
Interperiod Tax Allocation – Introduction
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A company adopts those accounting policies that management
perceives will best satisfy the objectives of the financial statement
users and preparers
preparers.
One general objective is to measure net income, which usually is
the result of many accruals and interperiod allocations.
In contrast, the objective of the Income Tax Act and Regulations
is to generate revenue for the government.
Because it is easier and more objective to assess taxes when cash
is flowing, tax policy generally includes revenues and expenses in
taxable income on the basis of cash flows rather than accounting
allocations, with some important exceptions relating primarily to
inventories, capital assets, and multi-period earnings processes
(e.g., revenue from long term contracts).
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16
Differences Between Taxable And
Accounting Income
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The difference between taxable income and accounting income
arises from two types of sources: permanent differences and
temporary differences.
Permanent differences are items of revenue, expense, gains or
losses that are reported for accounting purposes but never enter
into the computation of taxable income. Permanent differences
also include those rare items that enter into taxable income but are
never included in accounting income.
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16
Timing Or Temporary Differences?
■
Temporary differences arise when the tax basis of an asset or
liability is different from its carrying value on the financial
statements. Alternatively, temporary differences can be viewed as
those components of accounting net income that do enter into the
computation of taxable income, but do so in a different period than
they are recognized for financial reporting.
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EXHIBIT 16-1
Examples of Permanent Differences and Temporary Differences
Temporary Differences
For accounting purposes
For tax purposes
■ Permanent Differences:
depreciation;
CC A
amortization
fo r capitalized
pment imm
ediate ded uction
•
dividends
receiveddevelo
by Canadian
corporations
from other
costs; taxable Canadian corporations
amortization fo r capitalized interest;
deducted when paid
•
equity in earnings of significantly-influenced investees
write-do wn of inven tories or investm ents loss recognized only when realized
25%
of capital
gains valued at when realized
gains• and
losses
o n inventories
•
golf
clubincom
duese recognized at
installm
ent sales
when cash received
tim e•of sale;
50% of meals and entertainment expenses
bad deb t exp enses recognized in year of
when uncollectible
•
interest and penalties on taxes
percentage-of-com pletion accoun ting for comp leted con tract reporting (for
•
political contributions
contracts;
contracts lasting no m ore than two
warranty costs accrued in period of sale;
bond discount or prem ium, am ortized
years)
tax deductible when incurred
realized only when the prin ciple is settled
at matu rity
16
Conceptual Issues In Interperiod Tax
Allocation
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■
The objective of comprehensive interperiod income tax
allocation is to recognize the income tax effect of every item when
that item is recognized in accounting net income. Alternatives to
comprehensive allocation are the flow-through method and
partial allocation.
allocation
When the item of revenue, expense, gain or loss first enters the
calculation of either taxable income or accounting income, it is an
originating temporary difference.
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Extend Of Allocation
■
Extent of allocation refers to the range of temporary differences to which
interperiod tax allocation is applied. The three basic options are:
✜
✜
✜
■
■
■
No allocation: the flow-through method
Full allocation: the comprehensive method
Partial allocation
The flow-through method recognizes the amount of taxes assessed in
each year as the income tax expense for that year: income tax expense =
current income tax.
Comprehensive allocation is the opposite extreme: the tax effects of all
temporary differences are allocated, regardless of the timing or likelihood
of their reversal.
Partial allocation actually is a ‘family’ of alternatives that falls between
the two extremes of no allocation and full allocation. Under partial
allocation, interperiod income tax allocation is applied to some types of
temporary differences but not to all.
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16
Measurement Method
■
When the effects of temporary differences are measured,
should the tax rate be:
1 the rate in effect at the time that the temporary difference first
arises, or
2 the rate that is expected to be in effect when the temporary
difference reverses?
This is the measurement method issue.
Timing
+100,000 +50,000
-30,000
Difference
2 Y%
X%
Rate X%
1 X%
■
2000
2001
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2002
-80,000
Y%
2003
2004
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Discounting
■
If the deferred tax balances are discounted, interest is imputed on
the balance each year, using the same rate as was used for
discounting. The income tax expense on the income statement
would therefore include:
– the discounted present value of the future tax impact of
temporary differences that originated in the current period,
– plus interest on the balance at the beginning of the year,
– plus or minus adjustments to the ending balance for tax rate
increases or decreases,
– less drawdowns that occurred during the current period due to
reversal of the temporary difference.
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16
■
■
■
■
■
Effective Tax Rate
One objective of interperiod income tax allocation is to reflect in net
income the effective tax rate that the corporation is paying.
The effective tax rate as the ratio of the income tax expense
(including the tax expense relating to temporary differences) divided
by the pretax net income.
Financial analysts often calculate the effective tax rate as the ratio of
current income taxes (that is, without including the tax expense or
benefit related to temporary differences) to pretax net income.
However, the CICA Handbook speaks of the “income tax rate”
[CICA 3465.92(c)] in a context that includes the effects of temporary
differences,
The CICA Handbook requires that public companies provide a
reconciliation between the effective and statutory rate.
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16
■
■
■
Future Income Tax Assets
Future income taxes are not discounted.
Future income tax assets and liabilities are classified as
current assets/liabilities if the temporary differences relate to
current assets or liabilities. Future income tax balances that
relate to long-term assets and liabilities are reported
separately from other long-term assets and liabilities.
Future income tax assets arise from:
– Write-downs of inventory or other assets for accounting purposes,
tax deduction at the time of sale
– Deferred executive compensation treated as an expense for
accounting purposes, tax deduction when paid
– Warranty costs estimated and charged to income at the time of sale
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16
■
Balance Sheet Presentation
Within each classification of current and non-current, future
income tax balances relating to different items are netted
and reported as a single amount. Current and non-current
future tax liability balances may not be netted against each
other. Future income tax assets and liabilities that arise due
to differing tax and accounting treatments for the following
assets and liabilities will be classified as current.
–
–
–
–
Installment notes receivable
inventories
warranty liabilities
accrued liabilities
allowance for doubtful accounts
accrued receivables
notes payable
temporary investments
– This classification does not depend upon the period of reversal.
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EXHIBIT 16-2 Mirage Ltd.
Income Tax Allocation, Liability Method
(Income Statement Approach)
Net income, before tax
Permanent differences:
Intercorporate dividends
Golf club dues
Accounting income subject to tax
Timing differences:
Warranty expense
Warranty claims paid
Depreciation
Capital cost allowance (CCA)
Taxable income
Enacted tax rate
Current taxes payable
20x1
$ 825,000
20x2
$ 900,000
20x3
$ 725,000
–150,000
+25,000
$ 700,000
–100,000
0
$ 800,000
–125,000
0
$ 600,000
+150,000
–100,000
+200,000
–140,000
+160,000
–230,000
+200,000
–300,000
+200,000
–240,000
+200,000
–180,000
$ 650,000
$ 820,000
$ 550,000
40%
44%
45%
$ 260,000
$ 360,800
$ 247,500
16
Extended Illustration – Income Statement
Approach
■
Bear in mind that, under the liability method, the balance in the future income tax
account (on the balance sheet) at the end of any reporting period must be equal to
the accumulated temporary differences times the enacted tax rate. Therefore, if we
simply keep track of the accumulated temporary differences, we can easily derive
the correct ending balance of the future income tax accounts. The approach is the
same three-step process that we commonly use to make adjusting journal entries:
– This not quite the case if there are different enacted rates for two or more
future years; in that case, the reversals must be forecasted and the appropriate
rate used for each part of the balance.
– calculate the correct ending balance by multiplying the accumulated end-ofperiod temporary differences by the enacted tax rate;
– subtract the recorded beginning balance from the calculated ending balance;
and
– record an adjustment for the difference,
difference to bring the recorded balance up (or
down) to equal the calculated ending balance.
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Extended Illustration – Balance Sheet
Approach
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■
The advocates of the liability approach often argue that we should
be looking at the balance sheet instead of the income statement.
Indeed, temporary differences are defined in the CICA Handbook
by the differences between tax bases and balance sheet carrying
values.
Because the balance sheet approach may be a little more difficult
to conceptualize than the income statement approach, we
considered the income statement approach first.
However, we also must understand the balance sheet approach,
especially since this is the approach cited in the CICA Handbook.
Handbook
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EXHIBIT 16-5
Effective Tax Rate Disclosure,
Ipsco Inc., 1995
12. Income Taxes
Income tax expense differs from the amount computed by
applying the corporate income tax rates (Canadian Federal and
Provincial) to income before income taxes. The reason for this
difference is as follows:
Co rporate incom e tax rate
Pro visio n for incom e taxes based on corp orate in com e
tax rate
In crease (d ecrease) in taxes resultin g fro m
Manufacturing and processing pro fit
Large corporatio n tax
In com e taxed at d ifferent rates in foreign ju risdictio ns
Other
1995
45.1%
$53,649
199 4
43.8%
$37,845
199 3
43.8%
$20,529
(7,055)
(87)
(9,595)
362
$37,274
(5,555)
174
(1,519)
752
$31,697
(2,068)
700
−
(988)
$18,173
16
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Exhibit 16-7
Effective Tax Rate Disclosure—Provigo Inc.
Note 5 Income Taxes
1998 1997
The company’s consolidated effective income tax rate is as follows:
Statutory income tax rate
38.5% 39.2%
Non deductible amortization and write off of goodwill
.4
.6
Non deductible loss in investments
4.7
Non taxable gain on sale of subsidiary
(4.5)
Non deductible provisions
4.6
Other
1.5
5.8
Effective income tax rate
35.9% 54.9%
The provision for income taxes consists of:
Current
36.7 54.2
Deferred
10.9
(6.9)
47.6 47.3
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Exhibit 16-8
Effective Tax Rate Disclosure—The Molson
Companies Limited
Cdn $ in thousends
Earnings before income taxes
Income taxes at Canadian statutory rates
(1998 42.8% 1997 41.9%)
Increased (Decreased) by the tax effect of:
Manufacturing and processing credits
Non-taxable amortization of deferred gain
Tax-paid investment and equity income
Non-deductible and other items
Total income tax provisions on earnings
from continuing operations
Comprised of:
Current portion
Deferred portion
■
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1998
$91,824
1997
$41,309
39,301
17,308
(7,010)
(2,611)
(673)
4,286
(402)
(2,621)
(2,014)
4,565
$33,293 $16,818
$11,283 $12,948
$22,010 $3,870
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Cash Flow Statement
■
■
■
The cash flow statement will include only the amounts of taxes actually
paid or received for the year.
year All allocations, whether for temporary
differences or for tax loss carry forwards, must be reversed out.
The impact of income tax accounting on the cash flow statement is clear: all
tax allocation amounts must be reversed out of transactions reported on the
cash flow statement. The cash flow statement must include only the actual
taxes paid.
When the indirect method of presentation is used for operating cash flow,
future tax assets and liabilities that have been credited (or charged) to
income must be subtracted from (or added back to) net income. The
reversals include both (1) allocations relating to temporary differences
and (2) benefits recognized for the future benefits of tax loss carry
forwards. When the direct method of presentation is used, the cash used for
forwards
(or provided by) income taxes must include only the taxes actually paid (or
payable) to the government and tax refunds actually received (or receivable)
from the government.
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Appendix : The Investment Tax Credit
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The investment tax credit (ITC) is a direct reduction of income taxes that is
granted to enterprises that invest in certain types of assets or in research
and development costs.
There are two possible approaches to accounting for ITCs: (1) the flowthrough approach, and (2) the cost-reduction approach.
The CICA Handbook recommends using the cost-reduction approach,
wherein the ITC is deducted from the expenditures that gave rise to the
ITC..
ITC on expenditures that are reported as current expenses are usually
deducted from income tax expense rather than from the functional
expense itself.
When qualifying expenditures are made to acquire an asset (including
deferred development costs), the ITC can either be (1) deducted from the
asset’s carrying value, with depreciation based on the net amount, or (2)
deferred separately and amortized on the same basis as the asset itself.
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