CHAPTER I ACCOUNTING FOR INCOME TAXES (IAS12) by Yoseph T (MSc) 1-1 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Describe the fundamentals of accounting for income taxes. 2. Identify the key concepts of income taxes 3. Distinguish the difference between taxable income and accounting income. 4. Determine the temporary and permanent taxable and deductible differences 5. Differentiate the tax base of an asset and a liability as well as other items. 6. Apply accounting for Deferred tax assets and liabilities, 7. Apply accounting for non-recognized income taxes and identify the effects of various tax rates on deferred income taxes 8. Apply accounting for net operating loss carry back and a loss carry forward. 9. Know the basic principles of asset-liability method 10. Identify the presentation and disclosure requirements related to income taxes 1-2 PREVIEW OF CHAPTER 1 1-3 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. Among different types of direct tax, income tax is the one which levied directly on income of persons or a companies whose earnings exceeds over their expenses incurred in carrying on the theirs operations.. The term income is used in tax accounting to represent the excess of revenues earned over the expenses incurred in carrying on the one‟s operations. IFRS requires an entity to recognize, at each reporting date, the tax consequences expected to arise in future periods in respect of: the recovery of its assets, settlement of its liabilities, and other transactions and events of current period recognized at that date. 1-4 LO 1 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. Objective of IAS12 The objective of this Standard is to prescribe the accounting treatment for income taxes. The principal issue in accounting for income taxes is how to account for the current and future tax consequences of: (a) The future recovery (settlement) of the carrying amount of assets (liabilities) that are recognized in an entity‟s statement of financial position; and (b) Transactions and other events of the current period that are recognized in an entity‟s financial statements. 1-5 LO 1 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. Objective of IAS12 This Standard requires an entity to account for the tax consequences of transactions and other events that the reporting entity expects to recover or settle the carrying amount of that asset or liability. If it is probable that recovery or settlement of that carrying amount will make future tax payments larger (smaller) than they would be if such recovery or settlement were to have no tax consequences, this Standard requires an entity to recognize a deferred tax liability (deferred tax asset), with certain limited exceptions. 1-6 LO 1 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. Objective of IAS12 This Standard also deals with; The recognition of deferred tax assets arising from unused tax losses or unused tax credits, The presentation of income taxes in the financial statements and The disclosure of information relating to income taxes. 1-7 LO 1 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. Scope of IAS12 IAS12 is applied to accounting for all income taxes, which includes all domestic and foreign taxes that are based on taxable profits, as well as withholding and other taxes that are payable by subsidiaries on distributions to the reporting entity. Government grants that are dealt with by IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, and investment tax credits are excluded from the application of this standard. However, the temporary differences that arise out of these grants and tax credits are considered. 1-8 LO 1 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. Scope of IAS12 Ethiopian context income taxes includes all taxes levied on taxable income. “Taxable Income" shall mean the amount of income subject to tax after deduction of all expenses and other deductible items allowed under Income Tax Proclamation No. 286/2002, its amendments, regulations, directives and related circulars. Excludes taxes that are not based on income tax. 1-9 LO 1 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. The main basis of accounting for income taxes is the recognition of the current and future tax consequences of: The transactions that are recognized in the current period and Future recovery of assets and settlement of liabilities in the entity‟s statement of financial position. It is also assumed that the entity will settle its liabilities and recover its assets over a period of time and that the consequences of tax will be determined at that point in time and These consequences can be estimated reliably and cannot be avoided. 1-10 LO 1 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. As a result the key objectives of IAS 12 are to prescribe the accounting treatment for income taxes liability and related disclosures addressing; The distinction between permanent and timing differences; The future recovery or settlement of the carrying amount of deferred tax assets or liabilities; and Recognizing and dealing with losses for income tax purposes. Examples Income taxes are; Domestic and foreign taxes levied on taxable income. Withholding and other taxes by a subsidiary, associate or joint arrangement on distributions to the reporting entity. Temporary differences rises from government grants& investment tax credits. 1-11 LO 1 Fundamentals of Accounting for Income Taxes LEARNING OBJECTIVE 1 Describe the fundamentals of accounting for income taxes. Income tax has the following features. a direct tax. Levied on definite sources. Calculated on a total amount known as taxable income. Can be both cash and in kind. Can be a temporary or permanent. Can be a lump sum or installments. Is levied if the taxable income exceeds the maximum taxable limit. The rates of income tax increases with an increase in the income. 1-12 LO 1 Key Concepts of Income Taxes LEARNING OBJECTIVE 2 Key concepts of income taxes. The following terms are the key concepts for income tax under IAS12; 1. Accounting profit(loss) is profit or loss for a period before deducting tax expense. 2. Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable (recoverable). 3. Tax expense(tax income) is the aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax. It is a combination of current tax expense (current tax income) and deferred tax expense (deferred tax income). 1-13 LO 2 Key Concepts of Income Taxes LEARNING OBJECTIVE 2 Key concepts of income taxes. The following terms are the key concepts for income tax under IAS12; 4. Current tax is the amount of income taxes payable (or recoverable) on the taxable profit (or tax loss) for the current period. Current tax is income taxes payable(current tax expense) or the amount of income taxes recoverable (current tax income) in respect of the tax loss for a period 5. Deferred taxes are income taxes which arises in one period but because of timing difference will have to be actually paid in later years. 1-14 LO 2 Key Concepts of Income Taxes LEARNING OBJECTIVE 2 key concepts of income taxes. Deferred taxes are the taxes applicable on the current taxable income, but not due for payment in the current period because of the difference in the tax amount reported in the accounting period (tax expenses and the tax amount reported by the local tax authorities (tax liability). The tax expense is determined under IFRS whereas; The tax liability is determined under Internal Revenue Code. So that deferred tax may be Deferred tax liability or Deferred tax assets. 1-15 LO 2 Key Concepts of Income Taxes LEARNING OBJECTIVE 2 Key concepts of income taxes. 6. Deferred tax liabilities are income taxes payable in future periods on taxable temporary differences arise as a result of capital expenditure being more rapid than the accounting depreciation treatment. Deferred tax liability- arises due to net taxable amounts in the future. 7. Deferred tax assets are the amounts of income taxes recoverable in future periods for: deductible temporary differences; the carry-forward of unused tax losses; and the carry-forward of unused tax credits. Deferred tax assets- arises due to net deductible amounts in the future. 1-16 LO2 Accounting Vs Taxable Income LEARNING OBJECTIVE 3 Pretax Vs taxable income . Because IFRS and tax regulations differ in a number of ways, frequently the amounts reported for the following will differ: Income tax expense (IFRS) Income taxes payable (Tax Authority) 1-17 LO 3 Accounting Vs Taxable Income LEARNING OBJECTIVE 3 Pretax Vs taxable income . Internal revenue code which governs the accounting for tax liability is not same as IFRS which governs financial reporting. As a result taxable income reported to IRS using cash basis of accounting may not be the same as pretax profit that is reported to shareholders using accrual basis of accounting. Likewise the amount of tax liability due to IRS may not be the same as income tax expense that is reported on the income statement. We, therefore, speak of book accounting income (income reported to shareholders) and taxable income (income reported o IRS). 1-18 LO 3 Accounting Vs Taxable Income LEARNING OBJECTIVE 3 Pretax Vs taxable income . That is there may be differences between these two incomes which can be temporary differences when the book income higher than tax income this year but lower in future years, so that cumulative profit will same for both or There may be permanent differences which will not reverse arises due to IFRS treating some items as income or expenses that IRS does not, such as municipal bond income that is treated as income under GAAPS/IFRS but not taxed by the IRS. Generally differences between accounting and taxable income arises due to; Differences in allowances of expenses in income tax acct. Provisions for bad/ doubt full debts. Charging depreciation and amortization Accrual basis Vs cash receipt basis and so on. 1-19 LO 3 Accounting Vs Taxable Income Example 1.1 Consider a company that depreciates its assets LEARNING OBJECTIVE 3 Pretax Vs taxable income . using SLM for financial reporting purposes and an accelerated method for tax purposes which is atypical for most companies. Assume that income before depreciation is $15,000, then the pretax (financial reporting) and taxable (IRS) income might be reported as follows. Pre-tax Taxable 15,000 15,000 Income before depreciation Depreciation expense 2,000 3,000 Pretax/taxable income 13,000 12,000 Here taxable income is lower than accounting income, however, over the life of the asset the same amount of dep‟n will be reported under both methods and as a result taxable income and tax liability will be higher in future years. 1-20 LO 3 Accounting Vs Taxable Income LEARNING OBJECTIVE 3 Pretax Vs taxable income . We know the first year of the asset‟s life that taxable income will be higher in future years when accelerated depreciation is less than straight-line. We also know that the company‟s tax liability will be higher as well. Since the future tax liability exists and computed its amount we need report in the company's SFP(this is essence of deferred tax). A deferred tax liability is accrued for the future tax liability(taxable income * firm‟s tax rate) and this liability will remain on SPF until taxable income is, in effect, higher and the tax liability is paid. It is now time to know the concepts of tax expense reported in the come statement which is sum of tax liability currently payable plus the change in the deferred tax liability: (TI*TR=TL, TL+∆DT=Income tax expense for FR). So if we have a deferred taxes, tax expense will not be equal to tax paid. 1-21 LO 3 Accounting Vs Taxable Income LEARNING OBJECTIVE 3 Pretax Vs taxable income . Example 1. 2 Chelsea, Inc. reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations. For tax purposes, Chelsea reported the same expenses to the tax authority in each of the years. Chelsea reported taxable revenues of $100,000 in 2019, $150,000 in 2020, and $140,000 in 2021. What is the effect on the accounts of reporting different amounts of revenue for IFRS versus tax? 1-22 LO 3 LEARNING OBJECTIVE 3 Pretax Vs taxable income . Accounting vsTaxable Differences IFRS Reporting 2019 2020 2021 Total Revenues $130,000 $130,000 $130,000 $390,000 Expenses 60,000 60,000 60,000 180,000 Pretax financial income $70,000 $70,000 $70,000 $210,000 Income tax expense (40%) $28,000 $28,000 $28,000 $84,000 2019 2020 2021 Total Tax Reporting Revenues $100,000 $150,000 $140,000 $390,000 Expenses 60,000 60,000 60,000 180,000 Taxable income $40,000 $90,000 $80,000 $210,000 Income taxes payable (40%) $16,000 $36,000 $32,000 $84,000 1-23 LO 3 LEARNING OBJECTIVE 3 Comparison of Income Tax Expense to Income Taxes Payable Book vs. Tax Differences Comparison 2019 2020 2021 Total Income tax expense (IFRS) $28,000 $28,000 $28,000 $84,000 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) Income tax expense (40%) $28,000 $28,000 $28,000 Income tax payable (TA) Are the differences accounted for in the financial statements? 1-24 Year Reporting Requirement 2019 Deferred tax liability account increased to $12,000 2020 Deferred tax liability account reduced by $8,000 2021 Deferred tax liability account reduced by $4,000 $0 $84,000 Yes LO 3 Financial Reporting for 2019 Statement of Financial Position Assets: Income Statement 2019 2019 Revenues: Expenses: Liabilities: Deferred taxes Equity: 12,000 Income tax expense 28,000 Net income (loss) Where does the “deferred tax liability” get reported in the financial statements? 1-25 LO 3 Temporary Vs Permanent Differences LEARNING OBJECTIVE 4 Temporary vs permanent d/ces As we have seen above there are differences between carrying/book amount set by IFRS of an asset or liability and its tax base set by IRS reported in the financial statements that will result in taxable amounts(Deferred Tax Liability) or deductible amounts(Deferred Tax Assets)- in future years. Some of these differences are temporary and can reverse over time. Others are permanent and do not reverse. Temporary differences are differences between carrying/book amount of an asset and liability in the SFP and its tax base. Carrying amount: The amount attributed to that asset or liability as per IFRS. Temporary differences are differences between TI and AI for a period that originate in one period are capable of reversal in one or more subsequent period that will result in taxable amounts or deductible amounts in future years. 1-26 LO 4 Temporary Vs Permanent Differences LEARNING OBJECTIVE 4 Temporary vs permanent d/ces Deferred Tax Liability - is the deferred tax consequences attributable to taxable temporary differences. In other words, 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 Assets- is the deferred tax consequence attributable to deductible temporary differences. In other words, a 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. 1-27 LO 4 Temporary Vs Permanent Differences LEARNING OBJECTIVE4 Temporary Vs permanent Differences The difference between deferred tax liability and deferred tax asset Deferred Tax Liability Deferred Tax Asset 1. Accounting income is higher than 1. Accounting income is lower than taxable income. 2. The carrying amount of an asset is higher than the tax base. 3. The carrying amount of a liability is lower than the tax base. taxable income. 2. The carrying amount of the asset is lower than the tax base. 3. The carrying amount of a liability is higher than the tax base. 4. Expenses and losses deductible for 4. Revenues and gains included in accounting income but are taxable in the future periods. 1-28 tax purposes in the current period but also deductible for accounting purposes in future periods. LO 4 Examples of Temporary Differences LEARNING OBJECTIVE 4 Temporary Vs Permanent Differences Revenues or gains are taxable after they are recognized in financial income. An asset (e.g., accounts receivable or investment) may be recognized for revenues or gains that will result in taxable amounts in future years when the asset is recovered. Examples: 1. Sales accounted for on the accrual basis for financial reporting purposes and on the installment (cash) basis for tax purposes. 2. Contracts accounted for under the percentage-of-completion method for financial reporting purposes and the cost-recovery method (zero-profit method) for tax purposes. 3. Investments accounted for under the equity method for financial reporting purposes and under the cost method for tax purposes. 4. Gain on involuntary conversion of non-monetary asset which is recognized for financial reporting purposes but deferred for tax purposes. 5. Unrealized holding gains for financial reporting purposes (including use of the fair 1-29value option) but deferred for tax purposes. LO 2 Examples of Temporary Differences LEARNING OBJECTIVE 4 Temporary Vs Permanent Differences Expenses or losses are deductible after they are recognized in financial income. A liability (or contra asset) may be recognized for expenses or losses that will result in deductible amounts in future years when the liability is settled. Examples: 1. Product warranty liabilities. 2. Estimated liabilities related to discontinued operations or restructurings. 3. Litigation accruals. 4. Bad debt expense recognized using the allowance method for financial reporting purposes; direct write-off method used for tax purposes. 5. Share-based compensation expense. 6. Unrealized holding losses for financial reporting purposes (including use of the fair value option), but deferred for tax purposes. 1-30 LO 4 Examples of Temporary Differences LEARNING OBJECTIVE 4 Temporary Vs Permanent Differences Revenues or gains are taxable before they are recognized in financial income. A liability may be recognized for an advance payment for goods or services to be provided in future years. For tax purposes, the advance payment is included in taxable income upon the receipt of cash. Future sacrifices to provide goods or services (or future refunds to those who cancel their orders) that settle the liability will result in deductible amounts in future years. Examples: 1. Subscriptions received in advance. 2. Advance rental receipts. 3. Sales and leasebacks for financial reporting purposes (income deferral) but reported as sales for tax purposes. 4. Prepaid contracts and royalties received in advance. 1-31 LO 4 Examples of Temporary Differences LEARNING OBJECTIVE 4 Temporary Vs Permanent Differences Expenses or losses are deductible before they are recognized in financial income. The cost of an asset may have been deducted for tax purposes faster than it was expensed for financial reporting purposes. Amounts received upon future recovery of the amount of the asset for financial reporting (through use or sale) will exceed the remaining tax basis of the asset and thereby result in taxable amounts in future years. Examples: 1. Depreciable property, depletable resources, and intangibles. 2. Deductible pension funding exceeding expense. 3. Prepaid expenses that are deducted on the tax return in the period paid. 4. Development costs that are deducted on the tax return in the period paid. 1-32 LO 4 Summary of Temporary Differences LEARNING OBJECTIVE4 Temporary Vs Permanent Differences Revenues or gains are taxable after they are recognized in financial income. Expenses or losses are deductible after they are recognized in financial income. Revenues or gains are taxable before they are recognized in financial income. Expenses or losses are deductible before they are recognized in financial income. 1-33 LO 4 Temporary Vs Permanent Differences LEARNING OBJECTIVE 4 Temporary Vs permanent Differences Permanent Differences(PD) are substantive differences between TI & AI for the period that originate in period and do not reverse subsequently and will appear every time such as; Items are recognized for financial reporting purposes but not for tax purposes. Examples: 1. Interest received on tax exempt securities/on certain types of government obligations/. 2. Expenses incurred in obtaining tax-exempt income. 3. Tax penalties, surcharges, fines and expenses resulting from a violation of law. 4. Charitable donations recognized as expense but sometimes not deductible for tax purposes. 5. Life insurance premium. Items are recognized for tax purposes but not for financial reporting purposes. Examples: 1. “Percentage depletion” of natural resources in excess of their cost. 2. Tax -exempt dividend received from other corporations and etc. 1-34 LO 2 Temporary Vs Permanent Differences LEARNING OBJECTIVE 4 Temporary Vs permanent Differences Permanent Differences are specific differences pertain to non-taxable revenue and nondeductible expenses; Result from items that ► enter into pretax financial income but never into taxable income or ► enter into taxable income but never into pretax financial income. Affect only the period in which they occur. Do not give rise to future taxable or deductible amounts. There are no deferred tax consequences to be recognized. 1-35 LO 4 Summary of Permanent Differences LEARNING OBJECTIVE4 Temporary Vs Permanent Differences Items recognized for financial accounting purposes, but not for tax purposes Items recognized for tax purposes, but not for financial accounting purposes 1-36 LO 4 Tax base of An asset Vs A liability LEARNING OBJECTIVE5 Differentiate items‟ tax base Before going to see accounting treatment on both temporary and permanent differences it is better to know what is a tax base of an asset and a liability as well as tax base of other items. The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes. The Tax Base of an Asset Is the amount deductible for tax purposes against any taxable economic benefits that will flow to the entity as it recovers the carrying amount of the asset through use or sale. 1-37 The Tax Base of a liability Is an amount taxable for tax purposes in respect of the tax liability in future periods. LO 5 The Tax Base For An Asset Vs A Liability Examples LEARNING OBJECTIVE5 Differentiate items‟ tax base Certain assets give the rise to tax liability i.e. trade receivables; Trade receivables(asset) ----------xx Income (income statement) ---------- xx Income * current tax rate= tax liability; Tax expense------------xx Tax liability ------------------xx If the item is not taxed in the year of recognition, but in later years, the tax liability is deferred causing a taxable temporary differences, and These temporary differences reverse when the tax liability becomes due and is recognized as a current tax expense for that period. 1-38 LO 5 The Tax Base For An Asset Vs A Liability Examples Cont. LEARNING OBJECTIVE5 Differentiate items tax base Certain liability give the rise to decrease tax liability or a tax asset i.e. accrued expenses; Accrued expenses ------------xx Accrued liability -----------------xx Expense * current tax rate= deduction in tax liability; Tax liability -----------------xx Tax expenses ----------------xx If the tax asset is not deductible in the year of recognition, but in later years, the tax asset is deferred causing a deductible temporary differences, and reverse when the tax liability is reduced or a tax claim is made. 1-39 LO 5 The Tax Base For An Asset Vs A Liability Examples Cont. LEARNING OBJECTIVE5 Differentiate items‟ tax base In summary tax base of an asset is the tax deductible against taxable income at the time when the carrying amount of the asset is recovered. If income at that time is not taxable, then the carrying amount=tax base (no tax liability);examples Dividend receivable that are not taxable; Loan receivable with no tax consequences on repayment. Tax written down value of a machine. 1-40 LO 5 The Tax Base For An Asset Vs A Liability Examples Cont. LEARNING OBJECTIVE5 Differentiate items‟ tax base Tax base of a liability: carrying amount(CA) - amount deductible for tax in future periods(TDfp) Example accrued expense $100 1. Deduct against taxable income when cash paid (future periods) CA-TDfp= null; 100-100= null 2. Deduct against taxable income in current year CA-TDfp= 100; 100-0= 100 3. Accrued disallowed expenses(not tax deductible eg fines &penalties) CA-TDfp =CA; CA-0=CA 4. Loans repayment have no tax consequences therefore; CA-0= CA. 1-41 LO 5 The Tax Base For Revenue in Advance. LEARNING OBJECTIVE5 Differentiate items‟ tax base Tax base of revenue in advance: CA-revenue not taxable in future periods or any amount taxed in past& current periods. Example interest revenue received in advance $100 is taxed when cash was received; CA-taxed=nill;100-100=nill 1-42 LO 5 The Tax Base For Other Items. LEARNING OBJECTIVE5 Differentiate items‟ tax base All items may not recognized with the tax bases of assets and liabilities, examples Research costs $100; Dr. research cost and Cr. Cash If $60 is allowed as a tax deductible in future periods ($40 is disallowed) CA-TDfp=nill-$60=$60. There is no CA in SFP and there is a temporary difference between the accounting profit and tax profit of $60. There is a permanent difference between the accounting profit and tax profit of $40. 1-43 LO 5 Recognition of Current Tax Liabilities and Current Tax Assets Recognize LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. a current tax liability for Tax payable on taxable profit for the current and past periods (current tax) Current tax liabilities is unpaid charge for current and prior periods Recognize a current tax asset for The extent to which the amount paid exceeds the amount payable The benefit of a tax loss that can be carried back to recover tax paid in a previous period Is the amount claimed for overpaid for current and prior periods and recognized as tax receivable. 1-44 Tax loss carried back to prior periods tax profit to recover current charge of the prior period and recognized as tax receivable. LO 6 Recognition of Current Tax Liabilities and Current Tax Assets Recognize LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. a current tax asset for Recognized in period that loss occurs. Probable that benefit will flow to the entity and can be reliably measured Measure current tax liability (asset) at; The amount the entity expects to pay (recover) using substantively enacted tax rates. 1-45 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Government specifies that: Each year entities must pay a tax on taxable profit for the year (i.e. business income tax 30% in Ethiopian case) Taxable profit is determined in accordance with IFRS adjusted for specified expenses that are excluded from the calculation of taxable income (i.e. donations and entertainment) If the determination of taxable business income results in a loss in a tax period, that loss may be set off against taxable income in the next five (5) tax periods, earlier losses being set off before later losses. 1-46 LO 6 LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Recognition of Current Tax Liabilities and Current Tax Assets Difference between AI and TI Permanent Temporary Deductible 1-47 Taxable LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. IAS 12 considers deferred tax by taking a “balance sheet approach” to the accounting problem between the carrying values and the tax base of assets and liabilities. Recognize a deferred tax asset (liability) for tax recoverable (payable) in future periods as a result of past transactions or events. For example, when it is probable that recovery of the carrying amount of an asset will make future tax payments larger than they would be if such recovery were to have no tax consequences. 1-48 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. By exception, deferred tax liability is not recognized on; The initial recognition of goodwill (unless goodwill is deducted when calculating taxable income);and Outside of a business combination, when the initial recognition of an asset or a liability affects neither taxable profit nor accounting income. 1-49 Assets and liabilities that do not affect accounting or taxable profit/ loss. LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Deferred tax asset is recognized only to the extent that its recovery is probable. Probable is not defined in IAS12 Consistently with IAS37 entities often take probable to mean „more likely than not‟. however, IAS12 does not prohibit a higher threshold a „virtually certain‟ threshold should not be used. Probable is generally agreed to mean „at least more likely than not (i.e. a probability of greater than 50%)‟ 1-50 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Exception: DTA is not recognized on deductible temporary difference arising initial recognition of asset and liabilities on; Not part of business combination. That do not affect accounting or taxable profit and loss. The possibility that the temporary difference is expected to continue into the foreseeable future and there are no taxable profits available against which the temporary difference can be offset. Deferred tax assets also arise from the carry forward of unused tax losses and tax credits. 1-51 LO 6 Summary for Recognition of Current Tax Liabilities and Current Tax Assets Asset A Asset B LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Carrying Tax Base Assessment Amount 10 8 There is taxable temporary difference (i.e., the entity recognizes a deferred tax liability). There is deductible temporary difference (i.e., 8 10 the entity recognizes a deferred tax asset). Liability A 10 8 There is deductible temporary difference (i.e., the entity recognizes a deferred tax asset). Liability B 8 10 There is taxable temporary difference (i.e., the entity recognizes a deferred tax liability). 1-52 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Example 1.3. An asset that costs Br 600,000 has a carrying amount of Br 430,000. Cumulative depreciation for tax purposes is Br 200,000 and the tax rate is 30%. 1. What is the tax base of the asset? 2. What is the temporary difference? 3. Is it taxable or deductible temporary difference? 4. What is the deferred tax? 5. Is it a deferred tax asset or liability? 1-53 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Solution for Ex1.3. 1. TB= Br 600,000- Br 200,000=400,000 2. TD= Br 430,000- Br 400,000= 30,000 3. Taxable temporary difference 4. DT= Br 30,000 x 30%= 9,000 5. Deferred tax liability 1-54 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Example1.4 At the beginning of 2013, GK Company purchased equipment for Br 200,000. The equipment had a carrying amount of Br 180,000 at the beginning of 2014 and Br 160,000 at the end of 2014. The accumulated depreciation of the item as per the income tax law is Br 50,000 at the beginning of 2014 and Br 80,000 at the end of 2014. The tax rate is 30%. The accounting income before tax is Br 700,000 for 2013 and Br 900,000 for 2014. 1-55 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Example1.4 ; Required 1. What was the tax base of the equipment for 2013 and 2014? 2. What is the taxable income for 2013 and 2014? 3. What is the temporary difference for 2013 and 2014? Is it taxable or deductible temporary difference? 4. What is the deferred tax for 2013 and 2014? Is it deferred tax asset or deferred tax liability? 5. What is the current tax expense for 2013 and 2014? 6. What is the deferred tax expense for 2013 and 2014? 7. What is the appropriate journal entry for 2013 and 2014? 1-56 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Solution for Example1.4 1-57 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Solution for Example1.4 1-58 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Example1.5 In 2014, its first year of operation, North Company has pretax financial income of Br 250,000, a total of Br 28,000 of taxable temporary differences, and a total of Br 8,000 of deductible temporary differences. The tax rate is 30%. In 2015, North Company has pretax financial income of Br 450,000, aggregate taxable and deductible temporary differences of Br 75,000 and Br 36,000, respectively, and the tax rate remains 30%. 1. Determine the taxable income for 2014 2. Make the necessary journal entries for 2014 to record the deferred taxes 3. Determine the taxable income for 2015 4. Make the necessary journal entries for 2015 to record the deferred taxes 1-59 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Solution for Example1.5 1-60 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Soln Ex1.5 1-61 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Soln Ex1.5 1-62 LO 6 Recognition of Current Tax Liabilities and Current Tax Assets LEARNING OBJECTIVE 5 Recognition of criteria for CTL&CTA. Example 1.6 Loan receivables has a carrying amount of Br 8 million for which general bad debt provisions amounting to Br 100,000 have been made. These provisions have not yet been deducted for tax purposes but are expected to give rise to future deductible amounts. 1. What is the tax base of the receivable? 2. Is the temporary difference taxable or deductible? Solution The tax base of the loan receivable is Br 8.1 million which results in a deductible temporary difference of Br 100,000. 1-63 LO 6 Reversal of Temporary Difference LEARNING OBJECTIVE6 Accounting for DTLs For example 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, 2019, IFRS-basis statement of financial position. However, the receivables have a zero tax basis. ILLUSTRATION 19.5 Temporary Difference, Accounts Receivable 1-64 LO 6 Illustration on Future Taxable Amounts & DTLs LEARNING OBJECTIVE6 Accounting for DTLs Illustration: Reversal of Temporary Difference, Chelsea Inc. ILLUSTRATION 19.6 Chelsea assumes that it will collect the accounts receivable and report the $30,000 collection as taxable revenues in future tax returns. Chelsea does this by recording a deferred tax liability. 1-65 LO 6 LEARNING OBJECTIVE6 Accounting for DTLs Illustration on Future Taxable Amounts&DTLs Deferred Tax Liability 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. 2019 2020 2021 Total $28,000 $28,000 $28,000 $84,000 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) Income tax expense (40%) $28,000 $28,000 $28,000 Income tax expense (IFRS) Income tax payable (TA) $0 $84,000 ILLUSTRATION 19.4 Comparison of Income Tax Expense to Income Taxes Payable 1-66 LO 6 Illustration on Future Taxable Amounts&DTLs LEARNING OBJECTIVE6 Accounting for DTLs Because it is the first year of operations for Chelsea, there is no deferred tax liability at the beginning of the year. Chelsea computes the income tax expense for 2019 as follows: ILLUSTRATION 19.9 Computation of Income Tax Expense, 2019 1-67 LO 6 Illustration on Future Taxable Amounts&DTLs LEARNING OBJECTIVE6 Comparison of Income Tax Expense to Income Taxes Pay 2019 2020 2021 Total $28,000 $28,000 $28,000 $84,000 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) Income tax expense (40%) $28,000 $28,000 $28,000 Income tax expense (IFRS) Income tax payable (TA) $0 $84,000 Chelsea makes the following entry at the end of 2019 to record income taxes. Income Tax Expense 1-68 28,000 Income Taxes Payable 16,000 Deferred Tax Liability 12,000 LO 6 Illustration on Future Taxable Amounts&DTLs LEARNING OBJECTIVE6 Comparison of Income Tax Expense to Income Taxes Pay 2019 2020 2021 Total $28,000 $28,000 $28,000 $84,000 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) Income tax expense (40%) $28,000 $28,000 $28,000 Income tax expense (IFRS) Income tax payable (TA) $0 $84,000 Chelsea makes the following entry at the end of 2020 to record income taxes. Income Tax Expense 28,000 Deferred Tax Liability 8,000 Income Taxes Payable 1-69 36,000 LO 6 Illustration on Future Taxable Amounts&DTLs LEARNING OBJECTIVE6 Comparison of Income Tax Expense to Income Taxes Pay 2019 2020 2021 Total $28,000 $28,000 $28,000 $84,000 16,000 36,000 32,000 84,000 Difference $12,000 $(8,000) $(4,000) Income tax expense (40%) $28,000 $28,000 $28,000 Income tax expense (IFRS) Income tax payable (TA) $0 $84,000 Chelsea makes the following entry at the end of 2021 to record income taxes. Income Tax Expense 28,000 Deferred Tax Liability 4,000 Income Taxes Payable 1-70 32,000 LO 6 Illustration on Future Taxable Amounts&DTLs LEARNING OBJECTIVE6 Comparison of Income Tax Expense to Income Taxes Pay The entry to record income taxes at the end of 2021 reduces the Deferred Tax Liability by $4,000. The Deferred Tax Liability account appears as follows at the end of 2021 . ILLUSTRATION 19.12 Deferred Tax Liability Account after Reversals 1-71 LO 6 Financial Statement Presentation for DTI LEARNING OBJECTIVE 7 SFP Presentation, Deferred Tax Liabilities SFP Presentation The DT classification related to its underlying asset or liability. Classify the DT amounts as current or as non-current. Sum the various DTA and DTL classified as current. If net result is an asset, report as current asset, whereas If net result is liability, report as current liability. Sum the various DTA and DTL classify as non current. If net result is an asset, report as long term asset, and If net result is liability, report as long term liability 1-72 LO 6 Financial Statement Presentation for DTI LEARNING OBJECTIVE 7 SFP Presentation, Deferred Tax Liabilities Income Statement Presentation Income tax expense is allocated to; Continuing operations Discontinued operations Extraordinary items Cumulative effects of an accounting change(see FAS154) Prior period adjustments and Disclose other significant components such as Current tax expense and Deferred tax expense/benefits and etc. 1-73 LO 6 LEARNING OBJECTIVE 7 SFP Presentation, Deferred Tax Liabilities Financial Statement Effects 2019 2020 2021 2019 2020 2021 ILLUSTRATION 19.14 Income Statement Presentation, Income Tax Expense 1-74 LO 6 LEARNING OBJECTIVE 7 SFP Presentation, Deferred Tax Liabilities Financial Statement Effects 2019 2020 2021 ILLUSTRATION 19.14 Income Statement Presentation, Income Tax Expense ILLUSTRATION 19.15 Components of Income Tax Expense 1-75 LO 6 Illustration on Future Taxable Amounts&DTLs LEARNING OBJECTIVE7 Accounting for DTLs Example 1.7: Starfleet Corporation has one temporary difference at the end of 2014 that will reverse and cause taxable amounts of $55,000 in 2015, $60,000 in 2016, and $75,000 in 2017. Starfleet‟s pretax financial income for 2014 is $400,000, and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2014. Instructions a) Compute taxable income and income taxes payable for 2014. b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014. 1-76 LO 6 LEARNING OBJECTIVE 7 Accounting for DTLs Solution for Example 1.7 Illustration: Current Yr. INCOME: 2014 Financial income (IFRS) 400,000 Temporary Diff. Taxable income (TA) Tax rate Income tax b. 1-77 a. 2015 2016 2017 (190,000) 55,000 60,000 75,000 210,000 55,000 60,000 75,000 a. Income Tax Expense (plug) 30% 63,000 30% 16,500 30% 18,000 30% 22,500 120,000 Income Taxes Payable 63,000 Deferred Tax Liability 57,000 LO 6 Reversal of Temporary Difference LEARNING OBJECTIVE 7 Accounting for DTAs Example 1.8: During 2019, Cunningham Inc. estimated its warranty costs related to the sale of microwave ovens to be $500,000, paid evenly over the next two years. For book purposes, in 2019 Cunningham reported warranty expense and a related estimated liability for warranties of $500,000 in its financial statements. For tax purposes, the warranty tax deduction is not allowed until paid. ILLUSTRATION 19.16 Temporary Difference, Warranty Liability 1-78 LO 6 Illustration Future Deductible Amounts and DTAs Solution: Reversal of Temporary Difference. LEARNING OBJECTIVE7 Accounting for DTAs ILLUSTRATION 19.17 When Cunningham pays the warranty liability, it reports an expense (deductible amount) for tax purposes. Cunningham reports this future tax benefit in the December 31, 2019, statement of financial position as a deferred tax asset. A 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. 1-79 LO 6 Illustration Future Deductible Amounts and DTAs LEARNING OBJECTIVE7 Accounting for DTAs Example 1.9: Hunt Company has revenues of $900,000 for both 2019 and 2020. It also has operating expenses of $400,000 for each of these years. In addition, Hunt accrues a loss and related liability of $50,000 for financial reporting purposes because of pending litigation. Hunt cannot deduct this amount for tax purposes until it pays the liability, expected in 2020. As a result, a deductible amount will occur in 2020 when Hunt settles the liability, causing taxable income to be lower than pretax financial information. Shows the IFRS and tax reporting over the two years. 1-80 LO 6 ILLUSTRATION 19.18 IFRS and Tax Reporting, Hunt Company 1-81 LO 6 Illustration Future Deductible Amounts and DTAs LEARNING OBJECTIVE6 Accounting for DTAs Example1.9 Cont.: Hunt records a deferred tax asset of $20,000 at the end of 2019 because it represents taxes that will be saved in future periods as a result of a deductible temporary difference existing at the end of 2019. ILLUSTRATION 19.19 Computation of Deferred Tax Asset, End of 2019 1-82 LO 6 Illustration Future Deductible Amounts and DTAs LEARNING OBJECTIVE7 Accounting for DTAs Hunt can also compute the deferred tax asset by preparing a schedule that indicates the future deductible amounts due to deductible temporary differences. ILLUSTRATION 19.20 Schedule of Future Deductible Amounts 1-83 LO 6 LEARNING OBJECTIVE7 Accounting for DTAs Illustration Future Deductible Amounts and DTAs Assume that 2019 is Hunt‟s first year of operations, and income tax payable is $200,000, compute income tax expense. ILLUSTRATION 19.21 Computation of Income Tax Expense, 2019 Hunt made the entry at the end of 2019 to record income taxes. Income Tax Expense Deferred Tax Asset Income Taxes Payable 1-84 180,000 20,000 200,000 LO 6 Illustration Future Deductible Amounts and DTAs Computation of Income Tax Expense for 2020. LEARNING OBJECTIVE7 Accounting for DTAs ILLUSTRATION 19.22 Computation of Income Tax Expense, 2020 Hunt made the entry at the end of 2020 to record income taxes. Income Tax Expense Deferred Tax Asset Income Taxes Payable 1-85 200,000 20,000 180,000 LO 6 Financial Statement Effects LEARNING OBJECTIVE 7 SFP Presentation, DTA Illustn 19.24 Income Statement Presentation, Deferred Tax Asset The entry to record income taxes at the end of 2020 reduces the Deferred Tax Asset by $20,000 as shown below. 1-86 ILLUSTRATION 19.25 Deferred Tax Asset Account after Reversals LO 6 Illustration Future Deductible Amounts and DTAs LEARNING OBJECTIVE7 Accounting for DTAs Example 1.10: Columbia Corporation has one temporary difference at the end of 2018 that will reverse and cause deductible amounts of $50,000 in 2019, $65,000 in 2020, and $40,000 in 2021. Columbia‟s pretax financial income for 2018 is $200,000 and the tax rate is 34% for all years. There are no deferred taxes at the beginning of 2018. Columbia expects to be profitable in the future. Instructions a) Compute taxable income and income taxes payable for 2018. b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2018. 1-87 LO 6 Solution for Example10.5 Illustration LEARNING OBJECTIVE 6 Accounting for DTAs Current Yr. INCOME: 2018 Financial income (IFRS) 200,000 Temporary Diff. Taxable income (Tax) Tax rate a. Income tax 2019 2020 2021 155,000 (50,000) (65,000) (40,000) 355,000 (50,000) (65,000) (40,000) 34% 34% 34% (17,000) (22,100) (13,600) 34% 120,700 a. b. Income Tax Expense 68,000 Deferred Tax Asset 52,700 Income Taxes Payable 1-88 120,700 LO 6 Accounting for Additional Issues for Income Taxes Deferred Tax Asset (Non-Recognition) A company should reduce a deferred tax asset if it is probable that it will not realize some portion or all of the deferred tax asset. “Probable” means a level of likelihood of at least slightly more than 50 percent. 1-89 LO 7 Deferred Tax Asset (Non-Recognition) Example1.11 Callaway Corp. has a deferred tax asset account with a balance of €150,000 at the end of 2018 due to a single cumulative temporary difference of €375,000. At the end of 2019, this same temporary difference has increased to a cumulative amount of €500,000. Taxable income for 2019 is €850,000. The tax rate is 40% for all years. Instructions: Assuming that it is probable that €30,000 of the deferred tax asset will not be realized, prepare the journal entry at the end of 2019 to recognize this probability. 1-90 LO 7 Deferred Tax Asset (Non-Recognition) Illustration: INCOME: LEARNING OBJECTIVE 8 Identify additional issues in accounting for income taxes. Current Yr. 2018 Financial income (IFRS) 2019 2020 725,000 Temporary difference 375,000 125,000 (500,000) Taxable income (TA) 375,000 850,000 (500,000) Tax rate Income tax Income Tax Expense Deferred Tax Asset 40% 150,000 40% 340,000 Deferred Tax Asset 1-91 40% (200,000) 40% - 290,000 50,000 Income Taxes Payable Income Tax Expense 2021 340,000 30,000 30,000 LO 7 Income Statement Presentation LEARNING OBJECTIVE 8 Identify additional issues in accounting for income taxes. Formula to Compute Income Tax Expense ILLUSTRATION 19.27 Formula to Compute Income Tax Expense In the income statement or in the notes to the financial statements, a company should disclose the significant components of income tax expense attributable to continuing operations. 1-92 LO 7 Income Statement Presentation Given the previous information related to Chelsea Inc., Chelsea reports its income statement as follows. ILLUSTRATION 19.28 1-93 LO 7 Specific Differences Originating and Reversing Aspects of Temporary Differences. The specific differences can be future deductible amount, future taxable amount or permanent difference. Originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability. Reversing difference occurs when eliminating a temporary difference that originated in prior periods and then removing the related tax effect from the deferred tax account. 1-94 LO 7 Specific Differences Example1.12: Havaci Com reports pretax financial income of €80,000 for 2019. The following items cause taxable income to be different from 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 €27,000. 3.Fines for pollution appear as an expense of €11,000 on the income statement. Havaci‟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 2019. Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2019. 1-95 LO 7 Specific Differences E19-4: Current Yr. Deferred Deferred INCOME: 2019 Asset Liability Financial income (IFRS) € 80,000 Excess tax depreciation (16,000) Excess rent collected 27,000 Fines (permanent) 11,000 Taxable income (TA) Tax rate Income tax Income Tax Expense Deferred Tax Asset Deferred Tax Liability Income Tax Payable 1-96 102,000 € 16,000 (€ 27,000) (27,000) 16,000 30% 30% 30% € 30,600 (€ 8,100) € 4,800 27,300 8,100 4,800 30,600 LO 7 Examples of Temporary and permanent Differences Example1.13: Assume that Bio-Tech reports pretax financial income of €200,000 in each of the years 2020, 2021, and 2022. The company is subject to a 30% tax rate and has the following differences between pretax financial income and taxable income. 1. Bio-Tech reports an installment sale of €18,000 in 2020 for tax purposes it recognizes the sales over an 18-month period at a constant amount per month beginning January 1, 2021. It recognizes the entire sale for book purposes in 2020. 2. It pays life insurance premiums for its key officers of €5,000 in 2021 and 2022. Although not tax-deductible, Bio-Tech expenses the premiums for book purposes. 1-97 LO 7 Examples of Temporary and permanent Differences Example1.13Cont. The installment sale is a temporary difference, whereas the life insurance premium is a permanent difference. Table shows the reconciliation of Bio-Tech‟s pretax financial income to taxable income and the computation of income taxes payable. 1-98 LO 7 Examples of Temporary and permanent Differences Example1.13Cont. Bio-Tech records income taxes for 2020, 2021, and 2022 as follows. 1-99 LO 7 Tax Rate Considerations Future Tax Rates A company must consider presently enacted changes in the tax rate that become effective for a particular future year(s) when determining the tax rate to apply to existing temporary differences. If new rates are not yet enacted for future years, use the current rate. 1-100 LO 7 Future Tax Rates Example1.14 Wang Group at the end of 2016 has the following cumulative temporary difference of ¥300,000, computed as shown. ILLUSTRATION 19.33 Computation of Cumulative Temporary Difference Assume that the ¥300,000 will reverse and result in taxable amounts in the future, with the enacted tax rates shown. 1-101 ILLUSTRATION 19.34 Deferred Tax Liability Based on Future Rates LO 7 Future Tax Rates Example1.14.Cont. Assume that the ¥300,000 will reverse and result in taxable amounts in the future, with the enacted tax rates shown. ILLUSTRATION 19.34 The total deferred tax liability at the end of 2016 is ¥108,000. Wang may only use tax rates other than the current rate when the future tax rates have been enacted. If new rates are not yet enacted for future years, Wang should use the current rate. 1-102 LO 7 Tax Rate Considerations Revision of Future Tax Rates When a change in the tax rate is enacted, companies should record its effect on the existing deferred income tax accounts immediately. A company reports the effect as an adjustment to income tax expense in the period of the change. 1-103 LO 7 Revision of Future Tax Rates Example1.14: Assume that on Dec10, 2018, a new income tax act is signed into law that lowers the company tax rate from 40 percent to 35 percent, effective January 1, 2020. If Hostel Co. has one temporary difference at the beginning of 2018 related to $3 million of excess tax depreciation, then it has a Deferred Tax Liability account with a balance of $1,200,000 ($3,000,000 × 40%) at January 1, 2018. If taxable amounts related to this difference are scheduled to occur equally in 2019, 2020, and 2021, the deferred tax liability at the end of 2018 is $1,100,000. 1-104 ILLUSTRATION 19.35 Schedule of Future Taxable Amounts and Related Tax Rates LO 7 Revision of Future Tax Rates Hostel, therefore, recognizes the decrease of $100,000 ($1,200,000 − $1,100,000) at the end of 2018 in the deferred tax liability as follows. ILLUSTRATION 19.35 Schedule of Future Taxable Amounts and Related Tax Rates Deferred Tax Liability Income Tax Expense 1-105 100,000 100,000 LO 7 Accounting for Net Operating Losses LEARNING OBJECTIVE 3 Explain the accounting for loss carrybacks and loss carryforwards. Net operating loss (NOL) = tax - deductible expenses exceed taxable revenues. Tax laws permit taxpayers to use the losses of one year to offset the profits of other years (loss carryback and loss carryforward). Under this provision, a company pays no income taxes for a year in which it incurs a net operating loss. In addition, it may select one of the two options. 1-106 LO 8 Accounting for Net Operating Losses Loss Carryback Back 2 years and forward 20 years and receive refunds for income taxes paid in those years. Losses must be applied to earliest year first. It may carry forward any loss remaining after the two-year carryback up to 20 years to offset future taxable income. ILLUSTRATION 19.36 1-107 Loss Carryback Procedure LO 8 Accounting for Net Operating Losses Loss Carryforward May Use elect to forgo loss carryback and only the loss carry forward option, offsetting future taxable income for up to 20 years(Carry forward losses 20 years). ILLUSTRATION 19.30 Loss Carryforward Procedure 1-108 LO 8 Loss Carryback Example Example1.15: Groh Inc. has no temporary or permanent differences. Groh experiences the following. Year 2015 2016 2017 2018 Taxable Income of Loss $ 50,000 100,000 200,000 (500,000) Tax Rate 35% 30% 40% $ Tax Paid 17,500 30,000 80,000 0 In 2018, Groh incurs a net operating loss 500,000 that it decides to carry back. Prepare Gron‟s entry to record the effect of the loss carryback. 1-109 LO 8 Loss Carryback Example Illustration: 2015 2016 2017 2018 Financial income Difference Taxable income (loss) $ Rate Income tax 50,000 $ 35% 100,000 $ 30% 200,000 $ (500,000) $ (500,000) 40% $ 17,500 $ 30,000 $ 80,000 $ 50,000 $ 100,000 $ 200,000 NOL Schedule Taxable income Carryback (100,000) Taxable income 50,000 Rate Income tax (revised) Refund 1-110 35% $ 17,500 $ $ (200,000) - - 30% 40% - 30,000 $ $ - 80,000 300,000 (200,000) 0% $ - $110,000 LO 8 Loss Carryback Example Ex1.15 Cont.: Groh Inc. reports the account credited on the income statement for 2018 as shown. ILLUSTRATION 19.38 Recognition of Benefit of the Loss Carryback in the Loss Year 1-111 LO 8 Loss Carryforward Example In addition to recording the $110,000 Benefit Due to Loss Carryback, Groh Inc. records the tax effect of the $200,000 loss carry forward as a deferred tax asset of $80,000 assuming that the enacted future tax rate is 40 percent for 2018. The entry is made as follows: Illustration: 2015 2016 2017 2018 NOL Schedule Taxable income $ 50,000 $ Carryback 50,000 Rate 1-112 $ (100,000) Taxable income Income tax (revised) 100,000 35% $ 17,500 $ 200,000 (200,000) - - 30% 40% - $ $ - (500,000) 300,000 (200,000) 40% $ (80,000) LO 8 Carryforward (Recognition) Ex1.15.Cont.:The two accounts credited are contra income tax expense items, which Groh presents on the 2018 income statement as shown below. ILLUSTRATION 19.39 Recognition of the Benefit of the Loss Carryback and Carryforward in the Loss Year 1-113 LO 8 Carryforward (Recognition) For 2019, assume that Groh returns to profitable operations and has taxable income of $250,000 (prior to adjustment for the NOL carryforward), subject to a 40 percent tax rate. 2018 2019 NOL Schedule Taxable income $ Carryback (carryforward) $ 300,000 Taxable income 50,000 40% $ (80,000) 250,000 (200,000) (200,000) Rate Income tax (revised) (500,000) 40% $ 20,000 Groh records income taxes in 2019 as follows: Income Tax Expense Deferred Tax Asset Income Taxes Payable 1-114 100,000 80,000 20,000 LO 8 Carryforward (Recognition) The 2019 income statement does not report the tax effects of either the loss carryback or the loss carryforward because Groh had reported both previously. ILLUSTRATION 19.41 Presentation of the Benefit of Loss Carryforward Realized in 2019, Recognized in 2018 1-115 LO 8 Carryforward (Non-Recognition) Assume that Groh will not realize the entire NOL carryforward in future years. In this situation, Groh does not recognize a deferred tax asset for the loss carryforward because it is probable that it will not realize the carryforward. Groh makes the following journal entry in 2018. Income Tax Refund Receivable 110,000 Benefit Due to Loss Carryback (Income Tax Expense) 1-116 110,000 LO 8 Carryforward (Non-Recognition) Groh‟s 2018 income statement presentation is as follows: ILLUSTRATION 19.42 Recognition of Benefit of Loss Carryback Only 1-117 LO 8 Carryforward (Non-Recognition) In 2019, assuming that Groh has taxable income of $250,000 (before considering the carryforward), subject to a tax rate of 40 percent, it realizes the deferred tax asset. Groh records the following entries. Deferred Tax Asset 80,000 Benefit Due to Loss Carryforward Income Tax Expense 1-118 80,000 100,000 Deferred Tax Asset 80,000 Income Taxes Payable 20,000 LO 8 Carryforward (Non-Recognition) Assuming that Groh derives the income for 2019 from continuing operations, it prepares the income statement as shown. ILLUSTRATION 19.43 Recognition of Benefit of Loss Carryforward When Realized 1-119 LO 8 Non-Recognition Revisited Whether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period available under tax law. ILLUSTRATION 19.44 1-120 Possible Sources of Taxable Income LO 8 Financial Statement Presentation LEARNING OBJECTIVE 4 Describe the presentation of deferred income taxes in financial statements. Statement of Financial Position Deferred tax assets and deferred tax liabilities are also separately recognized and measured but may be offset in the statement of financial position. The net deferred tax asset or net deferred tax liability is reported in the non- current section of the statement of financial position. 1-121 LO 8 Statement of Financial Position 1-122 ILLUSTRATION 19.45 Classification of Temporary Differences LO 8 Financial Statement Presentation Income Statement Companies allocate income tax expense (or benefit) to 1-123 continuing operations, discontinued operations, other comprehensive income, and prior period adjustments. LO 8 Income Statement Components of income tax expense (benefit) may include: 1. Current tax expense (benefit). 2. Any adjustments recognized in the period for current tax of prior periods. 3. Amount of deferred tax expense (benefit) relating to the origination and reversal of temporary differences. 4. Amount of deferred tax expense (benefit) relating to changes in tax rates or the imposition of new taxes. 5. Amount of the benefit arising from a previously unrecognized tax loss, tax credit, or temporary difference of a prior period that is used to reduce current and deferred tax expense. 1-124 LO LO84 Financial Statement Presentation Tax Reconciliation Companies either provide: A numerical reconciliation between tax expense (benefit) and the product of accounting profit multiplied by the applicable tax rate(s), disclosing also the basis on which the applicable tax rate(s) is (are) computed; or A numerical reconciliation between the average effective tax rate and the applicable tax rate, disclosing also the basis on which the applicable tax rate is computed. 1-125 LO 8 Review of the Asset-Liability Method The IASB believes that the asset-liability method (sometimes referred to as the liability approach) is the most consistent method for accounting for income taxes. 1-126 ILLUSTRATION 19.50 Basic Principles of the Asset-Liability Method LO 9 ILLUSTRATION 19.51 Procedures for Computing and Reporting Deferred Income Taxes 1-127 LO 9 Required Presentation and Disclosures A. Taxation balances should be presented as follows: The balances are shown separately from other assets and liabilities in the Statement of Financial Position. Current tax payable is always shown as a current liability and deferred tax balances are noncurrent and should distinguished from current tax balances. Current and deferred tax balances should be shown as separate items cannot be offset. Deferred tax assets or liabilities should not be discounted. The tax expense (income) related to profit or loss from ordinary activities shall be presented as part of profit or loss in the statement(s) of profit or loss and other comprehensive income. 1-128 LO 10 Required Presentation and Disclosures Current tax balances can be offset when: there is a legal enforceable right to offset the recognized amounts; and there is an intention either to settle on a net basis, or to realize the asset and settle the liability simultaneously. Deferred tax balances can be offset when: there is a legal enforceable right to set off current tax assets against current tax liabilities; and deferred tax assets and liabilities relate to income tax levied by the same tax authority on either: o the same taxable entity; or o different taxable entities which intend either to settle current tax liabilities and assets on a net basis, or to realize the assets and settle the liabilities simultaneously in each future period. 1-129 LO 10 Required Presentation and Disclosures B. The statement of comprehensive income and notes should contain: Major components of tax expense (income), shown separately, including: a) current tax expense (income); b) any adjustments recognized in the period for current tax of prior periods; c) the amount of deferred tax expense (income) relating to the origination and reversal of temporary differences; d) the amount of deferred tax expense (income) relating to changes in tax rates or the imposition of new taxes; e) the amount of tax benefits arising from a previously unrecognized tax loss, tax credit or temporary difference of a prior period that is used to reduce the current or deferred tax expense as relevant; 1-130 LO 10 Required Presentation and Disclosures f) the amount of the benefit from a previously unrecognized tax loss, tax credit or temporary difference of a prior period that is used to reduce deferred tax expense; g) deferred tax arising from the write-down (or reversal of a previous writedown) of a deferred tax asset; and h) the amount of tax expense (income) relating to those changes in accounting policies and fundamental errors that are included in profit or loss in accordance with IAS 8, because they cannot be accounted for retrospectively. i) Exchange differences on deferred foreign tax liabilities or assets which can be deferred asset or liability and is most useful to users of financial reports. 1-131 LO 10 Required Presentation and Disclosures Reconciliation between tax amount and accounting profit or loss in monetary terms, or a numerical reconciliation of the applicable tax rate; The amount of income tax relating to each component of other comprehensive income; in respect of discontinued operations: the amount of tax expense related to the gain or loss on discontinuance; the amount of tax expense related to the profit or loss from ordinary activities of discontinued operation for the period; Explanation of changes in applicable tax rates compared to previous period(s); and For each type of temporary difference, and in respect of each type of unused tax loss and credit, the amounts of the deferred tax recognized in the Statement of Comprehensive Income. 1-132 LO 10 Required Presentation and Disclosures c. The statement of financial position and notes should include: Aggregate amount of current and deferred tax charged or credited directly to equity; Amount of deductible temporary differences, unused tax losses, and unused tax credits for which no deferred tax asset is recognized; Aggregate amount of temporary differences associated with investments in subsidiaries, branches, associates, and joint ventures for which deferred tax liabilities have not been recognized; Amount of a deferred tax asset and nature of the evidence supporting its recognition. 1-133 LO 10 Required Presentation and Disclosures The mount of a loss in either the current or preceding period; amount of income tax consequences of dividends to shareholders that were proposed or declared before the reporting date, but are not recognized as a liability in the financial statements; and the nature of the potential income tax consequences that would result from the payment of dividends to shareholders, that is, the important features of the income tax systems and the factors that will affect the amount of the potential tax consequences of dividends. 1-134 LO 10 End of Chapter-I 1-135 AcFn 4101 By Yoseph T Saturday, November 11, 2023