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
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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17
Chapter 17
■ Accounting
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For Tax Losses
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Introduction
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When a corporation has a loss, a matching issue arises.
A loss will normally have tax benefits, but the benefits may not be
realized in the period of the loss.
Should future benefits be recognized in order to achieve
matching, or should their recognition be delayed in the
interests of conservatism?
This chapter begins with an explanation of the income tax benefits
that arise from a loss.
The focus in this chapter will be on the new CICA Handbook
recommendations, which have been changed significantly with the
introduction of section 3465.
3465
The new recommendations are much easier to implement than
those of the older section 3470,
3470 which is being phased out by the
year 2000. (Appendix to the Chapter)
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Tax Loss Vs. Tax Benefits
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To help avoid confusion, it is necessary to keep track
separately of the amount of the tax loss and the
amount of the tax benefit.
benefit
The tax loss is the final number of taxable loss on the
tax return.
The tax benefit is the present and future benefit that
the company will be able to realize from the tax loss
through a reduction of income taxes paid to
governments.
Basically: Tax benefit = Tax loss X Tax rate
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Temporary Differences In A Loss Year
It is quite possible for temporary differences (and permanent differences) to
convert a pre-tax accounting profit to a tax loss. For example, assume the
following facts for Michelle Ltd. for the fiscal year ending 31 December 20x8:
• Net income before taxes of $100,000,
$100,000 after deducting depreciation
expense of $150,000;
• CCA totaling $280,000 deducted on the tax return;
• Net book value of capital assets of $1,700,000 and UCC of
$1,200,000 on 1 January 20x8, a temporary difference of $500,000 that
is reflected in an accumulated future income tax liability balance of
$200,000 at 1 January 20x8;
• No permanent differences;
differences
• Taxable income in the three-year carryback period of $360,000; and
• Tax rate of 40% in the current and previous years.
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Temporary Differences In A Loss Year
Michelle Ltd.’s taxable income for 20x8 will be computed as follows:
Accounting income subject to
$100,000
tax
Temporary difference:
Depreciation
+150,000
CCA
–280,000
Taxable income (loss)
$ (30,000)
The CCA/depreciation temporary difference of $130,000 is recorded as usual, with
an increase in the deferred tax credit balance on the balance sheet and a charge to
the income tax expense for $52,000 (i.e., $130,000 × 40%):
Income tax expense [I/S]
52,000
Future income tax liability – capital assets
52,000
[B/S]
The $30,000 tax loss is carried back, which results in a tax recovery (@40%) of
$12,000:
Income tax receivable – carryback benefit [B/S]
12,000
Income tax expense [I/S]
h o12,000
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Adjusting Temporary Differences
Since the company had available taxable income in the carryback
period against which the loss can be offset, good tax strategy calls for
taking the maximum allowable CCA in 20x8 in order to obtain a refund
of taxes previously paid.
If the company did not have taxable income in the preceding three
years a tax loss in 20x8 would not permit the company to realize any
tax benefit in 20x8.
Instead of having a tax loss, the company can simply reduce the
amount of CCA that it deducts on its tax return for 20x8 by $30,000,
from $280,000 to $250,000.
CCA is an optional deduction, up to the permitted limit.
A company will have a higher amount of undepreciated capital cost
(and CCA) in future years if it claims less CCA in the current year.
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Reducing CCA
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One way of increasing the likelihood that a company
will fully utilize a carryforward is to eliminate CCA in the
carryforward years. In some industries, CCA is very
large, both in absolute amount and in relation to net
income. Not claiming CCA has the effect of increasing
taxable income, against which the carryforward can be
used. After the carryforward benefits have all been
realized, the company can resume deducting full CCA
to reduce its future net income.
A further strategy is to amend prior years’ returns to
reduce or eliminate CCA. The relevant time frame is the
three previous years, those to which carrybacks apply
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Reassessment In Years Subsequent To The
Loss Year
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If the future benefits of loss carryforwards are recognized in
the year of the loss, the benefit should be given intraperiod
allocation, as appropriate to the cause of the loss.
Once the future tax benefit of a tax loss carryforward has
been recognized as an asset, the asset is subject to review
at each balance sheet date. If the probability of realization
drops to 50% or less, the future income tax asset should be
reduced [CICA 3465.31(a)]. There is nothing unusual about
this provision; assets are generally subject to review and to
writedown if their value has been impaired
impaired.. If an asset is
unlikely to recover its carrying value, either through use or
through sale, it should be written down.
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EXHIBIT 17-1
Excerpt from Canadian National Railways Annual Report
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The 1997 annual report of Canadian National Railway Company
(CN) provides an example of benefit recognition in a year that is
neither the loss year nor the year in which the benefits are realized.
CN’s income statement includes the following lines shown in
Exhibit 17-1. The results for 1996 show a net income before
income taxes of $142 million, increased by an income tax recovery
MHR $ 6 94 mi l l i o n . Th e
r e p o r t e d ne t
i
the pre-tax income
In million s
19 97
19 96
19 95
In com e (lo ss ) fro m co n tin uin g o pera tio ns
b efo re inc om e tax es
In com e tax (ex p en se) reco ve ry from c on tinu in g
o p eration s (No te 13)
$ 746
$ 142
$ (1,111)
(325)
694
19
In co me (loss) from con tin uin g op eration s
$ 421
$ 850
$ (1,092)
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Recognition of the Future Benefits of
Tax Loss Carryforwards
Scenario 1: Assuming future recovery is■
judged to be probable in the year of the
loss If the probability of realizing the future
tax benefit of the carryforward > 50% when
the 20x5 financial statements are being
prepared, the estimated future benefit of
the carryforward is recognized in the year
of the loss
Scenario 2: Assuming future recovery is■
judged to be improbable in the year of
the loss, but becomes probable in the ■
following year Now, suppose instead that,
due to Parravano’s erratic earnings history,
realization not to be probable. The entry to
record the tax benefit in 20x5 would then
be limited to the amount of taxes recovered
through the carryback
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Scenario 3: Partial recognition In
Scenario 2, we assumed that
Parravano recognized all of the
accumulated tax benefits in 20x6. It is
possible, however, that a company’s
management may decide that only
part of the benefit is more likely than
not to be recognized.
Scenario 4: Write-off of previously
recognized benefit
Like any other asset, the future benefit
of a tax loss carryforward must
continue to have probable future
benefit. If an asset no longer is likely
to be recoverable or realizable, it must
be written down to its probable future
benefit
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Which Tax Rate?
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What tax rate should be used to record the amount of a future
tax asset or liability?
The CICA Handbook recommends that future tax assets and
liabilities should be recognized at the rate(s) that are expected to
apply when the temporary differences reverse, “which would
normally be those enacted at the balance sheet date” [CICA
3465.56].
The word “normally” is used because, in Canada, the government
can announce changes in tax rates prior to the legislation actually
being enacted.
The CICA Handbook therefore refers to the substantively
enacted income tax rate,
rate and recommends that the substantively
enacted rate be used instead of the actual rate at the balance
sheet date.
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Tax Rate Changes
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Once a future income tax asset has been recorded for a tax
loss carryforward, the balance of that account must be
maintained at the tax rate that is expected to be in effect when
the carryforward is utilized.
Suppose that the tax rate goes down to 38% before Parravano
actually uses any of the carryforward. The asset will have to be
revalued to $330,000 × 38%, or $125,400. This change will be
included as part of the annual re-evaluation of the FIT asset or
liability.
Income tax expense
($132,000-$125,400)(I/S)
$6,600
Future Income Tax Asset—
Carryforward Benefit (B/S)
$6,600
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Basic Illustration
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To illustrate the recognition of tax loss carryforward
benefits over series of years, we will start with a fairly
simple example that has no other temporary differences
Dutoit Ltd. ($000’s)
20x1 20x2 20x3 20x4
Net income Before Taxes
$100 -$300 $150 $250
Taxable Rate
45% 40% 42% 43%
20x1 was the first year of operations for Dutoit
Assume that the tax rate for each year is determined
during that year.
For example, we do not know in 20x2 that the tax rate for
20x3 will be 42%.
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Assuming Realization Is Not
Likely—Greater than 50% probability of not
realizing the benefit
20x1 Income tax expense ($100,000 x 45%)
45,000
Income tax payable
45,000
20x2 Income tax receivable—carryforward
benefit ($100,000 x 45%)
45,000
Income tax expense (recovery)
45,000
unrealized tax loss carryforward of $200,000
20x3 Income tax on $150,000 @ 42% is offset by loss
carryforward benefit of the same amount—entries offset
20x4 Income tax expense ($250,000 x 45%)
107,500
Income tax payable
107,500
Income tax payable—carryforward
benefit ($50,000 x 43%)
21,500
Income tax expense (recovery)
21,500
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Assuming Realization Becomes Likely—in
20x3 More likely (>50%) that tax loss
benefit will be realized
20x3 Income tax expense ($150,000 x 42%)
Income tax payable
Income tax payable—
($150,000 carryforward used x 42%)
Income tax expense (recovery)
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20x4 Income tax expense ($250,000 x 43%)
Income tax payable
Income tax payable—carryforward
benefit ($50,000 x 43%)
Income tax expense (recovery)
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63,000
63,000
63,000
63,000
107,500
107,500
21,500
21,500
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Extended Illustration—Birchall Inc.
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20x1 acquire equipment costing $1,000,000
Depreciation straight line at 10%—full year in year of
acquisition
CCA
20x1 $350,000
20x2 $200,000
20x3 $150,000
20x4 $100,000
Tax Rate 20x1 and 20x2:
40%
20x3 tax rate increases to
42%
Earnings 20x1 $300,000
20x2 $(600,000)
20x3 $200,000
20x4 $600,000
Exhibit 17-2 shows the computation of Birchall’s taxable
income.
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EXHIBIT 17-2
Extended Illustration – Calculation of Taxable Income (Loss)
and Taxes Payable
Tax rate (t)
20x1
20x2
20x3
20x4
40%
40%
42%
43%
Accounting incom e (loss) subject to
tax
Temporary difference:
+ Depreciation
– CCA
Taxable incom e (loss) for current
year
$ 300,000
$ (600,000)
$ 200,000
$ 600,000
100,000
–350,000
$
50,000
100,000
–200,000
$ (700,000)
100,000
–150,000
$ 150,000
100,000
–100,000
$ 600,000
Income tax payable
Tax loss carryback used
Tax loss carryforw ard available
Tax loss carryforw ard used, 20x3
Tax loss carryforw ard used, 20x4
$
50,000
(650,000)
150,000
500,000
0
(150,000)
Taxable incom e after tax loss
carryforw ard
Income tax payable
20,000
(500,000)
$
0
0
$ 100,000
$ 43,000