Accounting for
Income Taxes
Chapter
19
Intermediate Accounting
12th Edition
Kieso, Weygandt, and Warfield
Prepared by Coby Harmon, University of California, Santa Barbara
Background
• Deferral approach to tax allocation
(APB Opinion 11)
– Income tax expense = amount of taxes that
would be paid if income statement numbers
appeared on the current year's tax return.
• Deferred taxes was the plug figure (difference
between taxes payable and tax expense).
• The effect of subsequent changes in tax rates on
deferred tax account were essentially ignored.
Matching Approach
Background
• A method that was proposed theoretically
(but has never been GAAP in US)
– Assets and liabilities would be recorded NET of
any deferred tax related to the item
Net-of-Tax Approach
Background
• Liability approach to tax allocation
(FASB 96, 109)
– Income tax expense = taxes currently payable
plus change in deferred taxes.
• If tax rates change, the effect on deferred tax
amounts affect income tax expense in the year the
change is enacted.
• If there are no changes in tax rates, income tax
expense should be approximately the same as under
APB Opinion 11.
Asset/Liability
Measurement Approach
Fundamentals of Accounting for Income Taxes
Financial Statements
Tax Return
vs.
Exchanges
Investors and Creditors
Pretax Financial Income
GAAP
Income Tax Expense

Taxable Income

Tax Code
Income Tax Payable
Temporary Differences
A Temporary Difference is the difference between the tax
basis of an asset or liability and its reported (carrying or
book) amount in the financial statements that will result in
taxable amounts or deductible amounts in future years.
Future Taxable
Deferred Tax
Liability
Amounts
represents the increase in taxes
payable in future years as a
result of taxable temporary
differences existing at the end
of the current year.
Future Deductible
Deferred Tax
Asset represents
Amounts
the increase in taxes refundable
(or saved) in future years as a
result of deductible temporary
differences existing at the end
of the current year.
Illustration 19-22 Examples of Temporary Differences
Temporary Differences (1)
• Revenues and gains, recognized in
financial income, are later taxed for
income tax purposes.
– Installment sales
• Expenses and losses are deducted for
income tax purposes before they are
recognized in financial income.
– MACRS depreciation
– Goodwill deduction on tax return
Called “taxable temporary differences”
Temporary Differences (2)
• Revenues and gains are taxed for
income tax purposes before they are
recognized in financial income.
– Subscription revenue
– Prepaid rent
• Expenses and losses, recognized in
financial income, are later deducted
for income tax purposes.
– Warranty expense
Called “deductible temporary differences”
Summary of Temporary Differences
When recorded
Transaction
in books
When recorded
on tax return
Deferred
tax effect
Rev or Gain
Earlier
Later
Liability
Rev or Gain
Later
Earlier
Asset
Exp or Loss
Earlier
Later
Asset
Exp or Loss
Later
Earlier
Liability
Permanent Differences
Sources of Permanent Differences
Some items
are recorded
in Books
Other items
are NEVER
recorded in books
but NEVER
on tax return
but recorded
on tax return
No deferred tax effects
for permanent differences
Permanent Differences: Examples
• Items, recognized for financial accounting
purposes, but not for income tax purposes:
– Interest revenue on Municipal Bonds
– Life insurance premiums and proceeds when corporation is
beneficiary
– Fines and penalties
• Items, recognized for tax purposes, but not
for financial accounting purposes:
– Dividend exclusion
– Statutory depletion
Deferred Tax Asset & Deferred
Tax Liability: Sources
• Deferred taxes may be a:
– Deferred tax liability, or
– Deferred tax asset
• Deferred tax liability arises due to net
taxable amounts in the future.
• Deferred tax asset arises due to net
deductible amounts in the future.
Valuation Allowance
for Deferred Tax Assets
If the deferred tax asset appears doubtful,
a Valuation Allowance account is needed.
Journal entry:
Income Tax Expense
$$
Allowance to Reduce
Deferred Tax Asset to
Expected Realizable Value
$$
The entry records a potential future tax benefit
that is not expected to be realized in the future.
Also be aware of guidance on uncertain tax positions (from
FIN 48) which is not quite the same thing
What Tax Rate to Apply
• Basic Rule: Apply the yearly tax rate to calculate
deferred tax effects.
– If future tax rates change: use the enacted tax rate
expected to apply in the future year.
– If new rates are not yet enacted into law for future
years, the current rate should be used.
• The appropriate enacted rate for a year is the
average tax rate [based on graduated tax
brackets].
Balance Sheet Presentation
• The deferred tax classification relates to its
underlying asset or liability.
– Classify the deferred tax amounts as current or
non-current.
• Presentation is
– NET amount related to current items
• If DR>CR, current deferred tax asset
• If DR<CR, current deferred tax liability
– NET amount related to noncurrent items
• If DR>CR, noncurrent deferred tax asset
• If DR<CR, noncurrent deferred tax liability
Net Operating Loss (NOL)
Net operating loss is tax terminology.
A net operating loss occurs when tax
deductions for a year exceed taxable
revenues.
Net loss or operating loss is a financial
accounting term.
NOL Rule (subject to change)
• NOL for each tax year is computed.
• The NOL of one year can be applied to
offset taxable income of other years,
possibly resulting in tax refunds
• Current rule: NOLs can be:
– carried back 2 years and carried forward
20 years (carryback option),
– or carried forward 20 years (carryforward
only)
Intraperiod Tax Allocation
Income tax expense, is allocated to:
•
•
•
•
Continuing operations
Discontinued operations
Extraordinary items
Cumulative effect of an accounting change,–
we won’t see this one any more after FAS154
• Prior period adjustments
Disclose other significant components,
such as:
• current tax expense,
• deferred tax expense/benefit, etc.
Other Items Affected
• Comprehensive income items
– Holding gain/loss on AFS securities
– Certain gains/losses related to foreign currency
and derivatives
– Pension & post-retirement benefit amounts not
yet recognized on income statement
• Correction of error/change in accounting
principle that affects beginning retained
earnings
• Expenses for employee stock-based
compensation
• Existing deferred amounts in quasireorganization
FIN 48 –Uncertain Tax Positions
• The key points in the Interpretation are:
– A tax benefit may be reflected in the financial
statements only if it is “more likely than not”
that the company will be able to sustain the tax
return position, based on its technical merits
– A tax benefit should be measured as the largest
amount of benefit that is cumulatively greater
than 50-percent likely to be realized
Examples of tax positions (1)
• A deduction taken on the tax return for a
current expenditure that the taxing
authority may assert should be capitalized
and amortized over future periods.
• A decision that certain income is nontaxable
under the tax law.
• The determination of the amount of taxable
income to report on intercompany transfers
between subsidiaries in different tax
jurisdictions.
Examples of tax positions (2)
• The determination as to whether an entity
qualifies as a real estate investment trust or
regulated investment company.
• The determination as to whether an entity is
subject to tax in a particular jurisdiction.
• The determination as to whether a spin-off
transaction is taxable or nontaxable.
• The calculation of the amount of a research
and experimentation credit.
FIN 48
• First, identify uncertain tax positions
– Determine the appropriate “unit of
account”
– Example – consider all R&D together or
consider each R&D project separately
– FASB did not specify
• Next, apply FIN 48 step process to
determine how much to recognize
FIN 48 – Step 1, Does it meet
recognition threshold?
• “More likely or not” of being accepted
by IRS on its technical merits
– Assumes taxing authority has full
knowledge of all relevant facts
• If not, entire amount must be
“reserved” (e.g., offset by the
allowance account)
FIN 48 – Step 2
Measure the tax benefit
• Measurement
• The benefit recognized for a tax
position meeting the more-likely-thannot criterion is measured based on the
largest benefit that is more than 50
percent likely to be realized.
• A new methodology is introduced
based on “cumulative probability”
– Example needed to explain (next slide)
FIN 48 – PWC example
• Assume that a position to claim a tax
credit of $1,000 is “more likely than
not,” based on its technical merits.
The company seeking to claim this
credit has developed the probability
table [next slide] of all possible
material outcomes.
1
2
Amount of the
“as filed” tax
benefit
$1000 $800
management
expects to
sustain
% likelihood
that it will be
10%
20%
sustained
Cumulative %
10%
30%
3
$600
4
5
$400 $200
25%
25%
20%
55%
80%
100%
FIN 48 – PWC example
• Assume that a position to claim a tax credit
of $1,000 is “more likely than not,” based on
its technical merits. The company seeking to
claim this credit has developed the
probability table [next slide] of all possible
material outcomes.
• Under the Interpretation, $600 denotes the
amount of tax benefit that would be
recognized in the financial statements; it
represents the maximum amount of benefit
that is more than 50-percent likely to be the
end result.
How much to disclose? A big deal??
FIN 48 Disclosures
• Must continuously monitor uncertain
tax positions
• Should have processes and controls to
identify material changes
– Will require much closer coordination
between tax dept and financial accounting
(public reporting) department!
From Para. A33 Example
FIN 48 – accruing interest
• Interest and penalties must be paid if
underpayment of tax liabilities exists
• A position that does not qualify as
“more likely than not” under GAAP is
effectively a LOAN from government
• Therefore, interest should be accrued
on the full balance on the liability for
unrecognized uncertain tax benefits
FIN 48 – Balance Sheet
• Uncertain tax positions result in recognition
of a tax liability or a decrease in recognized
tax assets on the balance sheet
• The tax liability for “uncertain positions” is
NOT a component of deferred taxes and
must be classified SEPARATELY from other
tax balances
– Current or noncurrent depending on expected
timing of cash flows to/from IRS
Deferred Taxes
IAS 12 vs FAS 109
versu
s
Which Tax Rate to Use
IFRS
• Enacted or
substantively
enacted tax rat
US GAAP
• Enacted tax rates
Deferred Tax Assets
IFRS
• Don’t recognize at
all unless it is
“more likely than
not” to be usable
in the future
US GAAP
• Use an allowance
account to reduce
to net realizable
value
• Uses same “more
likely than not”
criteria
Balance Sheet Presentation
IFRS
• Always classified
as noncurrent
• Plans to revise to
do it the FASB way
US GAAP
• Current items
netted
• Noncurrent items
netted