Essentials of Taxation
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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(slide 1 of 2)
• Raymond Jones, the CEO of Arctic Corporation, would like some help reconciling the income tax expense on Arctic’s financial statements with the income tax reported on the company’s corporate income tax return.
– Mr. Jones doesn’t understand why he can’t simply multiply the financial statement income by the company’s 35% marginal tax rate to get the financial tax expense.
•
While the financial statements show book income before tax of
$25 million, the reported Federal tax expense is only $7.7 million.
• In addition, the corporate tax return reports taxable income of
$19 million and Federal income taxes payable of only $6.65 million ($6.65 million X 35%).

(slide 2 of 2)
•
Without knowing the specifics of the company’s financial statements, does Arctic’s situation look reasonable?
• Why is Arctic’s financial tax expense not equal to $8.75 million ($25 million X 35%)?
•
What causes the $1.05 million difference between the taxes shown on the financial statements and the taxes due on the tax return?
•
Read the chapter and formulate your response.

• Significant differences may exist between a corp.'s
Federal income tax liability reported on Form 1120
(tax) and the corp.’s income tax expense on financial statements (book)
–
Differences are caused by any or all of the following:
•
Differences in reporting entities included in the calculation
• Different definition of taxes included in the income tax expense amount
• Different accounting methods
4

(slide 1 of 2)
•
For book purposes, a corporate group must consolidate all U.S. and foreign subsidiaries when the parent corporation has > 50% ownership
–
For 20% to 50% ownership, parent uses the equity method to account for earnings of sub
–
For < 20% ownership, use the cost method to account for income from these investments
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(slide 2 of 2)
•
For tax purposes:
–
U.S. corporation may elect to include any domestic subsidiaries that are 80% or more owned in its consolidated U.S. tax return
• The income of foreign subsidiaries and < 80% owned domestic subsidiaries is not included in consolidated tax return
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The Big Picture – Example 1
Different Reporting Entities
• Return to the facts of The Big Picture on p. 3-1.
•
Arctic Corporation owns the following:
– 100% of Gator, Inc., a domestic corporation;
–
100% of Hurricane, Ltd., a foreign corporation; and
– 40% of Beach, Inc., a domestic corporation.
• Arctic’s combined financial statement includes its own net income and the net income of both Gator and Hurricane.
– In addition, Arctic’s financial statement includes its 40% share of
Beach’s net income.
• Arctic’s financial statement includes the income of these subsidiaries regardless of whether Arctic receives any actual profit distributions from its subsidiaries.

The Big Picture – Example 2
Different Reporting Entities
• Return to the facts of The Big Picture on p. 3-1 and also assume the facts presented in Example 1.
•
If Arctic elects to include Gator as part of its consolidated
Federal income tax return, Arctic’s return includes its own taxable income and the taxable income generated by Gator.
– Hurricane’s taxable income is not included in the consolidated return because it is a non-U.S. corporation.
–
Beach, although a domestic corporation, cannot be consolidated with
Arctic because Arctic owns only 40% of the stock.
• Income from Hurricane and Beach will be included in Arctic’s
U.S. taxable income only when Arctic receives actual or constructive dividends.

• For book purposes, income tax expense includes:
–
Federal, state, local, and foreign income taxes
–
Both current and deferred tax expense amounts
•
For tax purposes:
– Amount is based on the U.S. corporation’s taxable income
–
State income taxes are reported on the Federal tax return, but as deductions in arriving at taxable income
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The Big Picture – Example 3
Different Taxes
• Return to the facts of The Big Picture on p. 3-1 and also assume the facts presented in Example 1.
•
For book purposes, Arctic, Gator, and Hurricane combine their income and expenses into a single financial statement.
–
The book tax expense for the year includes all Federal, state, local, and foreign income taxes paid or accrued by these three corporations.
– In addition, the book tax expense amount includes any future Federal, state, local, or foreign income tax expenses
(or tax savings) on income reported in the current income statement.

The Big Picture – Example 4
Different Taxes
• Return to the facts of The Big Picture on p. 3-1 and also assume the facts presented in Example 1.
• Arctic and Gator file a consolidated Federal tax return.
• The tax expense reported on the Form 1120 is only the U.S. Federal income tax expense for the consolidated taxable income of Arctic and Gator.
–
This tax expense does not include the income taxes that
Arctic and its subsidiaries paid to state, local, or foreign governments.

(slide 1 of 4)
•
Many differences exist between book and tax accounting methods
–
Some are temporary differences
•
Income and expenses appear in both the financial statement and tax return, but in different periods
–
Others are permanent differences
•
Items appear in financial statement or tax return, but not both
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(slide 2 of 4)
•
Examples of temporary differences include:
–
Depreciation on fixed assets
• MACRS used for tax, straight-line for book
–
Compensation-related expenses where, under
GAAP, corps must accrue future expenses related to certain postretirement benefits
•
Only deductible for tax purposes when paid
–
Accrued income and expenses such as warranty expenses
• Accrued for book purposes, but are not deductible for tax purposes until incurred
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(slide 3 of 4)
•
Examples of temporary differences include
(cont’d):
–
Net operating losses incurred in one year for book purposes may be used as a deduction for tax purposes in a different year
–
Certain intangible assets such as goodwill are not amortizable for book purposes, but for tax purposes, intangibles are amortized over 15 years
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(slide 4 of 4)
• Examples of permanent differences include:
–
Nontaxable income such as municipal bond interest, which is income for book purposes but is not taxable
–
Nondeductible expenses such as 50% of meals & entertainment expense and certain penalties that are not deductible for tax purposes but are expensed in arriving at book income
– Tax credits such as the research activities credit which reduce the Federal income tax liability but have no corresponding book treatment
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(slide 1 of 2)
• Used to reconcile book income to taxable income
– Contains positive and negative adjustments for both temporary and permanent differences
• Schedule M–3 is required for a consolidated tax group with total year-end assets ≥ $10 million
–
Income tax note of the financial statements also contains a tax reconciliation, but the purpose and content of this reconciliation are quite different
• Schedule M-1 or M-3 is typically the starting point for IRS audits of corporations
–
Identifies large differences between book and taxable income which may offer the IRS auditor insights into tax saving strategies
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(slide 2 of 2)
17

(slide 1 of 2)
•
The IRS requires that large corps. list the tax return positions they have taken that may not be fully supported by the law
– Schedule UTP (“uncertain tax positions”) is added to the Form 1120 for all corporations with assets of at least $10 million
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(slide 2 of 2)
• Disclosures on the Schedule UTP include tax return positions for the current and prior tax years where the taxpayer or a related party
– Recorded a reserve against the Federal income tax expense on its audited financial statements, and
–
Did not record a tax reserve based on its analysis of expected litigation
• This means that in the taxpayer’s view, the probability of settling the item with the IRS < 50%, and
•
The taxpayer determines that it is more likely than not ( > 50% likelihood) to prevail on the merits of the issue in litigation
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(slide 1 of 5)
•
Income tax expense under ASC 740 (SFAS
109) is made up of both current and deferred components
–
Current tax expense theoretically represents the taxes actually payable to (or refund receivable from) the government
–
Deferred tax expense or deferred tax benefit represents the future tax cost (or savings) connected with income reported in the currentperiod financial statement
• Created as a result of temporary differences
20

(slide 2 of 5)
•
ASC 740 (SFAS 109) adopts a balance sheet approach to measuring deferred taxes
–
Under this approach, the deferred tax expense or benefit is the change from one year to the next in the net deferred tax liability or deferred tax asset
•
A deferred tax liability is the expected future tax liability related to current income
(measured using enacted tax rates and rules)
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(slide 3 of 5)
•
A deferred tax liability is created in the following situations:
–
An expense is deductible for tax in the current period but is not deductible for book until some future period
–
Income is includible currently for book purposes but is not includible in taxable income until a future period
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(slide 4 of 5)
•
A deferred tax asset is the expected future tax benefit related to current book income
(measured using enacted tax rates and rules)
– A deferred tax asset is created in the following situations:
•
An expense is deductible for book in the current period but is not deductible for tax until some future period
• Income is includible in taxable income currently but is not includible in book income until a future period
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(slide 5 of 5)
•
Deferred tax assets and liabilities are reported on the balance sheet
–
Deferred tax liabilities represent an amount that may be paid to the government in the future
• In essence, an interest-free loan from the govt. with a due date perhaps many years in the future
–
Deferred tax assets are future tax benefits
•
Similar to a receivable from the government that may not be received until many years in the future
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(slide 1 of 3)
•
MollCo, Inc., earns net income before warranty expense of $400,000 in 2014 and $450,000 in 2015.
•
In 2014, MollCo deducts $30,000 in warranty expense for book purposes related to expected warranty repairs.
–
This warranty expense is not deductible for tax purposes until actually incurred.
•
Assume that the $30,000 warranty expense is paid in
2015 and that this is MollCo’s only temporary difference.
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(slide 2 of 3)
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(slide 3 of 3)
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(slide 1 of 2)
•
Under ASC 740 (SFAS 109),deferred tax assets are recognized only when it is probable that the future tax benefits will be realized
– When the more likely than not threshold is not met, a valuation allowance (a contra-asset account) must be created to offset all or a portion of the deferred tax asset
28

(slide 2 of 2)
•
To determine if a valuation allowance is required, both positive and negative evidence must be evaluated
– Examples of negative evidence include:
• History of losses
• Expected future losses
• Short carryback/carryforward periods
• History of tax credits expiring unused
– Examples of positive evidence include:
• Strong earnings history
•
Existing contracts
• Unrealized appreciation in assets
• Sales backlog of profitable orders
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The Big Picture – Example 13
(slide 1 of 2)
•
Return to the facts of The Big Picture on p. 3-1.
• Arctic Corporation’s $3 million deferred tax asset for an NOL carryforward is offset by a
$1 million valuation allowance, due to doubts over the levels of future sales and profitability.

The Big Picture – Example 13
(slide 2 of 2)
•
But this year, Arctic completed improvements to its inventory management system.
– This is likely to increase contribution margins of every product it sells.
• Two of Arctic’s largest customers have secured financing that will relieve the financial difficulties that have restricted them.
– Arctic just received purchase orders from those customers that will increase unit sales by 20% over the next 18 months.
• As a result, Arctic’s auditors now support a release of
$200,000 of the valuation allowance in the current quarter.

Tax Disclosures in the Financial Statements
(slide 1 of 5)
•
The Balance Sheet
–
Temporary differences create deferred tax liabilities or deferred tax assets
• These amounts appear in the corporation’s balance sheet
–
These accounts are classified as either current or noncurrent
•
Based on the assets or liabilities that created the temporary difference
• If not related to any asset, then the classification is based on the expected reversal period
32

Tax Disclosures in the Financial Statements
(slide 2 of 5)
• The Balance Sheet (cont’d)
–
A corporation may have both deferred tax assets and liabilities, current and noncurrent
•
The corporation reports the net current deferred tax assets or liabilities and the net noncurrent deferred tax assets or liabilities
33

The Big Picture – Example 15
•
Return to the facts of The Big Picture on p. 3-1.
•
Arctic Corporation holds the following deferred tax asset and liability accounts for the current year.
Current deferred tax assets
Current deferred tax liabilities
Noncurrent deferred tax assets
Noncurrent deferred tax liabilities
• On its balance sheet, Arctic reports:
– A $22,000 current net deferred tax liability
•
$72,000 - $50,000, and
– A $65,000 noncurrent net deferred tax asset
•
$93,000 - $28,000.
$50,000
72,000
93,000
28,000

Tax Disclosures in the Financial Statements
(slide 3 of 5)
• The Income Statement - reports corp.'s total income tax expense
– Consists of both the current and deferred tax expense (or benefit)
– Tax expense must be allocated to:
• Income from continuing ops
• Discontinued ops
• Extraordinary items
• Prior-period adjustments, and
•
The cumulative effect of accounting changes
–
Additional disclosures are required for some of these items
35

Tax Disclosures in the Financial Statements
(slide 4 of 5)
•
Financial Statement Footnotes – the income tax note contains the following info:
–
Breakdown of income between domestic and foreign
– Detailed analysis of provision for income tax expense
–
Detailed analysis of deferred tax assets and liabilities
– Effective tax rate reconciliation (dollar amount or percentage)
–
Information on use of ASC 740-30 (APB 23) for the earnings of foreign subsidiaries
– Discussion of significant tax matters
36

Tax Disclosures in the Financial Statements
(slide 5 of 5)
•
Rate Reconciliation
– Demonstrates how a corporation’s actual book effective tax rate relates to its “hypothetical tax rate” as if the book income were taxed at a rate of
35%
–
Similar to Schedule M–1 or M–3, but only reports differences triggered by permanent differences
•
Can provide substantial clues as to tax planning strategies adopted (or not adopted) by a company
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38

Financial Accounting for Tax Uncertainties
(slide 1 of 4)
•
Companies sometimes take positions in their tax returns that may not ultimately survive IRS scrutiny
– Companies may book a reserve (or “cushion”) for these uncertain tax positions
•
That is, rather than book the entire tax benefit (and thus reduce tax expense in the current year), the company may book only a portion (or none) of the tax benefit
39

Financial Accounting for Tax Uncertainties
(slide 2 of 4)
•
If the company later loses the actual tax benefit upon audit, the additional tax imposed is charged against the reserve (or “cushion”)
– The additional tax does not affect the future-year tax expense
• If the company’s tax position is not challenged in the future (or the company successfully defends any challenge), the reserve can be released
40

Financial Accounting for Tax Uncertainties
(slide 3 of 4)
•
The FASB was concerned that companies too freely used the tax reserve as a “cookie jar” to shift earnings from one period to another
–
To add more structure to the accounting for tax reserves, the FASB released ASC 740-10 (FIN
48), “Accounting for Uncertainty in Income
Taxes”
– FIN 48 results in significantly more disclosure about uncertain tax positions by companies
41

Financial Accounting for Tax Uncertainties
(slide 4 of 4)
•
ASC 740-10 (FIN 48) uses a two-step process of recognition and measurement
– First, a tax benefit from an uncertain tax position may be recognized only if it is more likely than not (> 50% likelihood) that the position would be sustained on its technical merits
• Audit or detection risk cannot be considered
• This first step determines whether any of the tax benefit is recognized
– If the uncertain tax position meets this threshold, the second step is to determine the amount of the tax benefit to report
•
Measurement is based on the probabilities associated with the position not being challenged or being challenged with a negotiated settlement or litigation
42

(slide 1 of 2)
• Corporate group’s financial stmts. include both domestic and foreign controlled subsidiaries
–
Foreign corps. controlled by U.S. shareholders, are not part of a U.S. consolidated tax return
• May achieve deferral of current U.S. taxes on foreign income if earned through foreign subsidiary corps in jurisdictions with lower tax rates than the U.S.
•
Effective tax rate for financial stmt. purposes may not reflect this deferral
– ASC 740 (SFAS 109) requires that a corporate group report both current and deferred income tax expense
43

(slide 2 of 2)
• ASC 740-30 (APB 23) provides a special exception to ASC 740 (SFAS 109) for income from foreign subs
– If a corp. documents it is permanently reinvesting earnings of its foreign subs outside the U.S., the corp. does not record as an expense any future U.S. income tax that the corp. may pay on such earnings
•
ASC 740-30 (APB 23) can be adopted in some years and not others
–
Even within a year it may be used for only a portion of foreign subsidiary earnings
44

The Big Picture – Example 21
•
Return to the facts of The Big Picture on p. 3-1.
•
Recall from Example 1 that Arctic Corporation has a wholly owned foreign subsidiary, Hurricane, Ltd.
– Assume that Arctic also owns 100% of another foreign corporation, Typhoon, Ltd.
•
Arctic can choose to apply ASC 740-30(APB 23) to:
– Both of its foreign subsidiaries in year 1, and
–
To only Hurricane in year 2.
• In year 3, Arctic can choose to use ASC 740-30 (APB
23) for:
– 40% of Hurricane’s earnings, and
– 80% of Typhoon’s earnings.

•
Reported income tax expense is a valuable source of information
– Provides clues about a company’s operational and tax planning strategies
–
Companies may benchmark their tax situation to other years’ results or to other companies within the same industry
•
The starting point is data from the income tax note rate reconciliation
46

(slide 1 of 5)
•
Raymond Jones should understand that tax expense reported on the company’s financial statements and tax payable on the company’s income tax returns are often different as a result of:
– Differences in reporting entities used in the calculation, and
– The different accounting methods used for book and tax purposes.

(slide 2 of 5)
• The use of different accounting methods may result in both temporary and permanent differences in financial statement income and taxable income.
– Examples of permanent differences include nontaxable income like municipal bond interest and tax credits.
–
Temporary differences include depreciation differences and other amounts that are affected by the timing of a deduction or inclusion but ultimately will result in the same amount being reflected in the financial statements and income tax returns.

(slide 3 of 5)
•
Permanent differences such as municipal bond interest cause Arctic’s book income to be greater than its taxable income.
•
In calculating the tax expense shown on the financial statements, Arctic’s book income must be adjusted for these permanent differences.
–
This results in an effective tax rate for financial statement purposes (30.8%) that is below the top
U.S. statutory corporate income tax rate of 35%.

(slide 4 of 5)
• In this case, Arctic’s income tax expense of
$7.7 million is higher than the current Federal income tax payable.
– This results from timing differences and creates a
$1.05 million deferred tax liability that is reported on the company’s balance sheet.
•
Unlike other liabilities, deferred tax liabilities are ‘‘good’’ in the sense that they represent an amount that may be paid to the government in the future rather than today.

(slide 5 of 5)
What If?
•
Mr. Jones is concerned about a newspaper article that said that companies reporting less tax on their tax returns than on their financial statements were cheating the IRS.
–
Is this an accurate assessment?
•
While differences in income taxes payable to the IRS and financial tax expense can result from aggressive and illegal tax shelters, differences also result from different methods of accounting that are required for financial statement reporting using GAAP and tax laws as enacted by Congress.

If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu
SUNY Oneonta
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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