Chapter 14
Taxes on the Financial
Statements
Corporations, Partnerships,
Estates & Trusts
© 2012 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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The Big Picture (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.
The Big Picture (slide 2 of 2)
• In addition, the corporate tax return reports taxable income of
$19 million and Federal income taxes payable of only $6.65
million.
• 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.
Book-Tax Differences
• 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
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Different Reporting Entities
(slide 1 of 2)
• For book purposes:
– For > 50% ownership, corporate group must
consolidate all U.S. and foreign subs
– 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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Different Reporting Entities
(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. 14-2.
• 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. 14-2 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.
Different Taxes
• 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. 14-2 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 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. 14-2 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.
Different Methods
(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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Different Methods
(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
13
Different Methods
(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, post-1993 intangibles are amortized over
15 years
14
Different Methods
(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
15
Schedule M–1
(slide 1 of 2)
• Used to reconcile book income to taxable income
– Contains positive and negative adjustments for both
temporary and permanent differences
• For tax years after 2004, 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
• 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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Schedule M–1
(slide 2 of 2)
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GAAP Principles (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
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GAAP Principles (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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GAAP Principles (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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GAAP Principles (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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GAAP Principles
(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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Deferred Tax Liability Example
(slide 1 of 3)
• PJ Enterprises earns net income before depreciation
of $500,000 in 2009 and $600,000 in 2010.
• PJ has one depreciable asset acquired in 2009 for
$80,000
– For tax purposes, PJ may deduct $60,000 in depreciation
expense for the first year and $20,000 for the second year
– For book purposes, assume that PJ depreciates the asset on
a straight-line basis over 2 years ($40,000 per year)
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Deferred Tax Liability Example
(slide 2 of 3)
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Deferred Tax Liability Example
(slide 3 of 3)
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Valuation Allowance
(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
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Valuation Allowance
(slide 2 of 2)
• To determine if a valuation allowance is needed, 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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Earnings Of Foreign Subsidiaries
(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
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Earnings Of Foreign Subsidiaries
(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
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The Big Picture – Example 15
ASC 740-30(APB 23)
• Return to the facts of The Big Picture on p. 14-2.
• 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 2010, and
– To only Hurricane in 2011.
• In 2012, Arctic can choose to use ASC 740-30 (APB
23) for:
– 40% of Hurricane’s earnings, and
– 80% of Typhoon’s earnings.
Tax Disclosures
(slide 1 of 4)
• Deferred tax liabilities or assets appear in the
corporation’s balance sheet
– Classified as either current or noncurrent, based on
the assets or liabilities that created the temporary
difference
– If not related to any asset, then classification is
based on the expected reversal period
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The Big Picture – Example 18
Balance Sheet Reporting
• Return to the facts of The Big Picture on p. 14-2.
• 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
(slide 2 of 4)
• 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
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Tax Disclosures
(slide 3 of 4)
• 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
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Tax Disclosures
(slide 4 of 4)
• Effective tax 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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Calculating Corporate
Income Tax Expense
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Benchmarking
• 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
37
The Big Picture – Example 26
Releasing Valuation Allowance (slide 1 of 2)
• Return to the facts of The Big Picture on p. 14-2.
• 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 26
Releasing Valuation Allowance (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.
Refocus On The Big Picture (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.
Refocus On The Big Picture (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.
Refocus On The Big Picture (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%.
Refocus On The Big Picture (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.
Refocus On The Big Picture (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
© 2012 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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