StIce | StIce |Skousen
Income Taxes
Chapter 16
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning Objectives
1. Understand the concept of deferred
taxes and the distinction between
permanent and temporary
differences.
2. Compute the amount of deferred tax
liabilities and assets.
3. Explain the provisions of tax loss
carrybacks and carryforwards, and
be able to account for these
provisions.
Learning Objectives
4. Schedule future tax rates, and determine
the effect on tax assets and liabilities.
5. Determine appropriate financial
statement presentation and disclosure
associated with deferred tax assets and
liabilities.
6. Comply with income tax disclosure
requirements associated with the
statement of cash flows.
7. Describe how, with respect to deferred
income taxes, International Accounting
Standards have converged toward the
U.S. Treatment.
Overview
• The primary goal of
financial accounting is to
provide useful
information to
management,
stockholders, creditors,
and other properly
interested.
• The primary goal of the
income tax system is the
equitable collection of
revenue.
Deferred Income Tax Overview
Two basic considerations in U.S.
corporations computed net income.
1. How to account for revenues
and expenses that have
already been recognized and
reported to shareholders in a
company’s financial
statements but will not affect
taxable income until
subsequent years.
Deferred Income Tax Overview
Two basic considerations in U.S.
corporations computed net income.
2. How to account for revenues
and expenses that have
already been reported to the
IRS but will not be recognized
in the financial statements
until subsequent years.
Stop and Think
This discussion
mentions two sets of
books the financial
and the income tax
records. Which ONE
of the following is the
most important third
set of accounting
records in a well-run
business?
Simple Deferred Income Tax
Liability
• Examples:
– Revenues (or gains) taxable after they are
recognized for financial reporting, such
as receivables from installment sales.
– Expenses (or losses) deductible for tax
purposes before they are recognized for
financial reporting purposes, such as
accelerated tax depreciation.
Simple Deferred Tax Liability
In 2007, Hernandez Company earned
revenues of $30,000. Hernandez has no
expenses other than income taxes. In
this case, Hernandez is taxed on cash
received. The company received $10,000
in 2007 and $20,000 in 2008. The
income tax rate is 40% and it is expected
to remain the same into the foreseeable
future.
Simple Deferred Tax Liability
Income Tax Expense
Income Taxes Payable
Deferred Tax Liability
12,000
4,000
8,000
$30,000 x .40
$10,000 x .40
$20,000 x .40
Hernandez Company
Income Statement
For the Year Ended December 31, 2007
Revenues
Income tax expense:
Current
Deferred
Net income
$30,000
$4,000
8,000
$18,000
Simple Deferred Income Tax
Asset
• Examples:
– Expenses (or losses) that are deductible
for tax purposes after they are recognized
for financial reporting purposes, such as
warranty expenses.
– Revenues (or gains) that are taxable
before they are recognized for financial
reporting purposes, such as
subscriptions received in advance.
Simple Deferred Tax Asset
In 2007, Shah Corporation generated
service revenues totaling $60,000, all
taxable in 2007. No warranty claims
were made in 2007, but Gupta estimates
that in 2008 warranty costs of $10,000
will incurred for claims related to 2007
service revenues. Assume a 40% tax
rate.
Simple Deferred Tax Asset
Income Tax Expense
Deferred Tax Asset
Income Taxes Payable
20,000
4,000
24,000
$30,000 x .40
Shah Company
$10,000 x .40
Income Statement
$20,000 x .40
For the Year Ended December 31, 2007
Revenues
Less: Warranty Expense
Income before taxes
Income tax expense:
Current
Deferred benefit
Net income
$60,000
10,000
50,000
$24,000
(4,000)
20,000
$30,000
Temporary Differences
• Permanent Differences- Nondeductible
expenses or nontaxable revenues that are
recognized for financial reporting purposes
but are never part of taxable income.
• Temporary Differences- Differences between
pretax financial income and taxable income
arising from business events that are
recognized for both financial and tax
purposes, but in different time periods.
Stop and Think
How can a company
have both deferred
tax assets and
deferred tax liabilities
at the same time?
Example of Permanent and
Temporary Differences
For the year ended December 31, 2007,
Monroe Corporation reported net
income before taxes of $420,000. This
amount includes $20,000 of
nontaxable revenues and $5,000 of
nondeductible expenses. The
depreciation method used for tax
purposes allowed a deduction that
exceeded the book approach by
$30,000.
Example of Permanent and
Temporary Differences
Pretax income from income statement $420,000
Add (deduct) permanent differences:
Nontaxable revenues
$(20,000)
Nondeductible expenses
5,000 (15,000)
Financial income subject to tax
$405,000
Add (deduct) temporary differences:
Excess of tax depreciation over
book depreciation
(30,000)
Taxable income
$375,000
Tax on taxable income (income
taxes payable): $375,000 x .35
$131,250
Annual Computation of Deferred
Tax Liabilities & Assets
•
Advantages of the asset and liability
method:
1. Assets and liabilities are recorded in
agreement with FASB definitions of
financial statement elements.
2. Method is flexible and recognizes
changes in circumstances and adjusts
the reported amounts accordingly.
3. Has better predictive value.
Annual Computation of Deferred
Tax Liabilities and Assets
Identify type and amounts of existing
temporary differences.
Measure the deferred
tax liability for taxable
temporary differences
(use enacted rates).
Measure the deferred
tax asset for deductible
temporary differences
(use enacted rates).
Establish valuation allowance account if
more likely than not some portion or all of
the deferred tax asset will not be realized.
Example 3 Deferred Tax Liability
For 2007, Roland computes pretax financial
income of $75,000. The only difference
between financial and taxable income is
depreciation. The enacted tax rate is 40%.
The 2007 tax is $24,000 (40% of $60,000).
Financial income subject to tax
$75,000
Deduct temporary difference:
Excess of tax depreciation ($40,000)
over book depreciation ($25,000) (15,000)
Taxable income
$60,000
Example 3 Deferred Tax Liability
Journal entry for 2007
Income Tax Expense
Income Taxes Payable
Deferred Tax Liability—
Noncurrent
30,000
24,000
6,000
$30,000 –
$6,000
$15,000 x .40
Stop and Think
How might the current
and deferred income
tax numbers for 2008
change if the 2008
income tax rate were
40% but Roland
expected tax rates in
future periods to be
30% instead of 40%.
Example 3 Deferred Tax
Liability
For 2008, Roland earned income of $75,000
and the taxable income is $70,000, or a tax of
$28,000.
Financial income subject to tax
$75,000
Deduct temporary difference:
Excess of tax depreciation ($30,000)
over book depreciation ($25,000)
(5,000)
Taxable income
$70,000
Tax @ 40%
$28,000
Example 3 Deferred Tax
Liability
Journal entry for 2008
Income Tax Expense
Income Taxes Payable
Deferred Tax Liability—
Noncurrent
30,000
28,000
2,000
Depreciation expense in 2009 is the same for
$30,000
both financial and tax, so the entry is
simple.– 2,000
Income Tax Exp. 30,000
Income Taxes Pay.
30,000
$5,000 x .40
Example 3 Deferred Tax
Liability
For 2010, Roland earned income of
$75,000 and the taxable income is
$95,000, or a tax of $38,000.
Financial income subject to tax $75,000
Add temporary difference:
Excess of book depreciation
($25,000) over tax depreciation
($5,000)
20,000
Taxable income
$95,000
Tax @ 40%
$38,000
Example 4: Deferred Tax Asset
Journal entry for 2010
Income Tax Expense
Deferred Tax Liability—
Noncurrent
Income Taxes Payable
30,000
8,000
38,000
$20,000 x .40
$30,000 +8,000
Example 4: Deferred Tax Asset
Some possible sources of taxable
income to be considered in evaluating
the realistic value of a deferred tax asset
are:
 Future reversals of existing taxable
temporary differences.
 Future taxable income exclusive of
reversing temporary differences.
 Taxable income in prior (carryback)
years.
Example 4: Deferred Tax Asset
For 2007, Sandusky Inc. computes
pretax financial income of $22,000. The
only difference between financial and
taxable income is the recognition of
warranty expense. Accrued warranty
expense for 2007 was $18,000; no actual
warranty expenditures were made in
2007. The warranty obligation is
considered one-third current and twothirds noncurrent.
Example 4: Deferred Tax Asset
Taxable income in 2007 is calculated as
follows:
Financial income subject to tax
Add temporary difference:
Excess of warranty expense
($18,000) over warranty
deductions ($0)
Taxable income
$22,000
Tax ($40,000 x .40)
$16,000
18,000
$40,000
Example 4: Deferred Tax Asset
Journal entry for 2007
Income Tax Expense
8,800
Deferred Tax Asset—Current 2,400 $18,000
x. 40 =
Deferred Tax Asset—
$7,200
Noncurrent
4,800
Income Taxes Payable $16,000 – 7,200
16,000
1/3 x $7,200
2/3 x $7,200
Example 4: Deferred Tax Asset
In the years 2008 through 2010, taxable income
would be $16,000, computed as follows:
Financial income subject to tax
Reversal of temporary difference:
Excess of warranty deductions
(1/3 x $18,000) over warranty
expense ($0)
Taxable income
$22,000
Tax ($16,000 x .40)
$ 6,400
(6,000)
$16,000
Example 4: Deferred Tax Asset
Journal entry for 2008
Income Tax Expense
Deferred Tax Asset—
Current
Deferred Tax Asset—
Noncurrent
Income Taxes Payable
11,200
2,400
2,400
6,400
Example 4: Deferred Tax Asset
Journal entry for 2009
Income Tax Expense
11,200
Deferred Tax Asset—
Current
2,400
Deferred Tax Asset—
Noncurrent
2,400
Income Taxes Payable
6,400
Example 4: Deferred Tax Asset
Journal entry for 2010
Income Tax Expense
Deferred Tax Asset—
Current
Income Taxes Payable
8,800
2,400
6,400
Example 5: Deferred Tax
Liabilities and Assets
For 2007, Hsieh reported pretax
financial income of $38,000. As of
December 31, 2007, the actual
depreciation expense was $25,000
and the actual warranty expense
was $18,000. For income tax
reporting, these expenses were
$40,000 and $0, respectively.
Example 5: Deferred Tax
Liabilities and Assets
Taxable income in 2007 is calculated as
follows:
Financial income subject to tax
$38,000
Add (deduct) temporary difference:
Excess of warranty expense
over warranty deductions
18,000
Excess of tax depreciation over
book depreciation
(15,000)
Taxable income
$41,000
Tax ($41,000 x .40)
$16,400
Example 5: Deferred Tax
Liabilities and Assets
Journal entry for 2007
Income Tax Expense
Income Taxes Payable
16,400
Deferred Tax Asset—Current 2,400
Deferred Tax Asset—
Noncurrent
4,800
Income Tax Benefit
Deferred Tax Liability—
Noncurrent
16,400
1,200
6,000
Valuation Allowance for
Deferred Tax Asset
• Statement No. 109 stipulates that
both positive and negative
evidence be considered when
determining whether deferred tax
assets will be fully realized.
Stop and Think
In what way do the data
regarding deferred tax
assets and liabilities
provide valuable
information to current and
potential investors and
creditors?
Carryback and Carryforward of
Operating Losses
Carryback Election
Year
-2
Loss
Year
Carryforward Election
Year
+20
Stop and Think
These net operating
loss carrybacks
sound like a great
feature of the tax
law. However,
what did the
company have to
do to take
advantage of this
aspect of the law?
Net Operating Loss (NOL)
Carryback
Year
2007
2008
2009
Income
(Loss)
Tax Rate
$10,000
14,000
(19,000)
35%
30
30
Income
Tax
$3,500
4,200
0
Journal Entry in 2009:
Income Tax Refund Receivable
6,200
Income Tax Benefit From NOL
Carryback
6,200
[$3,500 + (30% x $9,000)]
Accounting for NOL
Carryforward
Continuing with the Prairie Company
illustration, assume that in 2010 the firm
incurred an operating loss of $35,000.
Year
2009
20010
Income
(Loss)
$(19,000)
(35,000)
Tax Rate
30%
30%
Income
Tax
$0
0
The only loss remaining against which operating income
can be applied is $5,000 from 2008 ($14,000 – $9,000).
This leaves $30,000 to be carried forward from 2009 as
a future tax benefit of $9,000 ($30,000 x .30).
Accounting for NOL
Carryforward
The journal entry for 2010 to
record the tax benefits :
Income Tax Refund Receivable
1,500
Deferred Tax Asset—NOL
Carryforward
9,000
Income Tax Benefit from NOL
Carryback
1,500
Income Tax Benefit from NOL
Carryforward
9,000
Accounting for NOL
Carryforward
The firm reports a taxable income of $50,000
in 2011. The tax carryforward allows
management to deduct the carryforward from
the $15,000 tax ($50,000 x .30) that would be
due without the carryforward.
Journal Entry:
Income Tax Expense
Income Taxes Payable
Deferred Tax Asset—NOL
Carryforward
15,000
6,000
9,000
Accounting for NOL
Carryforward
• If
believes
that
will tax
continue
Asmanagement
a result of this
entry,
thelosses
deferred
asset
in the
and expected
the tax benefit
will not
be
is future
zero—the
realizable
value.
realized:
Journal Entry:
Income Tax Refund Receivable
1,500
Deferred Tax Asset—NOL
Carryforward
9,000
Income Tax Benefit from NOL
Carryback
1,500
Allowance to Reduce Deferred
Tax Assets to Realizable Value—
NOL Carryforward
9,000
Scheduling for Enacted Future
Tax Rates
• Proper recognition of deferred tax assets
and liabilities is required when future tax
rates are expected to differ from current tax
rates.
• The firm must determine the temporary
differences that will reverse.
• Statement No. 109 eliminates much of the
need for scheduling through the “morelikely-than-not” criterion for future income.
Financial Statement
Presentation and Disclosure
The following items must appear in the
income statement or an
accompanying note:
•
•
•
•
Current tax expense or benefit
Deferred tax expense or benefit
Investment tax credits
Government grants recognized as tax
reductions
Financial Statement
Presentation and Disclosure
The following items must appear in the
income statement or an accompanying
note:
• Benefits of NOL carryforwards
• Adjustments of a deferred tax liability or
asset for enacted changes in tax laws or
rates or a change in the tax status of an
enterprise
• Adjustments in beginning-of-the-year
valuation allowance because of a change in
circumstances
Stop and Think
What is the
rationale behind
excluding from a
corporation’s
taxable income
dividends
received from
another
corporation?
Deferred Taxes and the
Statement of Cash Flows
Callazo Company had the following information
for 2007:
Revenue (all cash)
$30,000
Income tax expense:
Current
$10,300
Deferred
Net income
1,700
(12,000)
$18,000
Cash paid for income taxes during 2007 totaled
$13,300.
Deferred Taxes and the
Statement of Cash Flows
12/31/07 12/31/07
Income tax refund receivable
Income taxes payable
Deferred tax liability
$2,000
0
9,700
$
0
1,000
8,000
Analysis
Income Statement
Adjustment
Revenue (all cash),
$30,000
No adjustment
SCF
$30,000 cash
collected from
customers
Deferred Taxes and the
Statement of Cash Flows
Analysis
Income Statement
Income tax
expense—current
$(10,300)
Adjustment
–$2,000—
Increase in
tax receivable
–$1,000—
Decrease in
taxes payable
SCF
$(13,300) Cash
paid for taxes
Deferred Taxes and the
Statement of Cash Flows
Analysis
Income Statement
Income tax
expense—deferred
$(1,700)
Adjustment
+$2,000—
Increase in
deferred tax
liability
SCF
No effect
Deferred Taxes and the
Statement of Cash Flows
Analysis
Income Statement
Net income, $18,000
Adjustment
–$1,300
SCF
$16,700 Cash
flow from
operations
Collazo Company
Statement of Cash Flows
(Direct Approach)
Cash collected from customers
Income taxes paid
Cash provided by operating activities
$30,000
(13,300)
$16,700
Deferred Taxes and the
Statement of Cash Flows
Collazo Company
Statement of Cash Flows
(Indirect Approach)
Net income
Decrease in income tax refund receivable
Decrease in income taxes payable
Increase in deferred tax liability
Cash provided by operating activities
$18,000
(2,000)
(1,000)
1,700
$16,700
International Accounting for
Deferred Taxes
• No-Deferral Approach- Ignore the
differences and report income tax expense
equal to the amount of tax payable for the
year.
• Comprehensive Recognition ApproachDeferred taxes are included in the
computation of income tax expense and
reported on the balance sheet.
• Partial Recognition Approach- A deferred tax
liability is recorded only to the extent that
the deferred taxes are actually expected to
be paid in the future.