Chapter 19: Accounting for Income Taxes

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Chapter 19 Accounting for Income Taxes
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Fundamental Differences between Financial and Tax
Reporting
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Deferred Taxes Basics

• Deferred taxes arise when income tax expense (FS)
  differs from income tax liability (return)
• Book tax differences
• Temporary reverse
• Permanent - do not reverse
• Deferred tax asset save future taxes
• Deductible temporary differences
• Increases in deferred tax benefit
• Deferred tax liability pay future taxes
• Taxable temporary differences
• Increases in deferred tax expense

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Deferred Tax Asset Deferred Tax Liability
Sources

• Deferred tax liability
• Arises due to net taxable amounts in the future
• Deferred tax asset
• Arises due to net deductible amounts in the future

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Deferred Taxes Basics

• Tax expense determined under GAAP
• Book income current tax rate
• Income tax liability determined under IRC
• Income tax from return

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Temporary Differences Examples

• Illustration 19-22, page 970
• Revenues/gains in financial income then taxable
  income
• Deferred tax liability
• Expenses/losses in financial income then taxable
  income
• Deferred tax asset
• Revenues/gains in taxable income then financial
  income
• Deferred tax asset
• Expenses/losses in taxable income then financial
  income
• Deferred tax liability

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Summary of Temporary Differences
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Permanent Differences Examples

• Recognized for financial accounting purposes but
  NEVER for income tax purposes
• NO deferred taxes provided
• Examples
• Interest income received on tax exempt securities
• Fines expenses
• Life insurance premiums on key officers/employees

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Recording a Valuation Allowance for Doubtful
Deferred Tax Assets

• Valuation Allowance
• Deferred tax asset appears doubtful
• Future tax benefit NOT expected to be realized in
  the future
• More likely than not wont realize
• Some or all
• At least slightly more than 50
• Valuation amount contra account

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Deferred Taxes Applying Tax Rates

• Basic Rule
• Yearly tax rate to calculate deferred tax effects
• Future tax rates change
• Enacted tax rate expected to apply in future
• New rates not yet enacted into law for future
  years
• Current rate
• Appropriate enacted rate for year average tax
  rate
• Based on graduated tax brackets

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Revision of Future Tax Rates

• Change in tax rate enacted
• Record effect immediately
• Effect reported as adjustment to tax expense in
  period of change
• Changes in tax rates change in estimate
• Prospectively

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Revision of Future Tax Rates Example

• End of 2002, rate changed from 40 to 35. New
  rate effective 1/1/04
• The deferred tax account (1/1/2002)
• Excess tax depreciation 3 million
• Deferred tax liability 1.2 million
• Related taxable amounts expected to occur
  equally over 2003, 2004, 2005
• Provide JE to reflect change

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Revision of Future Tax Rates Example

• Deferred tax liability end of 2005
• 2003 2004 2005
• Future tax inc 1,000,000 1,000,000 1,000,000
• Tax rate 40 35 35
• Deferred tax 400,000 350,000 350,000
• liability
• Entry
• Deferred Tax Liability 100,000 Income
  Tax Expense 100,000

1,200,000-1,100,000
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Net Operating Losses Basic Terminology

• Net operating loss occurs when tax deductions for
  year exceed taxable revenues
• Net loss or operating loss financial term
• NOL can be derived from net operating loss

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NOLs Rules of Application

• NOL for each tax year is computed
• NOL of one year can be applied to offset taxable
  income of other years
• NOLs can be
• Carried back 2 years
• Applied to earliest year first
• Carried forward 20 years
• Carried back 2 years AND any remainder forward 20
  years

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NOL Carryback Rules
Tax years
2001 2002 2003 2004 2005
2006 2007 2024
NOL 2004
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NOL Carryforward Rules
Tax years
2001 2002 2003 2004 2053 2006
2007 2024
NOL 2004
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Basic Principles of Asset-Liability Method

• Current tax liability or asset
• Recognized for estimated taxes payable/refundable
• On tax return for current year
• Deferred tax liability or asset
• Recognized for the estimated future tax effects
• Attributable to temporary differences
  carryforwards
• Measurement based on enacted tax law
• Effects of future changes NOT anticipated
• Measurement of deferred tax assets reduced by any
  tax benefits not expected to be realized

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Balance Sheet Presentation

• Current income tax payable
• Net with estimated payments
• Deferred tax classification relates to underlying
  asset or liability
• Current
• Sum various deferred current tax assets
  liabilities
• Installment sales
• Warranties
• Non-current
• Sum various deferred non-current tax assets
  liabilities
• Depreciation
• Litigation
• Net result asset, report as asset
• Net result liability, report as liability

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Income Statement Presentation

• Income tax expense allocated to
• Continuing operations
• Discontinued operations
• Extraordinary items
• Cumulative effect of an accounting change
• Prior period adjustments

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Income Statement Presentation

• Disclose other significant components
• Current tax expense
• Deferred tax expense/benefit, etc.
• Examples
• Illustration 19-21, page 969
• Illustration 19-32, page 977
• Illustration 19-41, page 981

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Class Exercises

• E19-6 E19-7
• E19-1 E19-4
• E19-9 E19-6
• E19-17 E19-23