Accounting for Income Taxes

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Accounting for Accounting for Income TaxesIncome Taxes

Accounting for Accounting for Income TaxesIncome Taxes

Chapter18

An electronic presentation by Douglas Cloud

Pepperdine University

An electronic presentation by Douglas Cloud

Pepperdine University

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1. Understand permanent and temporary differences.

2. Explain the conceptual issues regarding interperiod tax allocation.

3. Record and report deferred tax liabilities.4. Record and report deferred tax assets.5. Explain an operating loss carryback and

carryforward.

ObjectivesObjectives

ContinueContinueContinueContinue

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6. Account for an operating loss carryback. 7. Account for an operating loss carryforward. 8. Apply intraperiod tax allocation. 9. Classify deferred tax liabilities and assets.10. Discuss the additional conceptual issues

concerning interperiod income tax allocation (Appendix).

ObjectivesObjectives

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Overview and DefinitionsOverview and Definitions

The objective of financial reporting is to provide useful information about companies

to decision makers.

The objective of financial reporting is to provide useful information about companies

to decision makers.

Income State-ment

Income Tax

Return

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Income State-ment

Income Tax

Return

Frees CorporationIncome Statement

For Year Ended 12/31/04Revenues $180,000 Cost of goods sold (78,000 )Gross profit $105,000 Other expenses (60,000 )Pretax income from continuing operations $ 45,000 Income taxes (11,000 )Net income $ 34,000

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Income State-ment

Income Tax

Return

Frees CorporationIncome Tax Return

For Year Ended 12/31/04Revenues $170,000 Cost of goods sold (70,000 )Gross profit $100,000 Other expenses (60,000 )Pretax income from continuing operations $ 40,000 Income taxes ( 9,200 )Net income $ 30,800

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Causes of DifferencesCauses of Differences

• Permanent differences.

• Temporary differences.

• Operating loss carrybacks and carryforwards.

• Tax credits.

• Intraperiod tax allocations.

• Permanent differences.

• Temporary differences.

• Operating loss carrybacks and carryforwards.

• Tax credits.

• Intraperiod tax allocations.

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Permanent Differences Permanent Differences

Some items of revenue and expense that a corporation

reports for financial accounting purposes are never

reported for income tax purposes. These permanent differences never reverse in a

later accounting period.

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Permanent Differences

1. Nontaxable Revenues

2. Nondeductible Expenses

3. Allowable Deductions

For Example

Interest on municipal bonds

Life insurance proceeds

For Example

Life insurance premiums

Fines

For Example

Percentage depletion

Special dividend deduction

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Revenues that are recognized for financial reporting purposes but are never taxable (e.g., interest on municipal bonds, life insurance proceeds payable to a corporation upon death of insured).

Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes (e.g., life insurance premiums on officers, fines)

Revenues that are recognized for financial reporting purposes but are never taxable (e.g., interest on municipal bonds, life insurance proceeds payable to a corporation upon death of insured).

Expenses that are recognized for financial reporting purposes but are never deductible for income tax purposes (e.g., life insurance premiums on officers, fines)


ContinuedContinuedContinuedContinued

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Deductions that are allowed for income tax purposes but do not qualify as expenses under generally accepted accounting principles (e.g., percentage depletion in excess of cost depletion, special dividend deduction).

Deductions that are allowed for income tax purposes but do not qualify as expenses under generally accepted accounting principles (e.g., percentage depletion in excess of cost depletion, special dividend deduction).


Permanent differences affect either a corporation’s reported pretax financial

income or its taxable income, but not both.

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Temporary DifferencesTemporary Differences

A temporary difference causes a difference

between a corporation’s pretax financial income and taxable income that “originates” in one or

more years and “reverses” in later years.

A temporary difference causes a difference

between a corporation’s pretax financial income and taxable income that “originates” in one or

more years and “reverses” in later years.

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Revenues or gains are included in pretax financial income prior to the time they are included in taxable income. For example, gross profit on installment sales normally is recognized at the point of sale for financial reporting purposes, but for income tax purposes, in certain situations it is recognized as cash is collected.

Revenues or gains are included in pretax financial income prior to the time they are included in taxable income. For example, gross profit on installment sales normally is recognized at the point of sale for financial reporting purposes, but for income tax purposes, in certain situations it is recognized as cash is collected.


Future Taxable Income Will Be More Than Future Pretax Financial Income

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Expenses and losses are deducted to compute taxable income prior to the time they are subtracted to compute pretax financial income. For example, a depreciable asset may be depreciated using MACRS over the prescribed tax life for income purposes, but using straight-line depreciation over a longer life for financial reporting purposes.

Expenses and losses are deducted to compute taxable income prior to the time they are subtracted to compute pretax financial income. For example, a depreciable asset may be depreciated using MACRS over the prescribed tax life for income purposes, but using straight-line depreciation over a longer life for financial reporting purposes.

Future Taxable Income Will Be More Than Future Pretax Financial Income


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Revenue or gains are included in taxable income prior to the time they are included in pretax financial income. For example, items such as rent, interest, and royalties received in advance are taxable when received but are not reported for financial reporting purposes until the service actually has been provided.

Revenue or gains are included in taxable income prior to the time they are included in pretax financial income. For example, items such as rent, interest, and royalties received in advance are taxable when received but are not reported for financial reporting purposes until the service actually has been provided.

Future Taxable Income Will Be Less Than Future Pretax Financial Income


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Expenses or losses are subtracted to compute pretax financial income prior to the time they are deducted to compute taxable income. For example, product warranty costs may be estimated and recorded as expenses in the current year for financial reporting purposes but deducted, as actually incurred, for the determination of taxable income.

Expenses or losses are subtracted to compute pretax financial income prior to the time they are deducted to compute taxable income. For example, product warranty costs may be estimated and recorded as expenses in the current year for financial reporting purposes but deducted, as actually incurred, for the determination of taxable income.

Future Taxable Income Will Be Less Than Future Pretax Financial Income

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Conceptual IssuesConceptual Issues

1. Should corporations be required to make interperiod income tax allocations for temporary differences, or should there be no interperiod tax allocation?

2. If interperiod tax allocation is required, should it be based on a comprehensive approach for all temporary differences or on a partial approach for certain temporary differences?

3. Should interperiod tax allocation be applied using the asset/liability method, the deferred method, or the net-of-tax method?

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The FASB concluded that-- Interperiod income tax allocation of

temporary differences is appropriate.

The comprehensive allocation approach is to be applied.

The asset/liability method of income tax allocation is to be used.

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The FASB established four basic principles that a

corporation is to apply in accounting for its income

taxes at the date of its financial statements.

The FASB established four basic principles that a

corporation is to apply in accounting for its income

taxes at the date of its financial statements.


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1. A current tax liability or asset is recognized for the estimated income tax obligation or refund on its income tax return for the current year.

2. A deferred tax liability or asset is recognized for the estimated future tax effects of each temporary difference.



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3. The measurement of deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax law or rates are not anticipated.

4. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that are not expected to be realized.

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Income TaxesIncome Taxes

Interperiod Tax Allocation (Income tax

expense = Current income tax obligation)

Interperiod Tax Allocation Interperiod Tax Allocation (temporary differences)(temporary differences)

Partial Allocation

Asset/Liability Method (using Asset/Liability Method (using enacted future tax rates)enacted future tax rates)

Deferred Method (using originating tax rates)

Net-of-Tax Method

Conceptual AlternativesCurrent GAAP (FASB Statement No. 109)

Comprehensive Comprehensive AllocationAllocation

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MeasurementMeasurement

1. The applicable income tax rates.

2. Whether a valuation allowance should be established for deferred tax assets.

The FASB addressed two issues regarding the measurement of deferred tax liabilities or deferred tax asset in its financial statements.

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Steps in Recording and Reporting of Current and Deferred Taxes


Step 1. Measure the income tax obligation by applying the applicable tax rate to the current taxable income.

Step 2. Identify the temporary differences and classify each as either“taxable” or “deductible.”

Step 3. Measure the deferred tax liability for each taxable temporary difference using the applicable tax rate.


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Step 4. Measure the deferred tax asset for each deductible temporary difference using the applicable tax rate.

Step 5. Reduce deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

Step 6. Record the income tax expense income tax obligation, change in deferred tax liabilities and/or deferred tax assets, and change in valuation allowance (if any).

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Basic EntriesBasic Entries

In 2004 Track Company purchased an asset at a cost of $6,000. For financial reporting purposes, the asset has a 4-year life, no residual value, and

is depreciated by the units-of-output method over 6,000 units (2004: 1,600 units). For

income tax purposes the asset is depreciated under MACRS using the 3-year life (33.33% for

2004). The taxable income is $7,500 and the income tax rate is 30%.

In 2004 Track Company purchased an asset at a cost of $6,000. For financial reporting purposes, the asset has a 4-year life, no residual value, and

is depreciated by the units-of-output method over 6,000 units (2004: 1,600 units). For

income tax purposes the asset is depreciated under MACRS using the 3-year life (33.33% for

2004). The taxable income is $7,500 and the income tax rate is 30%.

This button will be used laterThis button will be used later

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Step 1. $7,500 (taxable income) x 30%Step 2. The depreciation difference is identified as the

only taxable temporary difference.Step 3. The $120 total deferred tax liability is

calculated by multiplying the total taxable temporary difference ($400) times the future tax rate (30%).

Steps 4 and 5. No deferred tax asset, so not required.Step 6. A journal entry is made.

Basic EntriesBasic Entries


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Example 1—Single DifferenceExample 1—Single Difference

Income Tax Expense 2,370Income Taxes Payable 2,250Deferred Tax Liability 120

$2,250 + $120

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Example 2—Multiple RatesExample 2—Multiple Rates

Assume the same facts as in Slide 26, except that the income tax rate for 2004 for 40%, but

Congress has enacted tax rates of 35% for 2005, 33% for 2006, and 30% for 2007 and beyond.

Assume the same facts as in Slide 26, except that the income tax rate for 2004 for 40%, but

Congress has enacted tax rates of 35% for 2005, 33% for 2006, and 30% for 2007 and beyond.

Financial Income Tax Year Depreciation Depreciation

2004 $2,800 $2,6672005 1,100 8892006 500 444

Click here to review Slide 26, then click the button on Slide 26 to return.

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2004 2005 2006

Deferred Tax Liability

Financial depreciation $2,800 $1,100 $500

Income tax depreciation (2,667 ) (889 ) (444 )

Taxable amount $ 133 $ 211 $ 56 = $400

Income tax rate 0.35 0.33 0.30

Deferred tax liability $ 47 $ 70 $ 17 = $134

Income Tax Expense 3,134Income Taxes Payable 3,000Deferred Tax Liability 134

Example 2—Multiple RatesExample 2—Multiple Rates

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Example 3: Deferred Tax AssetExample 3: Deferred Tax Asset

Klemper Company sells a product on which it provides a 3-year warranty. For financial

reporting purposes, the company estimates its future warranty costs and records a warranty expense/liability at

year-end. For income tax purposes the company deducts its warranty costs when paid.

Klemper Company sells a product on which it provides a 3-year warranty. For financial

reporting purposes, the company estimates its future warranty costs and records a warranty expense/liability at

year-end. For income tax purposes the company deducts its warranty costs when paid.

ContinuedContinued

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At the beginning of 2004, the company had a deferred tax asset of $330 related to its warranty plan. At the end of 2004, the company estimates that its ending warranty

liability is $1,400. In 2004 the company has taxable income of $5,000 and a tax rate of 30%.

At the beginning of 2004, the company had a deferred tax asset of $330 related to its warranty plan. At the end of 2004, the company estimates that its ending warranty

liability is $1,400. In 2004 the company has taxable income of $5,000 and a tax rate of 30%.

Income Tax Expense 1,410Deferred Tax Asset 90

Income Taxes Payable 1,500

Example 3: Deferred Tax AssetExample 3: Deferred Tax Asset

$1,500 – $90$420 – $330

$5,000 x 30%

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Operating Loss Carrybacks and Carryforwards


2004 Operating

Loss Car

ryba

ckC

arry

back

Carryback Period (2 years)

2002 2003

Previous Previous Taxable Taxable Income Income

ContinuedContinued

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Carryforward Period (20 years)

2005 2006 …2024

Future Future Future Taxable Taxable Taxable Income Income Income



Car

ryfo

rwar

dC

arry

forw

ard

2004 Operating

Loss

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FASB concluded in FASB Statement No. 109 that

GAAP for operating carrybacks and

carryforwards are...

FASB concluded in FASB Statement No. 109 that

GAAP for operating carrybacks and

carryforwards are...

ContinuedContinued

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1. A corporation must recognize the tax benefit of an operating loss carryback in the period of the loss as an asset on its balance sheet and as a reduction of the operating loss on its income statement.

2. A corporation must recognize the tax benefit of an operating loss carryforward in the period of the loss as a deferred tax asset. However, it must reduce the deferred tax asset by a valuation allowance if it is more likely than not that the corporation will not realize some or all of the deferred tax asset.


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Operating Loss Carryback ExampleOperating Loss Carryback Example

Monk Company reports a pretax operating loss of $90,000 in 2004 for both financial reporting and

income tax purposes, and that reported pretax financial income and taxable income for the

previous 2 years had been: 2002—$40,000 (tax rate 25%); and 2003—$70,000 (tax rate 30%).

Monk Company reports a pretax operating loss of $90,000 in 2004 for both financial reporting and

income tax purposes, and that reported pretax financial income and taxable income for the

previous 2 years had been: 2002—$40,000 (tax rate 25%); and 2003—$70,000 (tax rate 30%).

Income Tax Refund Receivable 25,000 Income Tax Benefit From Operating Loss Carryback 25,000

2002 $40,000 x 0.25 =2002 $40,000 x 0.25 =

$10,000$10,0002003 $50,000 x 0.30 =2003 $50,000 x 0.30 =

15,000 15,000

$25,000$25,000

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Operating Loss Carryforward Example


Lake Company reports a pretax operating loss of $60,000 in 2004 for both financial reporting and

income tax purposes. The income tax rate is 30% and no change in the tax rate has been enacted for future

years. The deferred tax asset is calculated to be $18,000 ($60,000 x 0.30).

Lake Company reports a pretax operating loss of $60,000 in 2004 for both financial reporting and

income tax purposes. The income tax rate is 30% and no change in the tax rate has been enacted for future

years. The deferred tax asset is calculated to be $18,000 ($60,000 x 0.30).

Deferred Tax Asset 18,000 Income Tax Benefit From Operating Loss Carryforward 18,000


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If the company establishes a valuation allowance for the entire amount of the deferred tax asset, it also

makes the following journal entry at the end of 2004.

If the company establishes a valuation allowance for the entire amount of the deferred tax asset, it also

makes the following journal entry at the end of 2004.

Income Tax Benefit From Operating Loss Carryforward 18,000 Allowance to Reduce Deferred Tax Asset to Realizable Value 18,000


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In 2005, Lake Company operates successfully and earns pretax operating income of $100,000 for both

financial reporting and tax purposes.

In 2005, Lake Company operates successfully and earns pretax operating income of $100,000 for both

financial reporting and tax purposes.

Income Tax Expense 12,000Allowance to Reduce Deferred Tax Asset to Realizable Value 18,000 Income Taxes Payable 12,000 Deferred Tax Asset 18,000

$40,000 x 0.30$40,000 x 0.30

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Intraperiod Tax AllocationIntraperiod Tax Allocation

Income tax allocation within a period is

mandatory under GAAP.

Income tax allocation within a period is

mandatory under GAAP.

Kalloway Company reports the following items of pretax financial and taxable income for 2004:

[Continued]

Kalloway Company reports the following items of pretax financial and taxable income for 2004:

[Continued]

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Income from continuing operations [$270,000 (revenues) – $190,000 (expenses)] $80,000 Gain on disposal of discontinued Segment X 18,000 Loss from operations of discontinued Segment X (5,000 )Extraordinary loss on bond redemption (10,000 )Cumulative effect of change in accounting principle (accelerated depreciation to S/L) 15,000 Prior period adjustment (error) (8,000 )Amount subject to income taxes $90,000


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Kalloway Company is subject to income tax rates of 20% on the first $50,000 of income and 30% on all income in excess

of $50,000.

Kalloway Company is subject to income tax rates of 20% on the first $50,000 of income and 30% on all income in excess

of $50,000.

Let’s take a look at Kalloway

Company’s schedule of income tax

expense for 2004.

Let’s take a look at Kalloway

Company’s schedule of income tax

expense for 2004.


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Pretax Amount

Income Tax Rate

Income Tax

Expense (Cr.)Component (Pretax)

Income from continuingoperations $50,000 0.20

$10,00030,000 0.30

9,000Gain on disposal of

discontinued Division X 18,000 0.305,400

Extraordinary loss from tornado (5,000 ) 0.30(1,500 )

x =


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Pretax Amount

Income Tax Rate

Income Tax

Expense (Cr.)Component (Pretax)

Cumulative effect of change in accounting principle on prior

year’s income$15,000 0.20$ 4,300

Prior period adjustment (8,000 ) 0.30 (2,400)

Total income tax expense$22,000

x =

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Now, let’s examine Kalloway Company’s

income statement for 2004.

Now, let’s examine Kalloway Company’s

income statement for 2004.

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(0.20 x $50,000) + (0.30 x $30,000)

Revenues (listed separately) $270,000 Expenses (listed separately) (190,000 )Pretax income from continuing operations $ 80,000 Income tax expense (19,000 )

Income Statementfor Year Ended December 31, 2004

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Income Statementfor Year Ended December 31, 2004Revenues (listed separately) $270,000 Expenses (listed separately) (190,000 )Pretax income from continuing operations $ 80,000 Income tax expense (19,000 )Income from continuing operations $ 61,000 Results of discontinued operations: Gain on disposal of discontinued Segment X (net of $5,400 tax) $12,600

Loss from operations of discontinued Segment X (net of $1,500 tax credit) (3,500 ) 9,100

Income before extraordinary item $ 70,100


$18,000 x 0.30$18,000 x 0.30

($5,000) x 0.30($5,000) x 0.30

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Income before extraordinary item $70,100 Extraordinary loss on bond redemption (net of $3,000 income tax credit) (7,000 )Cumulative effect of change in accounting principle (net of $4,500 income taxes) 10,500 Net Income $73,600

($10,000) x 0.30($10,000) x 0.30

$15,000 x 0.30$15,000 x 0.30

Prior period adjustments on the statement of retained earnings also would be

shown net of tax.

Prior period adjustments on the statement of retained earnings also would be

shown net of tax.

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Kalloway Company makes the following journal entry to record the 2004 intraperiod tax allocation:

Income Tax Expense 19,000Gain on Disposal of Division X 5,400Cumulative Effect of Change in Accounting Principle 4,500

Loss from Operations of Discontinued Division X 1,500Extraordinary Loss from Tornado 3,000Retained Earnings (prior period adj.) 2,400Income Taxes Payable 22,000

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Balance Sheet PresentationBalance Sheet Presentation

A corporation must report its deferred tax liabilities

and assets in two classifications...

A corporation must report its deferred tax liabilities

and assets in two classifications...

…a net current amount and a net

noncurrent amount.

…a net current amount and a net

noncurrent amount.

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Balance Sheet PresentationBalance Sheet Presentation

Account Related BalanceDeferred Tax Accounts Balance Sheet Account

Deferred Tax Liabilities

Installment sales $ 6,000 credit Accounts receivable

Depreciation 12,000 credit Property, plant, and equipment

Deferred Tax Assets

Warranty costs $ 3,400 debit Warranty liability

Rent revenue $ 2,500 debit Unearned revenue

CurrentCurrent

NoncurrentNoncurrent

CurrentCurrent

NoncurrentNoncurrent

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Press this button to skip the Appendix. Click anywhere else to go to Appendix

material.

Press this button to skip the Appendix. Click anywhere else to go to Appendix

material.

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Comprehensive AllocationComprehensive Allocation

Under comprehensive allocation, the income tax expense that a

corporation reports in an accounting period is affected by all the

transactions and events that it includes in determining its pretax financial income for that period.

Under comprehensive allocation, the income tax expense that a

corporation reports in an accounting period is affected by all the

transactions and events that it includes in determining its pretax financial income for that period.

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Partial AllocationPartial Allocation

Under partial allocation, the income tax expense that a corporation

reports in an accounting period is affected only by those temporary

differences that it expects to reverse in the foreseeable future.

Under partial allocation, the income tax expense that a corporation

reports in an accounting period is affected only by those temporary

differences that it expects to reverse in the foreseeable future.

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Comprehensive income tax allocation is more widely accepted for the following reasons:

Comprehensive income tax allocation is more widely accepted for the following reasons:

1. Individual temporary differences do reverse.

2. Accounting is primarily historical.

3. A corporation should report the income tax effects of temporary differences in the same period that it includes the related transactions and events in its pretax financial statement.

4. Accounting results should not be subject to manipulation by management.

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Alternative Allocation MethodsAlternative Allocation Methods

(1) The asset/liability method

(2) The deferred method

(3) The net-of-tax method

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Chapter18

The EndThe EndThe EndThe End

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Documents

Accounting for Income Taxes