Income Tax Reporting

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 13

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Learning objectives

1. The different objectives underlying income determination for financial reporting (book) purposes versus tax purposes.

2. The distinction between temporary (timing) and permanent differences, the items that cause these differences, and how each affects book income versus taxable income.

3. The distortions created when the deferred tax effects of temporary differences are ignored.

4. How tax expense is determined with interperiod tax allocation and the relation between taxes payable, changes in deferred taxes and tax expense.

5. Measuring and reporting valuation differences for deferred tax assets.

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Learning objectives:Concluded

6. How changes in tax rates are measured and recorded.

7. The reporting rules for net operating loss carrybacks and carry-forwards.

8. How to read and interpret tax note disclosures and how these footnotes can be used to enhance comparisons across firms.

9. Financial statement disclosures on uncertain tax positions.

10.How tax notes disclosures can be used to improve financial statement analysis.

11.Key differences between IFRS and U.S. GAAP rules for reporting of income taxes.

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Book income and taxable income

Intended to reflect increases in the firm’s “well-offness”.

Includes all earned inflows of net assets, even when the inflow is not immediately convertible into cash.

Reflects expenses as they accrue, not just when they are paid.

Governed by the “constructive receipt/ability to pay” doctrine.

The timing of taxation usually (but not always) follows the inflow of cash or equivalents.

Deductions generally are allowed only when the expenditures are made or when a loss occurs.

Book Income:Income computed for

financial reporting purposes

Taxable Income:Income computed for

tax compliance purposes≠

Divergence complicates the way income taxes are reflected in financial reports

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Understanding income tax reporting:Timing differences

A timing difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period.

Book Income

Taxable Income

≠

Timingdifferences:

Permanentdifferences

• Depreciation expense• Bad debt expense• Installment sales• Revenues received in advance

Current period

Later period

$100

$0

$0

$100

Originating

Reversing

Book income

Taxable income Type

Timing differences give rise to deferred tax assets and deferred tax liabilities because they are temporary (they eventually reverse):

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Understanding income tax reporting:Permanent differences

Permanent differences are caused by income items that: Enter into book income but never affect taxable income.

• Interest on state and municipal bonds.• Goodwill write-offs

Book Income

Taxable Income

≠

Enter into taxable income but never affect book income.

Because permanent differences do not reverse, they do not give rise to deferred tax assets or liabilities.

• Statutory depletion in excess of cost-based depletion• Dividend received deduction

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Timingdifferences:

Permanentdifferences

Mitchell Corporation buys new equipment for $10,000 on January 1, 2014. The asset has a five-year life and no salvage value. It will be depreciated using the straight-line method for book purposes, but for tax purposes the sum-of-the-years’-digits method will be used. (Technically, firms are required to use MACRS depreciation for tax purposes.)

Straight-line SYD method13-7

Understanding income tax reporting:Mitchell’s income tax payable

Assume for Mitchell Corporation that depreciation is the only book versus tax difference.

If income before depreciation is expected to be $20,000 each year over the next five years, and the statutory tax rate is 35%, then:

Taxes Due

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Understanding income tax reporting:Mitchell’s temporary differences

Depreciation Expense Income

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Understanding income tax reporting:The mismatch problem

If book income tax expense is set equal to actual taxes payable each year, then:

Expense increases with

taxes due

Book income declines

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Understanding income tax reporting:A financial reporting distortion When book income tax expense is set equal to the actual taxes

payable each year, there is a mismatch:

Figure 13.2MITCHELL

CORPORATIONTax Expense

without Interperiod Tax

Allocation

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Understanding income tax reporting:The FASB’s solution

Interperiod tax allocation overcomes the mismatch problem.

The “extra” tax depreciation in early years will be offset by lower tax depreciation in later years.

The “extra” tax depreciation thus generates a liability for future taxes.

Recording this deferred tax liability as it accrues eliminates the mismatch.

$3,333

$2,000

$1,333 of “extra” depreciation

in year 1

Tax depreciation

Book depreciation

Future tax liability is $1,333 X 35% or $467

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Deferred income tax accounting:Interperiod tax allocation

FASB ASC Topic 740, Income Taxes, requires that the journal entry for income taxes reflect both:

Taxes currently due Any liability for future taxes arising from current period book-versus-

tax differences that will reverse in later periods.

ReversingOriginating

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Deferred income tax accounting:Calculating tax expense

Relation between tax expense, taxes payable, and changes in deferred tax liabilities

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Deferred income tax accounting:The mismatch is eliminated

Figure 13.4MITCHELL

CORPORATIONTax Expense with

Interperiod Tax Allocation

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Deferred income tax assets:Computing income tax expense

Relation between tax expense, taxes payable, and changes in deferred tax assets and liabilities

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Deferred income tax assets:Valuation allowances

The FASB requires firms with deferred tax assets to assess the likelihood that those assets may not be fully realized in future periods.

Realization depends on whether or not the firm has future taxable income.

0% 50% 100%

“More likely than not ”

• DTA carrying value is reduced until the new amount falls within this range

Probability that DTA will NOT be realized

• Deferred tax asset (DTA) valuation allowance is then required

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Norman Corporation records a deferred tax asset in 2014 related to accrued warranty expenses:

Deferred income tax assets:Valuation allowance example

In early 2015, Norman determines that it is unlikely to earn enough taxable income in future years to realize more than $200,000 of the deferred tax asset. The entry made in 2015 is:

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Net operating losses:Carrybacks and carryforwards example

Unfortunato Corporation experienced a $1 million pre-tax operating loss in 2014. Under U.S. Income Tax Code, the company can either:

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Figure 13.6Illustration of Tax Loss Carryforward Provision

Figure 13.6Illustration of Tax Loss Carryback/Carryforward Provision

Net operating losses:Carryback and carryforward entries

Suppose Unfortunato had the following operating profit history:

The following entry would be made to reflect the carryback:

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If future pre-tax operating profits are expected to exceed $250,000, then the carryforward entry would be :

=$750,000 x 35%

$250,000 x 35%

Deferred income tax accounting:When tax rates change

When tax rates change, the tax effects of “reversals” change as well.

GAAP adopts the “liability approach” to measure deferred income taxes in this situation. In any year current or future tax rates are changed:

The income tax expense number absorbs the full effect of the change The relationship between that year’s tax expense and book income is

destroyed.

$700

Deferred tax liability

Year 1 Year 2

Reversal

Tax effect at 35%

at new 30%

$1,000 $1,000

350

300 300

350

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Deferred income tax accounting:When tax rates change

Under the FASB ASC Topic 740, Income Taxes,“liability approach”, income tax expense for 2016 would be:

$700 = ($1,333 + $667) x .35

Deferred tax liability before the tax rate change

$760

Deferred tax liability after the tax rate change

= ($1,333 + $667) x .38

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2016

Deferred income tax accounting:When tax rates change

Tax rate changes can inject one-shot (transitory) adjustments to earnings. The earnings impact depends on:

Whether the tax rates are increased or decreased. Whether the firm has net deferred tax assets or net deferred tax

liabilities. The magnitude of the deferred tax balance.

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Understanding income tax note disclosures:Tax expense components

GAAP tax expense

Taxes due

Due to temporary differences in revenue and expense items reported on Deere’s 2012 GAAP income statement versus what was reported on its 2012 tax return.

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Understanding the tax footnote:Intraperiod tax allocation

This reconciliation is required under GAAP rules for income tax disclosure

The divergence between the statutory tax rate and the effective tax rate arises from:1. Permanent difference items2. State and local taxes3. Differential tax rates in foreign jurisdictions4. Various tax credits

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Understanding the tax footnote:Intraperiod tax allocation

Items 6 and 7 represent the deferred tax item balances at December 31, 2012

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Measuring and Reporting Uncertain Tax Positions

Tax position – refers to a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current taxes payable or deferred income taxes. Uncertain tax positions arise, for example, when the firm claims a deduction for an expense that the IRS auditors may later disallow

GAAP procedures require a two-step process to determine how much benefit to recognize from an uncertain tax position and how to report its tax contingency reserve as a liability for unrecognized tax benefits.

Step 1 – determine if the threshold of more likely than not (more than 50%) is applicable.

Step 2 – measure the tax benefit as the largest amount of benefit that is greater than 50% likely of being realized.

Recorded as an increase in the Tax Contingency Reserve

account

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Assessing Disclosures on Uncertain Tax Positions

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Understanding the tax note:Analytical insights

Large increases in deferred income tax liabilities are a potential sign of deteriorating earnings quality.

Consider ChipPAC. The depreciation-induced increase in the company’s deferred tax liability could be due to:

Growth in capital expenditures Change in estimated useful lives of existing equipment

Sudden decreases in deferred income tax assets are also a potential sign of deteriorating earnings quality.

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Extracting Analytical Insights from Note Disclosures

Elsewhere ChipPAC said it increased the estimated useful lives of certain equipment from 5 to 8 years. This change decreased depreciation expense for the year by $29 million.

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Understanding the tax footnote:Using Deferred Tax Footnotes to Assess Earnings Quality

On January 1, 2014 Carson Company begins offering a one-year warranty on all sales. Its 2014 sales were $20 million, and Carson estimates that warranty expenses will be 1% of sales or $200,000. Warranty expense of $200,000 is deducted on Carson’s books in 2014. Tax deductions for warranties in 2014 are zero.

Shows that the deferred income tax asset balance will remain stable if the warranty estimate is accurate and if sales volume is unchanged.

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Using Tax Notes to Improve Interfirm Comparability

Cubic’s10-K states:

Nanometrics’10-K states:

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Using Tax Notes to Improve Interfirm Comparability

Global Vantage PointKey differences between IFRS and U.S. GAAP income tax accounting rules

Difference GAAP IFRSApproach for recognizing deferred tax assets

Uses a valuation account for deferred tax asset if book basis is different from the tax basis

No valuation account

Reconciliation of statutory and effective tax rates

Uses the domestic federal statutory rate

Uses a statutory rate

Reporting of deferred taxes on the balance sheet

Classifies deferred tax assets and liabilities as current or noncurrent depending on the nature of the temporary difference

Deferred tax assets and liabilities are reported as noncurrent

Disclosure of income tax amount recognized directly in equity

Not required Must disclose the aggregate amount of current or deferred income tax income or expense to Other Comprehensive Income

Uncertain tax positions Extensive guidance under FASB ASC 740

No specific guidance. IAS 12 calls for tax assets and liabilities to be measured at the amount expected to be paid

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Summary

The rules for computing income for financial reporting purposes—book income—differ from those for computing income for tax purposes.

The differences between book income and taxable income are caused by both permanent and temporary (timing) differences in the revenue and expense items reported on a company’s books versus its tax return.

Temporary differences give rise to both deferred tax assets and deferred tax liabilities.

Deferred tax accounting allows firms to report tax costs (or benefits) on the income statement in the same period as the related revenue or expense items are reported (matching principle).

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Summary concluded

The income tax foot provides useful information for understanding how much tax is paid and how much is deferred each year. Tax notes also help explain why effective tax rates may differ from the statutory rate.

Tax notes provide useful information that can be exploited to improve interfirm comparability and evaluate firms’ earnings quality.

GAAP disclosures are useful in assessing a firm’s uncertain tax positions and whether the firm is aggressive or conservative in recognizing the benefits associated with these positions.

There are a number of differences between IFRS and U.S. GAAP rules for accounting for income taxes that you should be aware of.

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