Temporary Differencessophiasapiens.chez.com/gestion/Financial-Accounting/Ch16... · Web viewDescribe the types of temporary differences that cause deferred tax liabilities and determine

Accounting for Income Taxes Overview

In this chapter we explore the financial accounting and reporting standards for the effects of income taxes. The discussion defines and illustrates “temporary differences,” which are the basis for recognizing deferred tax assets and deferred tax liabilities, as well as “permanent differences,” which have no deferred tax consequences. You also will learn how to adjust deferred tax assets and deferred tax liabilities when tax laws or rates change. We also discuss accounting for operating loss carrybacks and carryforwards and intraperiod tax allocation.

Learning ObjectivesAfter studying this chapter, you should be able to:LO16-1 Describe the types of temporary differences that cause deferred tax liabilities and determine

the amounts needed to record periodic income taxes. LO16-2 Identify and describe the types of temporary differences that cause deferred tax assets.LO16-3 Describe when and how a valuation allowance is recorded for deferred tax assets.LO16-4 Explain why non-temporary differences have no deferred tax consequences.LO16-5 Explain how a change in tax rates affects the measurement of deferred tax amounts.LO16-6 Determine income tax amounts when multiple temporary differences exist.LO16-7 Describe when and how an operating loss carryforward and an operating loss carryback are

recognized in the financial statements.LO16-8 Explain how deferred tax assets and deferred tax liabilities are classified and reported in a

classified balance sheet and describe related disclosures.LO16-9 Demonstrate how to account for uncertainty in income tax decisions.LO16-10 Explain intraperiod tax allocation.LO16-11 Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting

for income taxes.

Describe the types of temporary differences that cause deferred tax liabilities and determine the amounts needed to record periodic income taxes.

2. Identify and describe the types of temporary differences that cause deferred tax assets.3. Describe when and how a valuation allowance is recorded for deferred tax assets.4. Explain why permanent differences have no deferred tax consequences.5. Explain how a change in tax rates affects the measurement of deferred tax amounts.6. Determine income tax amounts when multiple temporary differences exist.7. Describe when and how an operating loss carryforward and an operating loss carryback are

recognized in the financial statements.8. Explain how deferred tax assets and deferred tax liabilities are classified and reported in a

classified balance sheet and describe related disclosures.9. Demonstrate how to account for uncertainty in income tax decisions.

10. Explain intraperiod tax allocation.11. Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting

for income taxes.

Lecture Outline

Part A: Deferred Tax Assets and Deferred Tax Liabilities

I. Temporary DifferencesA. Revenues and expenses included on a company’s income tax return usually are the same

as those reported on the company’s income statement for the same period. B. If GAAP and tax rules differ, tax payments might occur in years different from when the

revenues and expenses that cause the taxes are generated. This would produce a difference between pretax accounting income and taxable income and, consequently, between the reported amount of an asset or liability in the financial statements and its tax basis.

C. The difference is a temporary difference if it originates in one period and reverses, or "turns around," in one or more later periods. (T16-1)

D. Income tax expense includes both the current and deferred tax consequences of the activities of the reporting period.

II. Deferred Tax LiabilitiesA. A temporary difference causes a future taxable amount if the taxable income will be

increased relative to accounting income in the year(s) when the difference reverses. B. Such differences create deferred tax liabilities for the taxes to be paid on the future

taxable amounts. 1. Revenues or gains reported on the tax return after the income statement. (T16-2

through T16-4)2. Expenses or losses reported on the tax return before the income statement. (T16-5

through T16-11).

III. Deferred Tax AssetsA. A temporary difference causes a future deductible amount if the taxable income will be

decreased relative to accounting income in the year(s) when the difference reverses. B. Such differences create deferred tax assets for the taxes to be paid on the future taxable

amounts. 1. Expenses or losses reported on the tax return after the income statement. (T16-12

through T16-14)2. Revenue or gains reported on the tax return before the income statement.

IV. Valuation Allowance A. Deferred tax assets are recognized for all deductible temporary differences. B. A deferred tax asset is then reduced by a valuation allowance if it is “more likely than

not” that some portion or all of the deferred tax asset will not be realized. (T16-15)

V. Permanent Differences A. Permanent differences, are those caused by transactions and events that under existing tax

law will never affect taxable income or taxes payable. (T16-16)B. Permanent differences are disregarded when determining both the tax payable currently

and the deferred tax effect. (T16-17)

Part B: Other Tax Accounting Issues

I. Change in Tax Rates A. A deferred tax liability or asset is calculated using currently enacted tax rates and laws

rather than anticipated tax rates. If a phased-in change in rates is scheduled to occur, the specific tax rates of each future year are multiplied by the amounts reversing in each of those years. The total tax effect is the deferred tax liability or asset. (T16-18)

B. When a change in a tax law or rate occurs, we adjust the deferred tax liability or asset to reflect the change in the amount to be paid or recovered. The effect of the adjustment is reported in operating income in the year of the tax law or rate changes. (T16-19)

C. Although differences in the specific IFRS and U.S. GAAP guidance in several areas account for many of the disparities, the principal reason is that a great many of the non-tax differences between IFRS and U.S. GAAP affect deferred taxes. (T16-20)

II. Multiple Temporary Differences A. A company usually has several temporary differences, both originating and reversing, in

any particular year. B. This doesn’t change our approach. We multiply the total of the future taxable amounts

by the future tax rate to determine the appropriate balance for the deferred tax liability, and the total of the future deductible amounts by the future tax rate to determine the appropriate balance for the deferred tax asset. (T16-21 through T16-23)

III. Net Operating Losses A. An operating loss can be used to reduce taxable income in other, profitable years by

either: (T16-24)1. A carryback of the loss to the previous two years (T16-25), or 2. A carryforward of the loss to later years (up to 20). (T16-26)

B. The income tax benefit of both an operating loss carryback and an operating loss carryforward are recognized for accounting purposes in the year the operating loss occurs.

IV. Financial Statement PresentationA. In the balance sheet, deferred tax assets and deferred tax liabilities are classified as either

current or noncurrent depending on how the related assets or liabilities are classified for financial reporting. A net current amount and a net noncurrent amount are reported as either an asset or a liability. (T16-27)

B. Additional relevant information needed for full disclosure pertaining to deferred tax amounts is reported in disclosure notes, including the components of income tax expense and available operating loss carryforwards.

V. Dealing with UncertaintyA. The means of dealing with uncertainty in tax decisions is prescribed by FASB ASC 740–:

Income Taxes–Overall (previously “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109,” FASB Interpretation No. 48 (Norwalk, Conn.: FASB, June 2008)), commonly called FIN 48). This guidance allows companies to recognize in the financial statements the tax benefit of a position it takes only if it is “more likely than not” (greater than 50% chance) to be sustained if challenged. Guidance

also prescribes how to measure the amount to be recognized. The decision, then, is a “two-step” process.

B. Step 1. A tax benefit may be reflected in the financial statements only if it is "more likely than not" that the company will be able to sustain the tax return position, based on its technical merits.

Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50-percent likely to be realized. (T16-28) (T16-29)

VI. Intraperiod Tax AllocationA. Intraperiod tax allocation means the total income tax expense for a reporting period is

allocated among the financial statement items that gave rise to it. B. Each of the following income statement items is reported net of its respective income tax

effects. (T16-30)1. Income (or loss) from continuing operations2. Discontinued operations3. Extraordinary items

C. Extraordinary items are not reported separately under IFRS. IAS No. 1, “Presentation of Financial Statements” states that neither the income statement nor any notes may contain any items called “extraordinary.” As a result, the only income statement item reported separately net of tax using IFRS is discontinued operations.

Decision-Makers’ PerspectiveA. One of the most important aspects of most business decisions is the tax effect. B. Income tax is one of the largest expenditures many firms incur.C. Investors, creditors, and managers should be alert to choices that minimize or delay taxes

and to disclosures that indicate potential tax expenditures. 1. Investments in buildings and equipment can signify deferred tax liabilities from

temporary differences in depreciation. 2. New investments that cause the level of depreciable assets to at least remain

constant over time can effectively delay that deferred tax liability indefinitely. 3. Impending plant closings suggest declining levels of depreciable assets and

therefore might cause material paydowns of that deferred tax liability. D. Deferred tax assets represent future tax savings.

1. An operating loss carryforward is a deferred tax asset that often reflects sizable future tax deductions.

2. Operating loss carryforwards indicate potential future tax benefits because they allow large amounts of future income to be earned tax-free.

E. Because deferred tax liabilities increase debt, deferred tax liabilities increase risk as measured by the debt to equity ratio.

PowerPoint SlidesA PowerPoint presentation of the chapter is available at the textbook website.

An alternate version of the PowerPoint presentation also is available.

Teaching Transparency MastersThe following can be reproduced on transparency film as they appear here, or

you can use the disk version of this manual and first modify them to suit your particular needs or preferences.

TEMPORARY DIFFERENCES

Kent Land Management reported pretax accounting income in 2013, 2014, and 2015 of $100 million, plus additional 2013 income of $40 million from installment sales of property. However, the installment sales income is reported on the tax return when collected, in 2014 ($10 million) and 2015 ($30 million). The enacted tax rate is 40% each year.

($ in millions) Temporary Difference: originates reverses

2013 2014 2015

TotalPRETAX ACCOUNTING INCOME $140 $100 $100 $340 Installment sale income on the income statement (40) 0 0 (40) Installment sale income on the tax return 0 10 30 40TAXABLE INCOME $100 $110 $130 $340

Accounting income and taxable income are the same over the three-year period, but different in each individual year.

T16-1

DEFERRED TAX LIABILITY

Because tax laws permit the company to delay reporting this profit as part of taxable income, the company is able to defer paying the tax on that profit. The tax is not avoided – just deferred. In the meantime, the company has a liability for the income tax deferred.

Deferred Tax Liability

162013 ($40 million x 40%)2014 ($10 million x 40%) 42015 ($30 million x 40%) 12

0balance after 3 years

T16-2

RECORDING INCOME TAXES

Each year, income tax expense comprises both the current and the deferred tax consequences of events and transactions already recognized. This means we:

Calculate the income tax that is payable currently. Separately calculate the change in the deferred tax liability

(or asset). Combine the two to get the income tax expense.

($ in millions)Current Future Future

Year Taxable Taxable 2013 Amounts Amounts

2014 2015 [total]Pretax accounting income 140Temporary difference: Installment income (40 ) 10 30 40

Taxable income 100Enacted tax rate 40% 40% Tax payable currently 40 Deferred tax liability 16

Deferred tax liability: Ending balance (balance currently needed) $16 Less: Beginning balance 0 Change needed to achieve desired balance $16

Journal entry at the end of 2013Income tax expense (to balance) 56

Income tax payable (determined above) 40Deferred tax liability (determined above) 16

T16-3

TEMPORARY BOOK–TAX DIFFERENCE

The deferred tax liability each year is the tax rate times the temporary difference between the financial statement carrying amount of the receivable and its tax basis.

($ in millions) December 31

2013 2014 2015Receivable from installment sales of property:Accounting basis 40 $40 (10) $30 (30) $ 0Tax basis 0 0 (0 ) 0 (0 ) 0TEMPORARY DIFFERENCE 40 $40 (10) $30 (30) $ 0

Tax rate x 40% x 40% x 40%DEFERRED TAX LIABILITY $16 $12 $ 0

originating reversingdifference differences

T16-4

TYPES OF TEMPORARY DIFFERENCESRevenues (or gains) Expenses (or losses)

Reportedin the Income

Statement Now, but on the Tax Return Later

Installment sales of property (installment method for taxes)

Unrealized gain from recording investments at fair value (taxable when asset is sold)

Estimated expenses and losses (tax-deductible when paid)

Unrealized loss from recording investments at fair value or inventory at LCM (tax-deductible when asset is sold)

Reportedon the Tax

Return Now, but in

the Income Statement

Later

Rent collected in advance

Subscriptions collected in advance

Other revenue collected in advance

Accelerated depreciation on the tax return in excess of straight-line depreciation in the income statement

Prepaid expenses (tax-deductible when paid)

The temporary differences in the diagonal unshaded areas create deferred tax liabilities because they result in taxable amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse).

The temporary differences in the opposite diagonal (shaded) areas create deferred tax assets because they result in deductible amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse).

T16-5

EXPENSE REPORTED ON THE TAX RETURN BEFORE THE INCOME STATEMENT

To determine taxable income, we add back to accounting income the actual depreciation taken in the income statement and then subtract the depreciation deduction allowed on the tax return.

Woods Temporary Services reported pretax income in 2013, 2014, 2015, and

2016 of $100 million. In 2013, an asset was acquired for $100 million. The asset is

depreciated for financial reporting purposes over four years on a straight-line basis

(no residual value). For tax purposes the asset’s cost is deducted (by MACRS) over

2013-2016 as follows: $33 million, $44 million, $15 million, and $8 million. No

other depreciable assets were acquired. The enacted tax rate is 40% each year.

($ in millions) Temporary Difference:originates reverses

2013 2014 2015 2016 Total

ACCOUNTING INCOME $100 $100 $100 $100 $400 Depreciation on the income statement 25 25 25 25 100 Depreciation on the tax return (33 ) (44 ) (15 ) (8 ) (100)TAXABLE INCOME $ 92 $ 81 $110 $117 $400

T16-6

DETERMINING AND RECORDING INCOME TAXES - 2013

Taxable income is $8 million less than accounting income because that much more depreciation is deducted on the 2013 tax return ($33 million) than is reported on the income statement ($25 million).

($ in millions) Current Future FutureYear Taxable Taxable2013 Amounts Amounts

2014 2015 2016 [total]Pretax accounting income 100Temporary difference: Depreciation (8 ) (19) 10 17 8Taxable income 92Enacted tax rate 40 % 40% Tax payable currently 36 .8 Deferred tax liability 3.2

Deferred tax liability: Ending balance (balance currently needed) $3.2 Less: Beginning balance 0 .0 Change needed to achieve desired balance $3 .2


Income tax payable (determined above) 36.8Deferred tax liability (determined above) 3.2

Income tax expense is comprised of two components: the amount payable now and the amount deferred until later.

T16-7

2014 INCOME TAXES The cumulative temporary difference between the book basis

($50 million) and tax basis ($23 million) is both (a) the sum of the amounts originating in 2013 ($8 million) and in 2014 ($19 million) and (b) the sum of the amounts reversing in 2015 ($10 million) and in 2016 ($17 million).

($ in millions) Future FutureCurrent Taxable Taxable

Year Amounts Amounts

2013 2014 2015 2016 [total]Pretax accounting income 100Temporary difference: Depreciation (8) (19 ) 10 17 27Taxable income 81Enacted tax rate 40% 40% Tax payable currently 32 .4 Deferred tax liability 10.8

Deferred tax liability: Ending balance (balance currently needed) $10.8 Less: Beginning balance (3 .2) Change needed to achieve desired balance $ 7 .6 Journal entry at the end of 2014

Income tax expense (to balance) 40Income tax payable (determined above) 32.4Deferred tax liability (determined above) 7.6

Since a balance of $3.2 million already exists, $7.6 million must be added.

T16-8

2015 INCOME TAXES

A portion of the tax deferred from 2013 and 2014 is now being paid in 2015.

($ in millions) Future FutureCurrent Taxable Taxable

Year Amount Amount2013 2014 2015 2016 [total]

Pretax accounting income 100Temporary difference: Depreciation (8) (19) 10 17 17Taxable income 110Enacted tax rate 40% 40% Tax payable currently 44 Deferred tax liability 6.8

Deferred tax liability: Ending balance (balance currently needed) $ 6.8 Less: Beginning balance (10 .8) Change needed to achieve desired balance $( 4 .0)

Journal entry at the end of 2015Income tax expense (to balance) 40Deferred tax liability (determined above) 4

Income tax payable (determined above) 44

T16-9

2016 INCOME TAXES

Because the entire temporary difference has now reversed, there is a zero cumulative temporary difference, and the balance in the deferred tax liability should be zero.

($ in millions) Current FutureYear Taxable

2013 2014 2015 2016 Amount[total]

Pretax accounting income 100Temporary difference: Depreciation (8) (19) 10 17 0Taxable income 117Enacted tax rate 40% 40% Tax payable currently 46 .8 Deferred tax liability 0.0

Deferred tax liability: Ending balance (balance currently needed) $ 0.0 Less: beginning balance (6 .8) Change needed to achieve desired balance $(6 .8)

Journal entry at the end of 2016Income tax expense (to balance) 40.0Deferred tax liability (determined above) 6.8

Income tax payable (determined above) 46.8

T16-10

DEFERRED TAX LIABILITY The deferred tax liability increases the first two years and is

paid over the next two years.

Deferred Tax Liability ($ in millions)

3.22013 ($8 x 40%)7.62014 ($19 x 40%)

2015 ($10 x 40%) 4.02016 ($17 x 40%) 6.8

0balance after 4 years

T16-11

DEFERRED TAX ASSETS Deferred tax assets are recognized for the future tax benefits

of temporary differences that create future deductible amounts.

Lane Electronics reported pretax income in 2013, 2014, and 2015 of $70 million, $100 million, and $100 million, respectively. The 2013 income statement includes a $30 million warranty expense that is deducted for tax purposes when paid in 2014 ($15 million) and 2015 ($15 million). The income tax rate is 40% each year.

($ in millions) Temporary Difference:originates reverses

2013 2014 2015

TotalACCOUNTING INCOME $70 $100 $100 $270 Warranty expense on the income statement 30 30 Warranty expense on the tax return (15 ) (15 ) (30 ) TAXABLE INCOME $100 $ 85 $ 85 $270

T16-12

RECORDING INCOME TAXES

Because the warranty expense was subtracted on the 2013 income statement, but isn’t deductible on the 2013 tax return, it is added back to accounting income to find taxable income.

($ in millions) Current Future FutureYear Deductible Deductible2013 Amounts Amounts

2014 2015 [total]Pretax accounting income 70Temporary difference: Warranty expense 30 (15) (15) (30)Taxable income 100

(30)Enacted tax rate 40% 40% Tax payable currently 40 Deferred tax asset (12)

Deferred tax asset: Ending balance (balance currently needed) $12 Less: Beginning balance 0 Change needed to achieve desired balance $12

Journal entry at the end of 2013Income tax expense (to balance) 28Deferred tax asset (determined above) 12

Income tax payable (determined above) 40

The amounts deductible in 2014 and 2015 will produce tax benefits that are recognized now as a deferred tax asset.

T16-13

DEFERRED TAX ASSET At the end of 2013 and 2014, the company reports a deferred

tax asset for future income tax benefits.

Deferred Tax Asset

2013 ($30 million x 40%) 1262014 ($15 million x 40%)62015 ($15 million x 40%)

balance after 3 years 0

If we continue the assumption of $85 million taxable income in each of 2014 and 2015, income tax those years would be recorded this way:

2014Income tax expense (plug)...................................... 40

Deferred tax asset ($15 million x 40%)..................... 6Income tax payable ($85 million x 40%)................... 34

2015Income tax expense (plug)...................................... 40

Deferred tax asset ($15 million x 40%)..................... 6Income tax payable ($85 million x 40%)................... 34

T16-14

VALUATION ALLOWANCE Deferred tax assets are recognized for all deductible

temporary differences. However, a deferred tax asset is then reduced by a valuation allowance if it is “more likely than not” that some portion or all of the deferred tax asset will not be realized.

Assume management determines that it’s more likely than not that $3 million of an $8 million deferred tax asset will not ultimately be realized.

Income tax expense.................................................. 3Valuation allowance – deferred tax asset ............ 3

The deferred tax asset is reported at its estimated net realizable value:

Deferred tax asset $8Less: Valuation allowance – deferred tax asset (3 )

$5

T16-15

PERMANENT DIFFERENCES Provisions of the tax laws, in some instances, dictate that the

amount of a revenue that is taxable or expense that is deductible permanent ly differs from the amount reported on the income statement.

Interest received from investments in bonds issued by state and municipal governments (not taxable)

Investment expenses incurred to obtain tax-exempt income (not tax deductible)

Life insurance proceeds upon the death of an insured executive (not taxable)

Premiums paid for life insurance policies when the payer is the beneficiary (not tax deductible)

Compensation expense pertaining to some employee stock option plans (not tax deductible)

Expenses due to violations of the law (not tax deductible) Portion of dividends received from U.S. corporations that is

not taxable due to the “dividends received deduction” Tax deduction for depletion of natural resources (percentage

depletion) that permanent ly exceeds the income statement depletion expense (cost depletion)

T16-16

TEMPORARY AND PERMANENT DIFFERENCES

Kent Land Management reported pretax income in 2013, 2014, and 2015 of $100 million except for an additional income of $40 million from installment sales and $5 million interest from investments in municipal bonds in 2013. The installment sales income is reported for tax purposes in 2014 ($10 million) and 2015 ($30 million). The enacted tax rate is 40% each year.

($ in millions)Current Future Future

Year Taxable Taxable 2013 Amounts Amounts

2014 2015 [total]Accounting income 145Permanent difference: Municipal bond interest (5)Temporary difference: Installment income (40 ) 10 30 40

Taxable income 100Enacted tax rate 40% 40% Tax payable currently 40 Deferred tax liability 16

Deferred tax liability: Ending balance (balance currently needed) $16 Less: Beginning balance 0 Change needed to achieve desired balance $16


Income tax payable (determined above) 40Deferred tax liability (determined above) 16

T16-17

WHEN ENACTED TAX RATES DIFFER

When a phased-in change in rates is scheduled to occur, the specific tax rates of each future year are multiplied by the amounts reversing in each of those years. The total is the deferred tax liability or asset. Suppose the enacted tax rates are 40% for 2013 and 2014, and 35% for 2015.

Current Future Future ($ in millions) Year Taxable Taxable

2013 Amounts Amounts2014 2015 [total]

Accounting income 145Permanent difference: Municipal bond interest (5)Temporary difference: Installment income (40 ) 10 30 40

Taxable income 100Enacted tax rate 40% 40% 35% Tax payable currently 40 Deferred tax liability 4 10.5 14.5

Deferred tax liability: Ending balance (balance currently needed) $14.5 Less: Beginning balance 0 .0 Change needed to achieve desired balance $14 .5

Journal entry at the end of 2013Income tax expense (to balance) 54.5

Income tax payable (determined above) 40.0Deferred tax liability (determined above) 14.5

T16-18

CHANGES IN TAX LAWS OR RATES

Tax laws sometimes change. If a change in a tax law or rate occurs, the deferred tax liability or asset must be adjusted. The effect is reflected in operating income in the year of the enactment of the change in the tax law or rate. Assume Congress passed a new tax law in 2014 that will cause the 2015 tax rate to be 30%, instead of the previously scheduled 35% rate.

($ in millions)Current Future

Year Taxable 2014 Amount

2015Accounting income 100Temporary difference: Installment income 10 30Taxable income 110Enacted tax rate 40% 30%*

Tax payable currently 44 Deferred tax liability 9 9.0* 2015 rate enacted into law in 2014

Deferred tax liability: Ending balance (balance currently needed) $ 9.0 Less: beginning balance ( 14 .5) Change needed to achieve desired balance $ (5 .5)

Journal entry at the end of 2014Income tax expense (to balance) 38.5Deferred tax liability (determined above) 5.5

Income tax payable (determined above) 44.0

T16-19

INTERNATIONAL FINANCIAL REPORTING STANDARDS

Non-Tax Differences Affect Taxes. Despite the similar approaches for accounting for taxation under IAS 12, “Income Tax,” and U.S. GAAP, differences in reported amounts for deferred taxes are among the most frequent between the two reporting approaches. The reason is that a great many of the nontax differences between IFRS and U.S. GAAP affect deferred taxes as well. For example, we noted in Chapter 13 that we accrue a loss contingency under U.S. GAAP if it’s both probable and can be reasonably estimated and that IFRS guidelines are similar, but the threshold is “more likely than not.” This is a lower threshold than “probable.” In this chapter, we noted that accruing a loss contingency (like warranty expense) in the income statement leads to a deferred tax asset if it can’t be deducted on the tax return until a later period. As a result, under the lower threshold of IFRS, we might record a loss contingency and thus a deferred tax asset, but under U.S. GAAP we might record neither. So, even though accounting for deferred taxes is the same, accounting for loss contingencies is different, causing a difference in the reported amounts of deferred taxes under IRFS and U.S. GAAP.

T16-20

MULTIPLE TEMPORARY DIFFERENCES2013During 2013, its first year of operations, Eli-Wallace Distributors reported pretax accounting income of $200 million which included the following amounts:1. Income from installment sales of warehouses in 2013 of $9 million to be

reported for tax purposes in 2014 ($5 million) and 2015 ($4 million).

2. Depreciation is reported by the straight-line method on an asset with a four-year useful life. On the tax return, deductions for depreciation will be more than straight-line depreciation the first two years but less than straight-line depreciation the next two years ($ in millions):

Income Statement Tax Return Difference2013 $50 $66 $(16)2014 50 88 (38)2015 50 30 202016 50 16 34

$200 $200 0

3. Estimated warranty expense that will be deductible on the tax return when actually paid during the next two years. Estimated deductions are as follows ($ in millions):

Income Statement Tax Return Difference2013 $7 $72014 $4 (4)2015 3 (3 )

$7 $7 0

2014During 2014, pretax accounting income of $200 million included an estimated loss of $1 million from having accrued a loss contingency. The loss is expected to be paid in 2016 at which time it will be tax deductible. The enacted tax rate is 40% each year.

T16-21

MULTIPLE TEMPORARY DIFFERENCES-2013($ in millions)

FutureTaxable Future Future

Current (Deductible) Taxable DeductibleYear Amounts Amounts Amounts2013 2014 2015 2016 [total] [total]

Accounting income 200Temporary differences: Installment sales (9) 5 4 9 Depreciation (16) (38) 20 34 16 Warranty expense 7 (4) (3) (7)Taxable income 182

25 (7)Enacted tax rate 40 % 40 % 40 % Tax payable currently 72 .8 Deferred tax liability 10 Deferred tax asset (2.8)

Deferred tax Deferred taxliability asset

Ending balances (balances currently needed): $10 $2.8 Less: Beginning balances: 0 (0 .0) Changes needed to achieve desired balances $10 $2 .8

Journal entry at the end of 2013Income tax expense (to balance) 80.0Deferred tax asset (determined above) 2.8

Deferred tax liability (determined above) 10.0Income tax payable (determined above) 72.8

T16-22

MULTIPLE TEMPORARY DIFFERENCES-2014($ in millions)

FutureTaxable Future Future

Current (Deductible) Taxable DeductibleYear Amounts Amounts Amounts

2013 2014 2015 2016 [total]‡ [total]‡Accounting income 200Temporary differences: Installment sales (9) 5 4 4 Depreciation (16) (38) 20 34 54 Warranty expense 7 (4) (3) (3) Estimated loss 1 (1) (1)Taxable income 164

58 (4)Enacted tax rate 40 % 40% 40% Tax payable currently 65 .6 Deferred tax liability 23.2 Deferred tax asset (1.6)

Deferred tax Deferred liability tax asset

Ending balances (balances currently needed): $23.2 $1.6 Less: Beginning balances: (10 .0) (2 .8) Changes needed to achieve desired balances $13 .2 $(1 .2)

Journal entry at the end of 2014Income tax expense (to balance) 80.0

Deferred tax asset (determined above) 1.2Deferred tax liability (determined above) 13.2Income tax payable (determined above) 65.6

‡ Total future taxable and deductible amounts also are equal to the cumulative temporary differences in the related assets and liabilities.

T16-23

OPERATING LOSSES An operating loss can be carried back two years and forward

20 years:

Carryforward up to 20 years

2011 2012 LOSS 2014 2015 2016 2032 2033

2 years Carryback

Tax laws permit a choice. A company can elect to carry an operating loss back if taxable income was reported in either of the two previous years. By reducing taxable income of a previous year, the company can receive a refund of taxes paid that year.

T16-24

OPERATING LOSS CARRYFORWARDDuring 2013, its first year of operations, American Laminating Corporation reported an operating loss of $125 million for financial reporting and tax purposes. The enacted tax rate is 40%.

($ in millions) Current FutureYear Deductible2013 Amounts

[total]Operating loss (125) Loss carryforward 125 (125)

0Enacted tax rate 40% 40% Tax payable 0 Deferred tax asset (50)


Journal entry at the end of 2013Deferred tax asset (determined above) 50

Income tax benefit–operating loss (to balance) 50($ in millions)

Operating loss before income taxes $125 Less: Income tax benefit – operating loss 50Net operating loss $ 75

T16-25

OPERATING LOSS CARRYBACKDuring 2013, American Laminating Corporation reported an operating loss of $125 million. The enacted tax rate is 40% for 2013.

Taxable Income Income Tax Rates Taxes Paid

2011 $20 million 35% $7 million2012 55 million 40% 22 million

($ in millions) Current FuturePrior Years Year Deductible

2011 2012 2013 Amounts[total]

Operating loss (125) Loss carryback (20) (55) 75 Loss carryforward 50 (50)

0Enacted tax rate 35% 40% 40% 40% Tax payable (refundable) (7 ) (22 ) 0 Deferred tax asset (20)


Journal entry at the end of 2013Receivable – income tax refund ($7 + 22) 29Deferred tax asset (determined above) 20

Income tax benefit – operating loss (to balance) 49

T16-26

BALANCE SHEET CLASSIFICATION Classified as either current or noncurrent according to how the

related assets or liabilities are classified for financial reporting. Net current amount and the net noncurrent amount.

Warren Properties, Inc. had future taxable amounts and future deductible amounts relating to temporary differences between the tax bases of the assets and liabilities indicated below and their financial reporting amounts:($ in millions)

Classifi- Future Deferred cation Taxable Tax (Asset)

Related Balance current-C (Deductible) Tax LiabilitySheet Account noncurrent-N Amounts Rate C N

Receivable – installment sales C 10 x 40% 4Receivable – installment sales N 5 x 40% 2Depreciable assets N 105 x 40% 42Allowance – uncollectible accounts C (15) x 40% (6)Liability – subscriptions received C (20) x 40% (8)Estimated warranty liability C (30) x 40% (12)

Net current liability (asset) (22)Net noncurrent liability (asset) 44

BALANCE SHEET PRESENTATION:Current Assets:

Deferred tax asset $22

Long-Term Liabilities:Deferred tax liability $44

Note: Before offsetting assets and liabilities within the current and noncurrent categories, the total deferred tax assets is $26 ($6+8+12) and the total deferred tax liabilities is $48 ($4+2+42).

T16-27

Dealing with Uncertainty

GAAP allows companies to recognize in the financial statements the tax benefit of a position it takes only if it is “more likely than not” (greater than 50% chance) to be sustained if challenged. Guidance also prescribes how to measure the amount to be recognized. The decision, then, is a “two-step” process.

Step 1. A tax benefit may be reflected in the financial statements only if it is "more likely than not" that the company will be able to sustain the tax return position, based on its technical merits.

Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50-percent likely to be realized.

For the step-one decision as to whether the position can be sustained we assume that the position is reviewed by the IRS or other taxing authority (state and local governments) and litigated to the “highest court possible” and that the IRS has knowledge of all relevant facts.

T16-28

Dealing with UncertaintyIllustration

Derrick Company claims a deduction on its tax return that will save the company $8 million in 2013 income taxes. Derrick knows that, historically, the IRS has challenged many deductions of this type. Since tax returns usually aren't examined for one, two, or more years, uncertainty exists. Management believes the more-likely-than-not criterion is met. .

Suppose the following table represents management’s estimates of the likelihood of various amounts of tax benefit that would be upheld:

Likelihood Table:

The amount of tax benefit that Derrick can recognize in the financial statements (reduce tax expense) is $6 million because it represents the largest amount of benefit that is more than 50-percent likely to be the end result. So, Derrick would record tax expense as if there is a $6 million benefit, income tax payable that reflects the entire $8 million benefit of the deduction, and a liability that represents the potential obligation to pay the additional taxes if the deduction is not ultimately upheld:

($ in millions)Income tax expense (with $6 tax benefit) 26

Income tax payable (with $8 tax benefit) 24

Amount of the tax benefit that management expects to be sustained $8 $7 $6 $5 $4

Percentage likelihood that the tax position will be sustained at this level 10% 20% 25% 25% 20%

Cumulative probability that the tax position will be sustained 10% 30% 55% 80% 100%

Liability – projected additional tax ($8 – 6) 2T16-29

INTRAPERIOD TAX ALLOCATION

The total income tax expense for a reporting period should be allocated among the income statement items that gave rise to it. Each of the following items should be reported net of its respective income tax effects:

Income (or loss) from continuing operations

Discontinued operations

Extraordinary items

INTERNATIONAL FINANCIAL REPORTING STANDARDS

Extraordinary Items. Recall from Chapter 4 that extraordi-nary items are not reported separately under IFRS. IAS No. 1, “Presentation of Financial Statements” states that neither the income statement nor any notes may contain any items called “extraordinary.” As a result, the only income state-ment item reported separately net of tax using IFRS is dis-continued operations.

T16-30

Suggestions for Class Activities1. Dell Analysis

Have students, individually or in groups, go to the most recent Dell annual report at Dell’s web site at: www.dell.com/. Ask them to:

1. Determine the temporary difference that for Dell creates the largest deferred taxes. Given what you know about Dell, why do you suppose this is the largest contributor? Is the deferred tax effect getting higher or lower? Why?

2. Determine how deferred taxes are reported in the balance sheet.

3. Compare deferred taxes reported with those in the 2011 report that accompanied the text. Are there any discernible trends? How might they be interpreted?

Points to note:In 2011, the temporary difference that for Dell creates the largest deferred taxes was deferred

revenue. Dell reports revenue from extended warranty and service contracts, for which it is obligated to perform, as deferred revenue and subsequently recognized over the term of the contract or when the service is completed.

In 2011 and earlier years, Dell reported a net current asset and a net noncurrent asset in the balance sheet under “other” assets. A disclosure note details specific deferred tax assets and liabilities.

2. Professional Skills Development ActivitiesThe following are suggested assignments from the end-of-chapter material that will help your

students develop their communication, research, analysis, and judgment skills.

Communication Skills. In addition to Communication Case 16-5, Question 16-15 can be adapted to ask students to choose one of the two views and write a short paper defending that choice. Judgment Cases 16-4 and 16-12, Real World Case 16-6, Integrating Case 16-2 and Problem 16-7 do well as group assignments. Judgment Cases 16-4 and 16-12, and Integrating Case 16-3 are suitable for student presentation(s). Integrating Case 16-3, Research Case 16-7, and Question 16-7 create good class discussions.

Research Skills. The “Broaden Your Perspective” section includes Research Cases that direct students to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. Research Case 16-7 provides an excellent opportunity to help students develop this skill. In addition, Analysis Case 16-9 requires students to research the way Kroger reports deferred taxes.

Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct students to gather, assemble, organize, process, or interpret date to provide options for making business and investment decisions. In addition to Analysis Cases 16-1, 16-8, and 16-9, Exercise 16-14, Problems 16-3 and 16-11, Real World Case 16-6, and Integrating Cases 16-2 and 16-3 also provide opportunities to develop analysis skills.

Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require students to critically analyze issues to apply concepts learned to business situations in order to evaluate options for decision-making and provide an appropriate conclusion. In addition to Judgment Cases 16-10 and 16-12, Trueblood Case 11 and Integrating Case 16-4 also require students to exercise professional judgment.

3. Real World Scenario

In AT&T’s 2000 annual report, the company reported long-term deferred tax assets of $4,523,000,000 and current deferred tax assets of $1,791,000,000. Disclosure note 15 reported, in part:

“At December 31, 2000, we had net operating loss carryforwards (tax-effected), excluding Excite@Home, for federal and state income tax purposes of $79 and $164, respectively, expiring through 2017. In addition, we had federal tax credit carryforwards of $145, of which $64 have no expiration date and $81 expire through 2010. We also had state tax credit carryforwards (tax-effected) of $32 expiring through 2008. In connection with the TCI merger, we acquired certain federal and state net operating loss carryforwards subject to a valuation allowance of $59.”

Suggestion:

Ask students to consider the following questions:

1. As a potential investor, what significance would you place on the existence of operating loss carryforwards?

2. What might contribute to AT&T’s need to record a valuation allowance?

Points to note:Deferred tax assets represent future tax savings. Operating loss carryforwards create deferred tax

assets that can reflect sizable potential tax deductions. AT&T has large operating loss carryforwards, signifying that a large amount of future income can be earned tax-free. This is a tax shelter that should not be overlooked by a potential investor.

Deferred tax assets are recognized for every deductible temporary difference. At each reporting date, a deferred tax asset is then reduced by a valuation allowance if it is “more likely than not” that some portion or all of the deferred tax asset will not be realized. A future deductible amount reduces taxable income and saves taxes only if there is taxable income to be reduced when the future deduction is available. So, a valuation allowance is needed if taxable income is anticipated to be insufficient to realize the tax benefit. AT&T probably feels it will have sufficient future taxable income - as a whole - to reap the benefits of the deferred tax assets its reports. The need to report a valuation allowance presumably is due to the timing of deductions becoming available and the mix of foreign and domestic taxable income projections.

Documents

Temporary Differencessophiasapiens.chez.com/gestion/Financial-Accounting/Ch16... · Web viewDescribe the types of temporary differences that cause deferred tax liabilities and determine