Chapter 14: Income Taxes

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Chapter 14 Income Taxes Financial Accounting

• Income tax allocation
• MACR system
• SFAS no. 109
• Investment tax credit
• Empirical research

2
Income Tax Law of 1913

• Established income as a basis for taxation
• Since income for tax purposes was defined
  differently than income for accounting purposes
• Resulted in many items being recognized in
  different time periods for tax and book purposes
• Efforts to synchronize tax and book accounting go
  back to the 1930s

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Income Tax Allocation

• Made necessary by the timing differences between
  when a revenue or expense item reaches the
  published financial statements as opposed to when
  it appears on the tax return
• tax expense is based on the published before-tax
  income figure

4
Income Tax Allocation

• Comprehensive Allocation as long as timing
  differences arise
• tax allocation must take place,
• despite the possibility of relevant
  circumstantial differences
• Permanent differences between published
  statements and tax returns are not subject to the
  allocation process

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Intrastatement  or Intraperiod Tax Allocation

• items are shown net of the tax effect
• prior period adjustments
• extraordinary items
• changes in accounting principle
• operations of discontinued segments
• balance of the total tax expense figure then
  appears below net income before income taxes and
  extraordinary items

6
Timing Differences

• Referred to as temporary differences
• Tax liability would be greater than tax expense
  where
• revenues are recognized for tax purposes earlier
  than for published reporting purposes
• expenses are recognized more rapidly on the
  financial statements than on the tax return
• Tax expense is greater than tax liability when
  either revenues are recognized more slowly or
  expenses more rapidly for tax purposes than for
  book purposes

7
Depreciation

• Using straight line for book and accelerated for
  tax purposes creates
• timing differences for a non-growth company
• a potentially permanent deferral for a
  growth-type company
• Federal government uses accelerated depreciation
  to stimulate economic growth

8
Orientations to Income Tax Allocations

• No allocations...tax is a distribution of income
• New form of equities...tax allocation is in
  effect an investment in the firm by government
• Net-of-tax method...adjust book depreciation tax
  expense tax liability
• Partial allocation...only those credits expected
  to be paid in foreseeable future are recorded
• Discount deferred tax liabilities

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Modified Accelerated Cost Recovery System

• Came about in 1986 tax act
• Eliminates concept of useful depreciable life
• Uses six classes of capital assets with
  prescribed lives
• Salvage values not considered
• Eliminated IRS-corporation controversies over
  useful lives

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SFAS No. 96 (December 1987)

• Kept comprehensive income tax orientation of APB
  Opinion No. 11, but substituted a liability
  (asset-liability) approach in place of the
  deferred approach of APB Opinion 11
• Dissatisfaction with the conservative recognition
  of deferred tax assets in SFAS No. 96 led to its
  replacement by SFAS 109

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SFAS No. 109

• Carryback of deferred tax assets and the allowed
  carryforward against deferred tax liabilities of
  future years
• Allows recognition of deferred tax assets if
  realization is more likely than not
• Restores a consistency between deferred tax
  assets and liabilities
• Current or noncurrent designation is derived from
  the classification of the related asset or
  liability

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Net Operating Losses

• SFAS No. 96 also took a negative view of treating
  tax-loss carryforwards as assets like its
  predecessor, APB Opinion No. 11
• SFAS No. 109 took a complete turnaround on
  booking tax-loss carryforwards from its two
  predecessors. Tax-loss carryforwards will now be
  booked subject to the same valuation allowance
  for deferred tax assets.

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Empirical Research

• Beaver and Dukes
• Ayers
• Espahbodi, Espahbodi, and Tehranian
• Cheung, Krishnan, and Min
• Givoly and Hayn
• Chaney and Jeter

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Investment Tax Credit (ITC)

• First enacted in 1962.
• Provisions of the law have changed several times.
  
• As a tool of macroeconomic policy, the ITC is
  seen as a means of stimulating investment and,
  thus, fighting recession in the short run and
  combating inflation over the long run.
• Tax Reform Act of 1986 eliminated ITC

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Interpretations of the ITC Transaction

• Reduction of the cost of the asset.
• Allocation by means of a deferred investment
  credit account.
• Capital donated by the government.
• Flow through (immediate recognition of all
  benefits taken in the year of acquisition).

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Chapter 14 Income Taxes Financial Accounting

• Income tax allocation
• MACR system
• SFAS no. 109
• Investment tax credit
• Empirical research