Accounting for Income Taxes

1
Chapter 16

• Accounting for Income Taxes

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Outline

• Nature of the problem
• Objective of income tax accounting
• Temporary differences
• Permanent differences
• The mechanics
• Components of income tax expense
• Net operating loss
• Balance sheet classification

3
Nature of the Problem

• GAAP pretax income ? Taxable income
• Example 1
• First year of operations/cash basis taxpayer.
• 100,000 of revenues
• Ending accounts receivable of 10,000
• 50,000 of operating expenses (all paid in cash).
• Tax rate of 50
• Tax return will show taxable income of 40,000
  and taxes due of 20,000
• GAAP income statement will show pretax earnings
  of 50,000. How much tax expense to show on the
  GAAP financials?
• 20,000 amount due on tax return?
• 25,000 (amount due on tax return plus the 5,000
  in taxes that will be due in the future when
  receivables are collected in cash).
• The accrual basis of accounting requires the
  latter.
• Entry
• Income tax expense
  25,000
• Income tax payable
  20,000
• Deferred income tax liability
  5,000

4
Nature of the Problem

• Example 2
• First year of operations/cash basis taxpayer.
• 100,000 of revenues (all received in cash)
• Ending accrued expenses payable of 10,000.
• 50,000 of operating expenses.
• Tax rate of 50
• Tax return will show taxable income of 60,000
  and taxes due of 30,000
• GAAP income statement will show pretax earnings
  of 50,000. How much tax expense to show on the
  GAAP financials?
• 30,000 amount due on tax return?
• 25,000 (amount due on tax return minus the
  5,000 in taxes that will be saved in the future
  when accrued expenses are paid in cash and a tax
  deduction taken).
• The accrual basis of accounting requires the
  latter.
• Entry
• Income tax expense
  25,000
• Deferred income tax asset
  5,000
• Income tax payable
  30,000

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Objective of Income Tax Accounting

• To recognize a deferred tax asset or liability
  for the tax consequences of amounts that will
  become taxable or deductible in future years as a
  result of transactions or events that have
  already occurred.
• Example 1
• The future tax consequence relates to the taxes
  that will be due when we collect on the revenues
  that were earned but uncollected at 12/31/Y1.
• In tax accounting jargon, there arose in Year 1 a
  taxable temporary difference between pretax
  financial statement income and tax return taxable
  income.
• That difference will reverse in a future tax
  year when the receivables are collected in cash.
• The difference is called a taxable difference
  because its future reversal will increase taxable
  income (in the reversal year) relative to pretax
  financial statement income (in the reversal
  year).
• Example 2
• The future tax consequence relates to the taxes
  that will be saved when we report the accrued
  expenses on our tax return ( operating expense
  deduction) as they are paid in cash.
• In tax accounting jargon, there arose in Year 1 a
  deductible temporary difference between pretax
  financial statement income and tax return taxable
  income.
• That difference will reverse in a future tax
  year when the accrued expenses are paid in cash.
• The difference is called a deductible
  difference because its future reversal will
  decrease taxable income (in the reversal year)
  relative to pretax financial statement income (in
  the reversal year)

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Temporary Differences

• Definition
• Differences between pretax GAAP earnings and
  taxable income that arise in one period and
  reverse over one or more future periods.
• Temporary differences create a difference between
  the amount at which an asset (or liability) is
  carried in the GAAP accounting records versus the
  tax accounting records.
• By convention
• Book value (GAAP)
• Tax basis (Tax)
• Example 1
• Book value of receivables 10,000.
• Tax basis of receivables 0
• The entry debiting receivables and crediting
  revenue was never made in the tax cash-based
  accounting records, so zero basis.
• Example 2
• Book value of accrued expenses payable 10,000.
• Tax basis of accrued expenses payable 0.

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Temporary Differences

• Are either deductible or taxable.
• Deductible
• When reversing, they cause taxable income to
  decline relative to pretax GAAP earnings, or
  cause pretax GAAP earnings to increase relative
  to taxable income.
• Give rise to deferred tax assets when they arise.
• Taxable
• When reversing, they cause taxable income to
  increase relative to pretax GAAP earnings, or
  cause pretax GAAP earnings to decrease relative
  to taxable income.
• Give rise to deferred tax liabilities when they
  arise.

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Permanent Differences(a/k/a Nontemporary
Differences)

• Not all differences that arise between taxable
  income and pretax GAAP income in one year will
  reverse in one or more future years.
• Examples
• Interest earned on state and local obligations
• Key man life insurance
• Premiums not deductible to corporation.
• Proceeds upon death of key man not taxable to
  corporation.
• See Graphic 16-3 on page 791 for more examples.
• Deferred tax assets and liabilities are not
  created, increased, or decreased by permanent
  differences.

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The Mechanics

• At each balance sheet date
• 1. Determine the total amount of unreversed
  taxable temporary differences.
• Multiply this amount by the currently enacted tax
  rate that will be effective in the year(s) the
  temporary difference will reverse.
• The result is the desired balance in the deferred
  tax liability account.
• An adjusting entry is prepared to bring the
  balance in the deferred tax liability account to
  the desired balance.
• Income tax expense xx
• Deferred income tax liability xx
• Or
• Deferred income tax liability xx
• Income tax expense xx

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The Mechanics

• 2. Determine the total amount of unreversed
  deductible temporary differences.
• Multiply this amount by the currently enacted tax
  rate that will be effective in the year(s) the
  temporary difference will reverse.
• The result is the desired balance in the deferred
  tax asset account.
• An adjusting entry is prepared to bring the
  balance in the deferred tax asset account to the
  desired balance.
• Income tax expense xx
• Deferred income tax asset xx
• Or
• Deferred income tax asset xx
• Income tax expense xx
• Consider whether a deferred tax asset valuation
  allowance is required.
• Is necessary if more likely than not that there
  will be insufficient future taxable income to
  absorb the deductible temporary difference when
  it reverses.
• Example 2 again.
• Assume will not be any future taxable income in
  any year for the indefinite future.
• Then deduction of the 5,000 accrued expenses
  (when paid) will not save any tax dollars (you
  wouldnt have owed any tax anyway).
• Recording the allowance
• Income tax expense xx
• Valuation allowance deferred tax asset
  xx
• Is analogous to the allowance for doubtful
  accounts.

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The Mechanics

• 3. Calculate the amount of taxable income on the
  companys income tax return.
• Multiply this amount times the enacted tax rate
  for the current year.
• The result is the desired balance in the income
  tax payable account.
• An adjusting entry is prepared to bring the
  balance in the income tax payable account to the
  desired balance.
• Income tax expense xx
• Income tax payable xx

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Income Tax Expense

• Two components
• Deferred (the net of AJEs in 1 and 2 above).
• Notice from AJE 1 above that increasing
  (decreasing) the deferred income tax liability
  increases (decreases) the balance in the income
  tax expense account.
• Notice from AJE 2 above that increasing
  (decreasing) the deferred income tax asset
  account decreases (increases) the balance in the
  income tax expense account.
• Current (the amount from AJE 3).

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Net Operating Lossa/k/a NOL

• Is negative taxable income.
• An NOL can be carried back to the two prior
  taxable years and offset against previously
  reported taxable income, generating a tax refund.
• Any NOL that remains unabsorbed by previously
  reported taxable in year t-2 and t-1 can be
  carried forward and used to offset future taxable
  income to be reported in years t1 to t20.
• NOL carrybacks give rise to a certain tax refund
• Income tax refund receivable xx
• Income tax expense
  xx
• NOL carryforwards give rise to possible tax
  refunds
• Deferred tax asset xx
• Income tax expense
  xx
• The negative income tax expense created by an
  NOL carryback/carryforward is reported on the
  income statement as income tax benefit.

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Balance Sheet Classification

• Each unreversed temporary difference classified
  as giving rise to a current or noncurrent
  deferred tax asset/liability based on the balance
  sheet classification of the account to which the
  temporary difference relates.
• Example 1 again the deferred tax liability
  arising from the accounts receivable would be
  classified as a current liability since accounts
  receivable are a current asset.

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Footnote Disclosures

• See pages 803 and 804 for detail.