A Review of the Accounting Cycle

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Income Taxes
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Learning Objectives

• Understand the concept of deferred taxes and the
  distinction between permanent and temporary
  differences.
• Compute the amount of deferred tax liabilities
  and assets.
• Explain the provisions of tax loss carrybacks and
  carryforwards, and be able to account for these
  provisions.

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Learning Objectives

• Schedule future tax rates, and determine the
  effect on tax assets and liabilities.
• Determine appropriate financial statement
  presentation and disclosure associated with
  deferred tax assets and liabilities.
• Comply with income tax disclosure requirements
  associated with the statement of cash flows.

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Learning Objectives

• Describe how, with respect to deferred income
  taxes, international accounting standards have
  converged toward the U.S. treatment.

EXPANDED MATERIALS

• Perform intraperiod tax allocation.

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Deferred Tax Liabilities
Defined Income taxes expected to be paid on
future taxable amounts resulting from temporary
differences between financial and taxable income.
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Deferred Tax Liabilities

• Examples
• Revenues (or gains) taxable after they are
  recognized for financial reporting, such as
  receivables from installment sales.
• Expenses (or losses) deductible for tax purposes
  before they are recognized for financial
  reporting purposes, such as accelerated tax
  depreciation.

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Deferred Tax Assets

• Defined An expected benefit in the form of tax
  savings on future deductible amounts resulting
  from deductible temporary differences between
  financial and taxable income.

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Deferred Tax Assets

• Examples
• Expenses (or losses) that are deductible for tax
  purposes after they are recognized for financial
  reporting purposes, such as warranty expenses.
• Revenues (or gains) that are taxable before they
  are recognized for financial reporting purposes,
  such as subscriptions received in advance.

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Permanent and Temporary Differences

• Permanent Differences Nondeductible expenses or
  nontaxable revenues that are recognized for
  financial reporting purposes but are never part
  of taxable income.
• Temporary Differences Differences between
  pretax financial income and taxable income
  arising from business events that are recognized
  for both financial and tax purposes, but in
  different time periods.

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Illustration of Permanent and Temporary
Differences
For the year ended December 31, 2002, Monroe
Corporation reported net income before taxes of
420,000. This amount includes 20,000 of
nontaxable revenues and 5,000 of nondeductible
expenses. The depreciation method used for tax
purposes allowed a deduction that exceeded the
book approach by 30,000.
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Illustration of Permanent and Temporary
Differences
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Advantages of the Asset and Liability Method

• Because the assets and liabilities recorded under
  this method are in agreement with the FASB
  definitions of financial statement elements, the
  method is conceptually consistent with other
  standards.

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Advantages of the Asset and Liability Method

• The asset and liability method is a flexible
  method that recognizes changes in circumstances
  and adjusts the reported amounts accordingly.
  This flexibility may improve the predictive value
  of the financial statements.

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Annual Computation of Deferred Tax Liabilities
and Assets
Identify type and amounts of existing temporary
differences.
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Example Computation of Deferred Tax Liabilities
and Assets

• Rodneys Burger Barn had GAAP income of 4,200.
  Rodney identified the following possible
  differences between GAAP and Taxable income
• Interest from municipal bonds 100
• Premium for Life Insurance on Joe 50
• Straight-Line Depreciation 100
• MACRS Depreciation 200
• Franchising Fees Earned 500
• Cash Franchising Fees Received 800
• Rodneys enacted tax rate is 40.

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Annual Computation of Deferred Tax Liabilities
and Assets
Identify type and amounts of existing temporary
differences.
Measure the deferred tax liability for taxable
temporary differences (use enacted rates).
Measure the deferred tax asset for deductible
temporary differences (use enacted rates).
Establish valuation allowance account if more
likely than not some portion or all of the
deferred tax asset will not be realized.
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Example Identifying Type(s)of Differences for
Rodneys
Temporary/
Difference
Type
Permanent
Reduction in
Interest on bonds
Permanent
Taxable Income
Increase in
Life Insurance
Permanent
Taxable Income
Net
Deferred Tax
Temporary
Depreciation
Liability
Net Franchising
Deferred Tax
Temporary
Fees
Asset
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Example Identifying Amountof Differences for
Rodneys

• Pretax income 4,200
• Add (deduct) permanent differences
• Interest on municipal bonds (100)
• Life insurance 50 (50)
• Income subject to tax 4,150
• Add (deduct) temporary differences
• Net depreciation (100 - 200) (100)
• Net fran. revenue (800 - 500) 300
  200
• Taxable income 4,350

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Annual Computation of Deferred Tax Liabilities
and Assets
Identify type and amounts of existing temporary
differences.
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Example Measure DeferredTax Liabilities for
Rodneys

• Depreciation for financial income 100
• Depreciation for taxable income 200
• Net deferred amount 100
• Tax rate x 40
• Deferred tax liability 40

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Annual Computation of Deferred Tax Liabilities
and Assets
Identify type and amounts of existing temporary
differences.
Measure the deferred tax liability for taxable
temporary differences (use enacted rates).
Measure the deferred tax asset for deductible
temporary differences (use enacted rates).
Establish valuation allowance account if more
likely than not some portion or all of the
deferred tax asset will not be realized.
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Example Measure DeferredTax Assets for Rodneys

• Franchising revenue for
• financial revenue (500)
• Franchising revenue for taxable
• revenue 800
• Net deferred amount 300
• Tax rate x 40
• Deferred tax asset 120

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Deferred Tax Asset
Some possible sources of taxable income to be
considered in evaluating the realistic value of a
deferred tax asset are

• Future reversals of existing taxable temporary
  differences.
• Future taxable income exclusive of reversing
  temporary differences.
• Taxable income in prior (carryback) years.

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Deferred Tax Asset
A typical journal entry to record the deferred
portion of income tax expense is
Deferred Tax Asset--Current xxx Deferred Tax
Asset--Noncurrent xxx Allowance to Reduce
Deferred Tax Asset to Realizable Value--
Current xxx Allowance to Reduce Deferred Tax
Asset to Realizable Value-- Noncurrent
xxx Deferred Tax Liability--Noncurrent xxx
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Taxable Income
Commonly Confused Relationships
Income Statement
Pretax financial income /- Permanent
differences Financial income subject to
tax /- Temporary differences Taxable income
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Net Operating Losses (NOL)--Alternative Elections
Carryback Election
Year -2
Year 20
Loss Year
Carryforward Election
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Accounting for NOL Carryback
Income (Loss)
Income
Year
Tax Rate
Tax
2001 10,000 35 3,500 2002 14,000
30 4,200 2003 (19,000) 30 0
Journal Entry in 2003 Income Tax Refund
Receivable 6,200 Income Tax Benefit From
NOL Carryback 6,200 3,500 (30
x 9,000)
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Accounting for NOL Carryforward
Income (Loss)
Income
Year
Tax Rate
Tax
2003 (19,000) 30 0 2004 (35,000) 30 0
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Accounting for NOL Carryforward
The journal entry recorded at the end of 2004
indicates that is more likely than not that the
carryforward benefit will be realized in full.
Journal Entry Deferred Tax Asset--NOL
Carryforward 9,000 Income Tax Benefit From
NOL Carryforward 9,000
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Accounting for NOL Carryforward
The firm reports a taxable income of 50,000 in
2005. The tax carryforward allows management to
deduct the carryforward from the 15,000 tax
(50,000 x .30) that would be due without the
carryforward.
Journal Entry Income Tax Expense 15,000 Income
Taxes Payable 6,000 Deferred Tax Asset--NOL
Carryforward 9,000
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Accounting for NOL Carryforward
What if, due to a declining market, management
believes that losses will continue in the future
and the tax benefit will not be realized?
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Accounting for NOL Carryforward
Journal Entry Deferred Tax Asset--NOL
Carryforward 9,000 Allowance to Reduce Deferred
Tax Assets to Realizable Value--NOL
Carryforward 9,000
As a result of this entry, the deferred tax asset
is zero--the expected realizable value.
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Presentation inFinancial Statements
Balance Sheet
Classify deferred taxes as current or noncurrent
based on asset or liability to which they
relate. Report a net current and a net
noncurrent amount.
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Financial StatementPresentation and Disclosure
The following items must appear in the income
statement or an accompanying note

• Current tax expense or benefit
• Deferred tax expense or benefit
• Investment tax credits
• Government grants recognized as tax reductions

Continued
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Financial StatementPresentation and Disclosure
The following items must appear in the income
statement or an accompanying note

• Benefits of NOL carryforwards
• Adjustments of a deferred tax liability or asset
  (for enacted laws or rate changes)
• Adjustments in beginning-of-the-year valuation
  allowance (for a change in circumstances)

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Approaches to Deferred Tax Accounting

• No-Deferral Approach Ignore the differences and
  report income tax expense equal to the amount of
  tax payable for the year.
• Comprehensive Recognition Approach Deferred
  taxes are included in the computation of income
  tax expense and reported on the balance sheet.
• Partial Recognition Approach A deferred tax
  liability is recorded only to the extent that the
  deferred taxes are actually expected to be paid
  in the future.

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Intraperiod Tax Allocation
Using interperiod tax allocation, the income tax
effect of each special item is reported with the
individual item rather than being included with
income tax expense related to current operations.
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The End