Accounting for Income Taxes

Accounting for Income Taxes

Chapter

19Intermediate Accounting12th Edition

Kieso, Weygandt, and Warfield

Prepared by Coby Harmon, University of California, Santa Barbara

Background

• Deferral approach to tax allocation (APB Opinion 11)– Income tax expense = amount of taxes that

would be paid if income statement numbers appeared on the current year's tax return. • Deferred taxes was the plug figure (difference

between taxes payable and tax expense). • The effect of subsequent changes in tax rates on

deferred tax account were essentially ignored.

Matching Approach

Background

• A method that was proposed theoretically (but has never been GAAP in US)– Assets and liabilities would be recorded

NET of any deferred tax related to the item

Net-of-Tax Approach

Background

• Liability approach to tax allocation (FASB 96, 109)– Income tax expense = taxes currently

payable plus change in deferred taxes. • If tax rates change, the effect on deferred tax

amounts affect income tax expense in the year the change is enacted.

• If there are no changes in tax rates, income tax expense should be approximately the same as under APB Opinion 11.

Asset/Liability Measurement Approach

Tax Code

Exchanges

Investors and Creditors

Financial Statements

Pretax Financial Income

GAAP

Income Tax Expense

Taxable Income

Income Tax Payable

Tax Return

vs.

Fundamentals of Accounting for Income Taxes

Fundamentals of Accounting for Income Taxes

A Temporary Difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years.

Future Taxable Amounts

Future Deductible AmountsDeferred Tax Liability

represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year.

Deferred Tax Asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year.

Illustration 19-22 Examples of Temporary Differences

Temporary DifferencesTemporary Differences

Temporary Differences (1)

• Revenues and gains, recognized in financial income, are later taxed for income tax purposes.– Installment sales

• Expenses and losses are deducted for income tax purposes before they are recognized in financial income.– MACRS depreciation– Goodwill deduction on tax return

Called “taxable temporary differences”

• Revenues and gains are taxed for income tax purposes before they are recognized in financial income.– Subscription revenue – Prepaid rent

• Expenses and losses, recognized in financial income, are later deducted for income tax purposes.– Warranty expense

Called “deductible temporary differences”

Temporary Differences (2)

TransactionWhen recorded

in booksWhen recordedon tax return

Deferredtax effect

Rev or Gain Earlier Later Liability

Rev or Gain Later Earlier Asset

Exp or Loss Earlier Later Asset

Exp or Loss Later Earlier Liability

Summary of Temporary Differences

Sources of Permanent Differences

No deferred tax effectsfor permanent differences

Some items are recordedin Books

but NEVERon tax return

Other items are NEVERrecorded in books

but recordedon tax return

Permanent DifferencesPermanent Differences

Permanent Differences: Examples

• Items, recognized for financial accounting purposes, but not for income tax purposes:– Interest revenue on Municipal Bonds– Life insurance premiums and proceeds when

corporation is beneficiary– Fines and penalties

• Items, recognized for tax purposes, but not for financial accounting purposes:– Dividend exclusion– Statutory depletion

Deferred Tax Asset & Deferred Tax Liability:

Sources• Deferred taxes may be a:

– Deferred tax liability, or– Deferred tax asset

• Deferred tax liability arises due to net taxable amounts in the future.

• Deferred tax asset arises due to net deductible amounts in the future.

If the deferred tax asset appears doubtful, a Valuation Allowance account is needed.

Journal entry: Income Tax Expense $$

Allowance to Reduce Deferred Tax Asset to Expected Realizable Value $$The entry records a potential future tax benefit that is not expected to be realized in the future.

Valuation Allowance for Deferred Tax Assets

New GAAP = FIN 48 (not on a 2006 FARS)

• Basic Rule: Apply the yearly tax rate to calculate deferred tax effects.– If future tax rates change: use the enacted tax

rate expected to apply in the future year.– If new rates are not yet enacted into law for

future years, the current rate should be used.

• The appropriate enacted rate for a year is the average tax rate [based on graduated tax brackets].

What Tax Rate to Apply

• The deferred tax classification relates to its underlying asset or liability.– Classify the deferred tax amounts as current

or non-current.

• Presentation is – NET amount related to current items

• If DR>CR, current deferred tax asset• If DR<CR, current deferred tax liability

– NET amount related to noncurrent items • If DR>CR, noncurrent deferred tax asset• If DR<CR, noncurrent deferred tax liability

Balance Sheet Presentation

Net operating loss is tax terminology.

A net operating loss occurs when tax deductions for a year exceed taxable revenues.

Net loss or operating loss is a financial accounting term.

Net Operating Loss (NOL)

NOL Rule (subject to change)

• NOL for each tax year is computed.• The NOL of one year can be applied

to offset taxable income of other years, possibly resulting in tax refunds

• Current rule: NOLs can be:– carried back 2 years and carried

forward 20 years (carryback option), – or carried forward 20 years

(carryforward only)

2001 2002 2003 2004 2005 2006 2007 2001 2002 2003 2004 2005 2006 2007

NOL2004

NOL2004

Tax years

Apply first

next

Loss carryforward20 years forward

Expect tax refund

here

Expect tax refund

hereRecord all

tax effects hereRecord all

tax effects here

Expecttax

shieldhere

Expecttax

shieldhere

NOL Carryback

2001 2002 2003 2004 2053 2006 2007 2024 2001 2002 2003 2004 2053 2006 2007 2024

NOL2004NOL2004

Tax years

Loss carryforward20 years forward

Record alltax effects here

Record alltax effects here

Expecttax

shieldhere

Expecttax

shieldhere

Forgo 2year rule

NOL Carryforward

Income tax expense, is allocated to:• Continuing operations• Discontinued operations• Extraordinary items• Cumulative effect of an accounting change,–

we won’t see this one any more after FAS154

• Prior period adjustments

Disclose other significant components, such as:

• current tax expense, • deferred tax expense/benefit, etc.

Intraperiod Tax Allocation

Other Items Affected• Comprehensive income items

– Holding gain/loss on AFS securities– Certain gains/losses related to foreign

currency and derivatives– Pension & post-retirement benefit amounts

not yet recognized on income statement• Correction of error/change in accounting

principle that affects beginning retained earnings

• Expenses for employee stock-based compensation

• Existing deferred amounts in quasi-reorganization

FIN 48 –Uncertain Tax Positions

• The key points in the Interpretation are:– 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

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

Examples of tax positions (1)

• A deduction taken on the tax return for a current expenditure that the taxing authority may assert should be capitalized and amortized over future periods.

• A decision that certain income is nontaxable under the tax law.

• The determination of the amount of taxable income to report on intercompany transfers between subsidiaries in different tax jurisdictions.

Examples of tax positions (2)

• The determination as to whether an entity qualifies as a real estate investment trust or regulated investment company.

• The determination as to whether an entity is subject to tax in a particular jurisdiction.

• The determination as to whether a spin-off transaction is taxable or nontaxable.

• The calculation of the amount of a research and experimentation credit.

FIN 48

• First, identify uncertain tax positions– Determine the appropriate “unit of

account”– Example – consider all R&D together or

consider each R&D project separately– FASB did not specify

• Next, apply FIN 48 step process to determine how much to recognize

FIN 48 – Step 1, Does it meet recognition threshold?

• “More likely or not” of being accepted by IRS on its technical merits– Assumes taxing authority has full

knowledge of all relevant facts

• If not, entire amount must be “reserved” (e.g., offset by the allowance account)

FIN 48 – Step 2 Measure the tax benefit

• Measurement• The benefit recognized for a tax

position meeting the more-likely-than-not criterion is measured based on the largest benefit that is more than 50 percent likely to be realized.

• A new methodology is introduced based on “cumulative probability”– Example needed to explain (next slide)

FIN 48 – PWC example

• Assume that a position to claim a tax credit of $1,000 is “more likely than not,” based on its technical merits. The company seeking to claim this credit has developed the probability table [next slide] of all possible material outcomes.

1 2 3 4 5

Amount of the “as filed” tax benefit management expects to sustain

$1000

$800 $600$400

$200

% likelihood that it will be sustained

10% 20% 25% 25% 20%

Cumulative % 10% 30% 55% 80%

100%

FIN 48 – PWC example• Assume that a position to claim a tax

credit of $1,000 is “more likely than not,” based on its technical merits. The company seeking to claim this credit has developed the probability table [next slide] of all possible material outcomes.

• Under the Interpretation, $600 denotes the amount of tax benefit that would be recognized in the financial statements; it represents the maximum amount of benefit that is more than 50-percent likely to be the end result.

How much to disclose? A big deal??

FIN 48 Disclosures

• Must continuously monitor uncertain tax positions

• Should have processes and controls to identify material changes– Will require much closer coordination

between tax dept and financial accounting (public reporting) department!

From Para. A33 Example

FIN 48 – accruing interest

• Interest and penalties must be paid if underpayment of tax liabilities exists

• A position that does not qualify as “more likely than not” under GAAP is effectively a LOAN from government

• Therefore, interest should be accrued on the full balance on the liability for unrecognized uncertain tax benefits

FIN 48 – Balance Sheet

• Uncertain tax positions result in recognition of a tax liability or a decrease in recognized tax assets on the balance sheet

• The tax liability for “uncertain positions” is NOT a component of deferred taxes and must be classified SEPARATELY from other tax balances– Current or noncurrent depending on

expected timing of cash flows to/from IRS

Deferred Taxes

IAS 12 vs FAS 109

versus

US GAAP

• Enacted tax rates

Which Tax Rate to Use

• Enacted or substantively enacted tax rat

IFRS

US GAAP

• Use an allowance account to reduce to net realizable value

• Uses same “more likely than not” criteria

Deferred Tax Assets

• Don’t recognize at all unless it is “more likely than not” to be usable in the future

IFRS

US GAAP

• Current items netted

• Noncurrent items netted

Balance Sheet Presentation

• Always classified as noncurrent

• Plans to revise to do it the FASB way

IFRS