Income Tax Reporting

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Income Tax Reporting

• Revsine/Collins/Johnson Chapter 13

2
Learning objectives

• The different objectives underlying income
  determination for financial reporting (book)
  purposes versus tax purposes.
• The distinction between temporary (timing) and
  permanent differences, the items that cause these
  differences, and how each affects book income
  versus taxable income.
• The distortions created when the deferred tax
  effects of temporary differences are ignored.
• How tax expense is determined with interperiod
  tax allocation.
• How changes in tax rates are measured and
  recorded.

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Learning objectivesConcluded

• The reporting rules for net operating loss
  carrybacks and carry-forwards.
• How to read and interpret tax footnote
  disclosures and how these footnotes can be used
  to enhance comparisons across firms.
• How tax footnotes can be used to evaluate the
  degree of conservatism in firms book (GAAP)
  accounting choices.

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Book income and taxable income
Book Income Income computed for financial
reporting purposes
Taxable Income Income computed for tax
compliance purposes
?

• Intended to reflect increases in the firms
  well-offness.
• Includes all earned inflows of net assets, even
  when the inflow is not immediately convertible
  into cash.
• Reflects expenses as they accrue, not just when
  they are paid.

• Governed by the constructive receipt/ability to
  pay doctrine.
• The timing of taxation usually (but not always)
  follows the inflow of cash or equivalents.
• Deductions generally are allowed only when the
  expenditures are made or when a loss occurs.

Divergence complicates the way income taxes are
reflected in financial reports
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Understanding income tax reportingTiming
differences
Book Income

• Depreciation expense
• Bad debt expense
• Installment sales
• Revenues received in advance

Timing differences
?
Permanent differences
Taxable Income

• A timing difference results when a revenue (gain)
  or expense (loss) enters book income in one
  period but affects taxable income in a different
  (earlier or later) period.

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Understanding income tax reportingPermanent
differences
Book Income
Timing differences
?

• Interest on state and municipal bonds.
• Goodwill write-offs

Permanent differences
Taxable Income

• Permanent differences are caused by income items
  that
• Enter into book income but never affect taxable
  income.

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Understanding income tax reportingProblems
caused by temporary differences
Mitchell Corporation buys new equipment for
10,000 on January 1, 2005. The asset has a
five-year life and no salvage value. It will be
depreciated using the straight-line method for
book purpose, but for tax purposes the
sum-of-the-years-digits method will be used.
(Technically, firms are required to use MACRS
depreciation for tax purposes.)
Straight-line
SYD method
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Understanding income tax reportingMitchells
income tax payable

• Assume for Mitchell Corporation that depreciation
  is the only book versus tax difference.
• If income before depreciation is expected to be
  20,000 each year over the next five years, and
  the statutory tax rate is 35, then

Taxes due
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Understanding income tax reportingMitchells
temporary differences
Depreciation Expense
Income
10
Understanding income tax reportingThe mismatch
problem

• If book income tax expense is set equal to actual
  taxes payable each year, then

Expense increases with taxes due
Book income declines
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Understanding income tax reportingA financial
reporting distortion

• When book income tax expense is set equal to the
  actual taxes payable each year, there is a
  mismatch

Tax Expense Without Interperiod Tax Allocation
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Understanding income tax reportingThe FASBs
solution

• Interperiod tax allocation overcomes the mismatch
  problem.
• The extra tax depreciation in early years will
  be offset by lower tax depreciation in later
  years.
• The extra tax depreciation thus generates a
  liability for future taxes.
• Recording this deferred tax liability as it
  accrues eliminates the mismatch.

3,333
1,333 of extra depreciation in year 1
Tax depreciation
2,000
Future tax liability is 1,333 X 35 or 467
Book depreciation
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Deferred income tax accountingInterperiod tax
allocation

• SFAS No. 109 requires that the journal entry for
  income taxes reflect both
• Taxes currently due
• Any liability for future taxes arising from
  current period book-versus-tax differences that
  will reverse in later periods.

Originating
Reversing
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Deferred income tax accountingInterperiod tax
allocation journal entry
Originating

• The accounting entry for 2005 income taxes is

DR Income tax expense
7,000 CR Income tax
payable
6,533 CR Deferred income taxes
payable 467
Current and future tax payments are matched with
book income
15
Deferred income tax accountingCalculating tax
expense
Relation between tax expense, taxes payable, and
changes in deferred tax liabilities
7,000
6,533


467
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Deferred income tax accountingJournal entry
when timing differences reverse
Reversing

• The accounting entry for 2008 income taxes is

DR Income tax expense
7,000 DR Deferred income taxes
payable 233 CR
Income tax payable
7,233
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Deferred income tax accountingHow the accounts
change over time
Reversing
Originating
Book Tax Expense and Current Period Taxes Payable
Future Period Taxes Payable
18
Deferred income tax accountingThe mismatch is
eliminated
Tax Expense With Interperiod Tax Allocation
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Deferred income tax assetsAn example
In December 2005, Paul corporation leases its
office building to another company for 100,000.
The covers all of 2006 and specifies that the
tenant pays the 100,000 to Paul Corporation
immediately.
Cash Received in 2005
Revenue earned in 2006

• Paul Corporation makes the following entry in
  2005 on receiving the cash

DR Cash
100,000 CR Rent received in
advance 100,000
A book liability (deferred revenue) that will be
brought into income as earned in 2006
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Deferred income tax assetsComputing tax expense
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Deferred income tax assetsJournal entries

• The 2005 entry for income taxes

DR Income tax expense
525,000 DR Deferred income
tax asset
35,000 CR Income tax payable

560,000
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Deferred income tax assetsComputing SFAS No.
109 income tax expense
Relation between tax expense, taxes payable, and
changes in deferred tax assts and liabilities
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Deferred income tax assetsValuation allowances

• The FASB requires firms with deferred tax assets
  to assess the likelihood that those assets may
  not be fully realized in future periods.
• Realization depends on whether or not the firm
  has future taxable income.

More likely than not
Probability that DTA will NOT be realized
0
50
100

• Deferred tax asset (DTA) valuation allowance is
  then required

• DTA carrying value is reduced until the new
  amount falls within this range

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Deferred income tax assetsValuation allowance
example

• Norman Corporation records a deferred tax asset
  in 2005 related to accrued warranty expenses

DR Income tax expense (600,000 x .35)
210,000 DR Deferred income tax
asset (900,000 x .35) 315,000
CR Income tax payable (1,500,000 x .35)
525,000
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Deferred income tax assetsValuation allowance
disclosures
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Deferred income tax accountingWhen tax rates
change

• When tax rates change, the tax effects of
  reversals change as well.
• SFAS No. 109 adopts the liability approach to
  measure deferred income taxes in this situation.
  In any year current or future tax rates are
  changed
• The income tax expense number absorbs the full
  effect of the change,
• The relationship between that years tax expense
  and book income is destroyed.

Year 1
Year 2
700
Reversal
1,000
1,000
Tax effect at 35
350
350
300
300
at new 30
Deferred tax liability
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Deferred income tax accountingMitchell Company
example
760
700
(1,333 667) x .35
(1,333 667) x .38
Deferred tax liability before the tax rate change
Deferred tax liability after the tax rate change

• Under the SFAS No. 109 liability approach,
  income tax expense for 2007 would be

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Deferred income tax accountingMitchell Company
journal entries

• The accounting entry for 2007, the year that tax
  rates for 2008 and 2009 were increased

DR Income tax expense
7,060 CR Income
tax payable
7,000 CR Deferred
Income taxes payable
60
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Deferred income tax accountingAnalytical
insights

• Tax rate changes can inject one-shot (transitory)
  adjustments to earnings. The earnings impact
  depends on
• Whether the tax rates are increased or decreased.
• Whether the firm has net deferred tax assets or
  net deferred tax liabilities.
• The magnitude of the deferred tax balance.

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Net operating lossesCarrybacks and carryforwards

• The U.S. Income Tax code allows firms reporting
  operating losses to offset those losses against
  either past or future tax payments.

Loss incurred
Carry forward
Carry back
2004
2005
2006
2007
2008
Years
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Net operating lossesCarrybacks and
carryforwards example

• Unfortunato Corporation experienced a 1 million
  pre-tax operating loss in 2006. Under U.S.
  Income Tax Code, the company can either

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Net operating lossesCarryback and carryforward
entries

• Suppose Unfortunato had the following operating
  profit history
• The following entry would be made to reflect the
  carryback

DR Income tax refund receivable
262,500 CR Income tax expense
(carryback benefit) 262,500
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Understanding the tax footnoteTax expense
components
Taxes due
GAAP tax expense
34
Understanding the tax footnoteEffective tax rate
35
Understanding the tax footnoteDeferred tax
assets and liabilities
36
Understanding the tax footnoteIntraperiod tax
allocation
GAAP expense per Exhibit 13.12
1,172.6
311.5 increase?

• Other comprehensive income (58.9)
• Acquisitions distribution
  (74.4)
• Current period deferral 444.8

861.1
311.5
2002
2001
Net deferred tax liability
37
Understanding the tax footnoteAnalytical
insights

• Elsewhere ChipPAC said it increased the
  estimated useful lives of certain equipment from
  5 to 8 years. This change decreased depreciation
  expense for the year by 29 million.

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Understanding the tax footnoteAssessing
earnings quality

• Large increases in deferred income tax
  liabilities are a potential sign of deteriorating
  earnings quality.
• Consider ChipPAC. The depreciation-induced
  increase in the companys deferred tax liability
  could be due to
• Growth in capital expenditures
• Change in estimated useful lives of existing
  equipment
• Sudden decreases in deferred income tax assets
  are also a potential sign of deteriorating
  earnings quality.

On January 1, 2005 Carson Company begins offering
a one-year warranty on all sales. Its 2005 sales
were 20 million, and Carson estimates that
warranty expenses will be 1 of sales or
200,000. Warranty expense of 200,000 is
deducted on Carsons books in 2005. Tax
deductions for warranties in 2005 are zero.
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Understanding the tax footnoteAssessing
earnings quality
40
Understanding the tax footnoteImproving
interfirm comparability

• Lubrizols 10-K states
• Cambrexs 10-K states

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Understanding the tax footnoteImproving
interfirm comparability
42
Understanding the tax footnoteImproving
interfirm comparability
43
Understanding the tax footnoteAssessing
conservatism in accounting choices

• Conservative choices (like accelerated
  depreciation) decrease earnings and asset values
  relative to more liberal techniques (like
  straight-line depreciation).
• Other things being equal, the more conservative
  the set of accounting choices, the higher the
  quality of earnings.
• One way to assess accounting conservatism is by
  using the earnings conservatism ratio

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Understanding the tax footnoteComputing the EC
ratio
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Understanding the tax footnoteLimitations to
the EC ratio

• EC ratio comparisons over time can be misleading
  if the tax law has changed over the period of
  comparison.
• Comparisons across companies in different
  industries should be made cautiously since tax
  burdens can vary with business models (e.g.,
  capital intensity) and because of
  industry-specific tax rules (e.g., the oil
  depletion allowances).
• The EC ratio overlooks one category of
  deteriorating earnings conservatism one-shot
  earnings boost from a LIFO liquidation.

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Summary

• The rules for computing income for financial
  reporting purposesbook incomediffer from those
  for computing income for tax purposes.
• The differences between book income and taxable
  income are caused by both permanent and temporary
  (timing) differences in the revenue and expense
  items reported on a companys books versus its
  tax return.
• Temporary differences give rise to both deferred
  tax assets and deferred tax liabilities.

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Summary concluded

• Deferred tax accounting (SFAS No. 109) allows
  firms to report tax costs (or benefits) on the
  income statement in the same period as the
  related revenue or expense items are reported
  (matching principle).
• The income tax footnote provides useful
  information for understanding how much tax is
  paid and how much is deferred each year.
• Tax footnotes also help explain why effective tax
  rates may differ from statutory rates.
• Tax footnotes provide a wealth of information
  that can be exploited to improve interfirm
  comparability and evaluate firms earnings
  quality.