Accounting for Income Taxes

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Accounting for Income Taxes
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Fundamental Differences between Financial and Tax
Reporting
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Deferred Taxes

• Net income per books is determined under GAAP
• Taxable Income is determined based on tax laws
  (i.e. IRC, Regulations, etc)
• There are differences between book income and
  taxable income
• Some are temporary and reverse over time
• Others are permanent and do not reverse
• Only temporary differences create a difference
  between income tax expense per books and the
  income tax liability on the tax return
• FAS 109 is a BALANCE SHEET APPROACH

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Temporary Differences Examples

• Revenues and gains, recognized in financial
  income, are later taxed for income tax purposes.
• Expenses and losses, recognized in financial
  income, are later deducted for income tax
  purposes.
• Revenues and gains are taxed for income tax
  purposes before they are recognized in financial
  income.
• Expenses and losses are deducted for income tax
  purposes before they are recognized in financial
  income.

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Summary of Temporary Differences
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Permanent Differences Examples

• Items, recognized for tax purposes, but not for
  financial accounting purposes
• Items recognized for financial accounting
  purposes but not for tax purposes

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Summary of Permanent Differences
Sources of Permanent Differences
No deferred tax effects for permanent differences
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Deferred Tax Asset Deferred Tax Liability
Sources

• Deferred taxes may result in 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

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Deferred Tax Asset Deferred Tax Liability
Example 1

• Sales Company recognizes 150,000 gross profit
  from an installment sale for financial accounting
  in 2005. The gross profit will be taxable at
  30,000 per year from 2005-2009. The company
  earns 400,000 additional income each year and
  the tax rate is 34. This is the only book/tax
  difference.

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Deferred Tax Asset Deferred Tax Liability
Example 2

• Financial Magazine Company received 150,000 of
  subscriptions in January 2005. Subscription
  revenue will be earned equally in 2005, 2006 and
  2007. The company earns 400,000 additional
  income each year and the tax rate is 34. This is
  the only book/tax difference.

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Recording a Valuation Allowance for Doubtful
Deferred Tax Assets

• 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.

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Valuation Allowance Example

• Intels 2007 Financial Statements included
  2.281 billion in deferred tax assets with a
  corresponding 133 million valuation allowance
  related primarily to state tax capital loss
  carryforwards and credits that they did not
  expect to be able to benefit from.

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Deferred Taxes Applying Tax Rates

• 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.

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Revision of Future Tax Rates

• When a change in tax rate is enacted, its effect
  should be recorded immediately.
• The effect is reported as an adjustment to tax
  expense in the period of change.
• Changes in tax rates are treated just like any
  other change in estimate, prospectively.

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Revision of Future Tax Rates Example

• End of 2008, corporate tax rate is changed from
  35 to 30.
• The new rate is effective January 1, 2009.
• The deferred tax account prior to recording the
  effect of this change is as follows
• Deferred tax liability 1,050,000
• relates to excess tax depreciation of
  3,000,000. This difference is expected to
  reverse ratably over the next 3 years (09, 10,
  11)
• How would this change be recorded? What would be
  the new balance of the DTL?

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Basic Principles of Asset-Liability Method

• A current tax liability or asset is recognized
  for the estimated taxes payable or refundable on
  the tax return for current year.
• A deferred tax liability or asset is recognized
  for the estimated future tax effects attributable
  to temporary differences and carryforwards.
• The measurement of current and deferred tax
  liabilities and assets is based on provisions of
  enacted tax law, effects of possible future
  changes in tax law or rates are not anticipated.
• The measurement of deferred tax assets is
  reduced, if necessary, by the amount of any tax
  benefits that are not expected to be realized.

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Future Topics

• Balance Sheet Presentation
• Tax Footnote
• Accounting for Uncertain Tax Positions FIN 48