Part Six: Accounting for Enterprise Income Taxes

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Part Six Accounting for Enterprise Income Taxes
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Key Issues

1. Book (financial statement) vs. taxable income
2. Permanent differences
3. Effective vs. statutory tax rates
4. Temporary (timing) differences
5. Deferred taxes Assets, Liabilities, Expense
6. Possible cases and examples
7. Components of income tax expense (current vs
   deferred) 
8. Tax journal entries
9. Originating vs reversing differences
10. Asset, Liability (B/S) method vs I/S method
11. NOL carryback and carryforward
12. Deferred tax asset valuation allowance
13. Footnote disclosures

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3 Parts of Tax Disclosure

1. Current vs. deferred expense
2. Reconciliation between statuary vs. effective tax
   rates
3. Changes in Deferred Tax (DT) assets/liabilities
   and/or components of DT expense.

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Key Identity

• Pre-tax book (accounting) income 
• Permanent differences
• Temporary differences
  
• pre-tax taxable income 
•  

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Permanent Differences

• Definition
• Items of revenue or expense that are in book (or
  taxable) income of a period, but never part of
  taxable (or book) income.
• 2 types
• non-taxable revenues
• non-deductible expenses (ex. GW amortization)

(ex. interest income on municipal bonds)
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Importance of Permanent DifferencesEffective
vs. Statutory Tax Rate
tax expense
pre-tax (book) income

• def effective tax rate (ETR)
• def statutory tax rate (STR) rate set by
  government
• permanent diffs cause ETR ? STR
• non-taxable revenues lower the ETR
• non-deductible expenses raise the ETR
• ex. E13-7, E13-8 (Kent)

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Temporary (Timing) Differences

• Temp. diff. cause deferred tax assets,
  liabilities, expense
• Definitions
• Temp diff item of revenue or expense that are
  part of book and taxable income, in different
  periods
• Deferred tax asset future tax deductible due to
  current timing difference
• Deferred tax liability future tax payable due to
  current timing difference
• Q What is sum of temporary differences over
  firms life?

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4 Possible Types of Timing Differences
Revenues Expenses
recognize for books before taxes 1. Accrued (asset) revenue 3. Accrued (liab) expense
recognize for taxes before books 2. Deferred (unearned) revenue 4. Deferred (prepaid) expense
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Ex. 1. accrued asset, receivable

• Books accrual accounting Taxes cash
  accounting
• DR CR
  DR CR
  
  A/R 100 Rev 100
  N/A
• DR CR
  DR CR
• Cash 100 A/R 100 Cash
  100 Rev 100
• Note total revenue is the same, just timing
  differs

period 1
period 2
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Ex. 2. unearned revenue

• Books accrual accounting Taxes cash
  accounting
• DR CR
  DR CR
  
  Cash 100 Liab 100 Cash
  100 Rev 100
• DR CR
  DR CR
• Liab 100 Rev 100 N/A
• Note total revenue is the same, just timing
  differs

period 1
period 2
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Ex. 3. accrued liability, payable

• Books accrual accounting Taxes cash
  accounting
• DR CR
  DR CR
  
  Exp 100 Liab 100 N/A
• DR CR
  DR CR
• Liab 100 Cash 100 Exp 100 Cash
  100
• Note total expense is the same, just timing
  differs

period 1
period 2
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Ex. 4. prepaid expense

• Books accrual accounting Taxes cash
  accounting
• DR CR
  DR CR
  
  Asset 100 Cash 100 Exp 100 Cash
  100
• DR CR
  DR CR
• Exp 100 Asset 100 N/A
• Note total expense is the same, just timing
  differs

period 1
period 2
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Timing Differences Relation to Deferred Tax
Assets, Liab.
Revenues Expenses
recognize for books before taxes 1. Deferred tax liability 3. Deferred tax asset
recognize for taxes before books 2. Deferred tax asset 4. Deferred tax liability
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Components of Tax Expense and Tax JE
1. current (pay now) and

• Components of tax expense
• DR current tax expensea
  
• CR Cash or taxes payable
• a) Current tax expense taxable inc.current
  statutory tax rate
• DR deferred tax expenseb
  
• CR Deferred tax asset/liability
• b) Deferred tax expense
• net ? in deferred tax
  asset/liability

2. deferred (paid before or after)
Assumes positive taxable income
can DR or CR deferred tax expense, depending on
net ? deferred tax asset/liability
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Components of Tax Expense (contd)

•  Alternatively,
• DR total tax expensec
• CR Deferred tax asset/liability
• CR Cash
• c) Total tax expense current deferred

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Deferred Tax Accounting Inter-period Tax
Allocation

• Total income tax expense
• Current (paid now)
• Deferred (paid both before or after)

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Originating vs. Reversing Timing Diff.

• Originating differences create deferred tax
  assets (DR) and liabilities (CR)
• Reversing differences reduce deferred tax assets
  (CR) and liabilities (DR)

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Examples of Deferred Tax Assets/Liab

• Installment sale revenue is recognized up front
  for financial reporting, but is recognized for
  tax purposes later, when cash is received each
  period.
• Prepayment revenue is recognized for tax
  purposes up front as cash is received , while
  accrual accounting delays revenue recognition
  until revenue is earned later.
• Bad debts expense. The allowance method for books
  recognizes the expense in the period of sale by
  the adjusting entry (matching principle), while
  the direct write-off method recognizes the
  expense in a later period, when the receivable is
  actually written off.

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Examples of Deferred Tax Assets/ Liab (contd)

• depreciation expense firms use an accelerated
  method for taxes and SL for books. This
  combination recognizes some depreciation for
  taxes first and for books later.
• RCJ give additional examples of revenues and
  expenses that produce deferred tax assets and
  liabilities in Exhibit 13.1, Pg. 689-90.

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Calculation of Deferred Tax Expense, Asset,
Liability B/S Method

• deferred tax asset/liability cumulative timing
  difference STR
• deferred tax expense net ? in deferred tax
  asset/liability
• B/S method (also called asset/liability method)
• use STR expected to be in effect when timing
  difference reverses
• so, if STR changes, calculate deferred tax
  asset/liability as per (2), and calculate
  deferred tax expense ? deferred tax
  asset/liability
• I/S method
• for constant STR only,
• deferred tax expense current years timing
  difference STR
• B/S method is or constant or changing STR

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Deferred Tax Asset, Liability and Expense Depend
on Tax Rate

• Key point
• Deferred tax asset, deferred tax liability and
  deferred tax expense depend on the tax rate.

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Intuition

• Deferred tax asset
• amount of future tax deduction (or tax
  saving)
• timing difference STR
• Deferred tax liability
• amount of future tax payable
• timing difference STR

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Net Operating Loss (NOL)

• NOL negative taxable income
• Book income may be either positive or negative
• NOL can be carried back or forward
• NOL carryback
• Get a refund of past taxes paid
• DR cash or tax refund receivable
  
  CR (current) income tax expense
• The maximum carryback period is 2 years (offset
  the earlier year first, as in FIFO)

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Net Operating Loss (contd)

• NOL carryforward
• Offset future income (also FIFO), reducing future
  taxes payable
• DR deferred tax asset
• CR (deferred) income tax expense
• This is another reason for deferred tax asset in
  addition to timing differences.
• A firm can carryforward an NOL for up to 20
  years.

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Incentives for Carryback vs. Carryforward

• Cant carryback because of 2 years of losses
• Time value of money get the cash ASAP ?
  carryback
• If tax rates are expected to rise, a dollar of
  deduction will be worth more ? carryforward

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Deferred Tax Asset Valuation Allowance
Contra-asset account (CR balance on the B/S eg,
accd depreciation or AUA) that reduces the
deferred tax asset to its expected realizable
value

• Record the deferred tax asset in the usual way
  (as if there were no valuation allowance)
• Make an additional entry
• DR (deferred) income tax expense
• CR deferred tax asset valuation allowance
• increasing (decreasing) the allowance increases
  (decreases) deferred income tax expense
• allowances existence and magnitude reveals
  managements expectation of future earnings.
• management can use changes in the allowance to
  manipulate NI, by affecting income tax expense.
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Financial Statement Disclosures

• I/S total income tax expense
• B/S net current and net non-current deferred tax
  asset or liability
• Footnote disclosure
• Current and deferred components of total income
  tax expense (from Income From Continuing
  Operations, because the below the line components
  are shown net of tax).
• Reconciliation between the federal statutory and
  effective tax rates (in and/or ).
• C13-1, 2, 3, 5, 6

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Financial Statement Disclosures (contd)

• 3a. components of deferred tax assets and
  liabilities
• and/or
• 3b. Components of deferred tax expense
• (e.g., revenue and expense items that cause the
  deferred tax expense, assets, liabilities, such
  as depreciation, bad debts, installment sales,
  etc.)