Accounting for Income Taxes

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C
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hapter
Accounting for Income Taxes
An electronic presentation by Douglas Cloud
Pepperdine University
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Objectives

• 1. Understand permanent and temporary
  differences.
• 2. Explain the conceptual issues regarding
  interperiod tax allocation.
• 3. Record and report deferred tax liabilities.
• 4. Record and report deferred tax assets.
• 5. Explain an operating loss carryback and
  carryforward.

Continue
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Objectives
6. Account for an operating loss carryback.
7. Account for an operating loss carryforward.
8. Apply intraperiod tax allocation.
9. Classify deferred tax liabilities and
assets. 10. Discuss the additional conceptual
issues concerning interperiod income tax
allocation (Appendix).
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Overview and Definitions
The objective of financial reporting is to
provide useful information about companies to
decision makers.
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Overview and Definitions
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Overview and Definitions
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Causes of Differences

• Permanent differences.
• Temporary differences.
• Operating loss carrybacks and carryforwards.
• Tax credits.
• Intraperiod tax allocations.

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Permanent Differences
Some items of revenue and expense that a
corporation reports for financial accounting
purposes are never reported for income tax
purposes. These permanent differences never
reverse in a later accounting period.
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Permanent Differences
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Permanent Differences

• Revenues that are recognized for financial
  reporting purposes but are never taxable (e.g.,
  interest on municipal bonds, life insurance
  proceeds payable to a corporation upon death of
  insured).
• Expenses that are recognized for financial
  reporting purposes but are never deductible for
  income tax purposes (e.g., life insurance
  premiums on officers, fines)

Continued
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Permanent Differences

• Deductions that are allowed for income tax
  purposes but do not qualify as expenses under
  generally accepted accounting principles (e.g.,
  percentage depletion in excess of cost depletion,
  special dividend deduction).

Permanent differences affect either a
corporations reported pretax financial income or
its taxable income, but not both.
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Temporary Differences
A temporary difference causes a difference
between a corporations pretax financial income
and taxable income that originates in one or
more years and reverses in later years.
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Temporary Differences
Future Taxable Income Will Be More Than Future
Pretax Financial Income

• Revenues or gains are included in pretax
  financial income prior to the time they are
  included in taxable income. For example, gross
  profit on installment sales normally is
  recognized at the point of sale for financial
  reporting purposes, but for income tax purposes,
  in certain situations it is recognized as cash is
  collected.

Continued
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Temporary Differences
Future Taxable Income Will Be More Than Future
Pretax Financial Income

• Expenses and losses are deducted to compute
  taxable income prior to the time they are
  subtracted to compute pretax financial income.
  For example, a depreciable asset may be
  depreciated using MACRS over the prescribed tax
  life for income purposes, but using straight-line
  depreciation over a longer life for financial
  reporting purposes.

Continued
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Temporary Differences
Future Taxable Income Will Be Less Than Future
Pretax Financial Income

• Revenue or gains are included in taxable income
  prior to the time they are included in pretax
  financial income. For example, items such as
  rent, interest, and royalties received in advance
  are taxable when received but are not reported
  for financial reporting purposes until the
  service actually has been provided.

Continued
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Temporary Differences
Future Taxable Income Will Be Less Than Future
Pretax Financial Income

• Expenses or losses are subtracted to compute
  pretax financial income prior to the time they
  are deducted to compute taxable income. For
  example, product warranty costs may be estimated
  and recorded as expenses in the current year for
  financial reporting purposes but deducted, as
  actually incurred, for the determination of
  taxable income.

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Conceptual Issues

• 1. Should corporations be required to make
  interperiod income tax allocations for temporary
  differences, or should there be no interperiod
  tax allocation?
• 2. If interperiod tax allocation is required,
  should it be based on a comprehensive approach
  for all temporary differences or on a partial
  approach for certain temporary differences?
• 3. Should interperiod tax allocation be applied
  using the asset/liability method, the deferred
  method, or the net-of-tax method?

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Conceptual Issues
The FASB concluded that--

• Interperiod income tax allocation of temporary
  differences is appropriate.
• The comprehensive allocation approach is to be
  applied.
• The asset/liability method of income tax
  allocation is to be used.

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Conceptual Issues
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Conceptual Issues

• 1. A current tax liability or asset is recognized
  for the estimated income tax obligation or refund
  on its income tax return for the current year.
• 2. A deferred tax liability or asset is
  recognized for the estimated future tax effects
  of each temporary difference.

Continued
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3. The measurement of deferred tax liabilities
and assets is based on provisions of the enacted
tax law the effects of future changes in tax law
or rates are not anticipated. 4. 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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Conceptual Issues
Income Taxes
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Measurement
The FASB addressed two issues regarding the
measurement of deferred tax liabilities or
deferred tax asset in its financial statements.

• 1. The applicable income tax rates.
• 2. Whether a valuation allowance should be
  established for deferred tax assets.

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Steps in Recording and Reporting of Current and
Deferred Taxes

• Step 1. Measure the income tax obligation by
  applying the applicable tax rate to the current
  taxable income.
• Step 2. Identify the temporary differences and
  classify each as eithertaxable or deductible.
• Step 3. Measure the deferred tax liability for
  each taxable temporary difference using the
  applicable tax rate.

Continued
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Steps in Recording and Reporting of Current and
Deferred Taxes
Step 4. Measure the deferred tax asset for each
deductible temporary difference using the
applicable tax rate. Step 5. Reduce deferred tax
assets by a valuation allowance if, based on
available evidence, it is more likely than not
that some or all of the deferred tax assets will
not be realized. Step 6. Record the income tax
expense income tax obligation, change in deferred
tax liabilities and/or deferred tax assets, and
change in valuation allowance (if any).
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Basic Entries
In 2004 Track Company purchased an asset at a
cost of 6,000. For financial reporting
purposes, the asset has a 4-year life, no
residual value, and is depreciated by the
units-of-output method over 6,000 units (2004
1,600 units). For income tax purposes the asset
is depreciated under MACRS using the 3-year life
(33.33 for 2004). The taxable income is 7,500
and the income tax rate is 30.
This button will be used later
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Basic Entries

• Step 1. 7,500 (taxable income) x 30
• Step 2. The depreciation difference is identified
  as the only taxable temporary difference.
• Step 3. The 120 total deferred tax liability is
  calculated by multiplying the total taxable
  temporary difference (400) times the future tax
  rate (30).
• Steps 4 and 5. No deferred tax asset, so not
  required.
• Step 6. A journal entry is made.

Continued
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Example 1Single Difference
Income Tax Expense 2,370 Income Taxes
Payable 2,250 Deferred Tax Liability 120
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Example 2Multiple Rates
Assume the same facts as in Slide 26, except that
the income tax rate for 2004 for 40, but
Congress has enacted tax rates of 35 for 2005,
33 for 2006, and 30 for 2007 and beyond.
Click here to review Slide 26, then click the
button on Slide 26 to return.
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Example 2Multiple Rates
Deferred Tax Liability
2004 2005 2006
Financial depreciation 2,800 1,100 500
Income tax depreciation (2,667 )
(889 ) (444 ) Taxable amount 133 211
56 400 Income tax rate 0.35 0.33
0.30 Deferred tax liability 47 70
17 134
Income Tax Expense 3,134 Income Taxes
Payable 3,000 Deferred Tax Liability 134
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Example 3 Deferred Tax Asset
Klemper Company sells a product on which it
provides a 3-year warranty. For financial
reporting purposes, the company estimates its
future warranty costs and records a warranty
expense/liability at year-end. For income tax
purposes the company deducts its warranty costs
when paid.
Continued
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Example 3 Deferred Tax Asset
At the beginning of 2004, the company had a
deferred tax asset of 330 related to its
warranty plan. At the end of 2004, the company
estimates that its ending warranty liability is
1,400. In 2004 the company has taxable income
of 5,000 and a tax rate of 30.
1,500 90
5,000 x 30
420 330
Income Tax Expense 1,410 Deferred Tax Asset
90 Income Taxes Payable 1,500
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Operating Loss Carrybacks and Carryforwards
Carryback Period (2 years) 2002
2003 Previous Previous
Taxable Taxable Income Income
2004 Operating Loss
Continued
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Operating Loss Carrybacks and Carryforwards
Carryforward Period (20 years) 2005
2006 2024 Future Future
Future Taxable Taxable Taxable
Income Income Income
2004 Operating Loss
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Conceptual Issues
FASB concluded in FASB Statement No. 109 that
GAAP for operating carrybacks and carryforwards
are...
Continued
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Conceptual Issues
1. A corporation must recognize the tax benefit
of an operating loss carryback in the period of
the loss as an asset on its balance sheet and as
a reduction of the operating loss on its income
statement. 2. A corporation must recognize the
tax benefit of an operating loss carryforward in
the period of the loss as a deferred tax asset.
However, it must reduce the deferred tax asset by
a valuation allowance if it is more likely than
not that the corporation will not realize some or
all of the deferred tax asset.
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Operating Loss Carryback Example
Monk Company reports a pretax operating loss of
90,000 in 2004 for both financial reporting and
income tax purposes, and that reported pretax
financial income and taxable income for the
previous 2 years had been 200240,000 (tax
rate 25) and 200370,000 (tax rate 30).
Income Tax Refund Receivable 25,000 Income
Tax Benefit From Operating Loss
Carryback 25,000
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Operating Loss Carryforward Example
Lake Company reports a pretax operating loss of
60,000 in 2004 for both financial reporting and
income tax purposes. The income tax rate is 30
and no change in the tax rate has been enacted
for future years. The deferred tax asset is
calculated to be 18,000 (60,000 x 0.30).
Deferred Tax Asset 18,000 Income Tax Benefit
From Operating Loss Carryforward 18,000
Continued
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Operating Loss Carryforward Example
If the company establishes a valuation allowance
for the entire amount of the deferred tax asset,
it also makes the following journal entry at the
end of 2004.
Income Tax Benefit From Operating Loss
Carryforward 18,000 Allowance to Reduce
Deferred Tax Asset to Realizable
Value 18,000
Continued
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Operating Loss Carryforward Example
In 2005, Lake Company operates successfully and
earns pretax operating income of 100,000 for
both financial reporting and tax purposes.
Income Tax Expense 12,000 Allowance to Reduce
Deferred Tax Asset to Realizable Value 18,000
Income Taxes Payable 12,000
Deferred Tax Asset 18,000
40,000 x 0.30
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Intraperiod Tax Allocation
Kalloway Company reports the following items of
pretax financial and taxable income for
2004 Continued
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Intraperiod Tax Allocation
Income from continuing operations 270,000
(revenues) 190,000 (expenses) 80,000 Gain
on disposal of discontinued Segment X 18,000
Loss from operations of discontinued Segment
X (5,000 ) Extraordinary loss on bond
redemption (10,000 ) Cumulative effect of change
in accounting principle (accelerated
depreciation to S/L) 15,000 Prior period
adjustment (error) (8,000 ) Amount subject to
income taxes 90,000
Continued
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Intraperiod Tax Allocation
Lets take a look at Kalloway Companys schedule
of income tax expense for 2004.
Kalloway Company is subject to income tax rates
of 20 on the first 50,000 of income and 30 on
all income in excess of 50,000.
Continued
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Intraperiod Tax Allocation
Income Tax Expense (Cr.)
Income Tax Rate
Pretax Amount
Component (Pretax)
x

Income from continuing operations 50,000 0.20
10,000 30,000 0.30 9,000 Gain on disposal
of discontinued Division X 18,000 0.30 5,400 Ext
raordinary loss from tornado (5,000 ) 0.30 (1,500
)
Continued
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Intraperiod Tax Allocation
Income Tax Expense (Cr.)
Income Tax Rate
Pretax Amount
Component (Pretax)
x

Cumulative effect of change in accounting
principle on prior years
income 15,000 0.20 4,300 Prior period
adjustment (8,000 ) 0.30 (2,400) Total income
tax expense 22,000
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Intraperiod Tax Allocation
Now, lets examine Kalloway Companys income
statement for 2004.
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Income Statement for Year Ended December 31, 2004
Revenues (listed separately) 270,000 Expenses
(listed separately) (190,000 ) Pretax income
from continuing operations 80,000 Income
tax expense (19,000 )
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Income Statement for Year Ended December 31, 2004
Revenues (listed separately) 270,000 Expenses
(listed separately) (190,000 ) Pretax income
from continuing operations 80,000 Income
tax expense (19,000 ) Income from continuing
operations 61,000 Results of discontinued
operations Gain on disposal of discontinued
Segment X (net of 5,400 tax) 12,600 Loss
from operations of discontinued Segment X
(net of 1,500 tax credit) (3,500 ) 9,100
Income before extraordinary item 70,100
18,000 x 0.30
(5,000) x 0.30
Continued
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Income before extraordinary item 70,100
Extraordinary loss on bond redemption (net of
3,000 income tax credit) (7,000 ) Cumulative
effect of change in accounting principle (net
of 4,500 income taxes) 10,500 Net
Income 73,600
(10,000) x 0.30
15,000 x 0.30
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Intraperiod Tax Allocation
Kalloway Company makes the following journal
entry to record the 2004 intraperiod tax
allocation
Income Tax Expense 19,000 Gain on Disposal of
Division X 5,400 Cumulative Effect of Change in
Accounting Principle 4,500 Loss from Operations
of Discontinued Division X 1,500 Extraordinar
y Loss from Tornado 3,000 Retained Earnings
(prior period adj.) 2,400 Income Taxes
Payable 22,000
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Balance Sheet Presentation
A corporation must report its deferred tax
liabilities and assets in two classifications...
a net current amount and a net noncurrent amount.
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Balance Sheet Presentation

Account Related Balance Deferred Tax
Accounts Balance Sheet
Account
Deferred Tax Liabilities Installment sales
6,000 credit Accounts receivable Depreciation 12,0
00 credit Property, plant, and
equipment Deferred Tax Assets Warranty costs
3,400 debit Warranty liability Rent revenue
2,500 debit Unearned revenue
Current
Noncurrent
Current
Noncurrent
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Press this button to skip the Appendix. Click
anywhere else to go to Appendix material.
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Comprehensive Allocation
Under comprehensive allocation, the income tax
expense that a corporation reports in an
accounting period is affected by all the
transactions and events that it includes in
determining its pretax financial income for that
period.
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Partial Allocation
Under partial allocation, the income tax expense
that a corporation reports in an accounting
period is affected only by those temporary
differences that it expects to reverse in the
foreseeable future.
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Comprehensive income tax allocation is more
widely accepted for the following reasons
1. Individual temporary differences do
reverse. 2. Accounting is primarily
historical. 3. A corporation should report the
income tax effects of temporary differences in
the same period that it includes the related
transactions and events in its pretax financial
statement. 4. Accounting results should not be
subject to manipulation by management.
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Alternative Allocation Methods
(1) The asset/liability method (2) The deferred
method (3) The net-of-tax method
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