Accounting for Income Taxes

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Accounting for Income Taxes

• ACCTG 5120
• David Plumlee

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Accounting for Income Taxes
Why do accountants record Deferred Taxes?

• Income is measured in two different ways, taxable
  income and GAAP income. Deferred taxes result
  from timing differences between these two.

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Accounting Income Taxable Income
Why are GAAP and tax income computed differently?

• Tax income is intended to
• raise sufficient tax revenues
• stimulate or depress certain sectors of the
  economy
• GAAP is intended to provide relevant, reliable
  and representationally faithful
• GAAP is full accrual, while tax is accrual with
  some cash basis adjustments.

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Inter-period Tax Allocation
From an income statement perspective what is the
justification for inter-period tax allocation?
It improves matching of tax expense to related
accounting income.
From a balance sheet perspective what is the
justification for inter-period tax allocation?
It allows recognition of deferred tax assets and
liabilities associated with future deductible and
future taxable amounts.
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A Simple Example
Assume that 9,000 is received on day 1, year 1
in payment of year 1 and year 2 rent
(4,500/year). What is the taxable and
accounting income for each of these years?
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Cash Basis
Assume a tax rate of 30, then the 2,700 of
income tax would be paid in 2003.
What is wrong with this approach?
No matching of Tax Expense to related accounting
income.
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Accrual Basis
Using Interperiod Tax Allocation

• Total tax expense is still 2,750, but
• net income better reflects effort
• effective tax rate reflects statutory rate
• less volatility in earnings

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Is a deferred tax really a liability?

• Some say yes
• eventually the timing difference will be reversed
  and the tax recorded in the deferred tax
  liability account will become payable
• future cash outflow in the amount of the deferred
  tax liability (asset) will occur
• Some say no
• many reversing temporary differences continually
  replaced with new originating temporary
  differences
• in reality deferred income tax liabilities
  continually grow
• net temporary differences do not require future
  cash outflows
• not a legal obligation of the firm until tax
  return filed

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Permanent Differences

• A difference arising from an item that enters
  into accounting income but never taxable income
  (interest on state issued bonds)
• or enters into taxable income but never
  accounting income (excess depletion on wasting
  assets)

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Examples of Permanent Differences

• Interest on state/municipal bonds
• Proceeds from executive life insurance
• Premiums paid on executive life insurance
• Fines due to violations of the law
• Dividend received deduction - 70 - 80 of
  dividends received from U. S. corporations
• Excess depletion on wasting assets

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Example Interest Income on State Bonds

• A company receives 1,000 in interest income on
  state bonds and tax rate is 45. The company
  NEVER pays tax on this income. What if we did
  this?
• tax expense 450
• deferred tax liability 450

Deferred tax would stay on the books forever!
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Temporary Differences

• A difference between an asset or liabilitys tax
  basis and its amount for accounting purposes that
  will result in taxable or deductible amounts in
  future years
• Or, a difference between in the financial and tax
  amounts for income (or expense) in a given year
  (or years)

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How do we get taxable income?

• Start with GAAP/financial books
• Make tax-related adjustments
• permanent items that are in accounting income but
  not taxable or vice versa
• temporary/timing items that are included in
  financial income at a different time than taxable
  income
• Complete tax return and pay required taxes (taxes
  payable)

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Temporary Difference - Example

• A company purchases an asset for 100,000.
• Depreciation expense
• accounting - straight-line over 4 years
• tax - straight-line over 2 years

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Reconciliation - Year 1
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AJE to Record Tax Expense
What is adjusting entry at the end of year 1?
tax expense 80,000 tax payable 70,000 d
eferred tax liability 10,000
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Reconciliation - Year 2
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AJE to Record Tax Expense
What is the balance in Deferred Tax Liability at
the end of year 2?
(25,00025,000) x 40 20,000
What is adjusting entry at the end of year 2?

• tax expense 40,000
• tax payable 30,000
• deferred tax liability 10,000

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Reconciliation - Year 3
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AJE to Record Tax Expense
What is the balance in Deferred Tax Liability at
the end of year 3?
(25,00025,000-25,000) x 40 10,000
What is the entry to record tax expense for year
3?

• Tax Expense 72,000
• Deferred Tax Liability 10,000
• Tax Payable 82,000

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Changes in tax rates across time?
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AJE to Record Tax Expense
What is the balance in Deferred Tax Liability at
the end of year 4?

• Should be 0, but (25,00025000-25000) x 40
  (-25,000)x 30 2500

What is the entry to record tax expense for year
4?
Tax Expense 21,000 Deferred Tax Liability
7,500 Tax Payable 28,500
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Computing Tax Expense
differences that will reverse in the future. If
differences are permanent, ignore!
Compute taxes payable
Compute change in Deferred Tax balance
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Example

• Year 2000 pretax accounting income 500,000
• Current tax rate 40
• Deferred Tax liability (Jan 1, 2000) 320,000
• Year 2000 depreciation
• accounting 200,000
• tax 400,000
• Municipal Bond Interest 10,000

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Example (continued)

• As at the end of year 2000
• Book basis of depreciable assets 1,000,000
• Tax basis of depreciable assets
  0
• Cumulative temporary difference 1,000,000
• Additional information
• enacted tax rates as shown in schedule
• temporary differences expected to reverse as
  shown in schedule

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Change in Deferred Tax Balance
Closing deferred tax liability 350,000 Opening
deferred tax liability 320,000 Net increase in
deferred tax liability 30,000
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Compute Taxes Payable

• Pre-tax accounting income 500,000
• add accounting depr. 200,000
• subtract tax depr. (400,000)
• subtract non-taxable interest ( 10,000)
• Taxable income 290,000
• tax rate x 40
• Tax Payable (per tax return) 116,000

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Journal Entry

• tax expense (plug) 146,000
• tax payable 116,000
• deferred tax liability 30,000
• since we have a starting balance in DTL account,
  need to adjust to correct balance

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Net Operating Losses (NOL)
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Deferred Tax Asset Valuation Allowance

• Based on all available evidence it is more likely
  than not that some portion will not be realized
• Intended to adjust Deferred Tax asset to expected
  net realizable value
• tax expense xx
• valuation allowance xx
• Adjust to required ending balance each period

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Deferred Tax Asset Valuation Allowance

• In year of expected reversal future deductible
  amounts gt future taxable amounts
• Will there be sufficient future taxable income to
  absorb the excess?
• Could the excess be carried back to prior years?
• if answer is NO - valuation allowance required

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Balance Sheet Presentation

• Classify deferred tax balances based on
• classification of related asset/liability
• expected reversal date if not related
• For reporting purposes
• net current deferred tax balance
• net non-current deferred tax balance
• show deferred tax assets net of valuation
  allowance

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Intraperiod Tax Allocation

• Allocation of tax across different sources of
  income/loss within a given period including
• income from continuing operations
• discontinued operations
• extraordinary items
• cumulative changes in accounting policy
• items charged directly to retained earnings, for
  example
• prior period adjustments
• mark-to-market adjustments under FAS 115

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Intraperiod Tax Allocation

• A company has ordinary income of 50,000 and
  extraordinary income of 100,000
• tax rate is 45
• no permanent or temporary differences
• tax payable
• on ordinary income 22,500
• on extraordinary income 45,000

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Intraperiod Tax Allocation