aCCOUNTING FOR INCOmE TaxES - Pearson · PDF fileAccounting for income taxes involves both intraperiod ... taxes payable or a deferred tax liability (asset) ... the beginning of the

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a C C O U N T I N G F O R I N C O m E T a x E S

I. oVeRVIeW

Accounting for income taxes involves both intraperiod and interperiod tax allocation. Intraperiod allocation matches a portion of the provision for income tax to the applicable components of net income and retained earnings.

Income for federal tax purposes and financial accounting income frequently differ. Obviously, income for federal tax purposes is computed in accordance with the prevailing tax laws, whereas financial accounting income is determined in accordance with GAAP. Therefore, a company's income tax expense and income taxes payable may differ. The incongruity is caused by temporary differences in taxable and/or deductible amounts and requires interperiod tax allocation.

II. INtRAPeRIoD tAX ALLoCAtIoN

Intraperiod tax allocation involves apportioning the total tax provision for financial accounting purposes in a period between the income or loss from:

• Income from continuing operations,

• Discontinued operations,

• extraordinary items,

• Accounting principle change (retrospective)

• Othercomprehensiveincome

○ Pension funded status change

○ Unrealized gain/loss on available for sale security

○ Foreign translation adjustment

○ effective portion of cash flow hedge

○ Revaluation surplus (IFRS only)

• Componentsofstockholders'equity

○ Retainedearningsforpriorperiodadjustmentsandaccountingprinciplechanges (retrospective), and

○ Itemsofaccumulated(other)comprehensiveincome

A. General Rule

Any amount not allocated to continuing operations is allocated to other income statement items, other comprehensive income, or to shareholders' equity in proportion to their individual effects on income tax or benefit for the year. Such items (e.g., discontinued operation, extraordinary items, etc.) are shown net of their related tax effects.

The amount of income tax expense (or benefit) allocated to continuing operations is the tax effect of pretax income or loss from continuing operations plus or minus the tax effects of changes in:

1. Tax laws or rates.

2. Expected realization of a deferred tax asset.

3. Tax status of the entity.

Deferred Taxes

- - income Taxes

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III. CoMPReHeNsIVe INteRPeRIoD tAX ALLoCAtIoN

v e R s u sINCOmE Tax RETURN FINaNCIal STaTEmENTS

DiFFeRenCes

iRsTaxCoDe

FasBgaaPF/s

A. objective

The objective of interperiod tax allocation is to recognize through the matching principle the amount of current and future tax related to events that have been recognized in financial accounting income.

1. Current year taxes:

a. Payable (liability)

b. Refundable (asset)

2. Future year taxes:

a. Deferred tax liability

b. Deferred tax asset/benefit

B. Differences

There are two types of differences between pretax GAAP financial income and taxable income. All differences are either permanent differences or temporary differences.

1. Permanent Differences

a. Permanent differences do not affect the deferred tax computation. They only affect the current tax computation. These differences affect only the period in which they occur. They do not affect future financial or taxable income.

b. Permanent differences are items of revenue and expense that either:

(1) Enter into pretax GAAP financial income, but never enter into taxable income (e.g., interest income on state or municipal obligations), or

(2) Enter into taxable income, but never enter into pretax GAAP financial income (e.g., dividends received deduction).

OR

OR

Permanent Differences



2. temporary Differences

a. Temporary differences affect the deferred tax computation.

b. Temporary differences are items of revenue and expense that may:

(1) Enter into pretax GAAP financial income in a period before they enter into taxable income.

(2) Enter into pretax GAAP financial income in a period after they enter into taxable income.

C. Comprehensive Allocation

The asset and liability (sometimes referred to as the Balance Sheet Approach) method is required by GAAP for comprehensive allocation. Under comprehensive allocation, interperiod tax allocation is applied to all temporary differences. The asset and liability method requires that either income taxes payable or a deferred tax liability (asset) be recorded for all tax consequences of the current period.

1. Temporary differences are recognized for GAAP purposes before or after they are recognized for tax purposes; the related income tax effect will be recognized for GAAP purposes before or after it is recognized for tax purposes.

a. Items that are first recognized for tax purposes will eventually be recognized for GAAP purposes (or vice versa), therefore, the differences are temporary and will eventually "turn around."

b. These temporary differences affect future period(s) and require that:

(1) A liability (for future taxable amounts), or

(2) An asset (for future deductible amounts).

Should be recognized in the financial statement until the difference turns around completely.

D . Accounting for Interperiod tax Allocation

1. Total income tax expense (GAAP income tax expense) or benefit for the year is the sum of:

a. Current income tax expense/benefit, and

b. Deferred income tax expense/benefit.

2. Current income tax expense/benefit is equal to the income taxes payable or refundable for the current year, as determined on the corporate tax return (Form 1120) for the current year.

3. Deferred income tax expense/benefit is equal to the change in deferred tax liability or asset account on the balance sheet from the beginning of the current year to the end of the current year (called the "Balance Sheet Approach").

4. Thus, total income tax expense/benefit can be depicted as follows:

Current income tax payable or refundable as determined on the

corporate tax return±

Change in the deferred income tax asset or liability from the beginning to the end of the reporting period

=total income

tax expense or benefit

Temporary Differences

liability method



Tax RETURN FinanCial STaTEmENT

× Future (Enacted) tax Rate× Current tax Rate+ Deferred liability

Temporary Difference

Current liability-� Deferred Asset

= total tax Expense

P a s s K e y

total tax expense for financial statements is the combination of current tax plus/minus deferred taxes.

the CPA examiners frequently provide an incorrect calculation of financial statement income times the current tax rate. this is an incorrect method to determine the total expense for the following reasons:

• Useoffinancialstatementincome(whichhaspermanentdifferences)isincorrect

• Useofthecurrenttaxrateignoresfuturechangestotheenactedrate

IV. PeRMANeNt DIFFeReNCes

A permanent difference is a transaction that affects only income per books or taxable income, but not both. Income tax expense for a period is calculated only on taxable items. For example, tax- exempt interest (municipal and state bonds) is included in financial income, but is excluded in computing income tax expense.

In effect, permanent differences create a discrepancy between taxable income and financial accounting income that will never reverse.

A. No Deferred taxes

Because they do not reverse themselves, no interperiod tax allocation is necessary for permanent differences. The income tax provision for financial accounting purposes is computed on the basis of pretax book income adjusted for all permanent differences.

B. examples

Permanent differences are either (a) nontaxable, (b) nondeductible, or (c) special tax allowances. Examples are:

1. Tax-exempt interest (municipal, state);

2. Life insurance proceeds on officer's key man policy;

3. Life insurance premiums when corporation is beneficiary;

4. Certain penalties, fines, bribes, kickbacks, etc.;

5. Nondeductible portion of meal and entertainment expense;

6. Dividends-received deduction for corporations; and

7. Excess percentage depletion over cost depletion.

P a s s K e y

Investment interest expense is limited to net (taxable) investment income.



e x a m P l e

ABC Company reported $200,000 of pretax financial income. Included in this income was $10,000 of life insurance premiums for policies on which the corporation is the beneficiary and interest income on municipal bonds of $50,000.

What should ABC Company report on the income statement for federal taxes, assuming a 30% tax rate?

Tax RETURN

Income $ 160,000

municipal interest -�0-�

life ins. premium -�0-�

taxable income $ 160,000

TEmpORaRY dIFFERENCES

Permanent

Permanent

INCOmE STaTEmENT

Income $ 160,000

municipal interest 50,000

life ins. premium (10,000)

Pre-�tax financial income $ 200,000

× 30%

$ 48,000

× 30%

+ -�0-� =

$ 48,000

note that there are no deferred taxes resulting from temporary differences, and that the income tax expense and the income tax liability are the same.

Journal entry to record income tax expense and income tax liability:

DR Income tax expense $48,000CR Income tax payable $48,000

V. teMPoRARY DIFFeReNCes

Temporary differences are the differences between the tax basis of an asset or liability and its reported amount in the financial statement that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled, respectively.

A. transactions that Cause temporary Differences

There are four basic causes of temporary differences, which reverse in future periods.

1. Revenues or gains that are included in taxable income, after they have been included in financial accounting income, which results in a deferred tax liability.

2. Revenues or gains that are included in taxable income, before they are included in financial accounting income, which results in a deferred tax asset.

3. Expenses or losses deducted from taxable income, after they have been deducted from financial accounting income, which results in a deferred tax asset.



4. Expenses or losses deducted for taxable income, before they are deducted from financial accounting purposes, which results in a deferred tax liability.

1

3

2

4

FINaNCIal STaTEmENTINCOmE FIRST

Tax RETURNINCOmE laTER

FINaNCIal STaTEmENTExpENSE FIRST

Tax RETURNExpENSE laTER

Tax RETURNINCOmE FIRST

FINaNCIal STaTEmENTINCOmE laTER

Tax RETURNExpENSE FIRST

FINaNCIal STaTEmENTExpENSE laTER

Tax INC. laTER =

1. Installment sales2. Contractors accounting (% vs. completed)3. Equity method (undistributed dividends)

1. Bad debt expense (allowance vs. direct w/o)2. Est. liability/warranty expense3. Start-�up expenses

1. Prepaid rent*2. Prepaid interest*3. Prepaid royalties** -� the IRC uses the term "prepaid," GAAP usesthe term "unearned"

1. Depreciation expense2. Amortization of franchise3. Prepaid expenses (cash basis for tax)

Tax dEdUCT laTER =

Tax INC. FIRST =

Tax dEdUCT FIRST =

FUTURETaxlIaBIlITY

FUTURETaxBENEFIT (asset)

PRePaiDTaxBENEFIT (asset)

FUTURETaxlIaBIlITY

5. Additional causes of temporary differences are:

a. Differences between the financial reporting and tax basis of assets and liabilities arising in a business combination accounted for as a purchase.

b. Differences in the tax basis of assets due to indexing, whenever the local currency is the functional currency.

B. Deferred tax Liabilities and Assets Recognition

P a s s K e y

Dtl Future tax accounting income > Future financial accounting income.

DtA Future tax accounting income < Future financial accounting income.

1. Deferred tax Liabilities

Deferred tax liabilities are anticipated future tax liabilities derived from situations where future taxable income will be greater than future financial accounting income due to temporary differences. All deferred tax liabilities are recognized on the balance sheet.



e x a m P l e

Stone Co. began operations in Year 1 and reported $225,000 in financial income for the year. Stone Co.'s Year 1 tax depreciation exceeded its book depreciation by $25,000. Stone's tax rate for Year 1 and years thereafter was 30%. In its December 31, Year 1, balance sheet, what amount of deferred income tax liability should Stone report?

Tax RETURN

taxable Income $ 200,000

TEmpORaRY dIFFERENCE

$25,000

FINaNCIal STaTEmENT

Pre-�tax financial income $225,000

× 30%

$ 60,000

× 30%

+ $ 7,500 =

$ 67,500

the excess depreciation on the tax return results in a future liability, a financial accounting expense in future years that will not be deductible in future years because it was deducted in Year 1. the deferred tax liability reflects the fact that less depreciation will be deducted on the tax return in future years, compared to the financial statements. this yields a future taxable income which will be greater than the future financial accounting income.

Journal entry to record the taxes:

DR Income tax expense—current $60,000DR Income tax expense—deferred 7,500CR Deferred tax liability $7,500CR Income tax payable 60,000

the provision for income taxes in the income statement for the current period would appear as follows:

Provision for income taxes:

Current $60,000

Deferred 7,500

total provision for income taxes $67,500

total income tax expense for financial accounting purposes is the net of income tax payable and any changes in the deferred tax asset and deferred tax liability accounts.

In Year 2, book depreciation exceeded tax depreciation by $25,000. this is a reversal of the temporary difference between GAAP and tax accounting and results in the reversal of the deferred tax liability in Year 2.

Journal entry to record the Year 2 reversal of the deferred tax liability:

DR Deferred tax liability $7,500CR Income tax benefit—deferred $7,500

2. Deferred tax Assets

Deferred tax assets arise when the amount of taxes paid in the current period exceeds the amount of income tax expense in the current period. They are anticipated future benefits derived from situations where future taxable income will be less than future financial accounting income due to temporary differences.



3. Valuation Allowance (contra account)

If it is more likely than not (a likelihood of more than 50 percent) that part or all of the deferred tax asset will not be realized, a valuation allowance is recognized. The net deferred tax asset should equal that portion of the deferred tax asset that, based on available evidence, is more likely than not to be realized.

u . s . g a a P v s . i F R s

Valuation allowances are not permitted under IFRS. Instead, a deferred tax asset is recognized when it is probable (more likely than not) that sufficient taxable profit will be available against which the temporary difference can be utilized.

e x a m P l e

Black Co., organized on January 2, Year 1, had pretax accounting income of $500,000 and taxable income of $800,000 for the year ended December 31, Year 1. the enacted tax rate for all years is 30%. the only temporary difference is accrued product warranty costs which are expenses to be paid as follows:

Year 2, $100,000; Year 3, $100,000; Year 4, $100,000

Tax RETURN

taxable Income $800,000

TEmpORaRY dIFFERENCE

$300,000

FINaNCIal STaTEmENT


× 30%

$240,000

× 30%

-� $ 90,000 =

$150,000

Journal entry to record the Year 1 taxes:

DR Deferred tax asset $ 90,000DR Income tax expense—current 240,000CR Income tax payable $240,000CR Income tax benefit—deferred 90,000

When the company pays the warranty costs of $100,000 in Year 2, the company will take a $30,000 ($100,000 × 30%) tax deduction related to the warranty costs and will reverse out the related deferred tax asset.

Journal entry to record reversal of a portion of the deferred tax asset for warranty costs paid and deducted in Year 2.

DR Income tax expense—deferred $30,000CR Deferred tax asset $30,000

valuation allowance



e x a m P l e

Black expects to have taxable income of $100,000 in Year 2, but no taxable income after. the deferred tax asset would be limited to the amount to be realized in Year 2 ($30,000 = $100,000 × 30%). A deferred tax asset of $90,000 would be recognized, but a valuation account of $60,000 would result in a net deferred tax asset of $30,000.

Journal entry:

DR Deferred tax asset $ 90,000DR Income tax expense—current 240,000CR Deferred tax asset valuation allowance $ 60,000CR Income tax benefit—deferred 30,000CR Income tax payable 240,000

e x a m P l e

Foxy Inc.'s financial statement and taxable income for Year 1 follows (income before the effect of tax-�related differences was $140,000):

Tax RETURNIncome $ 140,000municipal interest -�0-�Penalty -�0-� $ 140,000Depreciation (40,000)



PermanentPermanent

$10,000

inComE STaTEmENTIncome $ 140,000municipal interest 12,000Penalty (7,000) $ 145,000Depreciation (30,000)

Pretax fin. income $ 115,000

× 40% $ 40,000

× 40%+ $ 4,000 =

$ 44,000

FINaNCIal STaTEmENT pRE-Tax INCOmE $ 115,000 Differences: municipal interest income (12,000) Penalty expense 7,000 tax depreciation $ 40,000 Book depreciation (30,000) Excess tax depreciation (10,000)

INCOmE Tax RETURN $ 100,000the enacted tax rate is 40% for this year and future years.

Journal entry:

DR Income tax expense—current $40,000DR Income tax expense—deferred 4,000CR Income taxes currently payable $40,000CR Deferred tax liability 4,000



C. Uncertain tax Positions

An uncertain tax position is defined as some level of uncertainty of the sustainability of a particular tax position taken by a company. U.S. GAAP requires a more-likely-than-not level of confidence before reflecting a tax benefit in an entity's financial statements.

1. scope

A tax position is a filing position that an enterprise has taken or expects to take on its tax return, including:

a. A tax deduction (the most common type of tax position).

b. A decision to not file a tax return.

c. An allocation or shift of income between jurisdictions.

d. The characterization of income, or a decision to exclude reporting taxable income, in a tax return.

e. A decision to classify a transaction, entity, or other position in a tax return as tax exempt.

2. two-step Approach

a. step 1—Recognition of the Tax Benefit

(1) test "More-Likely-than-Not"

Threshold that must be met before a tax benefit can be recognized in the financial statements.

(a) Assessment: If a dispute with the taxing authority were taken to the court of last resort.

(2) threshold Considerations(a) Based on the technical merits of the position.

(b) Presume that the relevant taxing authority will examine the tax position and has full knowledge of all relevant information.

(c) Each tax position should be evaluated separately.

(3) test Failed(a) Tax benefit is not recognized in the financial statements.

(b) Financial statement tax expense is increased.

b. step 2—Measurement of the Tax Benefit

(1) Recorded Amount(a) Recognize the largest amount of tax benefit that has greater than 50

percent likelihood of being realized upon ultimate settlement with the taxing authority.

(b) Tax position based on clear and unambiguous tax law—recognize the full benefit in the financial statements.

P a s s K e y

Step 1—the evaluation is based on the expected outcome in the court of last resort.

Step 2—the evaluation is based on the expected outcome in a settlement with the taxing authority.



e x a m P l e

Foxy, Inc. prepared their Year 1 tax return. Foxy, Inc. has taken a tax deduction for $1,000 that results in a $400 tax savings/benefit (40% tax rate). Foxy, Inc. believes that there is a greater than 50% chance that, if audited, the tax deduction would be sustained as filed (the tax deduction meets the "more-�likely-�than-�not" test). However, Foxy, Inc. concludes that if challenged, they would negotiate a settlement. the following is their assessment of outcomes:

Potential Outcomes Probability Cumulative Probability $400 savings 26% 26 $300 savings 25% 51 > 50% $200 savings 21% 72 $100 savings 18% 90 $0 savings 10% 100

Result:

• BasedonFoxy,Inc.'sassessmentofpossibleoutcomes,Foxy,Inc.shouldrecognizeatax savings/benefit of $300.

• Thisamountrepresentsthelargestbenefitthathasagreaterthan50%likelihoodofbeingrealized.

• Accordingly,Foxy,Inc.mustrecorda$100incometaxliability.


Uncertain tax positions are not specifically addressed by IFRS. Under IFRS, the tax consequences of events should be accounted for in a manner consistent with the expected resolution of the tax position with tax authorities as of the balance sheet date.

D. enacted tax Rate

Measurement of deferred taxes is based on the applicable tax rate. This requires using the enacted tax rate expected to apply to taxable items (temporary differences) in the periods the taxable item is expected to be paid (liability) or realized (asset).

e x a m P l e

Stone Co. began operations in Year 1 and reported $225,000 in income before income taxes for the year. Stone's Year 1 tax depreciation exceeded its book depreciation by $25,000. Stone's tax rate for Year 1 was 30%, and the enacted rate for years after is 25%. In its December 31, Year 1, balance sheet, what amount of deferred income tax liability should Stone report?

Tax RETURN

taxable Income $ 200,000


$25,000

FINaNCIal STaTEmENT


× 30%

$ 60,000

× 25%

+ $ 6,250 =

$ 66,250

DR Income tax expense—current $60,000DR Income tax expense—deferred 6,250CR Deferred tax liability $ 6,250CR Income tax payable 60,000

enacted Rate- -

Change in Tax Rate



P a s s K e y

Use the tax rate in effect when the temporary difference reverses itself. Do not allow the CPA examiners to trick you into using the following tax rates:

• Anticipated

• Proposed

• Unsigned


IFRS permits the use of enacted or substantively enacted tax rates.

e. treatment of and Adjustment for Changes

1. Changes in tax Laws or Rates

The liability method requires that the deferred tax account balance (asset or liability) be adjusted when the tax rates change. Thus if future tax rates have been enacted, not just proposed or estimated, the deferred tax liability and asset accounts will be calculated using the appropriate enacted future effective tax rate.

Changes in tax laws or rates are recognized in the period of change (enactment).

a. The amount of the adjustment is measured by the change in applicable laws/rates applied to the remaining cumulative temporary differences.

b. The adjustment enters into income tax expense for that period as a component of income from continuing operations.


Under IFRS, adjustments for changes in deferred tax balances due to changes in tax laws or rates are recognized on the income statement, except when the deferred tax balance arises from a transaction or event that is recognized in other comprehensive income. When a deferred tax balance arises from a transaction or event that is recognized in other comprehensive income, adjustments should also be recorded in other comprehensive income.

2. Change in the Valuation Allowance

A change in circumstances that causes a change in judgment about the ability to realize the related deferred tax asset in future years should be recognized in income from continuing operations in the period of the change.

3. Change in the tax status of an enterprise

a. An entity's tax status may change from taxable to nontaxable (e.g., corporation to partnership) or from nontaxable to taxable (S-corporation to C-corporation).

b. At the date a nontaxable entity becomes a taxable entity, a deferred tax liability or asset should be recognized for any temporary differences.



c. At the date a taxable entity becomes a nontaxable entity, any existing deferred tax liability or asset should be eliminated (written off).

d. The effect of recognizing or eliminating a deferred tax liability or deferred tax asset should be included in income from continuing operations in the period of the change.

F. Net temporary Adjustment (from beginning balance)

The deferred tax account is adjusted for the change in deferred taxes (asset or liability), due to the current year's events. The income tax expense/benefit – deferred is the difference between the beginning balance in the deferred tax account and the properly computed ending balance in the account.

e x a m P l e

Julie Co. had previously recorded temporary differences of $10,000. the enacted rate in the year the temporary differences originated was 20%. the deferred tax liability has a beginning balance of $2,000 ($10,000 × 20%). For the current year, taxable income is $100,000 and financial statement income is $120,000. the $20,000 difference is a temporary difference caused by depreciation. the newly enacted rate for the current and future periods is 30%. the previously recorded temporary differences have not yet reversed.

Tax RETURN



$ 10,000 (Beg) $ 20,000

FINaNCIal STaTEmENT

Pre-�tax financial inc. $ 120,000

× 30%

$ 30,000

$ 30,000 × 30% $ 9,000 <2,000> (Beg)+ $ 7,000 =

$ 37,000

Journal entry to record the taxes:

DR Income tax expense—current $30,000DR Income tax expense—deferred 7,000CR Deferred tax liability $ 7,000CR Income tax payable 30,000

G. Balance sheet Presentation

Under U.S. GAAP, deferred tax liabilities and assets should be classified and reported as a current amount and a noncurrent amount on the balance sheet.

1. Deferred tax items should be classified based on the classification of the related asset or liability for financial reporting. For example:

a. A deferred tax asset that relates to product warranty liabilities (accrued expenses) would be classified as "current" because warranty obligations are part of the current operating cycle.

b. A deferred tax liability that relates to asset depreciation (fixed assets) would be classified as "noncurrent" because the related assets are noncurrent.



2. Deferred tax items not related to an asset or liability should be classified (e.g., current or noncurrent) based on the expected reversal date of the temporary difference. Such items include:

a. Deferred tax assets related to carry forwards,

b. Organization costs expensed for GAAP financial income (no asset) but deducted in later years for tax purposes, and

c. Percentage completion method used for contracts for GAAP financial income (no asset or liability) but completed contract method used for tax purposes.

3. All deferred tax assets and liabilities classified as current must be offset (netted) and presented as one amount (a net current asset or a net current liability).

4. All deferred tax liabilities and assets classified as noncurrent must be offset (netted) and presented as one amount (a net noncurrent asset or a net noncurrent liability).

5. Any valuation allowance for a deferred tax asset should be allocated pro rata to current and noncurrent deferred assets.

P a s s K e y

Always remember to net across (the balance sheet) not up and down (the balance sheet).


Under IFRS, deferred tax assets and deferred tax liabilities are reported as noncurrent on the balance sheet. Deferred tax assets and deferred tax liabilities may be netted if the entity has a legally enforceable right to offset current tax assets against current tax liabilities and the deferred tax assets and deferred tax liabilities relate to income taxes levied by the same tax authorities.

VI. oPeRAtING Losses

Under the present U.S. tax law, an operating loss of a period may be carried back two years or forward twenty years and be applied as a reduction of taxable income in those periods as permitted by the tax laws. An election must be made in the year of loss to either (1) carryback the portion of the loss that can be absorbed by the prior years' taxable income, and carryforward any excess, or (2) carryforward the entire loss. Taxable income and financial accounting income will differ for the periods to which the loss is carried back or forward.

A. operating Loss Carrybacks

The tax effects of any realizable loss carryback should be recognized in the determination of the loss period net income. A claim for refund of past taxes is shown on the balance sheet as a separate item from deferred taxes. This income tax refund receivable is usually classified as current.

1. Tax carrybacks that can be used to reduce taxes due or to receive a refund for a prior period are a tax benefit (asset) and should be recognized (to the extent they can be used) in the period they occur.

Journal entry to record a current net operating loss that can be used to obtain a refund of $30,000 taxes previously paid would be recorded as:

DR tax refund receivable $30,000 CR tax benefit* $30,000

* this is a reduction of the book loss (not a contra-�expense).

operating loss



B. operating Loss Carryforwards

If an operating loss is carried forward, the tax effects are recognized to the extent that the tax benefit is more likely than not to be realized.

1. Tax carryforwards should be recognized as deferred tax assets (because they represent future tax savings) in the period they occur.

a. NOL carryforwards should be "valued" using the enacted (future) tax rate for the period(s) they are expected to be used.

b. Tax credit carryforwards should be "valued" at the amount of tax payable to be offset in the future. A current net operating loss of $100,000 (which is not and cannot be used as a tax carryback) is carried forward to be used in a period for which the current enacted tax rate is 40%.

Journal entry to record the deferred tax benefit:

DR Deferred tax asset $40,000

CR tax benefit* $40,000

* this is a reduction of the book loss (not a contra-�expense).

c. The deferred tax asset (DR) will reduce tax payable in a future period.

d. The tax benefit (CR) would reduce the net operating loss of the current period.



C O N C E p T E x E R C I S E

the pretax financial accounting income and taxable income of ABC Company were the same for each of the following years. no temporary or permanent differences exist.

Income Enacted RatesYear 1 $10,000 30%Year 2 15,000 30%Year 3 6,000 30%Year 4 5,000 35%Year 5 (current year) (60,000) 35%Year 6 (next year—expected) 4,000 40%Year 7 & forward – 0 – 40%

Assuming ABC elects to use the 2-�year carryback/20 carryforward option and that it is more likely than not that there will be no taxable earnings after Year 6, what is the journal entry to record the Year 5 income taxes? How will income taxes be presented in the income statement and balance sheet?

nOl Year 5 net operating loss (nOl) $ 60,000 nOl carryback: Year 3 (2 year carryback) $ 6,000 Year 4 (1 year carryback) 5,000 (11,000) nOl carryforward to Year 6 and future years $ 49,000

CARRYBACK Income tax receivable: Year 3 ($6,000 × 30%) $ 1,800 Year 4 ($5,000 × 35%) 1,750 Income tax refund receivable $ 3,550

C A R RY FO RWA R D [a] Deferred tax asset (nOl carryforward benefit): Year 6 and future years ($49,000 × 40%) $ 19,600 [b] Deferred tax asset valuation allowance: nOl carryforward $ 49,000 less: Year 6 income (4,000) Carryforward that will not be used $ 45,000 tax rate (enacted) × 40% Deferred tax asset valuation allowance $ 18,000 net realizable deferred tax asset (a – b) $ 1,600

J O U R n A l E n t RY

Journal entry to record income taxes for Year 5:

DR Income tax refund receivable [a] $ 3,550

DR Deferred tax asset [b] 19,600

CR Deferred tax asset valuation allowance [c] $18,000

CR Income tax benefit (residual) 5,150

Income Statement—Year 5

Income tax benefit Current $ 3,550 Deferred (net) 1,600 $ 5,150

Balance Sheet—Year 5

Current assets Income tax ref. rec. $ 3,550 Deferred tax asset $ 19,600 less: valuation allow. < 18,000> 1,600 $ 5,150



VII. INVestee's UNDIstRIBUteD eARNINGs

A. Income tax Return

Taxable income is the dividend received. Under U.S. tax law, there is a dividend received deduction (exclusion) based upon the percentage of ownership in the stock of the other corporation:

Ownership 0–19% 70% exclusion

Ownership 20%–80%: 80% exclusion

Ownership over 80%: 100% exclusion

B. GAAP Financial statement

Report percentage of investee's income using the equity method for an investment between 20% and 50%.

C. temporary Difference

It should be presumed that all undistributed earnings will ultimately be distributed to the investor/parent at some future time (REVERSE). Financial statement income of investee claimed by investor/parent as earnings is greater than actual dividends received from the investee that are claimed on the tax return.

e x a m P l e

Facts:

• 25%ownedinvestee(GAAPrequiresuseofequitymethod).

• Investee'snetincome$2,400,000($600,000=GAAPincome).

• Investee'sdividends$2,000,000($500,000=Taxreturn).

• Taxreturn:dividendreceiveddeduction(exclusion)is80%(Permanent).

• Taxrateis40%.

Tax RETURN

Investee div. income $ 500,000 temp & PermINCOmE STaTEmENT

Equity in earnings $600,000

80% Exclusion (400,000) (Permanent) (480,000)

taxable $ 100,000 $20,000 $120,000

× 40% $ 40,000

× 40%+ $ 8,000 =

$ 48,000

Journal entry:

DR Income tax expense—current $40,000

DR Income tax expense—deferred 8,000

CR Income taxes currently payable $ 40,000

CR Deferred tax liability 8,000

(Temporary)



VIII. INCoMe tAX DIsCLosURes

A. Balance sheet Disclosures

1. The components of a net deferred tax liability or asset should be disclosed, including the total of:

a. All deferred tax liabilities.

b. All deferred tax assets.

c. The valuation allowance for deferred tax assets.

2. Other balance sheet disclosures include:

a. The net change during the year in the total valuation allowance.

b. The tax effect of each type of temporary difference and carryforward that is significant to the deferred tax liability or asset.

B. Income statement Disclosures

The amount of income tax expense (or benefit) allocated to continuing operations and the amount(s) separately allocated to other item(s) must be disclosed.

1. The significant components of income tax expense attributable to continuing operations must be disclosed. These include:

a. Current tax expense or benefit.

b. Deferred tax expense or benefit.

c. Investment tax credits.

d. Government grants (that cause a reduction of income tax expense).

e. Benefits of NOL carryforwards.

f. Tax expense allocated to shareholders' equity items.

g. Adjustments of deferred taxes from changes in tax laws or rates.

h. Adjustments of the beginning-of-the-year deferred tax asset valuation due to changes in expectations.

2. The tax benefit of an operating loss carryback or carryforward should be reported in the same manner (I/S location) as the current year source of income or loss that gave rise to the benefit recognition.

3. A recognition (in either percentages or dollar amounts) of income tax expense attributable to continuing operations and the amount of income tax expense that would have resulted from applying the statutory rate to pretax income from continuing operations should be presented.



IX. sUMMARY

A. Method

Asset and liability approach—balance sheet approach.

B. Differences

Differences between income tax returns and GAAP financial statements fall into two groups:

1. Permanent

No deferred tax asset or liability is required because the difference will never reverse.

2. temporary

Deferred tax asset or liability must be recorded because the temporary difference will reverse.

a. Deferred tax Liability

The consequences of temporary differences that will reverse in the future and create future taxes.

b. Deferred tax Asset

The consequences of temporary differences that will reverse in the future and create future tax benefits.

(1) Valuation Allowance

The contra-asset that is to be established to reflect that it is "more likely than not" that the deferred tax asset will not be completely realized.

C. Measurement

Use applicable enacted tax rates. This is the tax rate expected to apply to taxable income in the future periods that the deferred tax asset or liability is expected to be paid or realized.

1. tax Rate Changes

Adjusted in the period of a new tax rate (when signed into law). The new impact (increase or decrease) to the deferred tax account will be reflected in "income from continuing operations" (IDEA).

D. Classification

Criteria for current vs. noncurrent:

1. Balance sheet Related

Classify according to the related asset or liability causing the temporary difference.

2. Non-balance sheet Related

Classify based upon the expected reversal or benefit period.

3. Netting / offsetting

• Current(assetandliability)mustbenetted.

• Noncurrent(assetandliability)fromaparticularjurisdictionmustbenetted.



CORpORaTE TaxaTION SUmmaRYgaaP

FInAnCIAl StAtEmEntSiRC

tAX REtURnTEmp PeRm none

gRoss inCome:

Gross sales Income Income Installment sales Income Income when received Rents and royalties in advance Income when earned Income when received State tax refund Income Income Dividends Equity method Income is subsidiary's earnings Income is dividends received 100 / 80 / 70% exclusion no exclusion Excluded forever ITEmS NOT INClUdIBlE IN "TaxaBlE INCOmE":

State and municipal bond interest Income not taxable income life insurance proceeds Income Generally not taxable income Gain / loss on treasury stock not reported not reported oRDinaRy exPenses:

Cost of goods sold Uniform capitalization rules Uniform capitalization rules Officers' compensation (top) Expense $1,000,000 limit Bad debt Allowance (estimated) Direct write-�off Estimated liability for contingency (e.g., warranty) Expense (accrue estimated) no deduction until paid Interest expense Business loan Expense Deduct tax-�free investment Expense not deductible Contributions All expensed limited to 10% of adj. taxable income loss on abandonment / casualty Expense Deduct loss on worthless subsidiary Expense Deduct Depreciation mACRS vs. straight line Slow depreciation Fast depreciation Section 179 depreciation not allowed (must depreciate) 2012 = $125,000 Different basis of asset Use GAAP basis Use tax basis Amortization Start up / organizational expenses Expense $5,000 maximum / 15 year excess

Franchise Amortize Amortize over 15 years Goodwill Impairment test Amortize over 15 years Depletion Percentage vs. straight line (cost) Cost over years Percentage of sales Percentage in excess of cost not allowed Percentage of sales Profit and pension expense Expense accrued no deduction until paid Accrued expense (50% owner / family) Expense accrued no deduction until paid State taxes (paid) Expense Deduct meals and entertainment Expense Generally 50% deductible Gaap ExpENSE ITEmS THaT aRE NOT Tax dEdUC TIONS:

life insurance expense (corporation) Expense not deductible Penalties Expense not deductible lobbying / political expense Expense no deduction Federal income taxes Expense not deductible SpECIal ITEmS:

net capital gain Income Income net capital loss Report as loss not deductible Carryback / carryover (3 years back / 5 years forward) not applicable Unused loss allowed as a StCl Related shareholder Report as a loss not deductible net operating loss Report as a loss Carryback 2 or carryover 20 Research and development Expense Expense / Amortize / Capitalize

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aCCOUNTING FOR INCOmE TaxES - Pearson · PDF fileAccounting for income taxes involves both intraperiod ... taxes payable or a deferred tax liability (asset) ... the beginning of the