CHAPTER 12

ACCOUNTING FORINCOME TAXES

Introduction

Income taxes are an expense Consistent with

the proprietary theory definition of comprehensive income

Accounting for income taxes is a controversial issue

Historical Perspective Income taxes first became a significant

issue because of the emerging facilities exception during World War II

ARB No. 23 required the allocation of some deferred income taxes did not provide clear measurement guidelines

The allocation of income taxes to the periods impacted is termed interperiod tax allocation

APB Opinion No. 11 extended interperiod tax allocation to all timing differences criticism because resulting balance sheet items did not reflect future tax

consequences result

FASB Statement No. 96 later FASB Statement No. 109

The Income Tax Allocation Issue

Most economic events have tax cash flow consequences These cash consequences are reported on tax returns in

accordance with the Internal Revenue Code (IRC)

The objective of financial accounting

provide information about the amount and timing of future

cash flows

The Income Tax Allocation Issue

The goal of the IRC is to raise revenue to run the government and in some cases to regulate the economy

These same economic events are reported for financial accounting purposes under GAAP

The Income Tax Allocation Issue

The goals of the IRC and GAAP sometimes result in reporting revenues and expenses in different accounting periods creating an originating difference

In subsequent years these differences will reverse creating a reversing difference

This issue is termed the income tax allocation issue

2004 2005

Revenue Expense

Permanent and Temporary Differences

Permanent differences are differences between taxable income and financial accounting that will never reverse federal economic policy or to alleviate a provision

of the IRC that falls too heavily on one segment of the economy

Taxable income

Financial income

Permanent and Temporary Differences

Temporary differences will reverse in a subsequent period some temporary differences are timing differences others occur because of different measurement bases

Permanent Differences Occur because provisions

of the IRC exempt certain types of

revenue from taxation or prohibit the deduction of

certain expensesTaxable income

Financial income

Types of Permanent Differences

Revenue recognized for financial accounting purposes that is never taxable interest on municipal bonds

Expenses recognized for financial accounting purposes that are never deductible for tax purposes life insurance premiums

Income tax deductions that do not qualify as expenses under GAAP life insurance proceeds

Taxable income

Financial income

Temporary Differences

Create timing differences Result in assets and liabilities

having differing bases for financial accounting and taxation purposes

Originating differences when they reverse create Taxable amounts Deductible amounts

Temporary Differences

Categories of timing differences Current financial accounting income exceeds

current taxable income Current financial accounting income is less

than current taxable income

Additional Temporary Differences

1 Reduction in the tax basis of depreciable assets because of tax credits

2 The ITC accounted for by the deferred method3 Foreign operations for which the reporting currency is

the functional currency4 An increase in the tax basis of assets because of

indexing for inflation5 Business combinations accounted for by the

purchase method

Net Operating Losses

Occurs when tax deductions are greater than taxable income in a period

IRC allows for these losses to be carried back two years and forward twenty years

Should the benefits of NOL’s be recognized?

Conceptual Issues Allocation versus Nonallocation Comprehensive versus Partial allocation Discounting deferred taxes

Alternative Interperiod Tax Allocation Methods

Deferred method uses rates in effect when

difference originates Asset/liability method

uses rates expected to be in effect when the difference reverses Net of tax method

use one of the above methods to adjust balance sheet items that caused the temporary difference

e. g. depreciable assets

FASB Dissatisfaction With the Deferred Method

APB Opinion No. 11 required the use of the deferred method

Did not meet SFAS No. 6 definition of assets and liabilities

Measurement and Reporting Under SFAS No. 96

Required the asset/liability approach to allocation Deferred tax liability Deferred tax asset

SFAS No. 96 limited the recognition of deferred tax assets

created by NOLs zero future income assumption

Business Dissatisfaction With SFAS No. 96

The cost of scheduling necessary under its provision

Loss of deferred tax assets under zero future income assumption

SFAS No. 109

Board remained committed to the asset/liability method

Allowed for the separate recognition and measurement of deferred tax assets and liabilities without regard to future income considerations

More likely than not criteria for deferred tax assets rather than zero future income assumption

Determining Deferred Asset and Liability Balances

1 Identify temporary differences, NOL carryforwards, and unused tax credits

2 Measure the total deferred tax liability by applying the expected tax rate to the future taxable amount

3 Measure the total deferred tax asset by applying the expected future rate to future deductible amounts and NOL carryforwards

4 Measure deferred tax assets for each type of unused tax credit

5 Measure the valuation allowance based on the more likely than not criterion

The Valuation Allowance

There may be insufficient future taxable income to derive the benefit from a deferred tax asset

Use allowance to reduce the deferred tax asset to amount expected to be realized under the more likely than not criterion

Do Assets and Liabilities Created by SFAS No. 109 Meet the Definitions in SFAC No. 6?

Deferred tax liability - meets the three characteristics of liabilities

Deferred tax asset - meets the three characteristics of assets

Financial Statement Disclosures

Income statement Balance sheet SEC disclosure requirements

FIN No. 48: Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Stmt No. 109

Tax contingencies too flexible Used to manipulate earnings Reporting & disclosure of tax positions

lacked transparency FIN 48 establishes proper

accounting treatment for uncertain tax positions.

FIN No. 48: Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Stmt No. 109

Evaluation of tax position is a 2-step process Recognition Measurement

Financial Analysis of Income Taxes Disclosure requirements allow

financial statement users to make better decisions including:1 Assessing the quality of earnings2 Assessing future cash flows 3 Calculation of actual tax rates

Financial Analysis of Income Taxes

The footnotes provide information on:1 Information on the amount of taxes that would be

paid at the federal statutory rate and the amount actually paid

2 Changes in the deferred tax asset and liability accounts

3 Information concerning income tax carrybacks and carryforwards

Financial Analysis of Income Taxes The earnings conservatism ratio

Pretax accounting incomea

Taxable incomeaIn the event a company reports material permanent income tax

differences, the amount of these differences adjusts the numerator.

Financial Analysis of Income Taxes

Earnings conservatism ratios for Hershey and Tootsie

1.00 1.00 1.00 1.00 1.00 1.01

0.00

0.20

0.40

0.60

0.80

1.00

1.20

2003 2004 2005

Her shey Tootsie

IAS No. 12:Accounting for Taxes on Income

Recently amended to require the liability (asset/liability) method

Considering other issues:1 Do tax consequences of recovery amounts of

assets and liabilities depend on the manner of recovery?

2 Disclosure of reconciliation between income tax expense and accounting profit

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Prepared by Kathryn Yarbrough, MBA