ACG 3141: Chapter 16 (Part 2)Class 16 Lecture Slides Accounting for Income Taxes
Topic Schedule • Class 16 (February 27, 2008): • Rate Application and Reconciliation • Net Operating Losses • Classification of Deferred Tax Liabilities and Assets • Intraperiod Tax Allocation
Tax Rates and Reconciliation • Tax Rates: Deferred Tax Assets and Liabilities reflect ENACTED tax rates. • Proposed legislation will not affect the calculation. • In the year of origination, the DTA or DTL must reflect the known tax rates of the future reversal years. • In the reversal years, the DTA or DTL must be adjusted to reflect rate changes. Look at E16-13 (assigned homework – solution also in the Homework solutions) Look at E16-14
E16-13 E 16-13: Allmond Corporation, organized on January 3, 2006, had pretax accounting income of $14 million and taxable income of $20 million for the year ended December 31, 2006. The 2006 tax rate is 35%. The only difference between accounting income and taxable income is estimated product warranty costs. Expected payments and scheduled tax rates (based on recent tax legislation) are as follows: 1. Determine the amounts necessary to record Allmond’s income taxes for 2006 and prepare the appropriate journal entry. 2. What is Allmond’s 2006 net income?
E16-14 Arnold Industries has pretax accounting income of $33 million for the year ended December 31, 2006. The tax rate is 40%. The only difference between accounting income and taxable income relates to an operating lease in which Arnold is the lessee. The inception of the lease was December 28, 2006. An $8 million advance rent payment at the inception of the lease is tax-deductible in 2006 but, for financial reporting purposes, represents prepaid rent expense to be recognized equally over the four-year lease term. Required: • Determine the amounts necessary to record Arnold’s income taxes for 2006 and prepare the appropriate journal entry. • Determine the amounts necessary to record Arnold’s income taxes for 2007 and prepare the appropriate journal entry. Pretax accounting income was $50 million for the year ended December 31, 2007. • Assume a new tax law is enacted in 2007 that causes the tax rate to change from 40% to 30% beginning in 2008. Determine the amounts necessary to record Arnold’s income taxes for 2007 and prepare the appropriate journal entry. • Why is Arnold’s 2007 income tax expense different when the tax rate change occurs from what it would be without the change?
Tax Rate Reconciliation • One of the disclosures required is a reconciliation of the effective tax rate shown on the face of the income statement from the U.S. federal tax rate. • Effective Tax Rate: Income tax expense ÷ GAAP pretax net income • Example: Assume that in 2006, Kent corporation has $145 million of GAAP net income. Kent’s Book-Tax differences are 1) a permanent difference of $5 million municipal bond interest, and 2) a future taxable amount of $40 related to an installment sale. Assume that the U.S. federal tax rate is 40%. Kent’s 2006 Taxable Income and IT Entries: GAAP Net Income $145 Less: Tax-Exempt Interest ( 5) Future Taxable Amount ( 40) 2006 Taxable Income $100 Entry: Dr. Income Tax Expense $56 (“plug”) Cr. Deferred Tax Liability $16 ($40 x .40%) Cr. Income Tax Payable $40 ($100 x 40%) Kent’s effective tax rate is 38.6% Income Tax Expense (56) = 38.6% GAAP Net Income (145) Kent’s 2006 Tax Rate Reconciliation: Statutory U.S. Rate 40.0% Decrease resulting from: Tax Exempt Interest ( .20) Installment Sale ( 1.24) Effective Tax Rate 38.6% Calculation: Difference between Statutory rate (40%) and Effective Rate (38.6%) = 1.4% TE Interest = 5 ÷ 45 x 1.4% Installment Sale = 40 ÷ 45 x 1.4%
Accounting for Net Operating Losses Net operating loss (NOL)= tax-deductible expenses exceed taxable revenues. The federal tax laws permit taxpayers to use the losses of one year to offset the profits of other years (carrybackand carryforward).
Accounting for Net Operating Losses Loss Carryback • Back 2 years and forward 20 years • Losses must be applied to earliest year first Loss Carryforward • May elect to forgo loss carryback and • Carryforward losses 20 years
NOLs – Carryback Example (Carryback)Valis Corporation had the following tax information. In 2007 Valis suffered a net operating loss of $450,000, which it elected to carry back. The 2007 enacted tax rate is 29%. Prepare Valis’s entry to record the effect of the loss carryback.
NOLs: Carryback Example $135,000
NOLs: Carryback example Journal Entry for 2007 (Refund due to carryback) Presumably, the company will file a refund claim with the IRS. Upon the receipt of refund proceeds (that will carry interest), the entry will be: Debit Cash 135,000 + interest Credit IT Refund Receivable 135,000 Credit Interest Revenue interest
NOLs: Carryback and Carryforward Example (Carryback and Carryforward)Zoop Inc. incurred a net operating loss of $500,000 in 2007. Combined income for 2005 and 2006 was $400,000. The tax rate for all years is 40%. Zoop elects the carryback option. Prepare the journal entries to record the benefits of the loss carryback and the loss carryforward.
NOLs: Carryback and Carryforward example Deferred Tax Asset $160,000
NOLs: Carryback and Carryforward Journal Entries for 2007
NOLs: Carryforward Valuation (Carryback and Carryforward with Valuation Allowance)Use the information for Zoop Inc. Assume that it is more likely than not that the entire net operating loss carryforward will not be realized in future years. Prepare all the journal entries necessary at the end of 2007.
NOLs: Carryforward Valuation Journal Entries for 2007 Thus, the amount of Income Tax Benefit reported on the financial statement, and the amount of Deferred Tax Asset related to the NOL Carryforward on the Balance Sheet would be 0.
Valuation Allowance Revisited. • Whether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period. • Based on management estimates
FAS 109: Financial Statement Presentation Balance Sheet Presentation An individual deferred tax liability or asset is classified as current or noncurrent based on the classification of the related asset or liability for financial reporting purposes. • Companies should classify deferred tax accounts on the balance sheet in two categories: • one for the net current amount, and • one for the net noncurrent amount.
Balance Sheet Classification, cont’d Disclose the following: • Total of all deferred tax liabilities. • Total of all deferred tax assets. • Total valuation allowance recognized. • Net change in valuation account. • Approximate tax effect of each type of temporary difference (and carryforward). Deferred tax assets/liabilities are classified as current or noncurrent based on the classification of the related asset or liability.
FAS 109: Additional Disclosures • Current portion of tax expense (benefit) • The portion related to the income tax payable • Deferred portion of tax expense (benefit) • The portion related to the change in the DTA and DTL. Note that some separate disclosures are required for the expense related to NOL carryforwards, tax rate changes, changes in valuation estimates, etc.
Disclosures Example (from E16-7)Kent, Inc.’s, reconciliation between financial statement and taxable income for 2006 follows: Additional Information: The enacted tax rate was 34% for 2005, and 40% for 2006 and years thereafter. • In its December 31, 2006, balance sheet, what amount should Kent report as deferred income tax liability? • In its 2006 income statement, what amount should Kent report as current portion of income tax expense?
Disclosures Example Solutions 1. 2006 Deferred Tax Liability 2006 Entry Deferred Tax Liability T Account Debit IT Expense 55,200 4,400 2006 Balance Credit DTL 3,600 3,600 2007 Entry Credit IT Payable 51,600 8,000 2007 Balance IT Payable: Taxable Income (129,000) x 40% rate = 51,600 Deferred Tax Liability: At 12/31/2006, the cumulative (i.e., gross) total in the account should be $20,000. $20,000 x the applicable tax rate (40%) is $8,000. $8,000 must be the ending balance. Beginning balance was gross amount of $11,000 x tax rate in 2005 34% = 4,400. $3,600 is the adjustment necessary to account for the rate change. Since the DTL increased, this is a credit. IT Expense: Plug 2. Current portion of IT Expense: $51,600 – the amount related to the income tax payable
Intraperiod Tax Allocation, cont’d • The total income tax expense for a reporting period should be allocated among the income statement items that gave rise to it. Each of the following items should be reported net of its respective income tax effects: • Income (or loss) from continuing operations. • Discontinued operations. • Extraordinary items. • The related tax effect can be either a tax expense or a tax benefit. For example, an extraordinary gain adds to a company’s tax expense, while an extraordinary loss produces a tax reduction because it reduces taxable income and therefore reduces income taxes. • This presentation is called “intraperiod” because total income tax expense for a single period is allocated between specific items. • Interperiod allocation would refer to allocating an item of income tax expense between tax periods.
Example of Intraperiod Tax Allocation Assume a company with a tax rate of 40% (and no future taxable or deductible amounts) reports $100 million pretax income that includes a $10 million extraordinary gain. The presentation of income tax expense (benefit) is as follows:
Example of Intraperiod Tax Allocation, cont’d Assume the same company with a tax rate of 40% (and no future taxable or deductible amounts) reports $100 million pretax income that includes a $10 million extraordinary loss. The presentation of income tax expense (benefit) is as follows:
FAS 109: Review of Asset – Liability Method • Companies apply the following basic principles: • Recognize a current tax liability or asset for the estimated taxes payable or refundable. • Recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards using enacted tax rate. • Base the measurement of current and deferred taxes on provisions of the enacted tax law. • Reduce the measurement of deferred tax assets, if necessary, by the amount of any tax benefits that, companies do not expect to realize.