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  1. Income Taxes RCJ Chapter 13

  2. Key Issues • Book (financial statement) vs. taxable income • Permanent differences • Effective vs. statutory tax rates • Temporary (timing) differences • Deferred taxes: Assets, Liabilities, Expense • Possible cases and examples • Components of income tax expense (current vs deferred) • Tax journal entries • Originating vs reversing differences • Asset, Liability (B/S) method vs I/S method • NOL carryback and carryforward • Deferred tax asset valuation allowance • Footnote disclosures: Paul Zarowin

  3. 3 Parts of Tax Disclosure • Current vs. deferred expense • Reconciliation between statuary vs. effective tax rates • Changes in Deferred Tax (DT) assets/liabilities and/or components of DT expense. Paul Zarowin

  4. Key Identity Pre-tax book (accounting) income ± Permanent differences ± Temporary differences = pre-tax taxable income ex. E13-7, E13-8 (Kent), P13-4 (Joy) Paul Zarowin

  5. Permanent Differences Definition: Items of revenue or expense that are in book (or taxable) income of a period, but never part of taxable (or book) income. 2 types: • non-taxable revenues • non-deductible expenses (ex. GW amortization) ex. E13-7 Exhibit 13.2, Pg. 690 (ex. interest income on municipal bonds) Paul Zarowin

  6. Importance of Permanent Differences:Effective vs. Statutory Tax Rate def:effective tax rate (ETR) = def:statutory tax rate (STR) = rate set by government • permanent diffs cause ETR  STR • non-taxable revenues lower the ETR • non-deductible expenses raise the ETR ex. E13-7, E13-8 (Kent) Paul Zarowin

  7. Temporary (Timing) Differences Temp. diff. cause deferred tax assets, liabilities, expense Definitions: • Temp diff: item of revenue or expense that are part of book and taxable income, in different periods • Deferred tax asset:future tax deductible due to current timing difference • Deferred tax liability:future tax payable due to current timing difference Q: What is sum of temporary differences over firm’s life? ex. E13-7 Paul Zarowin

  8. 4 Possible Types of Timing Differences Paul Zarowin

  9. Ex. 1. accrued asset, receivable Books = accrual accountingTaxes = cash accounting DRCRDRCR A/R 100 Rev 100 N/A DRCRDRCR Cash 100 A/R 100 Cash 100 Rev 100 Note: total revenue is the same, just timing differs period 1: period 2: Paul Zarowin

  10. Ex. 2. unearned revenue Books = accrual accountingTaxes = cash accounting DRCRDRCR Cash 100 Liab 100 Cash 100 Rev 100 DRCRDRCR Liab 100 Rev 100 N/A Note: total revenue is the same, just timing differs period 1: period 2: Paul Zarowin

  11. Ex. 3. accrued liability, payable Books = accrual accountingTaxes = cash accounting DRCRDRCR Exp 100 Liab 100 N/A DRCRDRCR Liab 100 Cash 100 Exp 100 Cash 100 Note: total expense is the same, just timing differs period 1: period 2: Paul Zarowin

  12. Ex. 4. prepaid expense Books = accrual accountingTaxes = cash accounting DRCRDRCR Asset 100 Cash 100 Exp 100 Cash 100 DRCRDRCR Exp 100 Asset 100 N/A Note: total expense is the same, just timing differs period 1: period 2: Paul Zarowin

  13. Timing Differences: Relation to Deferred Tax Assets, Liab. Paul Zarowin

  14. Components of Tax Expense and Tax JE 1. current (pay now); and Components of tax expense: • DRcurrent tax expensea CR Cash or taxes payable a)Current tax expense = taxable inc.*current statutory tax rate • DR deferred tax expenseb CR Deferred tax asset/liability b)Deferred tax expense = net  in deferred tax asset/liability 2. deferred (paid before or after) Assumes positive taxable income can DR or CR deferred tax expense, depending on net  deferred tax asset/liability Paul Zarowin

  15. Components of Tax Expense (cont’d) Alternatively, • DRtotal tax expensec CR Deferred tax asset/liability CR Cash c)Total tax expense = current + deferred ex. E13-7 Paul Zarowin

  16. Deferred Tax Accounting = Inter-period Tax Allocation Total income tax expense = Current (paid now) + Deferred (paid both before or after) Paul Zarowin

  17. Originating vs. Reversing Timing Diff. • Originating differences create deferred tax assets (DR); and liabilities (CR) • Reversing differences reduce deferred tax assets (CR) and liabilities (DR) Paul Zarowin

  18. Examples of Deferred Tax Assets/Liab • Installment sale; revenue is recognized up front for financial reporting, but is recognized for tax purposes later, when cash is received each period. • Prepayment; revenue is recognized for tax purposes up front as cash is received , while accrual accounting delays revenue recognition until revenue is earned later. • Bad debts expense. The allowance method for books recognizes the expense in the period of sale by the adjusting entry (matching principle), while the direct write-off method recognizes the expense in a later period, when the receivable is actually written off. Paul Zarowin

  19. Examples of Deferred Tax Assets/ Liab (cont’d) • depreciation expense; firms use an accelerated method for taxes and SL for books. This combination recognizes some depreciation for taxes first and for books later. • RCJ give additional examples of revenues and expenses that produce deferred tax assets and liabilities in Exhibit 13.1, Pg. 689-90. Paul Zarowin

  20. Calculation of Deferred Tax Expense, Asset, Liability: B/S Method • deferred tax asset/liability = cumulative timing difference * STR • deferred tax expense = net  in deferred tax asset/liability B/S method (also called asset/liability method) • use STR expected to be in effect when timing difference reverses • so, if STR changes, calculate deferred tax asset/liability as per (2), and calculate deferred tax expense =  deferred tax asset/liability I/S method • for constant STR only, deferred tax expense = current year’s timing difference * STR • B/S method is or constant or changing STR ex. E13-3 different rates over time, vs. E13-2 change in rates Paul Zarowin

  21. Deferred Tax Asset, Liability and Expense Depend on Tax Rate Key point: Deferred tax asset, deferred tax liability and deferred tax expense depend on the tax rate. Ex. E13-8, E13-9, E13-10 Paul Zarowin

  22. Intuition • Deferred tax asset = $ amount of future tax deduction (or tax saving)= $ timing difference * STR • Deferred tax liability = $ amount of future tax payable = $ timing difference * STR Paul Zarowin

  23. Net Operating Loss (NOL) NOL = negative taxable income • Book income may be either positive or negative NOL can be carried back or forward NOL carryback: Get a refund of past taxes paid: DR cash or tax refund receivable CR (current) income tax expense • The maximum carryback period is 2 years (offset the earlier year first, as in FIFO) Paul Zarowin

  24. Net Operating Loss (cont’d) NOL carryforward: Offset future income (also FIFO), reducing future taxes payable: DR deferred tax asset CR (deferred) income tax expense This is another reason for deferred tax asset in addition to timing differences. • A firm can carryforward an NOL for up to 20 years. EX. E13-13, 14, 16 Paul Zarowin

  25. Incentives for Carryback vs. Carryforward • Can’t carryback because of 2 years of losses • Time value of money: get the cash ASAP  carryback • If tax rates are expected to rise, a dollar of deduction will be worth more  carryforward ex. P13-7 Paul Zarowin

  26. Deferred Tax Asset Valuation Allowance Contra-asset account (CR balance on the B/S ; eg, acc’d depreciation or AUA) that reduces the deferred tax asset to its expected realizable value • Record the deferred tax asset in the usual way (as if there were no valuation allowance) • Make an additional entry: DR (deferred) income tax expense CR deferred tax asset valuation allowance • increasing (decreasing) the allowance increases (decreases) deferred income tax expense • allowance’s existence and magnitude reveals management’s expectation of future earnings. • management can use changes in the allowance to manipulate NI, by affecting income tax expense. ex. E13-17 Paul Zarowin

  27. Financial Statement Disclosures I/S : total income tax expense B/S: net current and net non-current deferred tax asset or liability Footnote disclosure: • Current and deferred components of total income tax expense (from Income From Continuing Operations, because the below the line components are shown net of tax). • Reconciliation between the federal statutory and effective tax rates (in $ and/or %). C13-1, 2, 3, 5, 6 Paul Zarowin

  28. Financial Statement Disclosures (cont’d) 3a. components of deferred tax assets and liabilities and/or 3b. Components of deferred tax expense (e.g., revenue and expense items that cause the deferred tax expense, assets, liabilities, such as depreciation, bad debts, installment sales, etc.) Paul Zarowin