Chapter 16 Income Tax 16-1

Transcription

1 Chapter 16 Income Tax 1. The concept of deferred taxes and the permanent and temporary differences 2. Compute the deferred tax liabilities and assets 3. The tax loss carrybacks and carryforwards 4. Future tax rates and the effect on deferred taxes 5. Financial statement presentation and disclosure associated with deferred taxes 6. Income tax disclosure requirements associated with the statement of cash flows 7. International accounting standards with respect to deferred income taxes 16-1

2 1. Understand the concept of deferred taxes and the distinction between permanent and temporary differences Deferred Income Tax Overview Corporations in the United States compute two different income numbers: Financial income for reporting to stockholders and Taxable income for reporting to the Internal Revenue Service (IRS). 16-2

3 Deferred Income Tax Overview The primary goal of financial accounting is to provide useful information to management, stockholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system is the equitable collection of revenue. (continued) 16-3

4 Deferred Income Tax Overview The difficulty of determining what is income tax expense stems from two basic considerations: 1. How to account for revenues and expenses that have already been recognized and reported to shareholders in a company s financial statements but will not affect taxable income until subsequent years. 2. How to account for revenues and expenses that have already been reported to the IRS but will not be recognized in the financial statements until subsequent years. 16-4

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6 Example 1: Simple Deferred Income Tax Liability In 2013, Ibanez Company earned revenues of $30,000. Ibanez has no expenses other than income taxes. In this case, the income tax law specifies that income is taxed when received in cash and that Ibanez received $10,000 in 2013 and expects to receive $20,000 in The income tax rate is 40% and it is expected to remain the same into the foreseeable future. 16-6

7 Example 1: Simple Deferred Income Tax Liability The journal entry to record all the tax-related information for Ibanez for 2013 is as follows: Income Tax Expense 12,000 Income Taxes Payable 4,000 Deferred Tax Liability 8,000 $30, $4,000 current year + $8,000 deferred $10, (continued) $20,

8 Example 1: Simple Deferred Income Tax Liability Ibanez Company Income Statement For the Year Ended December 31, 2013 Revenues $30,000 Income tax expense: Current $4,000 Deferred 8,000 12,000 Net income $18,

9 Example 2: Simple Deferred Income Tax Asset In 2013, its first year of operation, Gupta Company generated service revenues totaling $60,000, all taxable in No warranty claims were made in 2013, but Gupta estimates that in 2014 warranty costs of $10,000 will be incurred for claims related to 2013 service revenues. Assume a 40% tax rate and that Gupta Company had no expenses in 2013 other than warranty costs and income taxes. (continued) 16-9

10 Example 2: Simple Deferred Income Tax Asset The journal entry to record all the tax-related information for Gupta for 2013 is as follows: Income Tax Expense 20,000 Deferred Tax Asset 4,000 Income Taxes Payable 24,000 $24,000 current year $4,000 deferred $50, $60, $10, (continued) 16-10

11 Example 2: Simple Deferred Income Tax Asset Gupta Company Income Statement For the Year Ended December 31, 2013 Revenues $60,000 Warranty expense 10,000 Income before taxes $50,000 Income tax expense: Current $24,000 Deferred benefit (4,000) 20,000 Net income $30,

12 Permanent and Temporary Differences Permanent differences are created by political and social pressures to favor certain segments of society or to promote certain industries or economic activities. Nontaxable revenue proceeds from insurance policies; interest received on municipal bonds Nondeductible expenses fines for violations of laws; payment of insurance premiums (continued) 16-12

13 Permanent and Temporary Differences More commonly, differences between pretax financial income and taxable income arise from business events that are recognized for both financial reporting and tax purposes but in different time periods. These differences are referred to as temporary differences. Exhibit 16-2 on Slide provides many other temporary differences. (continued) 16-13

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15 Permanent and Temporary Differences The first category in Exhibit 16-2 includes differences, called taxable temporary differences, that will result in taxable amounts in future years. The second category in Exhibit 16-2 includes differences, called deductible temporary differences, that will result in deductible amounts in future years

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17 Illustration of Permanent and Temporary Differences For the year ended December 31, 2013, Monroe Corporation reported net income before taxes of $420,000. This amount includes $20,000 of nontaxable revenues and $5,000 of nondeductible expenses. The depreciation method used for tax purposes allowed a deduction that exceeded the book approach by $30,000. (continued) 16-17

18 Illustration of Permanent and Temporary Differences Pretax income from income statement $420,000 Add (deduct) permanent differences: Nontaxable revenues $(20,000) Nondeductible expenses 5,000 (15,000) Financial income subject to tax $405,000 Add (deduct) temporary differences: Excess of tax depreciation over book depreciation (30,000) Taxable income $375,000 Tax on taxable income (income taxes payable): $375, $131,250 (continued) 16-18

19 Illustration of Permanent and Temporary Differences The permanent differences are not included in either the financial income subject to tax or the taxable income. Permanent differences have no impact on income taxes payable in subsequent periods. In general, the accounting for temporary differences is referred to as interperiod tax allocation

20 2. Compute the amount of deferred tax liabilities and assets including the use of a valuation allowance and the uncertainty of tax positions Annual Computation of Deferred Tax Liabilities and Assets FASB ASC Topic 740 reflects the Board s preference for the asset and liability method of interperiod tax allocation, which emphasizes the measurement and reporting of balance sheet amounts. One drawback of this method is that in some ways, it is still too complicated

21 Annual Computation of Deferred Tax Liabilities and Assets The major advantages of the asset and liability method of accounting for deferred taxes are as follows: 1. Assets and liabilities are recorded in agreement with FASB definitions of financial statement elements. 2. This method is flexible and recognizes changes in circumstances and adjusts the reported amounts accordingly. This flexibility may improve the predictive value of the financial statements. (continued) 16-21

22 Annual Computation of Deferred Tax Liabilities and Assets Identify type and amounts of existing temporary differences. Measure the deferred tax liability for taxable temporary differences (use enacted rates). Measure the deferred tax asset for deductible temporary differences (use enacted rates). Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized

23 Example 3: Deferred Tax Liability For 2013, Roland computes pretax financial income of $75,000. The only difference between financial and taxable income is depreciation. Roland uses the straight-line method of depreciation for financial reporting purposes and ACRS on its tax return. The depreciation amounts for existing plant assets for the years 2013 through 2016 are shown on Slide

24 Example 3: Deferred Tax Liability 16-24

25 Example 3: Deferred Tax Liability The enacted tax rate for 2013 and future years is 40%. Roland s taxable income for 2013 is $60,000, computed as follows: Financial income subject to tax $75,000 Deduct temporary difference: Excess of tax depreciation ($40,000) over book depreciation ($25,000) (15,000) Taxable income $60,000 Tax ($60,000 x 0.40) $24,000 (continued) 16-25

26 Example 3: Deferred Tax Liability Roland s Journal Entry for 2013 Income Tax Expense 30,000 Income Taxes Payable 24,000 Deferred Tax Liability Noncurrent 6,000 $24,000 current + $6,000 deferred (continued) $15, $30,000 $6,

27 Example 3: Deferred Tax Liability Income taxes would be shown on Roland s 2013 income statement as follow: Income before income taxes $75,000 Current $24,000 Deferred 6,000 30,000 Net income $45,000 The December 31, 2013, balance sheet would report a current liability of $24,

28 Example 3: Deferred Tax Liability Roland earns financial income of $75,000 in each of the years 2014 through Roland reports taxable income of $70,000, computed as follows: Financial income subject to tax $75,000 Deduct temporary difference: Excess of tax depreciation ($30,000) over book depreciation ($25,000) (5,000) Taxable income $70,000 Tax ($70, ) $28,000 (continued) 16-28

29 Example 3: Deferred Tax Liability Roland s Journal Entry for 2014 Income Tax Expense 30,000 Income Taxes Payable 28,000 Deferred Tax Liability Noncurrent 2,000 $28,000 current + $2,000 deferred (continued) $5,000 x 0.40 $30,000 $2,

30 Example 3: Deferred Tax Liability Depreciation expense in 2015 is the same for both financial and tax, so the entry is simple. Income Tax Expense 30,000 Income Taxes Payable 30,000 $75, (continued) 16-30

31 Example 3: Deferred Tax Liability For 2016, Roland earns income of $75,000 and the taxable income is $95,000, computed as follows: Financial income subject to tax $75,000 Add temporary difference: Excess of book depreciation ($25,000) over tax depreciation ($5,000) 20,000 Taxable income $95,000 Tax ($95, ) $38,000 (continued) 16-31

32 Example 3: Deferred Tax Liability Roland s Journal Entry for 2016 Income Tax Expense 30,000 Deferred Tax Liability Noncurrent 8,000 Income Taxes Payable 38,000 $38,000 current $8,000 deferred benefits $95, (continued) 16-32

33 Example 3: Deferred Tax Liability 16-33

34 Effect of Currently Enacted Changes in Future Tax Rates If changes in future tax rates have been enacted, the deferred tax liability (or asset) is measured during the enacted tax rate for the future years when the temporary difference is expected to reverse. Under IAS 12, deferred tax items are to be measured at the income tax rates that have been enacted or substantively enacted by the end of the reporting period

35 Subsequent Changes in Enacted Tax Rates Using the Roland, Inc. example, assume that the enacted rate for 2016 changed from 40% to 35% during The balance in the deferred tax liability at the beginning of 2014 is $6,000. The following adjusting entry would be made for 2016: Deferred Tax Liability Noncurrent 750 Income Tax Benefit Rate Change 750 $15,000 x

36 Example 4: Deferred Tax Asset Taxable income for 2013 is computed as follows: Financial income subject to tax $22,000 Add temporary difference: Excess of warranty expense over warranty deductions 18,000 Taxable income $40,000 Tax Payable ($40, ) $16,000 (continued) 16-36

37 Example 4: Deferred Tax Asset Sandusky s Journal Entry for 2013 Income Tax Expense 8,800 Deferred Tax Asset Current 2,400 Deferred Tax Asset Noncurrent 4,800 Income Taxes Payable 16,000 $16,000 current $7,200 deferred benefits 2/3 $7,200 1/3 $7,

38 Example 4: Deferred Tax Asset Sandusky s 2013 income statement would present income tax expense as follows: Income before income taxes $22,000 Income tax expense: Current $16,000 Deferred (benefit) (7,200) 8,800 Net income $13,200 (continued) 16-38

39 Example 4: Deferred Tax Asset In the years 2014 through 2016, taxable income would be equal to $16,000, computed as follows: Income subject to tax $22,000 Reversal of temporary difference: Excess of warranty deductions (1/3 $18,000) over warranty expense ($0) (6,000) Taxable income $16,000 Tax Payable ($16,000.40) $ 6,

40 Example 4: Deferred Tax Asset The following table illustrates the journal entries that would be made each year: 16-40

41 Example 5: Deferred Tax Liabilities and Assets For 2013, Hsieh reported pretax financial income of $38,000. As of December 31, 2013, the actual depreciation expense was $25,000 and the actual warranty expense was $18,000. For income tax reporting, these expenses were $40,000 and $0, respectively. The table on Slide summarizes 2014 through (continued) 16-41

42 Example 5: Deferred Tax Liabilities and Assets (continued) 16-42

43 Example 5: Deferred Tax Liabilities and Assets For 2013, taxable income would be computed as follows: Financial income subject to tax $38,000 Add (deduct) temporary differences: Excess of warranty expense over warranty deductions 18,000 Excess of tax depreciation over book depreciation (15,000) Taxable income $41,000 Tax Payable ($41,000.40) $16,400 (continued) 16-43

44 Example 5: Deferred Tax Liabilities and Assets Heich s December 31, 2013 Entries Income Tax Expense 16,400 Income Taxes Payable 16,400 Deferred Tax Asset Current 2,400 Deferred Tax Asset Noncurrent 4,800 Income Tax Benefit 1,200 Deferred Tax Liability Noncurrent 6,000 These two are netted against one another and a single $1,200 amount is shown as a noncurrent tax liability ($6,000 $4,800)

45 Valuation Allowance for Deferred Tax Assets A deferred tax asset represents future income tax benefits. The tax benefit will be realized only if there is sufficient taxable income from which the deductible amount can be deducted. Topic 740 requires that the deferred tax asset be reduced by a valuation allowance, a contra asset account that reduces the asset to its expected realizable value. (continued) 16-45

46 Valuation Allowance for Deferred Tax Assets Some possible sources of taxable income to be considered in evaluating the realizable value of a deferred tax asset are as follows: 1. Future reversals of existing taxable temporary differences 2. Future taxable income exclusive of reversing temporary differences 3. Taxable income in prior (carryback) years 16-46

47 Valuation Allowance for Deferred Tax Assets In 2013, Hsieh Company has a $15,000 excess of aggregate tax depreciation over aggregate book depreciation. The reversal of this temporary difference will provide taxable income in the future against which the $18,000 warranty deduction can be offset. Accordingly, the total deferred tax asset is $7,200 ($18,000 x 0.40), but the realized amount is only $6,000 ($15,000 x 0.40). The $1,200 difference would be recorded as a valuation allowance. (continued) 16-47

48 Valuation Allowance for Deferred Tax Assets First, the deferred tax asset and liability are recognized, as follows: Deferred Tax Asset Current 2,400 Deferred Tax Asset Noncurrent 4,800 Income Tax Benefit 1,200 Deferred Tax Liability Noncurrent 6,000 Note that this is the same as the deferred tax journal entry shown earlier on Slide (continued) A subtraction from income tax expense 16-48

49 Valuation Allowance for Deferred Tax Assets The second journal entry represents the fact that it is more likely than not that $1,200 of the deferred tax asset will not be realized. Income Tax Expense 1,200 Allowance to Reduce Deferred Tax Asset to Realizable Value Current 400 Allowance to Reduce Deferred Tax Asset to Realizable Value Noncurrent

50 Valuation Allowance Under IAS 12 Under the provisions of IAS 12, there is no valuation allowance. Instead, deferred tax assets are recognized only to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised [utilized]

51 Accounting for Uncertain Tax Positions Topic 740 requires the use of a 2-step process to determine the recognition of any tax benefit associated with an uncertain tax position. 1. Step 1 Determine if it is more likely than not that a tax position would be sustained if it were examined, and it must be assumed that the tax position will be examined. 2. Step 2 The measurement of the tax benefit is based on a probability assessment of the likelihood of specific outcomes and the amounts of those outcomes

52 Accounting for Uncertain Tax Positions Case 1: Highly Certain Tax Position If the probability that the tax benefit of $100 would be achieved were greater than 50%, this would be deemed a highly certain position. In other words, it is more likely than not that the position taken and the amount in question would be upheld if reviewed

53 Accounting for Uncertain Tax Positions Case 2: Uncertain Tax Position More Likely Than Not Assume the following assessment of probabilities: 16-53

54 Accounting for Uncertain Tax Positions If Company A determines that the technical merits of its position exceed the more-than-not threshold (Step 1), the amount of tax benefit to be recognized for financial statement purposes is $60, the amount at which the cumulative probability exceeds 50% (Step 2)

55 Accounting for Uncertain Tax Positions The required journal entry is as follows: Income Tax Expense 40 Unrecognized Tax Benefit 40 Classified as current if payment is anticipated within one year of the current operating cycle 16-55

56 Accounting for Uncertain Tax Positions Case 3: Uncertain Tax Position NOT More Likely Than Not If the company completes Step 1 of the analysis and determines that it is NOT more likely than not that the tax position will be sustained, then the entire amount of the position must be recognized as a liability. Income Tax Expense 100 Unrecognized Tax Benefit

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58 3. Explain the provisions of the tax loss carrybacks and carryforwards, and be able to account for these provisions Carryback and Carryforward of Operating Losses Net operating loss Carryback Election carryback is applied to the preceding two years in reverse order Year 2 Loss Year Carryforward Election Net operating loss carryforward is applied to income over the next 20 years Year

59 Net Operating Loss (NOL) Carryback Prairie Company had the following pattern of income and losses for 2012 through 2014: Journal Entry in 2014: Income Tax Refund Receivable 6,200 Income Tax Benefit from NOL Carryback 6,200 [$3,500 + (30% $9,000)] (continued) 16-59

60 Net Operating Loss (NOL) Carryback The refund will be reflected on the income statement as a reduction of the operating loss as follow: Net operating loss before tax benefit $(19,000) Income tax benefit from NOL carryback 6,200 Net loss $(12,800) 16-60

61 Net Operating Loss (NOL) Carryforward If an operating loss exceeds income for the two preceding years, the remaining unused loss may be applied against income earned over the next 20 years as a net operating loss (NOL) carryforward. A valuation allowance is used to reduce the asset if it is more likely than not that some or all of the future benefits will not be realized

62 Net Operating Loss (NOL) Carryforward Example: To illustrate the carryforward provisions, let s continue the previous example and assume that in 2015 Prairie Company incurred an operating loss of $35,000. This loss would be carried back to the years 2013 and 2014 in that order. However, the only income remaining against which operating losses can be applied is $5,000 from After applying $5,000 to the 2013 income, $30,000 is left to carry forward against future income. The tax benefit from the carryback is $1,500 ($5, ). Assuming the enacted tax rate for future years is 30%, the potential tax benefit from the carryforward is $9,000 ($30, )

63 Net Operating Loss (NOL) Carryforward The journal entry for 2015 to record the tax benefits: Income Tax Refund Receivable 1,500 Deferred Tax Asset NOL Carryforward 9,000 Income Tax Benefit from NOL Carryback 1,500 Income Tax Benefit from NOL Carryforward 9,000 (continued) Current asset if expected to be realized in

64 Net Operating Loss (NOL) Carryforward The firm reports a taxable income of $50,000 in The tax carryforward allows management to deduct the carryforward from the $15,000 tax ($50,000.30) that would be due without the carryforward. The journal entry in 2016 would be as follows: Income Tax Expense 15,000 Income Taxes Payable 6,000 Deferred Tax Asset NOL Carryforward 9,

65 Accounting for NOL Carryforward If, however, it is more likely than not that some portion or all of the deferred tax asset will not be realized, a valuation allowance account is needed to reduce the asset to its estimated realizable value. Prairie Company s recent losses resulting from a declining market for its products and that the weight of available evidence indicates continuing losses in subsequent years. As a result, management believes it is more likely than not that none of the asset will be realized. (continued) 16-65

66 Accounting for NOL Carryforward The journal entry to record the carryback and carryforward would be as follows: Income Tax Refund Receivable 1,500 Deferred Tax Asset NOL Carryforward 9,000 Income Tax Benefit from NOL Carryback 1,500 Allowance to Reduce Deferred Tax Asset to Realizable Value NOL Carryforward 9,000 As a result of this entry, the net deferred tax asset is zero. (continued) 16-66

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68 4. Schedule future tax rates, and determine the effect on deferred tax assets and liabilities Scheduling for Enacted Future Tax Rates The firm must determine the temporary differences that will reverse. In 1992, the FASB eliminated much of the need for scheduling through the more-likely-thannot criterion for future income and because deferred tax assets and liabilities are classified according to the classification of the underlying items instead of the expected reversal period. However, scheduling is still required in a limited number of cases

69 Scheduling for Enacted Future Tax Rates Assume in the Hsieh Company example that the enacted tax rates are as follows: 2013, 40%; 2014, 35%, 2015, 30%; and 2016, 25%. As of December 31, 2013, a valuation can be obtained by applying the tax rate expected to be in effect when the differences reverse, as shown on the next slide. (continued) 16-69

70 Scheduling for Enacted Future Tax Rates (continued) 16-70

71 Scheduling for Enacted Future Tax Rates The journal entry to record the deferred portion of income tax expense for 2013 would be as follows: Deferred Tax Asset Current 2,100 Deferred Tax Asset Noncurrent 3,300 Income Tax Benefit 1,650 Deferred Tax Liability Noncurrent 3,750 A subtraction from income tax expense 16-71

72 5. Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities Financial Statement Presentation and Disclosure The income statement must show, either in the body of the statement or in a note, the following components of income taxes related to continuing operations. 1. Current tax expense or benefit 2. Deferred tax expense or benefit 3. Investment tax credits 4. Government grants recognized as tax reductions 16-72

73 Financial Statement Presentation and Disclosure 5. Benefits of operating loss carryforwards 6. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of an enterprise 7. Adjustments in beginning-of-the-year valuation allowance because of a change in circumstances 16-73

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78 6. Comply with income tax disclosure requirements associated with the statement of cash flows Deferred Taxes and the Statement of Cash Flows FASB ASC Topic 230 requires a separate disclosure of the amount of cash paid for income taxes during a period. This separate disclosure is required for just two items: Cash paid for income taxes Cash paid for interest Income taxes affect the Operating Activities section of the statement of cash flows

79 Deferred Taxes and the Statement of Cash Flows Collazo Company had the following information for 2013: Revenue (all cash) $30,000 Income tax expense: Current $10,300 Deferred 1,700 12,000 Net income $18,000 (continued) 16-79

80 Deferred Taxes and the Statement of Cash Flows The operating activities section of Collazo s statement of cash flows is as follows if the direct method is used. Cash collected from customers $30,000 Income taxes paid (13,300) Cash provided by operating activities $16,700 (continued) 16-80

81 Deferred Taxes and the Statement of Cash Flows Collazo Company Statement of Cash Flows (Partial) (Indirect Approach) Cash provided by operating activities: Net income $18,000 Increase in income tax refund receivable (2,000) Decrease in income taxes payable (1,000) Increase in deferred tax liability 1,700 Cash provided by operating activities $16,700 If the indirect method is used, the amount of cash paid for income taxes, $13,300, must be separately disclosed either in the SCF or in the notes to the financial statements

82 7. Describe how, with respect to deferred income taxes, international accounting standards have converged toward the U.S. treatment International Accounting for Deferred Taxes No-deferral approach: Using this approach, the differences are ignored. Income tax expense equal to the amount of tax payable for the year is reported. Comprehensive recognition approach: Deferred taxes are included in the computation of income tax expense and reported on the balance sheet. The IASB has embraced this approach

83 International Accounting for Deferred Taxes Partial recognition approach: Historically, the United Kingdom employed this innovate technique. A deferred tax liability is recorded only to the extent that the deferred taxes are actually expected to be paid in the future. In recent years, this method has lost favor internationally because it is so subjective (relying heavily on management expectations about future events)