Income Taxes

RCJ Chapter 13

Key Issues
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 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:
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3 Parts of Tax Disclosure

1. 2. Current vs. deferred expense Reconciliation between statuary vs. effective tax rates

3.

Changes in Deferred Tax (DT) assets/liabilities and/or components of DT expense.

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Key Identity
Pre-tax book (accounting) income Permanent differences Temporary differences

pre-tax taxable income

ex. E13-7, E13-8 (Kent), P13-4 (Joy)

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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: 1. non-taxable revenues

(ex. interest income on municipal bonds)

2.

non-deductible expenses (ex. GW amortization)

ex. E13-7 Exhibit 13.2, Pg. 690

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Importance of Permanent Differences: Effective vs. Statutory Tax Rate

def: effective tax rate (ETR) =
tax expense

pre-tax (book) income

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)

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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 difference difference

Deferred tax asset: future tax deductible due to current timing

Deferred tax liability: future tax payable due to current timing

Q: What is sum of temporary differences over firms life?

ex. E13-7
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4 Possible Types of Timing Differences

Revenues
recognize for books before taxes recognize for taxes before books 1. Accrued (asset) revenue 2. Deferred (unearned) revenue

Expenses
3. Accrued (liab) expense 4. Deferred (prepaid) expense

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Ex. 1. accrued asset, receivable

Books = accrual accounting
period 1: DR A/R 100 DR Cash 100 CR Rev 100 CR A/R 100

Taxes = cash accounting

DR N/A CR

period 2:

DR Cash 100

CR Rev 100

Note: total revenue is the same, just timing differs

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Ex. 2. unearned revenue

Books = accrual accounting
period 1: DR Cash 100 DR Liab 100 CR Liab 100 CR Rev 100

Taxes = cash accounting

DR Cash 100 DR N/A CR Rev 100 CR

period 2:

Note: total revenue is the same, just timing differs

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Ex. 3. accrued liability, payable

Books = accrual accounting
period 1: DR Exp 100 DR Liab 100 CR Liab 100 CR Cash 100

Taxes = cash accounting

DR N/A CR

period 2:

DR Exp 100

CR Cash 100

Note: total expense is the same, just timing differs

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Ex. 4. prepaid expense

Books = accrual accounting
period 1: DR Asset 100 DR Exp 100 CR Cash 100 CR Asset 100

Taxes = cash accounting

DR Exp 100 DR N/A CR Cash 100 CR

period 2:

Note: total expense is the same, just timing differs

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Timing Differences: Relation to Deferred Tax Assets, Liab.

Revenues recognize for books before taxes recognize for taxes before books 1. Deferred tax liability 2. Deferred tax asset Expenses 3. Deferred tax asset

4. Deferred tax liability

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Components of Tax Expense and Tax JE

Components of tax expense: 1. current (pay now); and 1. DR current tax expensea CR Cash or taxes payable
2. deferred (paid before or after)
Assumes positive taxable income

a) Current tax expense = taxable inc.*current statutory tax rate

2.

DR deferred tax expenseb CR Deferred tax asset/liability

b) Deferred tax expense = net in deferred tax asset/liability
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can DR or CR deferred tax expense, depending on net deferred tax asset/liability

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Components of Tax Expense (contd)

Alternatively, 3. DR total tax expensec CR Deferred tax asset/liability CR Cash
c) Total tax expense = current + deferred

ex. E13-7

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Deferred Tax Accounting = Inter-period Tax Allocation

Total income tax expense =
Current (paid now) + Deferred (paid both before or after)

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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)

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Examples of Deferred Tax Assets/Liab

1. Installment sale; revenue is recognized up front for financial reporting, but is recognized for tax purposes later, when cash is received each period. 2. Prepayment; revenue is recognized for tax purposes up front as cash is received , while accrual accounting delays revenue recognition until revenue is earned later. 3. 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.
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Examples of Deferred Tax Assets/ Liab (contd)

4. 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.

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Calculation of Deferred Tax Expense, Asset, Liability: B/S Method

1. 2. 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 years 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
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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

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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

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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)

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Net Operating Loss (contd)

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

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Incentives for Carryback vs. Carryforward

1. 2. 3. Cant 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

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Deferred Tax Asset Valuation Allowance

Contra-asset account (CR balance on the B/S ; eg, accd depreciation or AUA) that reduces the deferred tax asset to its expected realizable value
1.

2.

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 allowances existence and magnitude reveals managements expectation of future earnings. management can use changes in the allowance to manipulate NI, by affecting income tax expense.
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ex. E13-17

Financial Statement Disclosures

I/S : total income tax expense B/S: net current and net non-current deferred tax asset or liability

Footnote disclosure: 1. 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).

2. Reconciliation between the federal statutory and effective tax rates (in $ and/or %).
C13-1, 2, 3, 5, 6
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Financial Statement Disclosures (contd)

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.)

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