© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 16 Accounting for Income Taxes.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Chapter 16

Accounting for Income Taxes


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The Internal Revenue Code is

the set of rules for preparing tax

returns.

The Internal Revenue Code is

the set of rules for preparing tax

returns.

Financial statement income tax expense.

Financial statement income tax expense.

IRS income taxes payable.

IRS income taxes payable.

GAAP is the set of rules for preparing

financial statements.

GAAP is the set of rules for preparing

financial statements.

Usually. . . Results in . . . Results in . . .

The difference between tax expense and tax payable is referred to as deferred taxes.

The difference between tax expense and tax payable is referred to as deferred taxes.

Deferred Tax Assets/Liabilities


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Deferred Tax Assets/LiabilitiesExample

Examine the December 31, 2003, information for X-Off Inc.

X-Off uses straight-line depreciation for financial reporting and accelerated depreciation

for income tax reporting.

X-Off’s tax rate is 30%.


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Deferred Tax Assets/LiabilitiesExampleCompute X-Off’s income tax expense

and income tax payable.

Income TaxStatement Return Difference

Revenues ? ? ?Less: Depreciation ? ? ? Other expenses ? ? ?Income before taxes ? ? ?

× Tax rate ? ? ?Income taxes ? ? ?


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Revenues 1,000,000$ Less: Depreciation 200,000 Other expenses 650,000 Income before taxes 150,000$

× Tax rate 30%Income taxes 45,000$

Compute X-Off’s income tax expense and income tax payable.

The income tax amount computed based on financial statement income

is income tax expense for the

period.

The income tax amount computed based on financial statement income

is income tax expense for the

period.


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Revenues 1,000,000$ Less: Depreciation 200,000 Other expenses 650,000 Income before taxes 150,000$

× Tax rate 30%Income taxes 45,000$

Next, compute income

taxes for the tax return.

Next, compute income

taxes for the tax return.



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Revenues 1,000,000$ 1,000,000$Less: Depreciation 200,000 320,000 Other expenses 650,000 650,000 Income before taxes 150,000$ 30,000$

× Tax rate 30% 30%Income taxes 45,000$ 9,000$

Income taxes based on tax

return income are the taxes

payable for the period.

Income taxes based on tax

return income are the taxes

payable for the period.



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Revenues 1,000,000$ 1,000,000$ -$ Less: Depreciation 200,000 320,000 (120,000) Other expenses 650,000 650,000 - Income before taxes 150,000$ 30,000$ 120,000$

× Tax rate 30% 30% 30%Income taxes 45,000$ 9,000$ 36,000$

The deferred tax for the period of $36,000 is the difference

between income tax expense of $45,000 and income tax

payable of $9,000.

The deferred tax for the period of $36,000 is the difference

between income tax expense of $45,000 and income tax

payable of $9,000.



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The entry to record the deferred taxes would appear as follows:

The entry to record the deferred taxes would appear as follows:


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Temporary Differences

These are called temporary

differences.

Often, the difference between pretax accounting income and taxable income results from items entering the income

computations at different times.

Often, the difference between pretax accounting income and taxable income results from items entering the income

computations at different times.


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Temporary differences will reverse out in one or more future periods.

Temporary differences will reverse out in one or more future periods.

Temporary Differences

Financial Income > Taxable Income

Future Taxable Amounts

Deferred Tax Liability

Financial Income < Taxable Income

Future Deductible Amounts

Deferred Tax Asset


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The temporary differences in the yellow boxes create deferred tax assets because they result in

deductible amounts in the future.

The temporary differences in the yellow boxes create deferred tax assets because they result in

deductible amounts in the future.

Revenues (or gains) Expenses (or losses)

Items reported on

the tax return

Installment sales of property (installment method for taxes)

Estimated expenses and losses (tax deductible when paid)

AFTER the income

statement

Unrealized gain from recording investments at fair value (taxable when asset is sold)

Unrealized loss from recording investments at fair value or inventory at LCM (tax deductible when asset is sold)

Items reported on

the tax return

Rent or subscriptions collected in advance

Accelerated depreciation on tax return (straight-line on income statement)

BEFORE the income

statement

Other revenue collected in advance

Prepaid expenses (tax deductible when paid)


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The temporary differences in the gray boxes create deferred tax liabilities because they result

in taxable amounts in the future.

The temporary differences in the gray boxes create deferred tax liabilities because they result

in taxable amounts in the future.

Revenues (or gains) Expenses (or losses)

Items reported on

the tax return

Installment sales of property (installment method for taxes)

Estimated expenses and losses (tax deductible when paid)

AFTER the income

statement

Unrealized gain from recording investments at fair value (taxable when asset is sold)

Unrealized loss from recording investments at fair value or inventory at LCM (tax deductible when asset is sold)

Items reported on

the tax return

Rent or subscriptions collected in advance

Accelerated depreciation on tax return (straight-line on income statement)

BEFORE the income

statement

Other revenue collected in advance

Prepaid expenses (tax deductible when paid)


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Deferred Tax LiabilitiesIn 2001, Baxter records $100,000 on its books resulting from revenue earned. The revenue will be taxed as the cash is collected in 2002 and 2003. Baxter expects to

collect $70,000 in 2002 and the remaining $30,000 in 2003.

The company is subject to a 32% tax rate.

There are no other temporary differences.

In 2001, Baxter records $100,000 on its books resulting from revenue earned. The revenue will be taxed as the cash is collected in 2002 and 2003. Baxter expects to

collect $70,000 in 2002 and the remaining $30,000 in 2003.

The company is subject to a 32% tax rate.

There are no other temporary differences.

2001 2002 2003Financial Income 300,000$ 200,000$ 200,000$ Installment Sale (100,000) 70,000 30,000 Taxable Income 200,000$ 270,000$ 230,000$

Let’s look at Baxter’s 2001 tax entry.


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Deferred Tax Liabilities

Income tax expense = $300,000 × 32% = $96,000Income tax expense = $300,000 × 32% = $96,000

Income tax payable = $200,000 × 32% = $64,000Income tax payable = $200,000 × 32% = $64,000



Description Debit CreditIncome tax expense 96,000

Income tax payable 64,000 Deferred tax liability 32,000

General Journal


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2002 2003 Total

Future taxable amounts 70,000$ 30,000$ 100,000$

Enacted tax rate 32% 32%

Deferred tax liability 22,400$ 9,600$ 32,000$

Description Debit CreditIncome tax expense 96,000

Income tax payable 64,000 Deferred tax liability 32,000

General Journal

32,000 2001Deferred Tax Liability

The Deferred Tax Liability

represents the future taxes Baxter

will pay in 2002 and 2003.


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Recall this information for Baxter for 2002.





Description Debit CreditIncome tax expense 64,000 Deferred tax liability 22,400 Income tax payable 86,400

General JournalDescription Debit Credit

Income tax expense 64,000 Deferred tax liability 22,400 Income tax payable 86,400

General Journal


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2002 22,400 32,000 20019,600 Balance


Originating difference




General Journal

Reversing difference


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2003 Total

Future taxable amounts 30,000$ 30,000$

Enacted tax rate 32%

Deferred tax liability 9,600$ 9,600$

Future Taxable Amount

Schedule

2002 22,400 32,000 20019,600 Balance


The Deferred Tax Liability represents the future taxes Baxter will pay in 2003.


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General Journal

Recall the information for Baxter, Inc. for 2003:2001 2002 2003

Financial Income 300,000$ 200,000$ 200,000$ Installment Sale (100,000) 70,000 30,000 Taxable Income 200,000$ 270,000$ 230,000$



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2002 22,400 32,000 20019,600 Balance

2003 9,600 0 Balance


Reversing difference





General Journal


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Health Magazine received $150,000 of subscriptions in advance during 2001.

Subscription revenue will be earned equally in 2002, 2003 and 2004 for financial accounting purposes.

The entire $150,000 will be taxed in 2001.

There is additional income of $500,000 in each year. The company is subject to a 30% tax rate in each year.

2001 2002 2003 2004Financial Income 500,000$ 550,000$ 550,000$ 550,000$ Subscription Rev. 150,000 (50,000) (50,000) (50,000) Taxable Income 650,000$ 500,000$ 500,000$ 500,000$

Deferred Tax Assets


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Calculation of Deferred Tax Asset 2001 2002 2003 2004Future deductible amount 150,000$ 100,000$ 50,000$ -$ Tax rate 30% 30% 30% 30%Deferred tax asset at year-end 45,000$ 30,000$ 15,000$ -$


Deferred Tax Assets

Now, let’s record the income tax entry for 2001.

This is the computation for the Deferred Tax Asset.


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Deferred Tax Assets


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2001 45,000 Balance 45,000

Deferred Tax Asset

Deferred Tax Assets

After posting this entry, the Deferred Tax Asset account will have a balance of $45,000.


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Deferred Tax Assets





Let’s see the income tax entry for 2002.

In 2002, the balance in the Deferred Tax Asset should decrease to

$30,000.

In 2002, Health Magazine earns $50,000 for

financial reporting purposes.


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Deferred Tax Assets





2001 45,000 15,000 2002Balance 30,000

Deferred Tax Asset

Reversing differenceOriginating difference


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Deferred Tax Assets

Calculation of Deferred Tax Asset 2001 2002 2003 2004Future deductible amount 150,000$ 100,000$ 50,000$ -$ Tax rate 30% 30% 30% 30%Deferred tax asset at year-end 45,000$ 30,000$ 15,000$ -$


This is the computation for the Deferred Tax Asset.

Can you finish Health Magazine’s income tax entries for 2003 and 2004?


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Deferred Tax Assets

2001 45,000 15,000 200215,000 200315,000 2004

Balance -

Deferred Tax Asset

This would be the entry for 2003 and 2004.

At the end of 2004, the balance in the Deferred Tax Asset would be zero.


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Sharpen Your Pencil . . . There Is Still More!!


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Valuation Allowance

A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized.

The deferred tax asset is then reported at its net realizable value.

A valuation allowance account is required when it is more likely than not that some portion of the deferred tax asset will not be realized.

The deferred tax asset is then reported at its net realizable value.


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Non-Temporary Differences

Created when an income item is included in taxable income or

accounting income but will never be included in the computation of the

other.

Example: Interest on tax-free municipal bonds is included in

accounting income but is excluded from taxable income


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Non-Temporary Differences

Also called permanent differences.

Also called permanent differences.

Disregarded when determining both taxes

payable and the deferred tax asset or

liability.

Disregarded when determining both taxes

payable and the deferred tax asset or

liability.


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Tax Rate Considerations

Deferred tax assets and liabilities should be determined using the future tax rates, if known.

The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs.

Deferred tax assets and liabilities should be determined using the future tax rates, if known.

The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs. IRC


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Net Operating Losses (NOL)

Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or

subsequent periods.

Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or

subsequent periods.

When used to offset earlier taxable income:

Called: operating loss carryback.

Result in a tax refund.

When used to offset earlier taxable income:

Called: operating loss carryback.

Result in a tax refund.

When used to offset future taxable income:

Called: operating loss carryforward.

Result in reduced tax payable.

When used to offset future taxable income:

Called: operating loss carryforward.

Result in reduced tax payable.


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Carryback and Carryforward

Current Year

-1-2

Carryback Period

+3+2+1 . . . +20+4 +5

Carryforward Period

The NOL may first be applied against taxable income from two previous years.

Unused NOL may be carried forward for 20 years.

The NOL may first be applied against taxable income from two previous years.

Unused NOL may be carried forward for 20 years.


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In 2003 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a

30% tax rate. In 2001, Garson reported taxable income of $20,000, and in 2002,

taxable income was $10,000. The company elects to carryback the NOL.

In 2003 Garson, Inc. incurred an $85,000 net operating loss. The company is subject to a

30% tax rate. In 2001, Garson reported taxable income of $20,000, and in 2002,

taxable income was $10,000. The company elects to carryback the NOL.


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Net Operating Losses (NOL) Tax year

Taxable Income

Tax rate

Taxes Paid

2001 20,000$ 30% 6,000$

2002 10,000 30% 3,000

In 2003, no taxes are paid and Garson claims a tax refund of $9,000 for taxes paid in 2001 and 2002.

Description Debit CreditIncome tax refund receivable 9,000 Benefits of NOL carryback 9,000


Income tax refund receivable 9,000 Benefits of NOL carryback 9,000

General Journal


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Operating loss before income taxes (85,000)$ Benefit of NOL carryback 9,000 Net loss (76,000)$

Garson, Inc.Partial Income Statement

For the Year Ended December 31, 2003Operating loss before income taxes (85,000)$ Benefit of NOL carryback 9,000 Net loss (76,000)$


For the Year Ended December 31, 2003

Garson’s Income Statement for 2003 looks like this . . .

Now let’s look at the treatment of the remaining NOL of $55,000 ($85,000 - $20,000 - $10,000).

Now let’s look at the treatment of the remaining NOL of $55,000 ($85,000 - $20,000 - $10,000).


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Year

Estimated Taxable Income

Enacted Tax Rate

Taxes to be Paid

2004 25,000$ 30% 7,500$ 2005 25,000 30% 7,500 2006 30,000 40% 12,000

Garson prepares this estimate of taxable income based upon the best available evidence at

12/31/03.

Year

Estimated Taxable Income

NOL Carryforward

Future Tax Savings

2004 25,000$ (25,000)$ 7,500$ 2005 25,000 (25,000) 7,500 2006 30,000 (5,000) 2,000

(55,000)$ 17,000$

The NOL carryforward will provide a tax benefit of $17,000.


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It is likely that Garson will receive the benefits of the NOL in future periods. As a result, the

following journal entry is made . . .

Description Debit CreditDeferred tax asset 17,000 Benefits of NOL carryforward 17,000


Deferred tax asset 17,000 Benefits of NOL carryforward 17,000

General Journal

Garson’s income statement for 2003 willlook like this . . . . . .

Garson’s income statement for 2003 willlook like this . . . . . .


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Operating loss before income taxes (85,000)$ Benefit of NOL carryback 9,000 Benefit of NOL carryforward 17,000 Net loss (59,000)$


For the Year Ended December 31, 2003Operating loss before income taxes (85,000)$ Benefit of NOL carryback 9,000 Benefit of NOL carryforward 17,000 Net loss (59,000)$


For the Year Ended December 31, 2003

The deferred tax asset account created by the benefit of the carryforward will be used to lower

income taxes payable in future years.

The deferred tax asset account created by the benefit of the carryforward will be used to lower

income taxes payable in future years.


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Disclose the following: Total of all deferred tax

liabilities and assets. Total valuation allowance

recognized. Net change in valuation account. Approximate tax effect of each

type of temporary difference (and carryforward).

Disclose the following: Total of all deferred tax

liabilities and 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.

Deferred tax assets/liabilities are classified as

current or noncurrent based

on the classification of the related asset

or liability.

Balance Sheet Classification


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Current portion of tax expense (benefit) Deferred portion of tax expense (benefit),

with separate disclosure for Portion that does not include the effect of the

following separately disclosed amounts. Operating loss carryforwards. Adjustments due to changes in tax laws or

rates. Adjustments to the beginning-of-the-year

valuation allowance due to revised estimates. Investment tax credits.

Current portion of tax expense (benefit) Deferred portion of tax expense (benefit),

with separate disclosure for Portion that does not include the effect of the

following separately disclosed amounts. Operating loss carryforwards. Adjustments due to changes in tax laws or

rates. Adjustments to the beginning-of-the-year

valuation allowance due to revised estimates. Investment tax credits.

Additional Disclosures


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Intraperiod Tax Allocation

SFAS No. 109 requires intraperiod tax allocation for: Income from continuing

operations. Discontinued operations. Extraordinary items. Changes in accounting principle. Prior period adjustments (to the

beginning retained earnings).

SFAS No. 109 requires intraperiod tax allocation for: Income from continuing

operations. Discontinued operations. Extraordinary items. Changes in accounting principle. Prior period adjustments (to the

beginning retained earnings).


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End of Chapter 16

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 16 Accounting for Income Taxes.

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Transcript of © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 16 Accounting for Income Taxes.