Income Taxes

RCJ Chapter 13

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Key Issues1. Book (financial statement) vs. taxable income2. Permanent differences3. Effective vs. statutory tax rates4. Temporary (timing) differences5. Deferred taxes: Assets, Liabilities, Expense6. Possible cases and examples7. Components of income tax expense (current vs

deferred) 8. Tax journal entries9. Originating vs reversing differences10. Asset, Liability (B/S) method vs I/S method11. NOL carryback and carryforward12. Deferred tax asset valuation allowance13. Footnote disclosures:

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3 Parts of Tax Disclosure1. Current vs. deferred expense

2. 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

2. non-deductible expenses (ex. GW amortization)

ex. E13-7 Exhibit 13.2, Pg. 690

(ex. interest income on municipal bonds)

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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)

tax expense

pre-tax (book) income

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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

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

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4 Possible Types of Timing Differences

Revenues Expenses

recognize for books before taxes

1. Accrued (asset) revenue

3. Accrued (liab) expense

recognize for taxes before books

2. Deferred (unearned) revenue

4. Deferred (prepaid) expense

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Ex. 1. accrued asset, receivable Books = accrual accounting Taxes = cash

accounting DR CR DR CR A/R 100 Rev 100 N/A

DR CR DR CRCash 100 A/R 100 Cash 100 Rev

100

Note: total revenue is the same, just timing differs

period 1:

period 2:

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Ex. 2. unearned revenue

Books = accrual accounting Taxes = cash accounting DR CR DR CR Cash 100

Liab 100 Cash 100 Rev 100

DR CR DR CRLiab 100 Rev 100 N/A

Note: total revenue is the same, just timing differs

period 1:

period 2:

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Ex. 3. accrued liability, payable

Books = accrual accounting Taxes = cash accounting DR CR DR CR Exp 100

Liab 100 N/A

DR CR DR CRLiab 100 Cash 100 Exp 100 Cash

100

Note: total expense is the same, just timing differs

period 1:

period 2:

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Ex. 4. prepaid expense

Books = accrual accounting Taxes = cash accounting DR CR DR CR Asset 100

Cash 100 Exp 100 Cash 100

DR CR DR CRExp 100 Asset 100 N/A

Note: total expense is the same, just timing differs

period 1:

period 2:

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Timing Differences: Relation to Deferred Tax Assets, Liab.

Revenues Expenses

recognize for books before taxes

1. Deferred tax liability

3. Deferred tax asset

recognize for taxes before books

2. Deferred tax asset

4. Deferred tax liability

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Components of Tax Expense and Tax JEComponents of tax expense:

1. DR current tax expensea

CR Cash or taxes payable

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

Assumes positive taxable income

1. current (pay now); and2. deferred (paid before or after)

can DR or CR deferred tax expense, depending on net deferred tax asset/liability

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Components of Tax Expense (cont’d)

 Alternatively,3. DR total tax expensec

CR Deferred tax asset/liabilityCR 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/Liab1. 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 (cont’d)

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 Method1. deferred tax asset/liability = cumulative timing difference * STR2. 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

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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 (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

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Incentives for Carryback vs. Carryforward

1. Can’t carryback because of 2 years of losses

2. Time value of money: get the cash ASAP carryback

3. 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

1. Record the deferred tax asset in the usual way (as if there were no valuation allowance) 2. Make an additional entry:

DR (deferred) income tax expenseCR 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     

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

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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 (cont’d)

3a. components of deferred tax assets and liabilities

and/or3b. 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.)