Income taxes

Income Taxes RCJ Chapter 13 Key Issues 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: Paul Zarowin 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 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 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 types: non-taxable revenues (ex interest income on municipal bonds) non-deductible expenses (ex GW amortization) ex E13-7 Exhibit 13.2, Pg 690 Paul Zarowin 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) Paul Zarowin 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 Possible Types of Timing Differences Revenues Expenses recognize for books before taxes Accrued (asset) revenue Accrued (liab) expense recognize for taxes before books Deferred (unearned) revenue Deferred (prepaid) expense Paul Zarowin Ex accrued asset, receivable Books = accrual accounting period 1: DR 100 CR N/A Taxes = cash accounting DR CR A/R 100 Rev period 2: DR Cash 100 CR A/R 100 DR Cash 100 CR Rev 100 Note: total revenue is the same, just timing differs Paul Zarowin Ex unearned revenue Books = accrual accounting period 1: DR Liab 100 CR Cash 100 Taxes = cash accounting DR CR DR CR N/A Cash 100 Rev 100 period 2: DR Liab 100 CR Rev 100 Note: total revenue is the same, just timing differs Paul Zarowin 10 Components of Tax Expense and Tax JE Components of tax expense: current (pay now); and deferred (paid before or after) DR current tax expensea CR Cash or taxes payable Assumes positive taxable income 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 Paul Zarowin can DR or CR deferred tax expense, depending on net ∆ deferred tax asset/liability 14 Components of Tax Expense (cont’d) Alternatively, DR total tax expensec CR Deferred tax asset/liability CR Cash c) Total tax expense = current + deferred ex E13-7 Paul Zarowin 15 Deferred Tax Accounting = Inter-period Tax Allocation Total income tax expense = Current (paid now) + Deferred (paid both before or after) Paul Zarowin 16 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 17 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 18 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 19 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 20 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 21 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 22 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 years (offset the earlier year first, as in FIFO) Paul Zarowin 23 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 24 Incentives for Carryback vs Carryforward Can’t carryback because of 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 25 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 26 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, Paul Zarowin 27 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 28 [...]... 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 23 Net Operating Loss (cont’d) NOL carryforward: Offset future income (also FIFO),... 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 Paul Zarowin 13 Components of Tax Expense and Tax JE Components of tax expense: 1 current (pay now); and 2 deferred (paid before or after) 1 DR current tax expensea CR Cash or taxes payable Assumes positive taxable income a) Current tax expense... 2 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... manipulate NI, by affecting income tax expense ex E13-17 Paul Zarowin 26 1 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... carryback period is 2 years (offset the earlier year first, as in FIFO) Paul Zarowin 23 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... the receivable is actually written off Paul Zarowin 18 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 Paul...Ex 3 accrued liability, payable Books = accrual accounting period 1: DR 100 Taxes = cash accounting CR DR CR Cash 100 DR Exp 100 N/A CR Exp 100 Liab period 2: DR Liab 100 CR Cash 100 Note: total expense is the same, just timing differs Paul Zarowin 11 Ex 4 prepaid expense Books = accrual accounting period 1: 100 DR Exp 100 CR Taxes = cash accounting DR Cash 100 Asset 100 CR period 2: DR Exp 100 CR Asset... Alternatively, 3 DR total tax expensec CR Deferred tax asset/liability CR Cash c) Total tax expense = current + deferred ex E13-7 Paul Zarowin 15 Deferred Tax Accounting = Inter-period Tax Allocation Total income tax expense = Current (paid now) + Deferred (paid both before or after) Paul Zarowin 16 Originating vs Reversing Timing Diff  Originating differences create deferred tax assets (DR); and liabilities ... 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. .. revenue or expense that are in book (or taxable) income of a period, but never part of taxable (or book) income types: non-taxable revenues (ex interest income on municipal bonds) non-deductible expenses... taxable income Permanent differences Effective vs statutory tax rates Temporary (timing) differences Deferred taxes: Assets, Liabilities, Expense Possible cases and examples Components of income