Solution manual intermediate accounting 15e by stice ch16

Chapter 16 61 CHAPTER 16 QUESTIONS Income measurement for financial reporting purposes is designed to measure as fairly as possible the increase in equity arising from operations during the period Income measurement for tax purposes is selected by the company to minimize its income tax liability and by the government to raise revenue and to meet changing economic and policy objectives These different objectives frequently result in different accounting methods for financial reporting and for income tax purposes Certain expenses will never be deductible for tax purposes because of provisions within the tax law These are referred to as permanent differences or nondeductible expenses Temporary differences are differences between taxable and financial income that result in taxable or deductible amounts when the reported amount of an asset or liability in the financial statements is recovered or settled, respectively A temporary difference that results in a larger current-year taxable income will reverse in a future year and result in a deductible amount to offset against other taxable income While a nondeductible expense is never deductible for tax purposes, a temporary difference is deductible in future periods A taxable temporary difference is one that will result in taxable amounts in future years Taxable temporary differences involve reporting high deductions for tax purposes now with corresponding low deductions in future years An example is the difference between straight-line depreciation for financial reporting purposes and MACRS for tax purposes A taxable temporary difference can also stem from reporting low revenue for tax purposes now with corresponding high taxable revenue in future years An example is the difference between the installment sales method for tax purposes and the accrual method for financial reporting 62 Chapter 16 A deductible temporary difference is one that will result in deductible amounts in future years Deductible temporary differences involve reporting low deductions for tax purposes now with corresponding high deductions in future years An example is the difference between reporting an estimate of future warranty costs as an expense in the year of the sale for financial reporting and waiting to record the deduction for tax purposes until the actual warranty costs are paid A deductible temporary difference can also stem from reporting high revenue for tax purposes now, with corresponding low taxable revenue in future years An example is the difference between reporting the receipt of advance rent payments as revenue for tax purposes when they are received and waiting to report the revenue until it is earned for financial reporting purposes The no-deferral approach is simple, but it violates a fundamental precept of accrual accounting: Reported expenses should reflect all current and future outflows resulting from a transaction The nodeferral approach ignores the fact that transactions in one period often have foreseeable tax consequences in future periods The major advantages of the asset and liability method are that the assets and liabilities recorded under this method match the conceptual definitions for these elements and that the method allows for recognition of changes in circumstances and changes in enacted tax rates One drawback of the asset and liability method is that in some ways it is too complicated Many financial statement users claim that they ignore deferred tax assets and liabilities anyway; thus, efforts devoted to deferred tax accounting are just a waste of time When rate changes are enacted after a deferred tax liability or asset has been recorded, the beginning deferred tax account is adjusted to reflect the new enacted rates The income effect of the change is shown as either an addition to or subtraction from income tax expense for the period A valuation allowance is necessary when available evidence indicates that it is more likely than not that some portion or all of the benefit of a deferred tax asset will not be realized The Board indicated that “more likely than not” means a level of likelihood that is at least more than 50% The FASB did not establish specific criteria for evaluating more likely than not but did suggest that if a company has a history of operating losses, has had tax carryforwards expire unused, or has prospective future losses even if the company has been profitable in the past, it may be more likely than not that the benefit of deferred tax assets may not be realized 10 Some possible sources of income through which the tax benefit of a deferred tax asset can be realized are as follows: (a) Future reversals of existing taxable temporary differences (b) Future taxable income (c) Taxable income in prior carryback years 11 Current federal tax laws provide for an optional 2-year carryback and a 20-year carryforward of net operating losses If the carryback provision is used, the earliest carryback year (second previous year) is used first If there is still unused loss, it is carried forward to the immediately succeeding year Any remaining unused portion of the loss is then forwarded to the next year and so on until 20 years have passed or until the loss is completely offset against income, whichever comes first 12 Deferred tax assets arising from NOL carryforwards are classified according to the expected time of their utilization If the NOL carryforward is expected to be used in the coming year, the deferred tax asset is classified as current Otherwise, it is classified as noncurrent Chapter 16 13 FASB Statement No 109 requires scheduling when differences in enacted future tax rates from one year to the next make it necessary to schedule the timing of a reversal in order to match the reversal with the tax rate expected to be in effect in the year in which it occurs 14 Prior to FASB Statement No 109, income tax carryforwards could be recognized only if future income was assured beyond reasonable doubt If Statement No 96 had been implemented, income tax carryforwards would never have been recognized However, under FASB Statement No 109, income tax carryforwards can be recognized unless it is more likely than not that future income will not be sufficient to realize a benefit from the carryforward 15 Changes in the amount of deferred tax assets and liabilities not require or provide cash However, they affect the amount of income tax expense that is deducted in arriving at net income Therefore, a statement of cash flows must adjust for this fact Under the indirect method, changes in the deferred balances are reported as adjustments to net income in arriving at cash flow from operations Under the direct method, the actual income tax payments or refunds would be reported rather than the amount reported as income tax expense or benefit 16 Income tax carrybacks and carryforwards reduce the amount reported as an operating loss for the current period However, they not provide cash flows until carryback refunds are received or future tax payments are reduced due to the existence of the carryforward The statement of cash flows must show these carrybacks and carryforwards as adjustments to cash flow from operations 17 Current deferred tax assets and current deferred tax liabilities are netted against one another and reported as a single amount Also, noncurrent deferred tax assets and liabilities are netted and reported as a single amount 18 In many foreign countries, generally accepted accounting standards are based on the income tax laws of the country Thus, in these countries very few, if any, temporary 63 differences exist between reported income and taxable income 19 In 1996, the IASB revised IFRS 12; the accounting required in the revised version is very similar to the deferred tax accounting practices used in the United States 20 The partial recognition approach results in a deferred tax liability being recorded only to the 64 Chapter 16 extent that the deferred taxes are actually expected to be paid in the future The reasoning behind the partial recognition approach is that if a liability is deferred indefinitely, the present value of that liability is zero Despite its conceptual attractiveness, the partial recognition approach is on the verge of being dropped in the United Kingdom in the interest of international harmonization Chapter 16 65 PRACTICE EXERCISES PRACTICE 161 SIMPLE DEFERRED TAX LIABILITY Income statement Sales Income tax expense: Current ($70,000  0.25) Deferred ($30,000  0.25) Total income tax expense Net income $100,000 $17,500 7,500 Income Tax Expense Income Tax Payable Deferred Tax Liability PRACTICE 162 (25,000) $ 75,000 25,000 17,500 7,500 SIMPLE DEFERRED TAX ASSET Income statement Sales $100,000 Expenses (75,000) Bad debt expense (5,000) Income before income taxes $ 20,000 Income tax expense: Current ($25,000  0.30) $(7,500) Deferred benefit ($5,000  0.30) 1,500 Total income tax expense (6,000) Net income $ 14,000 Income Tax Expense Deferred Tax Asset Income Tax Payable PRACTICE 163 6,000 1,500 7,500 PERMANENT AND TEMPORARY DIFFERENCES Pretax financial income $50,000 Add (deduct) permanent differences: Nontaxable interest revenue on municipal bonds$(10,000) Nondeductible expenses 17,000 7,000 Financial income subject to tax $57,000 Add temporary difference on warranty expenses 8,000 Taxable income $65,000 Financial income subject to tax = $57,000 Taxable income = $65,000 Income tax expense = $57,000  0.30 = $17,100 Net income = $50,000  $17,100 = $32,900 66 Chapter 16 PRACTICE 164 DEFERRED TAX LIABILITY Income Tax Expense Income Tax Payable Deferred Tax Liability 3,780 3,500 280 Income tax expense: ($10,000 + $800 unrealized gain)  0.35 = $3,780 Income tax payable: $10,000  0.35 = $3,500 PRACTICE 165 DEFERRED TAX LIABILITY Income statement for 2005: Revenue Depreciation expense (straight line) Income before income taxes Income tax expense: Current [($20,000  $10,000)  0.40] Deferred ($4,000  0.40) Total income tax expense Net income $20,000 6,000 $14,000 $4,000 1,600 5,600 $ 8,400 2005 Income Tax Expense Income Tax Payable Deferred Tax Liability 5,600 Income Tax Expense Income Tax Payable Deferred Tax Liability 5,600 4,000 1,600 2006 4,800 800 Income tax payable: ($20,000  $8,000)  0.40 = $4,800 2007 Income Tax Expense Income Tax Payable 5,600 5,600 Income tax payable: ($20,000  $6,000)  0.40 = $5,600 2008 Income Tax Expense Deferred Tax Liability Income Tax Payable 5,600 800 6,400 Income tax payable: ($20,000  $4,000)  0.40 = $6,400 2009 Income Tax Expense Deferred Tax Liability Income Tax Payable Income tax payable: ($20,000  $2,000)  0.40 = $7,200 PRACTICE 166 VARIABLE FUTURE TAX RATES 5,600 1,600 7,200 Chapter 16 67 Income Tax Expense Income Tax Payable Deferred Tax Liability 3,836 3,500 336 Income tax expense: Current $10,000  0.35 = $3,500 Deferred $800  0.42 = $336 PRACTICE 167 CHANGE IN ENACTED TAX RATES As of the beginning of 2007, the accumulated excess of tax depreciation over book depreciation is $6,000 composed of a $4,000 ($10,000  $6,000) excess in 2005 and a $2,000 ($8,000  $6,000) excess in 2006 This means that the existing deferred tax liability is $2,400 ($6,000  0.40) Deferred Tax Liability Income Tax BenefitRate Change 300 300 Change in deferred tax liability: $2,400  ($6,000  0.35) = $300 Income Tax ExpenseRate Change Deferred Tax Liability 360 360 Change in deferred tax liability: ($6,000  0.46)  $2,400 = $360 PRACTICE 168 DEFERRED TAX ASSET Income Tax Expense Deferred Tax Asset Income Tax Payable 1,845 405 2,250 Income tax expense: ($5,000  $900 unrealized loss)  0.45 = $1,845 Income tax payable: $5,000  0.45 = $2,250 PRACTICE 169 DEFERRED TAX ASSET Income statement: Revenue Postretirement health care expense Bad debt expense Income before income taxes Income tax expense: Current [($60,000  $2,000)  0.35] Deferred benefit [($8,000 + $15,000)  0.35] Total income tax expense Net income $ 60,000 (15,000) (10,000) $ 35,000 $20,300 (8,050) Income Tax Expense 12,250 Deferred Tax Asset 8,050 Income Tax Payable 20,300 PRACTICE 1610 DEFERRED TAX LIABILITIES AND ASSETS Income statement: 12,250 $ 22,750 68 Chapter 16 Income before trading securities, restructuring, and taxes Unrealized gain on trading securities ($2,300  $1,000) Restructuring charge (impairment write-down) Income before income taxes Income tax expense: Current ($10,000  0.35) Deferred expense ($1,300  0.35) Deferred benefit ($3,000  0.35) Total income tax expense Net income Income Tax Expense Deferred Tax Asset Deferred Tax Liability Income Tax Payable $10,000 1,300 (3,000) $ 8,300 $ 3,500 455 (1,050) 2,905 $ 5,395 2,905 1,050 455 3,500 It must be assumed that future income will be sufficient to allow for the full utilization of the $3,000 deduction from the decline in the value of the manufacturing facility The unrealized gain of $1,300 on the trading securities will provide a portion, but not all, of the necessary future income PRACTICE 1611 DEFERRED TAX LIABILITIES AND ASSETS Income statement: Income before trading securities, depreciation, and taxes Unrealized loss on trading securities ($1,000  $700) Depreciation ($10,000/4 years) Income before income taxes Income tax expense: Current [($4,000  $3,300)  0.40] Deferred expense [($3,300  $2,500)  0.40] Deferred benefit ($300  0.40) Total income tax expense Net income Income Tax Expense Deferred Tax Asset Deferred Tax Liability Income Tax Payable $ 4,000 (300) (2,500) $ 1,200 $ 280 320 (120) 480 $ 720 480 120 320 280 The reversal of the temporary depreciation difference will create $800 of additional taxable income in future years This is a probable source of future taxable income against which the $300 unrealized loss on the trading securities can be offset So, in this case there is already strong evidence, without additional assumptions, that there will be sufficient future taxable income to allow for the full utilization of the unrealized loss Chapter 16 69 PRACTICE 1612 VALUATION ALLOWANCE The amount of the $900 loss that can be used as a tax deduction in future years is $400 Thus, even though a $405 ($900  0.45) deferred tax asset has been recognized, only $180 ($400  0.45) of the future benefit will be realized The necessary adjustment is as follows: Income Tax Expense Valuation Allowance ($405  $180) 225 225 The net deferred tax asset is now $180 = $405 deferred tax asset  $225 valuation allowance PRACTICE 1613 VALUATION ALLOWANCE The amount of the future $8,000 bad debt write-off and the future $15,000 retiree health care expenditure that can be used as a tax deduction in future years is limited to $20,000 Thus, even though a $8,050 ($23,000  0.35) deferred tax asset has been recognized, only $7,000 ($20,000  0.35) of the future benefit will be realized The necessary adjustment is as follows: Income Tax Expense 1,050 Valuation Allowance ($8,050  $7,000) 1,050 The net deferred tax asset is now $7,000 = $8,050 deferred tax asset  $1,050 valuation allowance More precise estimates of the timing of the future taxable income would be needed to determine how the valuation allowance should be allocated between the bad debt and the postretirement health care portions of the overall deferred tax asset PRACTICE 1614 NET OPERATING LOSS CARRYBACK The $50,000 net operating loss is first carried back two years to recover the tax paid on the $40,000 taxable income reported in 2003 The remaining $10,000 ($50,000  $40,000) NOL is carried back to 2004 The income tax refund is computed as follows: NOL Carried Back to 2003 2004 Total refund Taxable Income $40,000 10,000 Income Tax Rate 30% 35 Journal entry: Income Tax Refund Receivable 15,500 Income Tax BenefitNOL Carryback 15,500 Tax Refund $12,000 3,500 $15,500 70 Chapter 16 PRACTICE 1615 NET OPERATING LOSS CARRYFORWARD The $100,000 net operating loss is first carried back two years to recover the tax paid on the $40,000 taxable income reported in 2003 The remaining $60,000 ($100,000  $40,000) NOL is carried back to 2004 The income tax refund is computed as follows: NOL Carried Back to 2003 2004 Total refund Taxable Income $40,000 30,000 Income Tax Rate 30% 35 Tax Refund $12,000 10,500 $22,500 Journal entry: Income Tax Refund Receivable 22,500 Income Tax BenefitNOL Carryback 22,500 No assumption is necessary here; this is a straightforward request to the government to refund cash paid for income taxes in prior years The two-year carryback used $70,000 ($40,000 + $30,000) of the net operating loss, leaving $30,000 ($100,000  $70,000) as an NOL carryforward The future benefit of the NOL carryforward in terms of future tax reductions is $12,000 ($30,000  0.40) The journal entry to record the NOL carryforward is as follows: Deferred Tax AssetNOL Carryforward 12,000 Income Tax BenefitNOL Carryforward 12,000 One must assume that it is more likely than not that future taxable income will be sufficient, within the 20-year carryforward period, to allow the company to utilize the $30,000 in NOL carryforwards PRACTICE 1616 NET OPERATING LOSS CARRYFORWARD Treatment of NOL in 2006: NOL Carried Back to 2004 2005 Total refund Taxable Income $15,000 20,000 Income Tax Rate 35% 35 Tax Refund $ 5,250 7,000 $12,250 The carryback period is just two years, so the NOL in 2006 cannot be carried back against 2003 taxable income The NOL carryforward remaining in 2006 is $65,000 ($100,000  $15,000  $20,000) In 2007, the $65,000 NOL carryforward will be offset against the $50,000 taxable income for the year No income tax will be paid in 2007, and there will remain a $15,000 ($65,000  $50,000) NOL carryforward from 2006 In 2008, there is no taxable income against which the $200,000 NOL can be carried back; the $50,000 in taxable income in 2007 was offset against the NOL carryforward from 2006 So, the entire $200,000 NOL from 2008 is carried forward The NOL carryforward is worth $80,000 ($200,000  0.40) in future tax benefits The appropriate journal entry is as follows: Deferred Tax AssetNOL Carryforward 80,000 Income Tax BenefitNOL Carryforward 80,000 Of course, one must assume that it is more likely than not that future taxable income will be sufficient, within the 20-year carryforward period, to allow the company to utilize the $215,000 in NOL carryforwards ($15,000 remaining from 2006 plus $200,000 from 2008) With the company’s rocky recent past, this may not be a reasonable assumption 90 Chapter 16 16–49 (Concluded) Year 2002 2003 Amount of 2004 Loss Applied to Income $ 2,050* 32,000 $34,050 Income Tax Rate 46% 40 Amount of Refund Due from Prior Years’ Income Taxes $ 943 12,800 $13,743 Income tax refund due in 2004 $13,743 Amount of loss carryforward: ($58,700 – $2,050 – $32,000) $24,650 *There is $2,050 available at December 31, 2004, because $14,550 is used by the operating loss carryforward from 2001 ($16,600 – $14,550 = $2,050) The expected tax benefit from the NOL carryforward would be reported as an asset It would be valued using the enacted tax rate expected to prevail when the NOL carryforward is used The deferred tax asset would be reduced by a valuation allowance if it were deemed more likely than not that taxable income in the carryforward period would not be sufficient to fully realize the tax benefit The deferred tax asset would be classified current or noncurrent, according to the expected time of its realization Income taxes paid, 2002 and 2005: 2002 net income Less: Loss carryforward from 2001 Taxable income Tax rate Income taxes paid $16,600 14,550 $ 2,050  46% $ 943 2005 net income Less: Loss carryforward from 2004 Taxable income Tax rate Income taxes paid $65,000 24,650 $40,350  40% $16,140 Because the benefit of the net operating loss carryforward was recognized in 2004, there would be no credit to income tax expense in 2005 The entry to record the income tax liability would be as follows: Income Tax Expense ($65,000  0.40) Income Taxes Payable [see (3)] Deferred Tax Asset—NOL Carryforward ($24,650  0.40) 26,000 16,140 9,860 Chapter 16 91 DISCUSSION CASES Discussion Case 16–50 This case introduces students to the long-standing debate over the merits of interperiod tax allocation The principal issue is whether income taxes are an expense that should be accrued or an annual assessment made against income as defined by the government at rates determined each year Those who defend interperiod tax allocation might argue as follows: Income taxes are an expense of doing business If revenues are reported to the government on a timing basis that is different from that used for the general-purpose financial statements, a proper matching of expenses with revenues requires interperiod tax allocation The current income tax expense should be computed on the basis of the reported financial income, not on the basis of the taxable income A proper matching of expense against revenue is possible only if this approach is used The fact that the total balance of deferred income taxes continues to grow is irrelevant In a growing company, all accounts increase The total accounts payable grows, yet individual balances are paid according to the contractual terms This is also true of deferred income tax assets and liabilities Individual timing differences always reverse, or they would not be timing differences Generally accepted accounting principles require interperiod tax allocation If Hurst desires audited statements, it must comply with currently accepted GAAP If taxes were charged to expense as paid, net income would not be comparable across years Treatment of revenues and expenses on the books that is different from that used on the tax returns could be applied so as to manipulate reported net income and possibly mislead statement users Those who are opposed to interperiod tax allocation might argue as follows: The deferral is not a liability There is no obligation to pay any amount in the future Payment is contingent on the earning of income, the continuity of operations, and the tax laws in effect when the items reverse Many analysts recognize the “softness” of this amount by excluding it from analysis If deferral is to be followed, it should be in terms of a partial allocation, not a comprehensive one Only those timing differences that are nonrecurring in nature should be deferred The type of timing difference that recurs will never be liquidated in total Therefore, it gives rise to large balances on the financial statements that have little meaning Income taxes are a charge made against businesses annually Tax laws are designed to raise revenue and to control the economy The amounts are determinable each year by legislative bodies Income taxes are really divisions of business profits, not an expense of doing business Class discussion should be lively for this case Instructors are encouraged to explore these arguments with the students Discussion Case 16–51 The theoretical basis for deferred income taxes under the asset and liability method includes the following concepts: (a) Deferred tax accounting requires that a current or deferred tax liability or asset be recognized for the current or deferred tax consequences of all events that have been recognized in the financial statements The asset or liability created must meet the definitions of Concepts Statement No (b) The current or deferred consequences of events are measured in accordance with provisions of enacted tax law (c) Deferred tax assets are reduced by a valuation allowance if all available evidence indicates that it is more likely than not that the deferred tax asset will not be fully realized 92 Chapter 16 (d) The recorded valuation of deferred tax liabilities and assets is changed in response to enacted changes in future tax rates Chapter 16 93 Reporting higher depreciation for tax purposes than for financial reporting purposes results in a taxable temporary difference A deferred tax liability is recorded to represent the higher taxes that will be paid when the temporary difference reverses The deferred tax liability is valued using the enacted tax rate expected to be in effect when the difference reverses The deferred tax liability is classified as noncurrent since the underlying depreciable asset is noncurrent The rent revenue received in advance gives rise to a deductible temporary difference A deferred tax asset is recorded to represent the fact that the taxes on the revenue have already been paid even though the revenue has not yet been recognized for financial reporting purposes The deferred tax asset is valued using the enacted tax rate expected to be in effect when the difference reverses The deferred tax asset is classified as current because the underlying unearned revenue liability is current If it is more likely than not that part or all of the entire deferred tax asset will not be realized, the reported amount of the deferred tax asset is reduced by a valuation allowance Discussion Case 16–52 With the asset and liability approach to deferred taxes adopted by the FASB, a credit in the deferred tax account represents a liability, and, as such, the measurement of its value is an important issue Conceptually, it seems clear that a deferred tax liability should reflect the time value of money If not, then the advantage of deferring taxes until later periods is not reflected in the financial statements The FASB decided not to consider the issue of discounting in Statement No 109 for a variety of practical reasons The implementation issues associated with the discounting of deferred taxes could be numerous and complex For example, an appropriate discount rate would have to be specified It was thought that discounting would add unnecessary complexity and that consideration of discounting of deferred taxes should be addressed in the broader context of discounted values in the financial statements Discussion Case 16–53 The 1986 corporate tax rate reduction coincided with the adoption of FASB Statement No 96 by many firms Statement No 96 incorporated the asset and liability method and, accordingly, required adjustment of the reported deferred tax asset and liability amounts in response to a change in the enacted tax rate Recall also that Statement No 96 disallowed the recognition of most deferred tax assets Therefore, the large majority of firms using Statement No 96 reported larger deferred tax liabilities than deferred tax assets Consider how a reduction in tax rates would be recorded by a company with a deferred tax liability The amount of the liability would be reduced through a journal entry like the following: Deferred Tax Liability XXX Income Tax Benefit—Rate Change XXX As Congress considered raising the corporate tax rate in 1993, most firms had adopted or would soon adopt FASB Statement No 109 Like Statement No 96, Statement No 109 also incorporates the asset and liability method However, unlike Statement No 96, Statement No 109 allows for the recognition of most deferred tax assets Therefore, the mix between firms with net deferred tax assets and those with net deferred tax liabilities is more equal A tax rate increase would increase the recorded amounts of both deferred tax assets and liabilities and would be recognized through journal entries like the following: Deferred Tax Asset Income Tax Benefit—Rate Change XXX Income Tax Expense—Rate Change Deferred Tax Liability XXX XXX XXX It is clear that none of the journal entries needed to adjust a deferred tax asset or liability involve cash Financial statement users sometimes mistakenly think of deferred tax liabilities, accumulated depreciation, and retained earnings as if they represent piles of cash tucked away somewhere 94 Chapter 16 Discussion Case 16–54 The carryback and carryforward provisions of the U.S tax code impact the recognition of deferred tax assets but not the recognition of deferred tax liabilities The realization of a deferred tax liability is not contingent on the existence of other future tax events However, the realization of a deferred tax asset depends on the existence of future taxable income against which the deductible temporary difference can be offset Possible sources of future taxable income include the following: (a) Future reversals of existing taxable temporary differences (b) Future taxable income (c) Taxable income in prior carryback years Under Cardassian tax law, source (c) would be completely eliminated In addition, sources (a) and (b) would be greatly restricted because, with no carrybacks and carryforwards, the future taxable income would have to occur in the exact year of the deductible temporary difference reversal In summary, implementation of Statement No 109 under Cardassian tax law (no carrybacks or carryforwards) would require careful scheduling of the reversal of temporary differences and careful forecasting of future taxable income to determine whether sufficient taxable income would exist in the exact years of deductible difference reversals Discussion Case 16–55 You may find it difficult to answer your friend’s perceptive question FASB Statement No that establishes the standard for recognizing contingent liabilities was issued in the mid-1970s It requires recognition of contingent liabilities only if it is probable the liability will have to be paid No attempt was made in the statement or in later pronouncements to define the cutoff for probable Research studies of statement users discovered a wide range of interpretations—from 50% to 99% probability If a contingent liability is deemed to have only a reasonable possibility of occurrence, the contingent liability must be disclosed only in notes to the statements FASB Statement No 109 introduced for the first time the probability term “more likely than not.” The statement indicates that the cutoff for this term is 50% Thus, contingent assets may be reported at a lower level than that used by many preparers for contingent liabilities You must tell your friend that this difference has not been dealt with by the FASB as yet, although some accountants have suggested that the criteria for Statement No need to be reconsidered in light of the new term used in Statement No 109 This case would make a good debate question or the basis for a written research assignment Discussion Case 16–56 This case gives students the opportunity to consider how difficult it can be in practice to decide whether a valuation allowance for deferred tax assets is necessary and how it might be measured If a company has been experiencing financial difficulty and has had several loss years, the presumption would most likely be that an allowance would be required “More likely than not” is defined as being above 50% probability If a company has positive sales prospects, has a strong liquidity position, and past years have been profitable, the assumption would be that an allowance would not be required In addition, to the extent that a company has profitable years to carry back an operating loss or has deferred tax liabilities against which deferred tax assets can be offset, a valuation allowance would not be required Chapter 16 95 SOLUTIONS TO STOP & THINK Stop & Think (p 989): This discussion mentions two sets of books, the financial accounting and the income tax records Does a large corporation legitimately maintain any other sets of accounting-related books? An obvious third set of books, arguably the most important, is the managerial accounting system Of course, the managerial records would be tailored to the needs of each company Different aspects of the managerial records would emphasize control, evaluation, and planning A small business would combine the functions of all three sets of books—financial, tax, and managerial—into one set of reports As a company’s information needs become more sophisticated, there is increased divergence among these three sets of books Stop & Think (p 992): How can a company have both deferred tax assets and deferred tax liabilities? Deferred tax assets and deferred tax liabilities result from different types of transactions For example, a deferred tax asset can result from warranties, and a deferred tax liability can result from a depreciable asset The differences between GAAP and tax law provide numerous instances that can result in either deferred assets or deferred liabilities Stop & Think (p 995): How might the numbers for 2005 change if Roland expected tax rates in future periods to be 30% instead of 40%? As will be pointed out in an upcoming section of the text, deferred tax assets and deferred tax liabilities are to be measured using tax rates expected to be applicable in the period of the reversal Thus, if rates in the future are expected to be 30%, the deferred amount would be multiplied by 30% instead of 40% Stop & Think (p 1003): Now that you have been introduced to deferred tax assets and liabilities, you think the results of all the computations provide valuable information to current and potential investors and creditors? The objective of this question is to cause students to stop and think about the value of the information being provided Their opinions may vary, but they should at least consider the issue of value Stop & Think (p 1004): These net operating loss carrybacks sound like a great feature of the tax law However, what did the company have to to take advantage of this aspect of the law? While carrybacks and carryforwards work to the benefit of the company in that it is able to either receive a refund of taxes previously paid or to reduce the amount of taxes to be paid in the future, one must remember that the company had to report a net operating loss in order to take advantage of this feature of the tax law The carryback provision eases the pain of an operating loss Stop & Think (p 1010): What is the rationale behind excluding from a corporation’s taxable income dividends received from another corporation? Dividends paid to shareholders are already double taxed The corporation must pay tax on the income, leaving less income to pay to shareholders as dividends Then the shareholders must pay income tax when they receive the dividends When a corporation is a shareholder and receives dividends, then that dividend income would be taxed for a third time unless the special tax provision excluded the dividends from income taxation for the receiving corporation 96 Chapter 16 SOLUTIONS TO STOP & RESEARCH Stop & Research (p 997): Access a copy of MICROSOFT’s most recent annual report, and identify the source of the company’s largest deferred tax liability ( Hint: You will have to search the financial statement notes and find the one on “Income Taxes.”) In the notes to its June 30, 2001, financial statements, Microsoft reported that its largest deferred tax liability was $1.667 billion for “international earnings.” This is income tax that Microsoft expects to pay in the future on income it has earned outside the United States that has already been reported as income in the financial statements but that has not yet been taxed Stop & Research (p 998): Access a copy of CISCO SYSTEMS’ most recent annual report, and identify the source of the company’s largest deferred tax asset In the notes to its July 28, 2001, financial statements, Cisco reported that its largest deferred tax asset was $706 million for “inventory allowances and capitalization.” This represents the future tax benefits expected to arise when inventory is sold at a reduced price because of poor market conditions Cisco has already recognized the decline in the inventory value through a lower-of-cost-or-market write-down Chapter 16 97 SOLUTIONS TO NET WORK EXERCISE Net Work Exercise (p 1005): As of the end of 2001, Coca-Cola’s total net operating loss carryforwards available for future years were $1,229 million The amount of future tax benefit associated with those carryforwards is $286 million Coca-Cola reported the following about the expiration of its tax operating loss carryforwards: On December 31, 2001, we had $1,229 million of tax operating loss carryforwards available to reduce future taxable income of certain international subsidiaries Loss carryforwards of $440 million must be utilized within the next five years; $789 million can be utilized over an indefinite period A valuation allowance has been provided for a portion of the deferred tax assets related to these loss carryforwards 98 Chapter 16 SOLUTIONS TO BOXED ITEM History of Accounting for Deferred Taxes (pp 1000–1001) The FASB has no legal standing with which to enforce adherence to its standards The standards are followed because they are “generally accepted.” If the FASB loses the confidence of the regulatory and financial communities, there is a greater possibility that its standards will be opposed or ignored In the extreme case, standard-setting authority could be taken away from the private sector Accounting standard setting always involves a trade-off between the costs imposed on statement preparers and the benefits realized by statement users It would clearly be inappropriate to set standards in a theoretical vacuum without regard to the practical implications of those standards However, issues of cost and practicality must not be allowed to entrench bad accounting A complicating factor is that the costs to preparers are usually easier to quantify than are the benefits to users Because of the issue of practicality, the FASB treats the development of accounting standards as an “evolutionary” process, with attempts made to avoid radical departures from existing practice even when such departures could be justified from a theoretical standpoint Many financial statement users claim they ignore deferred tax assets and liabilities when analyzing a firm’s financial statements Accordingly, in their view, efforts devoted to deferred tax accounting are a waste of time On the other hand, research using stock market data suggests that investors compute values of companies as if the reported deferred tax liabilities are bona fide liabilities Whether the information benefits of deferred tax accounting are worth the preparation costs is still an open question Chapter 16 99 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 16–1 (The Walt Disney Company) From the income statement we can determine that Disney reported income tax expense for the year ended September 30, 2001, of $1,059 million Note of Disney’s annual report breaks income tax expense into two parts: current and deferred The portion of income tax expense related to current items totals $1,001 million and the portion related to deferred items amounts to $58 million By dividing income tax expense ($1,059 million) by income before income taxes ($1,283 million), we can arrive at the 82.5% number The journal entry establishing this allowance account would have involved a credit to the allowance account itself and a debit to income tax expense In Note 6, we see that the higher effective tax rate was caused primarily by three items — nondeductible intangible asset amortization, nondeductible intangible asset impairment writedowns, and additional income taxes paid to states The nondeductible intangible asset amortization and impairment reduced income before taxes (for financial reporting purposes) but did not reduce income expense because it is not, nor never will be, deductible for income tax purposes The addition to the tax rate from state income taxes occurs because most states require the payment of income taxes over and above federal income taxes Effective income tax rates can differ from company to company for many reasons, including the following: a Some companies don’t have any nondeductible intangible asset amortization like Disney has For these companies, the effective tax rate would be lower (closer to 35.0%) b There are other nondeductible expenses and nontaxable revenues that would impact the effective tax rate c Some companies are based in, or their business in, states that not have an income tax For example, the great state of Texas does not have an income tax These companies would have a lower effective tax rate d For U.S multinationals, there are also differing tax rates from country to country These differing rates can cause a difference in effective tax rate In general, differences in effective tax rates are caused by permanent differences For example, in Disney’s case, the nondeductible intangible asset amortization will never be deductible, and Disney will never receive a return of the additional income taxes it pays to the states In general, temporary differences (such as accelerated depreciation) not cause a change in the effective tax rate because the computed income tax expense reflects the fact that these temporary differences will reverse in the future All U.S companies are required to give supplemental disclosure of cash paid for income taxes (and cash paid for interest) This information is sometimes in the notes and sometimes at the bottom of the cash flow statement At the bottom of its cash flow statement, Disney reports that it paid $881 million in taxes in 2001 The deferred portion of income tax expense reflects the amount of income tax expense (included in the computation of net income) that is not legally due to be paid this year Thus, the deferred portion of income tax expense does not involve any cash outflow Using the indirect method, this amount must then be added back in the computation of cash flow from operating activities Note that the cash flow statement amount of $58 million reconciles with the amount of deferred tax expense reported in Note This perfect reconciliation is not always possible and can be frustrating For example, the change in deferred taxes does not reconcile with the total change in the deferred tax accounts shown in Disney’s balance sheet The differences arise from a host of events during the year, such as the acquisition of a new business (or the selling of an old business) that has deferred tax amounts associated with it Deciphering 16–2 (Sara Lee Corporation) 100 Chapter 16 From the information provided, we can see that Sara Lee reported income tax expense of $248 million Further disclosure indicates that this is split between current and deferred portions with $160 million being allocated to current and $88 million being allocated to deferred tax benefits The journal entries to record this would have been (numbers in millions): Income Tax Expense—Current Income Taxes Payable 160 Income Tax Expense—Deferred Deferred Tax Liability 88 160 88 As noted near the bottom of the information provided, Sara Lee paid $259 million in taxes for the year The journal entry to record this event would have been (numbers in millions): Income Taxes Payable Cash 259 259 Deciphering 16–3 (Berkshire Hathaway, Deferred Taxes, and Other Comprehensive Income) Net earnings $1,901.6 + Other comprehensive income items ($10,574.5 – $1,106.3 – $3,318.9 – $95.3) = $7,955.6 Cash ($3,397.5 + $779.6 + $2,015.6) Realized Gain Investment Securities 6,192.7 1,106.3 5,086.4 This is the amount of realized gains that are reclassified out of accumulated other comprehensive income and into retained earnings (via net earnings for the year) Investment Securities Deferred Income Tax Liability Other Comprehensive Income 10,574.5 3,318.9 7,255.6 The debit to Investment Securities could also be to a Market Adjustment account The net “deferred gain” reported as part of Other Comprehensive Income is $7,255.6, which is the amount of the increase in the value of the securities less the deferred taxes that are expected to be paid when these appreciated securities are sold Note that when this deferred income tax liability is recognized, there is no corresponding increase in income tax expense This is because the deferred gain itself was not reported as part of net income If these were trading securities, the $10,574.5 million would be recorded as a gain in the income statement, and income tax expense would be increased by $3,318.9 million Deciphering 16–4 (Microsoft, Employee Stock Options, and Income Taxes) $2.066 billion/0.330 = $6.261 billion $6.261 billion/47,600 employees = $131,534 Chapter 16 Income Tax Payable Additional Paid-In Capital 101 2,066 2,066 We know that the credit must be to Additional Paid-In Capital because this is reported as an increase (credit) to this equity account in the statement of changes in stockholders’ equity We also know that this amount represents a reduction in the amount of taxes that Microsoft must pay Hence, the reduction (debit) in Income Tax Payable As shown in entry (3), the stock option income tax benefit reduces the amount of cash paid for income taxes but does not reduce reported income tax expense Recall that, with the indirect method, the computation of operating cash flow starts with Net Income In the computation of Microsoft’s net income, the entire amount of income tax expense was subtracted However, we now know that the amount of cash Microsoft had to pay for taxes was actually $2.066 billion less than the reported income tax expense Accordingly, this amount is added back in the computation of operating cash flow The classification of this adjustment is included in the operating activities section in accordance with EITF Issue No 00–15 Before 2000, Microsoft reported this as an addition to cash flow from financing activities This accounting for ESOs results in a reduction in income tax payable without a corresponding reduction in income tax expense Thus, the “current taxes” amount of $3.757 billion reported by Microsoft is not what would be shown on this hypothetical worldwide income tax return That amount would be reduced by the $2.066 billion in tax benefit associated with the ESOs Thus, “Total tax for the year” for Microsoft for 2001 would be somewhere around $3.757 billion – $2.066 billion = $1.691 billion This number is supported by the fact that the cash paid for taxes for Microsoft in 2001 was $1.3 billion, as shown just below the operating cash flow information Sample CPA Exam Questions The correct answer is b A company will net current deferred tax assets against current deferred tax liabilities and noncurrent deferred tax assets against noncurrent deferred tax liabilities As a result, Bren would offset the $3,000 noncurrent deferred tax asset against the $15,000 noncurrent deferred liability and report a net noncurrent deferred tax liability of $12,000 The current deferred tax asset of $8,000 will be reported separately in the current assets section of the balance sheet The correct answer is a The provision for current income taxes is calculated by multiplying taxable income of $150,000 by the tax rate of 30%, giving an amount of $45,000 Writing Assignment: Crystallization The objective of this assignment is to get students thinking about ways in which accounting principles and concepts differ around the world In this case, the United Kingdom historically incorporated present value concepts in valuing deferred taxes while the United States has not However, the rationale for not recognizing deferred taxes that will not crystallize breaks down when applied to accounts payable Total accounts payable increases each year in a growing firm—the old accounts that are paid off are more than replaced by new accounts payable Using the “crystallization” concept, accounts payable could also be reported as $0 because the ultimate payoff of the entire balance is far in the future for a going concern This illustrates, the authors think, a hole in the old UK approach The most theoretically correct approach is one that is midway between the U.S and UK approaches—recognize all deferred tax liabilities (U.S.) but take into consideration the timing of the reversal in computing the present value of the deferred tax liability As mentioned in the chapter, the Accounting Standards Board in the United Kingdom has dropped its partial recognition approach to deferred tax accounting 102 Chapter 16 Research Project: Reviewing actual financial statements and associated notes The objective of this research project is to get students to review annual reports and to realize that the issues and concepts discussed in class are actually used by companies A review of note information relating to deferred taxes will allow students to see that the material covered in the chapter is sufficient to obtain an understanding of complex note disclosures They will also realize that deferred taxes is often a large component on the balance sheet and tends to get larger for most companies A sample solution is given using the 2001 financial statements of AT&T The effective tax rates for AT&T in 2001, 2000, and 1999 were 76.4%, 136.1%, and 37.3%, respectively The percentage of total tax expense that was current in 2001, 2000, and 1999 was 100.0% (there was a net deferred tax benefit for the year), 82.0%, and 85.0%, respectively From 2000 to 2001, AT&T’s net long-term deferred tax liability decreased from $32.054 billion to $28.160 billion In Note 3, AT&T disclosed that cash paid for income taxes in 2001, 2000, and 1999 was $803 million, $2,369 million, and $3,948 million, respectively As of December 31, 2001, AT&T’s largest deferred tax item was a $16.839 billion deferred tax liability related to “franchise costs.” Unfortunately, no explanation of this item is given in AT&T’s financial statement notes The Debate: Account for deferred taxes or not! While ignoring deferred taxes would certainly make life a lot easier for the accountant, would we be eliminating useful information from the financial statements? Through this debate, students should gain an appreciation for the fact that while accounting for deferred taxes involves dealing with estimates and projections, it is all in an effort to report information relating to a probable liability or asset The debate format will allow students to examine extreme positions and hopefully realize that there is value in our efforts as accountants Ethical Dilemma: The valuation allowance In this case, the accountant is making projections about the future profitability of the company If it is not expected that profits will be available against which previous losses can be offset, then a valuation allowance account must be used If the accountant’s assessment of the future does not coincide with management’s, a debate between the two can result Accountants must understand that their assumptions and estimates can have a material impact on the financial results of a company In this case, using a valuation allowance account actually increases the amount of income tax expense reported, thereby increasing the amount of the reported loss Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Chapter 16 103 Internet Search A Google search using “deferred tax” and “financial analysis” located the following interesting article on balance sheets for farms The Web address is http://www.farmdoc.uiuc.edu/manage/newsletters/html/011601.html January 16, 2001 DEFERRED TAXES—A FINANCIAL CONSIDERATION Deferred taxes are a financial liability that is receiving more and more consideration from agricultural lenders, accountants and other consultants that work with agricultural producers What are deferred taxes? Deferred taxes are the income and self-employment taxes that would be due if a producer completely liquidated his or her assets in the farm business For many producers this can be a substantial amount The reason for this is that most farm operators file their income taxes on a cash basis All the expenses of raising a crop or feeding livestock are deducted in the year the expenses are paid Many producers retire or leave the farm business with a significant dollar amount of grain and/or livestock inventory Frequently this inventory is sold in the year or years following when the production expenses of raising this inventory have been deducted This results in a large amount of income with minimal expenses to offset this income SALE OF MACHINERY AND EQUIPMENT The sale of machinery and equipment used in the farming business can also result in significant taxable income The sale of a modern line of well-kept equipment can result in a substantial gain over the remaining book value or tax basis If a producer sells their machinery at an auction, this gain is realized all in one year Producers who have family members taking over the business may spread this tax burden out over time by selling a piece or two of machinery every year or leasing the machinery over a number of years The question that arises is should deferred tax liability be included as a liability on a producer's balance sheet Historically, this has not been the case Generally, agricultural lenders have not required that this liability be included and producers normally would not include this unless asked to so Listing other assets and liabilities, which are easier to value and more tangible, takes a higher priority Why has this not been a concern? This only becomes an issue when a producer retires or liquidates part of their assets For most ongoing businesses, realization of this liability is not of an immediate concern Is this becoming more of an issue? It's beginning to be The Farm Financial Standards Council, which is an organization with a goal of standardizing the financial statement reporting and analysis of farm businesses, has been debating this issue recently and recommending that this liability be included on the balance sheet From a practical standpoint, as more producers are considering retirement, the realization of this liability is becoming more common In addition, as businesses grow in size, the size of the deferred tax liability usually grows STUDY ESTIMATING AMOUNT OF DEFERRED TAXES Inclusion of this liability can change the financial analysis of a farm business significantly A recent study done by Charles Cagley, State Coordinator for the Illinois FBFM Association, analyzed modified cost and fair market value balance sheets from 229 producers enrolled in the FBFM record keeping and business analysis program The study estimated the deferred tax liability on the current assets (grain, market livestock, etc.) at $62,000, on the intermediate assets (machinery and breeding livestock) at $42,000 and on the long-term assets (land and buildings) at $37,000 The total deferred tax liability was $141,000 If included, the net worth of these businesses would drop by almost 19 percent 104 Chapter 16 EFFECT ON FINANCIAL RATIOS Besides the drop in net worth, financial analysis ratios also changed significantly For example, the current ratio (current assets minus current liabilities) dropped from a respectable 1.76 to 1.19, a decrease of 32 percent The debt to net worth ratio (total liabilities divided by total net worth) increased from 37 to 68, a significant jump Although we are not seeing many agricultural lenders or producers routinely include this liability when completing a balance sheet, producers that are nearing retirement or considering selling some of their farm assets should consider the effect of deferred taxes to their long range plans For many producers, deferred taxes will become a liability that will have to be reckoned with, even if it is not listed on the balance sheet It will reduce the amount of cash available for retirement purposes Issued by Dale Lattz, Department of Agricultural and Consumer Economics ... taxable income 19 In 1996, the IASB revised IFRS 12; the accounting required in the revised version is very similar to the deferred tax accounting practices used in the United States 20 The partial... that they ignore deferred tax assets and liabilities anyway; thus, efforts devoted to deferred tax accounting are just a waste of time When rate changes are enacted after a deferred tax liability... liabilities are netted and reported as a single amount 18 In many foreign countries, generally accepted accounting standards are based on the income tax laws of the country Thus, in these countries very