Income taxes

Deferred taxes: Assets, Liabilities, Expense 6.. Components of income tax expense current vs deferred 8.. Permanent Differences Definition: Items of revenue or expense that are in book

Income Taxes

RCJ Chapter 13

Key Issues

1 Book (financial statement) vs taxable income

2 Permanent differences

3 Effective vs statutory tax rates

4 Temporary (timing) differences

5 Deferred taxes: Assets, Liabilities, Expense

6 Possible cases and examples

7 Components of income tax expense (current vs deferred)

8 Tax journal entries

9 Originating vs reversing differences

10 Asset, Liability (B/S) method vs I/S method

11 NOL carryback and carryforward

3 Parts of Tax Disclosure

1. 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

Key Identity

Pre-tax book (accounting) income

± Permanent differences

± Temporary differences

= pre-tax taxable income

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)

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

tax expense pre-tax (book) income

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

4 Possible Types of Timing Differences

recognize for

taxes before

books

2 Deferred (unearned) revenue

4 Deferred (prepaid) expense

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 CR Cash 100 A/R 100 Cash 100 Rev 100

Note: total revenue is the same, just timing differs

period 1:

period 2:

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 CR Liab 100 Rev 100 N/A

Note: total revenue is the same, just timing differs

period 1:

period 2:

Ex 3 accrued liability, payable

Books = accrual accounting Taxes = cash accounting

DR CR DR CR Exp 100 Liab

100 N/A

DR CR DR CR Liab 100 Cash 100 Exp 100 Cash 100

Note: total expense is the same, just timing differs

period 1:

period 2:

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 CR Exp 100 Asset 100 N/A

Note: total expense is the same, just timing differs

period 1:

period 2:

recognize for

taxes before

books

2 Deferred tax asset 4 Deferred tax liability

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 expense b

CR Deferred tax asset/liability

b) Deferred tax expense =

Assumes positive taxable income

1 current (pay now); and

2 deferred (paid before or after)

can DR or CR deferred tax expense, depending

on net ∆ deferred

Components of Tax Expense (cont’d)

Alternatively,

3. DR total tax expensec

CR Deferred tax asset/liability

CR Cash

c) Total tax expense = current + deferred

ex E13-7

Deferred Tax Accounting =

Inter-period Tax Allocation

Current (paid now)

+ Deferred (paid both before or after)

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)

Examples of Deferred Tax Assets/Liab

1. Installment sale; revenue is recognized up front

for financial reporting, but is recognized for tax

purposes later, when cash is received each period

2. Prepayment; revenue is recognized for tax

purposes up front as cash is received , while accrual accounting delays revenue recognition until revenue

is earned later

3. Bad debts expense The allowance method for

books recognizes the expense in the period of sale

by the adjusting entry (matching principle), while the direct write-off method recognizes the expense

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

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

1 deferred tax asset/liability = cumulative timing difference * STR

2 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

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

 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

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)

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

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

Paul Zarowin 26

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 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

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

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

Financial Statement Disclosures (cont’d)

3a components of deferred tax assets and liabilitiesand/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.)