Intermediate accounting 19th by stice stice chapter 16

Ibanez CompanyIncome Statement For the Year Ended December 31, 2013 Example 1: Simple Deferred Income Tax Liability... Annual Computation of Deferred Tax Liabilities and Assets The maj

Deferred Income Tax Overview

• Corporations in the United States compute two different income numbers:

 Financial income for reporting to

stockholders and

 Taxable income for reporting to the

Internal Revenue Service (IRS).

(continued)

• The primary goal of financial accounting is to provide useful information to management, stockholders, creditors, and others properly interested; the major responsibility of the

accountant is to protect these parties from

The difficulty of determining what is “income tax expense” stems from two basic

considerations:

1 How to account for revenues and

expenses that have already been

recognized and reported to shareholders

in a company’s financial statements but

will not affect taxable income until

subsequent years.

Deferred Income Tax Overview

(continued)

2 How to account for revenues and

expenses that have already been

reported to the IRS but will not be

recognized in the financial statements

until subsequent years.

Deferred Income Tax Overview

• In 2013, Ibanez Company earned revenues of

$30,000 Ibanez has no expenses other than income taxes

• In this case, the income tax law specifies that income is taxed when received in cash and

that Ibanez received $10,000 in 2013 and

expects to receive $20,000 in 2014

• The income tax rate is 40% and it is expected

to remain the same into the foreseeable

future

Example 1: Simple Deferred

Income Tax Liability

Example 1: Simple Deferred

Income Tax Liability

Ibanez Company

Income Statement For the Year Ended December 31, 2013

Example 1: Simple Deferred

Income Tax Liability

• In 2013, its first year of operation, Gupta

Company generated service revenues totaling

$60,000, all taxable in 2013

• No warranty claims were made in 2013, but

Gupta estimates that in 2014 warranty costs of

$10,000 will be incurred for claims related to

2013 service revenues

• Assume a 40% tax rate and that Gupta

Company had no expenses in 2013 other than warranty costs and income taxes

(continued)

Example 2: Simple Deferred Income Tax Asset

Income Tax Expense 20,000

Deferred Tax Asset 4,000

Income Taxes Payable 24,000

Gupta Company

Income Statement For the Year Ended December 31, 2013

Permanent differences are created by political

and social pressures to favor certain segments

of society or to promote certain industries or

economic activities

 Nontaxable revenue—proceeds from

insurance policies; interest received on

municipal bonds

 Nondeductible expenses—fines for

violations of laws; payment of insurance

premiums

Permanent and Temporary

Differences

(continued)

More commonly, differences between pretax

financial income and taxable income arise from business events that are recognized for both

financial reporting and tax purposes but in

different time periods These differences are

referred to as temporary differences

Permanent and Temporary

Differences

(continued)

• The first category includes differences,

called taxable temporary differences , that will result in taxable amounts in future years.

• The second category includes differences, called deductible temporary differences , that will result in deductible amounts in

future years

Permanent and Temporary

Differences

included in either the financial income

subject to tax or the taxable income.

income taxes payable in subsequent

periods.

Illustration of Permanent and

Temporary Differences

Annual Computation of Deferred Tax

Liabilities and Assets

• FASB ASC Topic 740 reflects the

liability method of interperiod tax

measurement and reporting of balance

sheet amounts.

some ways, it is still too complicated.

(continued)

1 Assets and liabilities are recorded in

agreement with FASB definitions of financial

statement elements

2 This method is flexible and recognizes

changes in circumstances and adjusts the

reported amounts accordingly This flexibility may improve the predictive value of the

financial statements

Annual Computation of Deferred Tax

Liabilities and Assets

The major advantages of the asset and liability

method of accounting for deferred taxes are as follows:

(continued)

Establish valuation allowance account if more

likely than not some portion or all of the

deferred tax asset will not be realized.

Measure the deferred tax

liability for taxable

temporary differences (use

enacted rates).

Measure the deferred tax asset for deductible temporary differences (use

enacted rates).

Identify type and amounts of existing

temporary differences.

Annual Computation of Deferred Tax

Liabilities and Assets

• For 2013, Roland computes pretax financial income of

$75,000 The only difference between financial and

taxable income is depreciation

• Roland uses the straight-line method of depreciation for financial reporting purposes and ACRS on its tax return

(continued)

Example 3: Deferred Tax Liability

Financial income subject to tax $75,000 Deduct temporary difference:

Excess of tax depreciation ($40,000)

(continued)

The enacted tax rate for 2013 and future years

is 40% Roland’s taxable income for 2013 is

$60,000, computed as follows:

Example 3: Deferred Tax Liability

Income Tax Expense 30,000

Income Taxes Payable 24,000

Deferred Tax Liability—

$30,000 – $6,000

$15,000 × 40

Roland’s Journal Entry for 2013

Roland’s Journal Entry for 2013

$24,000 current + $6,000 deferred

(continued)

Example 3: Deferred Tax Liability

Income taxes would be shown on Roland’s

2013 income statement as follow:

The December 31, 2013, balance sheet

would report a current liability of $24,000.

Example 3: Deferred Tax Liability

Roland earns financial income of $75,000 in each

of the years 2014 through 2016 Roland reports taxable income of $70,000, computed as follows:

Deduct temporary difference:

Excess of tax depreciation ($30,000)

Income Tax Expense 30,000

Income Taxes Payable 28,000

Deferred Tax Liability—

Roland’s Journal Entry for 2014

Roland’s Journal Entry for 2014

Depreciation expense in 2015 is the same for

both financial and tax, so the entry is simple

Income Tax Expense 30,000

Income Taxes Payable 30,000

$75,000 × 0.40

(continued)

Example 3: Deferred Tax Liability

For 2016, Roland earns income of $75,000 and the taxable income is $95,000, computed as

follows:

Add temporary difference:

Excess of book depreciation

($25,000) over tax depreciation

Income Tax Expense 30,000

Deferred Tax Liability—

Income Taxes Payable 38,000

Roland’s Journal Entry for 2016

Roland’s Journal Entry for 2016

Effect of Currently Enacted Changes

in Future Tax Rates

• If changes in future tax rates have been

enacted, the deferred tax liability (or asset) is measured during the enacted tax rate for the future years when the temporary difference is expected to reverse

• Under IAS 12, deferred tax items are to be

measured at the income tax rates “that have been enacted or substantively enacted by the end of the reporting period.”

Subsequent Changes in

Enacted Tax Rates

Using the Roland, Inc example, assume that the enacted rate for 2016 changed from 40%

to 35% during 2014 The balance in the

deferred tax liability at the beginning of 2014

is $6,000 The following adjusting entry would

Example 4: Deferred Tax Asset

Taxable income for 2013 is computed as follows:

Financial income subject to tax $22,000

Add temporary difference:

Excess of warranty expense over

warranty deductions 18,000

Taxable income ($40,000 × 0.40) $16,000

(continued)

Income Tax Expense 8,800

Deferred Tax Asset—Current 2,400

Deferred Tax Asset—

Income Taxes Payable 16,000

1/3 × $7,200

Sandusky’s Journal Entry for 2013

Sandusky’s Journal Entry for 2013

Income before income taxes $22,000

Income tax expense:

Sandusky’s 2013 income statement would

present income tax expense as follows:

(continued)

Example 4: Deferred Tax Asset

In the years 2014 through 2016, taxable

income would be equal to $16,000, computed

as follows:

Income subject to tax

$22,000

Reversal of temporary difference:

Excess of warranty deductions

• For 2013, Hsieh reported pretax financial income of $38,000

• As of December 31, 2013, the actual

depreciation expense was $25,000 and the actual warranty expense was $18,000.

• For income tax reporting, these expenses were $40,000 and $0, respectively

Example 5: Deferred Tax Liabilities and Assets

Add (deduct) temporary differences:

Excess of warranty expense

Excess of tax depreciation over

Income Tax Expense 16,400

Income Taxes Payable 16,400

Heich’s December 31, 2013 Entries

Heich’s December 31, 2013 Entries

Deferred Tax Asset—Current 2,400

Deferred Tax Asset—

Deferred Tax Liability—

These two are netted against one another and

a single $1,200 amount is shown as a

Example 5: Deferred Tax Liabilities and Assets

Valuation Allowance for Deferred Tax Assets

• A deferred tax asset represents future

income tax benefits

• The tax benefit will be realized only if there

is sufficient taxable income from which the

deductible amount can be deducted

• Topic 740 requires that the deferred tax

asset be reduced by a valuation

allowance, a contra asset account that

reduces the asset to its expected realizable

value

(continued)

Some possible sources of taxable income to be considered in evaluating the realizable value of a deferred tax asset are as follows:

1 Future reversals of existing taxable temporary

differences

2 Future taxable income exclusive of reversing

temporary differences

3 Taxable income in prior (carryback) years

Valuation Allowance for Deferred Tax Assets

Valuation Allowance for Deferred Tax Assets

• In 2013, Hsieh Company has a $15,000

excess of aggregate tax depreciation over

aggregate book depreciation

• The reversal of this temporary difference will provide taxable income in the future against

which the $18,000 warranty deduction can be offset Accordingly, the total deferred tax asset

is $7,200 ($18,000 x 0.40), but the realized

amount is only $6,000 ($15,000 x 0.40) The

$1,200 difference would be recorded as a

valuation allowance

(continued)

Valuation Allowance for Deferred Tax Assets

(continued)

First, the deferred tax asset and liability are

recognized, as follows:

Deferred Tax Asset—Current 2,400

Deferred Tax Asset—

Deferred Tax Liability—

A subtraction from income tax expense

Note that this is the same as the deferred tax journal entry shown earlier on Slide 16-50

the deferred tax asset will not be realized.

Income Tax Expense 1,200

Allowance to Reduce Deferred

Tax Asset to Realizable Value—

Allowance to Reduce Deferred

Tax Asset to Realizable Value—

Valuation Allowance

Under IAS 12

Under the provisions of IAS 12, there is no

valuation allowance Instead, deferred tax assets are recognized only “to the extent that it is probable that taxable profit will be available against which the deductible

temporary difference can be utilised

[utilized].”

Accounting for Uncertain

Tax Positions

Topic 740 requires the use of a 2-step process

to determine the recognition of any tax benefit

associated with an uncertain tax position

1 Step 1—Determine if it is more likely than not

that a tax position would be sustained if it were examined, and it must be assumed that the

tax position will be examined

(continued)

is based on a probability assessment of the

likelihood of specific outcomes and the

amounts of those outcomes

Accounting for Uncertain

Tax Positions

Case 1: Highly Certain Tax Position

Case 1: Highly Certain Tax Position

If the probability that the tax benefit of $100 would be achieved were greater than 50%, this would be deemed a “highly certain”

position In other words, it is more likely

than not that the position taken and the

amount in question would be upheld if

reviewed.

Case 2: Uncertain Tax Position—

More Likely Than Not

Case 2: Uncertain Tax Position—

More Likely Than Not

Assume the following assessment of probabilities:

(continued)

Accounting for Uncertain

Tax Positions

Case 3: Uncertain Tax Position—

NOT More Likely Than Not

Case 3: Uncertain Tax Position—

NOT More Likely Than Not

If the company completes Step 1 of the

analysis and determines that it is NOT more

likely than not that the tax position will be

sustained, then the entire amount of the

position must be recognized as a liability

Unrecognized Tax Benefit 100

Accounting for Uncertain

Tax Positions

earned over the next 20 years as a net

operating loss (NOL) carryforward

• A valuation allowance is used to reduce the asset if it is more likely than not that some

or all of the future benefits will not be

realized.

Financial Statement Presentation and Disclosure

The income statement must show, either in the body of the statement or in a note, the following components of income taxes related to

continuing operations

1 Current tax expense or benefit

2 Deferred tax expense or benefit

3 Investment tax credits

4 Government grants recognized as tax

reductions

(continued)

5 Benefits of operating loss carryforwards

6 Adjustments of a deferred tax liability or asset

for enacted changes in tax laws or rates or a change in the tax status of an enterprise

7 Adjustments in beginning-of-the-year

valuation allowance because of a change in circumstances

Financial Statement Presentation and Disclosure

Deferred Taxes and the Statement of Cash Flows

disclosure of the amount of cash paid for

income taxes during a period.

• This separate disclosure is required for just two items:

 Cash paid for income taxes

 Cash paid for interest

• Income taxes affect the Operating Activities section of the statement of cash flows.

(continued)

Income tax expense:

Cash collected from customers $30,000

The operating activities section of Collazo’s

statement of cash flows is as follows if the direct method is used

Deferred Taxes and the Statement of Cash Flows

Collazo Company Statement of Cash Flows (Partial)

(Indirect Approach)

Cash provided by operating activities:

If the indirect method is used, the amount of cash paid for income taxes, $13,300, must

be separately disclosed either in the SCF or

in the notes to the financial statements.

If the indirect method is used, the amount of cash paid for income taxes, $13,300, must

be separately disclosed either in the SCF or

in the notes to the financial statements.

Deferred Taxes and the Statement of Cash Flows

International Accounting

for Deferred Taxes

• No-deferral approach: Using this approach, the differences are ignored Income tax

expense equal to the amount of tax payable

for the year is reported

• Comprehensive recognition approach:

Deferred taxes are included in the computation

of income tax expense and reported on the

balance sheet The IASB has embraced this

approach

(continued)

• Partial recognition approach: Historically,

the United Kingdom employed this innovate

technique

• A deferred tax liability is recorded only to the extent that the deferred taxes are actually

expected to be paid in the future

• In recent years, this method has lost favor

internationally because it is so subjective

(relying heavily on management expectations about future events)

International Accounting

for Deferred Taxes