PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Accounting for Income Taxes

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McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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The Internal Revenue Code is the set of

rules for preparing tax returns.

Financial statement income tax expense.

IRS income taxes payable.

GAAP is the set of rules for preparing

financial statements.

Usually. . . Results in . . . Results in . . .

The objective of accounting for income taxes is to recognize a deferred tax liability or deferred tax assetfor the tax consequences of amounts that will become

taxable or deductible in future years as a result of transactions or events that already have occurred.

Deferred Tax Assets and Deferred Tax Liabilities

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Temporary Differences

This results in temporary

differences.

The difference in the rules for computing between pre-tax accounting income

(according to GAAP) and taxable income (according to the IRS) often causes

amounts to be reported in different years.

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Temporary differences will reverse in one or more future periods.

Temporary Differences

Accounting Income > Taxable Income

Future Taxable Amounts

Deferred Tax Liability

Accounting Income < Taxable Income

Future Deductible Amounts

Deferred Tax Asset

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Deferred Tax Liabilities

A temporary difference originates in one period and reverses, or turns around, in one or more subsequent periods.

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Deferred Tax Liabilities

Calculate income tax that is currently payable: $100 × 40% = $40

Calculate change in deferred tax liability: ($40 × 40%) = $16

Combine the two to get the income tax expense: $40 + $16 = $56

Income tax expense 56Income tax payable 40Deferred tax liability 16

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The FASB’s Balance Sheet Approach

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Types of Temporary Differences

Deferred tax liabilities result in taxable amounts

in the future.

Deferred tax assets result in deductible

amounts in the future.

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Deferred Tax Liabilities

A temporary difference originates in one period and reverses, or turns around, in one or more subsequent periods.

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Deferred Tax Liabilities

Calculate income tax that is currently payable: $92 × 40% = $36.8

Calculate change in deferred tax liability: ($25 - $33) × 40% = $3.2

Combine the two to get the income tax expense: $36.8 + $3.2 = $40

Journal entry at the end of 2011Income tax expense 40.0

Income tax payable 36.8Deferred tax liability 3.2

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Deferred Tax Liabilities

Calculate income tax that is currently payable: $81 × 40% = $32.4

Calculate change in deferred tax liability: (($25 - $44) × 40%)) = $7.6

Combine the two to get the income tax expense: $32.4 + $7.6 = $40

Journal entry at the end of 2012Income tax expense 40.0

Income tax payable 32.4Deferred tax liability 7.6

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Deferred Tax Liabilities

Calculate income tax that is currently payable: $110 × 40% = $44

Calculate change in deferred tax liability: (($25 - $15) × 40%)) = $4

Combine the two to get the income tax expense: $44 – 4 = $40

Journal entry at the end of 2013Income tax expense 40Deferred tax liability 4

Income tax payable 44

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Deferred Tax Liabilities

Journal entry at the end of 2014Income tax expense 40.0Deferred tax liability 6.8

Income tax payable 46.8

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Deferred Tax AssetsRDP Networking reported pretax accounting income in 2011, 2012, and 2013 of $70 million, $100 million, and $100 million, respectively. The 2011 income statement includes a $30 million warranty expense that is deducted for tax purposes when paid in 2012 ($15 million) and 2013 ($15 million). The income tax rate is 40% each year.

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Deferred Tax Assets

Calculate income tax that is currently payable: $100 × 40% = $40

Calculate change in deferred tax asset: $30 × 40% = $12

Combine the two to get the income tax expense: $40 – 12 = $28

Journal entry at the end of 2011Income tax expense 28Deferred tax asset 12

Income tax payable 40

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Deferred Tax AssetsJournal entry at the end of 2012 and 2013Income tax expense 40

Deferred tax asset 6Income tax payable 34

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Valuation Allowance

• A valuation allowance account is needed if it is more likely than not that some portion of the deferred tax asset will not be realized.

• The deferred tax asset is then reported at its estimated net realizable value.

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Permanent DifferencesCreated when an income item is included in taxable income or accounting income

but will never be included in the computation of the other.

Example: Interest on tax-free municipal bonds is included in accounting income but is never

included in taxable income.

Permanent differences are disregarded when determining both the tax payable currently and the

deferred tax asset or liability.

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U.S. GAAP vs. IFRS

• For example, U.S. GAAP requires a loss contingency be accrued if it is both probable and can be reasonably estimated. Accruing a loss contingency leads to a deferred tax asset.

Despite the similar approaches for accounting for income taxes under IFRS and U.S. GAAP, differences in reported amounts for deferred taxes are among the most frequent

between the two reporting approaches.

• For loss contingencies, IFRS uses a “more likely than not” threshold, which is lower than the U.S. “probable” requirement. As a result, under the lower threshold of IFRS, a loss contingency and a deferred tax asset sometimes is recorded for IFRS but not for U.S. GAAP.

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Tax Rate Considerations

• Deferred tax assets and liabilities should be determined using the future tax rates, if known.

• The deferred tax asset or liability must be adjusted if a change in a tax law or rate occurs.

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Multiple Temporary DifferencesIt would be unusual for any but a very small

company to have only a single temporary difference in any given year.

Categorize all temporary differences according to whether they create …

Future taxable amounts

Future deductible amounts

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Net Operating Losses (NOL)

Tax laws often allow a company to use tax NOLs to offset taxable income in earlier or

subsequent periods.

When used to offset earlier taxable income:

Called: operating loss carryback.

Result: tax refund.

When used to offset future taxable income:

Called: operating loss carryforward.

Result: reduced tax payable.

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Net Operating Losses (NOL)

Current Year

-1-2

Carryback Period

+3+2+1 . . . +20+4 +5

Carryforward Period

The NOL may first be applied against taxable income from two previous years.

Unused NOL may be carried forward for 20 years.

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Operating Loss Carryforward

Deferred tax asset 50Income tax benefit-operating loss 50

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Operating Loss Carryback

The carryback of the NOL must be applied to the earlier year first and then to the next year.

Any remaining NOL may be carried forward.

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Operating Loss Carryback

Receivable—income tax refund 29Deferred tax asset 20

Income tax benefit-operating loss 49

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Balance Sheet Classification

A deferred tax asset that is not related to a specific asset or

liability should be classified according to

when the underlying temporary difference

is expected to reverse.

Deferred tax assets/liabilities are classified as current or noncurrent based on the

classification of the related asset or liability.

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Disclosure NotesDeferred Tax Assets and Deferred Tax Liabilities

• Total of all deferred tax liabilities. • Total of all deferred tax assets.• Total valuation allowance

recognized.• Net change in valuation account.• Approximate tax effect of each

type of temporary difference (and carryforward).

Operating Loss Carryforwards• Amounts. • Expiration dates.

Income Tax Expense• Current portion of the

tax expense (or benefit).• Deferred portion of the

tax expense (or benefit) with separate disclosures of amounts attributable to several specific items.

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Coping with Uncertainty in Income Taxes

Two-step Decision ProcessStep 1. A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits.Step 2. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50 percent likely to be realized.

If the tax benefit is not “more likely than not,” then none of the tax

benefit is allowed to be recorded.

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Intraperiod Tax Allocation

Income Statement:• Income from continuing operations.• Discontinued operations.• Extraordinary items.

Other Comprehensive Income:• Investments. • Postretirement benefit plans.• Derivatives.• Foreign currency translation.

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U.S. GAAP vs. IFRS

• GAAP separately reports both discontinued operations and extraordinary items on the income statement and each are shown net of tax.

The approach for accounting for intraperiod tax allocation is the same under IFRS and U.S. GAAP, but the categories

used on the income statement are different.

• IFRS does not separately report extraordinary items on the income statement. As a result, the only income statement item reported separately net of tax using IFRS is discontinued operations.

End of Chapter 16