1Income Taxes I. General Objectives A. Matching Provide a proper matching ofearnings and income tax expense This means the financial statements convey an accurate picture of the relationship between earnings and the cash actually paid out for income taxes B. Recognition and Valuation Report on the Balance Sheet 1. Current Year Cash Flows for Taxes a. Tax Refund Receivable b. Tax Payable 2I.B. Recognition and Valuation (continued) 2. Future Years Tax-Related Cash Flows (Out/In) a. Business events that have already occurred and are recorded in financial income

i.Tax law excludes event from incomeuntil later ii. Example: Credit Sales GAAP records when revenue earned Event taxed when cash isreceived Causes Deferred Tax Liability(similar to an accrued tax payable) b. Business events that have already occurred and are recorded in taxable income i.GAAP excludes event from income untillater ii. Example: Rent Collected In Advance GAAP does not record income until earned Event taxed when cash is received Causes Deferred Tax Asset (similar to a prepaid tax)

3I. C.Disclosure 1. Disclose components of tax expense\benefit

a. Current portion Total Tax From currentyear tax return

b. Deferred portion Change in deferred tax accounts during the year 2. Allocate total tax expense to - a. Income Statement

i. Operations ii.Extraordinary Items iii. Discontinued Operations b. Statement of Retained Earnings i. Retroactive Adjustment to RE for Effect of Change in Accounting Principle ( effect of accounting changes on tax liab. ) 4II. Background Information A. Most firms keep at least 2 sets of records 1. Financial Reporting a. GAAP rules followed Revenues recorded when earned Expenses recorded when incurred b. Publish financial statements c. Compute: Pretax Financial Income (PFI) 2. Federal tax return a. Federal tax law followed (cash basis taxpayer) Revenues taxable when cash collected Certain revenues are not taxable (ever) Expenses deductible when cash paid Certain expenses are not deductible (ever) b. File tax return (Form 1120 for corporations) c. Compute: Taxable Income (TI) Note: Tax Records are maintained for each jurisdiction (State or Country) that imposes an income tax. So a company will actually maintain more than 2 sets of records. In this class we will limit our discussion toGAAP basis records and Federal tax records.5II. B.Accounting Problem 1. Differences in GAAP and Tax Law result in Pretax Financial Income Taxable Income 2. Result Actual cash paid for taxes in a given year does not usually provide a good matching between PFI and Tax Expense 3. Types of Differences a. Permanent Nature of the item (rev. or exp.) is such that over the life of the firm cumulative PFI cumulative TI. (difference never reverses out) Examples:Nontaxable interest income Nondeductible fines b. Temporary - Nature of the item (rev. or exp.) is such that over the life of the firm cumulative PFI = cumulative TI (difference reverses out) Examples:Revenue earned but not collected Revenue collected but not earned Expenses incurred but not paid Expenses paid but not incurred 6II.B. 4. Significance of Type of Difference a.Permanent Difference Do not cause Taxes Paid to yield a misleading relationship between PFI and Tax Expense Result: Acceptable Matching

b.Temporary Differences Cause Taxes Paid to yield a misleading relationship betweenPFI and Tax Expense Result: Poor Matching Note: If all differences between PFI and TI were permanent differences, then Total Tax from the tax return would be a good measure of financial Tax Expense7II.B. 5. Example: Temporary Difference For year ended December 31, X1 Jones Co. had sales as follows: Cash = $100 Credit= $80 Total Sales= $180 Expenses paid (in cash) during year = $40 At year end the credit sale has not been collected Federal Tax Law (Cash Basis Taxpayer) Revenue reported on tax return (taxed) when cash is received Note: This provision of Tax Law makes the uncollected credit sale aTemporary Difference. Expenses reported on tax returnwhen cash ispaid out Tax rate is a flat 50% for the current and all future years 8II.B. 5. Example: Temporary Difference(continued) Tax Return Year X1:Federal Tax Law Taxable Sales100 Deductible Expenses(40) Taxable Income 60 Tax at 50%x .50 Federal Tax30 If we use Tax Paid as Tax Expense Income Statement Year X1 GAAP Sales180 Expenses(40) Pretax Financial Income 140 Tax Expense(30) Net Income 110 Question:Do we really expect Tax Expenseto be21% (30/140) of PFI in future? Answer:No... When the Credit Sale is collected Federal Taxes will increase significantly! Result:This Income Statement presents a misleading relationshipbetween PFI and Tax Expense 9II.B. 6. Example: Permanent Difference For year ended December 31, X1 Jones Co. had sales as follows: Cash = $100 Credit= $80 Total Sales= $180 $100 Jones Co. owns municipal bonds andreceived in cash (nontaxable) interest = $80 Expenses paid (in cash) during year = $40 At year end the credit sale has not been collected Federal Tax Law (Cash Basis Taxpayer) Revenue reported on tax return (taxed) when cash is received Interest earned on municipal bonds is notsubject to tax (ever). Note: This feature of Tax Law makes the $80 of interest income a Permanent Diff. Expenses reported on tax returnwhen cash ispaid out 10II.B. 6. Example: Permanent Difference(continued) Tax Return Year X1:Federal Tax Law Taxable Sales100 Deductible Expenses(40) Taxable Income 60 Tax at 50%x .50 Federal Tax30 If we use Tax Paid as Tax Expense Income Statement Year X1 GAAP Sales100 Interest Income80 Expenses(40) Pretax Financial Income 140 Tax Expense(30) Net Income 110 Question:Do we really expect Tax Expenseto be21% (30/140) of PFI in future? Answer:Yes... Because the Interest Income is not taxable (ever)! Result: This Income Statement presents anaccurate picture of the relationshipbetweenPFI and Tax Expense 11 II. C.Solution to Problem Caused by Temporary Diff. 1. Interperiod Tax Allocation a. Definition The process of estimating actual taxes that will be paid over multipleyearsandthen allocating the totalback toindividual years to achieve a proper matching of earnings (PFI)and taxes(Tax Expense) 12 II. C.Solution to Problem Caused by Temporary Diff. 1. Interperiod Tax Allocation b. Strategy -For events that have occurred i. Calculate actual taxes for current year (from current tax return) Record as: Tax Payable (cr) Tax Refund Receivable (dr) ii.Estimate future cash outflows for taxes arising from amounts taxable on future tax return (Future Taxable Amounts)

Record as: Deferred Tax Liability (cr) (like tax payable) iii. Estimate future reductions in cash outflows for taxes arising from amounts deductible on future tax return (Future Deductible Amounts)

Record as: Deferred Tax Asset (dr) (like prepaid tax) 13II.C.1. c. How to calculate amounts i.Actual Taxes for Current Year Complete Federal Tax Return ii.Future Tax Cash Flows Attributable to Temporary Differences Identify if the business transaction creates a future taxable amount (FTA) orfuture deductible amount (FDA) (Need this information since a taxable amount [revenue] causes a cash outflow while a deductible amount [expense] yieldsa reduction in cash outflow Determine (estimate) when the revenue difference or expense difference will appear on a future tax return (Need this information to determine the correct tax rate to use since tax rates varyby tax year) 14II.C.1.c. ii. Future Cash Flows (calculating) Calculate the incremental cash flow that will be caused by the revenue difference or expense difference when it appears on the future tax return Estimated RevenueTax= Future Tax Differencex RatePayment (DTL) Estimated ExpenseTax= Reduction in Difference xRateFuture Tax Payments (DTA) Note 1:Use the tax rate that will apply on the future taxreturn based on current law (ignore proposed changes in law) Note 2:Incremental means the additional cash flows for taxes, over and above those already included on the tax return (Total Tax) of the current and prior years. Note 3:When estimating future cash flows we do not include those that will arise in future businessactivity. We only consider business events that have already occurred.15II.C. 2. Example: Interperiod Tax Allocation forJones Co. (first set of facts) Temporary Difference is: Credit Sale of $80 Next year (Year X2) when collected Jones will pay taxes of:.50 x $80 =$40 So... We have an estimated future tax payable related to this Temporary Difference This estimated future tax payable is recordedas a Deferred Tax Liability The Year X1 journal entry is: [From Year X1 Tax Return] Tax Payable 30Get B/S Deferred Tax Liability 40CorrectTax Expense70 [plug] Notice the strategy here is to get theBalance Sheet accounts correct and then compute Tax Expense as the balancing amount. This is called the Asset/Liability Method 16II.C. 2. Example: Interperiod Tax Allocation (continued) So Year X1 Income Statement GAAPis:

Sales180 Expenses(40) Pretax Financial Income 140 Tax Expense(70) Net Income 70 Now.... We have a proper matching of PFI and Tax Expense. Caution: In the above example another way to calculate the Tax Expense would appear to be Tax Expense = Tax RatexPFI =.50 x140 = 70 Problem: This simplified approach to calculating Tax Expense will not reliably calculate the correct amount of Tax Expense because of o Variations in tax rates across years o Presence of Permanent Differences o Time limits for certain deductions 17III. More Complex Example of Interperiod Tax Allocation A. Facts: Chelsea Inc. Pretax Financial Income (GAAP)Year 1 Year 2 Year 3Revenues Cash Sales100 130 130 Credit Sales30 0 0130 130 130Expenses(60) (60) (60)Pretax Financial Income 70 70 70

Taxable Income (Tax Law) Year 1 Year 2 Year 3Cash Revenues From: Current Year Sales100 130 130Credit Sales of Prior Yrs.0 20 10100 150 140Expenses(60) (60) (60)Taxable Income 40 90 80Tax Liability at 40% 16 36 32 Question: What amounts should be reported as Tax Expense each year?

18III. B.Solution to Chelsea Inc. 1. Year 1 We will use a worksheet format to help calculate current period taxes and future cash flows for taxes This worksheet presents a reconciliation between PFI and TI This reconciliation helps to identify all Temporary and Permanent Differences Note 1: In this reconciliation, each item is the difference between the financial record amount and the amount for tax purposes Note 2: Students often have difficulty determining the correct sign of reconciling items. So ... I offer the following cookbook rule. Sign of Reconciling Item is Comparison ofCurrent Year Financial Amount versus Tax Return Amount For RevenuesFor Expenses Financial Amount Larger-+ Tax Return Amount Larger +- 19III. B.Solution to Chelsea Inc. 1. Year 1 (continued) Future YearsCurrent Year 1Year 2Year 3 Pretax Financial Income70 Reconciling Items: Credit SalesO(30)FTA R20 FTAR10 Taxable Income40Tax Rate x . 40 x . 40x . 40Income Tax 16 84Less: Payments(0)Tax Payable 16FTA= Future Taxable Amount O=Originating Difference R=Reversing Difference [Year end BS balances] Note 1: Reconciling items are always the difference between the amount for Financial purposes and the amount for Tax purposes. Note 2: In the first year that a Temp. Diff. arises, the sumof the originating and reversingdifferences is 0 (as in the above example)

20III. B.Solution to Chelsea Inc. 1. Year 1 (continued) Calculation of AJE amounts Tax PayableDeferred Tax Liability Desired G/L Balance16 cr 12 crUnadjusted G/L Balance0 cr 0 crAJE amount 16 cr 12 cr AJE: Tax Payable16[from above] Deferred Tax Liability12[from above] Tax Expense 28[plug] 21III. B.Solution to Chelsea Inc. 2. Year 2

Future YearsCurrent Year 2Year 3 Pretax Financial Income70 Reconciling Items: Credit SalesR20FTA R10 Taxable Income90 Tax Rate x . 40 x . 40 Income Tax 36 4 Less: Payments(0)Tax Payable 36FTA= Future Taxable Amount R=Reversing Difference [Year end BS balances] Note 1: Reconciling items are always the difference between the amount for Financial purposes and the amount for Tax purposes. 22III. B.Solution to Chelsea Inc. 2. Year 2 (continued) Assume: Year 1 taxes were paid Calculation of AJE amounts Tax PayableDeferred Tax Liability Desired G/L Balance36 cr 4 crUnadjusted G/L Balance0 cr 12crAJE amount 36 cr 8 dr AJE: Tax Payable36[from above] Deferred Tax Liability8 [from above] Tax Expense 28 [plug] 23III. B.Solution to Chelsea Inc. 3. Year 3

Future YearsCurrent Year 3 Pretax Financial Income70 Reconciling Items: Credit Sales 10 Taxable Income80 Tax Rate x . 40Income Tax 32Less: Payments(0)Tax Payable 32 [Year end BS balance]

Note 1: Reconciling items are always the difference between the amount for Financial purposes and the amount for Tax purposes.

Note 2: At the end of Year 3 the company has nofuture taxable or future deductible amounts. Hence, there is no longer a need for any deferred tax balances on the Balance Sheet. 24III. B.Solution to Chelsea Inc. 3. Year 3 (continued) Assume: Year 2 taxes were paid Calculation of AJE amounts Tax PayableDeferred Tax Liability Desired G/L Balance32 cr 0 crUnadjusted G/L Balance0 cr4 cr AJE amount 32 cr 4 dr AJE: Tax Payable32[from above] Deferred Tax Liability4 [from above] Tax Expense 28 [plug] 25III. C.Recap of 3-year results Year 1 Year 2 Year 3Total All Years Taxes Paid16363284 Tax Expense28282884 PFI707070 Comments: 1. Cumulative Taxes Paid = 84 (this is reality) 2. Cumulative Tax Expense = 84 3. Relationship betweenTax Expense and PFI makes sense Every year that has the same PFI should have thesame expense (assuming same tax rate)26IV. Accounting for Net Operating Losses (NOL) A. Definition: NOL = Negative Taxable Income (loss) for a specific year B. Treatment Under Federal Tax Law 1. Pay no taxes in loss year 2. Firm Permitted to Carryforward Loss a. Reduce taxes owed in future years i.Deduction Claimed on form 1120-Line 29 b. Current Federal Law i. Carryforward period is 20 years (maximum) ii.Must start with nearest year and work forward until loss is fully offset by TI or carryforward period expires

27IV.B. 3. May Elect to Carryback Loss a. Claim a refund of prior taxes paid i.File amended return for each prior year, or ii. File form 1139 (best approach) b. Current Federal Law i.Carryback period is 2 years ii. Must start with earliest year first and workforward until loss is fully offset by TI or carryforward period expires

28IV. C.Accounting Treatment of NOL in Loss Year 1. For Carryback a. Record income benefit of the tax refund i. Benefit Due To Loss Carryback (cr) ii.This is the expected cash inflow from the refund claimed iii. Report as Negative Tax Expense iv. Calculation of refund amount - CarrybackxTax Rate in Effect Amountfor Prior Tax Returns

b. Record as an asset i.Income Tax Refund Receivable(dr) ii.This is the amount of the tax refund claimed 29IV.C.1. (Accounting for NOL Carryback) c. Journal Entry Income Tax Refund ReceivableX Benefit Due To Loss CarrybackX [A component of Tax Expense]30IV. C.Accounting Treatment of NOL in Loss Year 2. For Carryforward a. Record maximum income benefit of claiming NOL CF on future tax returns i. Benefit Due To Loss Carryforward (cr) ii.This is a the tax savings (reduction in future cashoutflows for taxes) from using the remaining carryforward assuming all of the CF is used (none of the CF expires) iii. Report as Negative Tax Expense iv. Calculation of maximum benefit amount - Tax xTax Rate in Effect CarryforwardWhen CF Claimed Amount on future Tax Return Note: The tax rate used in this calculation is the rate which is specified in currently enacted law. Proposed or expected changes in future tax rates are not considered.31IV.C.2. b. Record as an asset i.Deferred Tax Asset (dr) ii.This is the maximum tax savings from using the NOL CF on future tax returns Note: DTA is recorded only when there is an existing Temporary Differencebetween Financial records and Tax records. Question:What Temporary Difference Exists? Answer:For Financial purposes the firm records all the expected income benefit of the CF in the lossyear (CF used up) For Tax purposes, none of the CF income benefit is claimed on the loss year tax return Tax use of the CF must wait until income is earned and future tax returns are filed

This creates a Temporary Difference in the amount of the CF used forFin. purposes versus Tax Purposes 32IV.C.2. c. Journal Entry

Deferred Tax AssetX Benefit Due To Loss CarryforwardX [A component of Tax Expense] 33IV.C.2. d. Reduce DTA to Expected Value if needed i.If it is More likely than not that some portion of the CF benefit will expire before use ii.Estimate how much of the tax savings from the CF will not be used in the carryforward period

iii. Calculation CarryforwardxTax Rate in Effect AmountWhen CF Claimed Lost on future Tax Return iv. Journal Entry Benefit Due To Loss CarryforwardX Allowance to Reduce DTA to Expected Realizable Value X [Contra-Asset account] 34IV. D.Accounting Treatment of NOL After Loss Year 1. Strategy - At the end of each year update estimated values of the DTA and Allowance . 2. For DTA a.Estimate the maximum future tax savings from using the remaining CF on future tax returns b.Adjust the DTA to the estimated maximum value Note: As the CF is used on the Tax Return the Temporary Difference between the Financial and Tax Carryforwards will diminish. This will require a reduction in the DTA. c. Journal Entry Deferred Tax Expense XX Deferred Tax AssetXX Company has expense because it has used up an asset --- the DTA35IV.D. 3. For the Allowance account a.Estimate how much of the tax savings from the remaining CF will expire in the remaining carryforward period b.Adjust the Allowance account to the amount of the tax savings that is expected to be lost. Note: This adjustment might increase or reduce the allowance depending on the circumstances 36IV.D.3. c. Journal Entry i. Allowance Decreases Allowance to reduce. XX Adjustment to Tax Expense for change in ValuationAllowance of DTAXX [A part of Tax Expense] ii. Allowance Increases Adjustment to Tax Expense for change in Valuation Allowance of DTA XX Allowance to reduce XX 37IV. E. NOL Example 1. Facts:Operations began in Year X1 No Temporary Differences Exist No Permanent Differences Exist At X4 future income highly uncertain Tax law carryback period = 2 years Year TI or Loss (also PFI) Tax RateTax Paid X150 .35 17.5 X2100 .30 30.0 X3200 .40 80.0 X4(500) .45 0 X5? .40 ? 2. Loss Year: X4 a. JE for Carryback With loss of (500) company elects to carryback. Start with X2 and work forward. Refund Claimed: X2 = 30 X3 = 80 110 Entry: Income Tax Refund Receivable110 Benefit of NOL Carryback 110 38IV.E.2. Loss Year: X4 (continued) b. JE for Carryforward Carryback used up 300 of NOL Remaining NOL CF is 200 If used on X5 Tax Return benefit = .4 x 200 = 80 GAAP requires booking of maximum benefit whether or not we expect to realize the maximum benefit. Entry:

Deferred Tax Asset 80 Benefit of NOL Carryforward 80 Note: If we do not expect to utilize the maximum benefit we will establish an Allowance to reduce the DTA to the expected benefit.39IV.E.2. Loss Year: X4 (continued) c. JE for Allowance Account Since future income is highly uncertain There is significant doubt that any benefit attributable to the NOL CF will be realized So the realizable value of the DTA may be much less than its recorded amount ($80) Company needs to fully reserve the DTA with an Allowance This means reduce the DTA to its expected realizable value via use of an Allowance Entry: Benefit due to NOL Carryforward 80 Allowance to Reduce DTA to Expected Realizable Value80 40IV.E.2. Loss Year: X4 (continued) d. Financial Statement Presentation i.12-31-X4 Balance Sheet Income Tax Refund Receivable110 Deferred Tax Asset80 Allowance to reduce DTA to Expected Realizable Value(80) 0 ii. Income Statement Operating loss before income tax (500) Income Tax Benefit110 Net Loss (390) 41IV.E.2. Loss Year: X4 (continued) d. Financial Statement Presentation iii. Footnote Disclosure Calculation of Deferred Tax Expense\Benefit DTA Allowance to Reduce DTADTLNet Ending Balance80 dr 80 cr 0 cr0 crBeg. Balance0 dr 0 cr 0 cr0 drChange0 cr A net 0 change means deferred taxexpense\benefit = 0 42IV.E.2. Loss Year: X4 (continued) d. Financial Statement Presentation iii. Footnote Disclosure Components of Tax Expense: ComponentAmount Current Tax Expense before Use of NOL CB 0 Tax Benefit of NOL CB110 Current Tax Benefit110 Deferred Tax Benefit0 Total Income Tax Benefit 110 Note: If the company had been confidentthat the full benefit of the CF would be realized on future tax returns thenthere would have been no need for theAllowance to reduce the DTA to its expected realizable value. In that case, there would have beena net dr increase in the deferred taxaccounts during the year and the company would report a deferred taxbenefit (due to NOL CF) of $80. This benefit would represent the expected tax savings on future tax returns from using the NOL CF.43IV.E. 3. Year following Loss Year: X5 a. Facts: At start of year - Unused NOL CF is 200 Additional Facts: PFI =TI = 250 income Tax law carryforward period = 20 years b. Journal Entries Calculation of Current and Deferred Tax Amounts

Current YearX5 Future Years PFI250 Temp. Diff 0 TI (before use of NOL CF)250 NOL CF used on tax return(200) TI50 Tax rate for Year X5 X .40 Tax 20 Less: Payments (0) Tax Payable 20 Note: Carryforward is used up so no need for the DTA orAllowance to reduce DTA (no future benefit) 44IV.E.3.b. Journal Entries for X5 Calculation of X5 Year End AJE DTA Allowance To Reduce DTADTL Tax PayableTemp. Diff.- - - Tax Owed20 crDesired Balance0 dr 0 cr 0 cr20 crUnadjusted Bal.80 dr 80 cr 0 cr0 crAJE Amount80 cr 80 dr 0 cr20 cr Year End Entries: DTA 80Adjust Allowance to reduce DTA80Accounts Tax Payable20 Tax Expense 20 [plug] 45IV.E.3. Year following Loss Year: X5 c. Financial Statement Presentation i.12-31-X5 Balance Sheet Income Tax Payable 20 ii. Income Statement Operating income before income tax250 Income Tax Expense( 20) Net Income230 46IV.E.3. Year following Loss Year: X5(continued) c. Financial Statement Presentation iii. Footnote Disclosure Calculation of Deferred Tax Expense\Benefit DTA Allowance to Reduce DTA DTLNet Ending Balance0 dr 0 cr 0 cr0 crBeg. Balance80 dr 80 cr 0 cr0 drChange0 cr Note: Net change of 0 means deferred tax expense=0 Components of Tax Expense: ComponentAmountComment Current Tax Expense before Use of NOL CF 100 .4 x 250 Tax Benefit of CF(80) .4 x 200 Current Tax Expense20Deferred Tax Expense0Total Income Tax Expense 2047V. Accounting for Tax Credits A. Description -Federal Law provides a direct reduction in income taxes if firm purchases certain assets, hires certain employees, or engages in activities encouraged by the Federal government If entire credit cannot be used, the unused portion can be used on future tax returns 1. Investment Tax Credit Example a. Tax Law - If firm purchases new PPE that meets certain requirements of law, firm receives a credit on income taxes b. Example:Tax Credit Rate = 10% Qualifying purchase = $1,000 Credit =.10 x 1,000= $100 So tax liability in year PPE purchased is reduced by $10048V. B. Alternative Accounting Methods 1. Flow-Through Method - a. Firm treats credit as reduction of tax expensein year credit earned and adjusts JE to record taxes payable b. Most common method used due to simplicity c. Example -Income Tax before credit =$500 Credit= ($100) Net Owed=$400 Journal Entry - Tax Expense400 Income Tax Payable400 49V. B. Alternative Accounting Methods 2. Deferred Method a. Firm prorates the reduction in tax expense over the life of the asset whose purchase led to the credit being earned Theory - Credit is really a reduction in the priceof the asset (but not recorded as such) So cost of using asset each year has been reduced, and this benefit shouldbe spread over asset life to get proper matching. b. Method preferred by FASB due to belief that it provides a better matching 50V. B. Alternative Accounting Methods 2. Deferred Method c. Example -Income Tax before credit= $500 Credit = ($100) Net Owed =$400 Credit relates to PPE with 10 yr life Set up Journal Entry (1st year only) - Tax Expense500 Deferred Tax Credit 100 Income Tax Payable400 Yearly AJE to Tax Expense (for life of asset) Deferred Tax Credit10 Deferred Tax Expense10 [Reduces DTC][Reduces Tax Expense] 51V. Accounting for Tax Credits C. Accounting When Entire Credit Cannot Be Used 1. Description - Taxable Income is too low in the year thecredit is earned, so the companycannot fully use the benefit of the tax credit in the year earned 2. Example:ABC Co. earns $100 credit in year X1 X1 taxable income = $80 Tax Rate= x .50 Tax before credit = $40

Credit Usedin X1 = (40) Final X1 tax liability =0 Tax credit carryforward=$ 60 [Future reduction in cash outflow]52V. Accounting for Tax Credits

C. Accounting When Entire Credit Cannot Be Used 3. Expected future cash flow benefit of unusedtax credit is recorded as a Deferred Tax Asset and Tax expense on the Income Statement is reduced to reflect the expected benefit of the tax credit Note: The general ledger account for the expected future benefit of the tax credit is - Benefit of Tax Credit Carryforward 4. Journal entries i.Year credit earned record DTA Deferred Tax Asset60 Benefit of Tax Credit Carryforward60 [Negative Tax Expense] 53V.C.4. Journal Entries (continued) ii. Future years As credit is used on tax return reduce DTA and record corresponding increase in Deferred Tax Expense Example:ABC Co. has X2 income of $70 X2 taxable income = $70 Tax Rate= x .50 Tax before credit = $35

Credit Usedin X2 = (35) Final X2 tax liability =0 Tax credit carryforward=$ 25 Deferred Tax Expense 35 Deferred Tax Asset35 So X2 Income Statement is ... Income before Tax$70 Income Tax Expense (35) Net Income $35 54VI. Miscellaneous Issues

A. Tax Rates Used in Calculations The measurement of current and deferred taxliabilities and assets is based on provisions of the enacted tax law; the effects of future changes intax laws or rates are not anticipated.

B.Discounting Amounts of Deferred Taxes The deferred tax liability or asset shall not beaccounted for on a discounted basis.

C. Computation of Deferred Tax Expense Deferred tax expense or benefit is the changeduring the year in an enterprise's deferred tax liabilities and assets.

D. Computation of Total Tax Expense Total income tax expense (or benefit) for the yearis the sum of deferred tax expense (or benefit)andthe total tax (payable or refundable) from the income tax return. 55VI. Miscellaneous Issues

E. Accounting for Change in the BeginningValuation Allowance 1.The effect of a change in the beginningbalance of a valuation allowance that results froma change in circumstances(tax rates, expected future income, etc.) that causes a changein judgment about therealizability of the related deferred tax asset in future years ordinarily shall be included inincome from continuing operations. 2.This will be reported as a separate component of tax expense.

Note: This just means treat the adjustment as a change-in-estimate and record in current year income Do not restate prior years recorded amounts 56VI. Miscellaneous Issues F. Accounting for an Enacted Change in Tax Lawor Rates 1. Deferred tax liabilities and assets shall be adjusted for the effect of a change in tax laws orrates. 2. The effect shall be included in income fromcontinuing operations for the period that includesthe enactment date. 3. This will be reported as a separate component of tax expense Note: If tax rates change, this means that the DTAs and DTLs will change. Treat such changes as a change-in-estimate and record in current year income.57VI. Miscellaneous Issues G. Procedures for Identifying Temporary and Permanent Differences 1. Do a reconciliation between PFI and TI 2. ConsultSchedule M-1 on tax form 1120 and other tax records

58VI. Miscellaneous Issues H. Balance Sheet Presentation 1. An enterprise shall separate deferred tax liabilitiesand assets into a current amount and anoncurrent amount. 2. Deferred tax liabilities and assets shall be classified as current or noncurrent based on theclassification of the related asset or liability forfinancial reporting. 3. A deferred tax liability or asset that is not related to an asset or liability for financial reportingincluding deferred tax assets related tocarryforwards, shall be classified according to the expected reversal date. 4. The valuation allowance for a particular tax jurisdiction shall be allocated between current and noncurrent deferred tax assets for that taxjurisdiction on a pro rata basis. 59VI. Miscellaneous Issues H. Balance Sheet Presentation (continued) 5. For a particular tax-paying component of anenterprise and within a particular tax jurisdiction, a. All current deferred tax liabilities and assets shall be offset and presented as a single amount and b. All noncurrent deferred tax liabilities and assetsshall be offset and presented as a single amount. 60VI. Miscellaneous Issues I. Income Statement Presentation 1. The significant components of income taxexpense shall be disclosed in thefinancial statements or footnotes.Those componentswould include, for example: a. Current tax expense or benefit b. Deferred tax expense or benefit(exclusive of the following components) c. Investment tax credits d. The benefits of operating loss carryforwards e. Adjustments of a deferred tax liability or assetforenacted changes in tax laws or rates or achangein the tax status of the enterprise f.Adjustments of the beginning-of-the-yearbalance of a valuation allowance because of achange incircumstances that causes a change in judgment about the realizability of the relateddeferred tax asset in future years.

61VII. Steps in Recording Tax Expense A. Prepare reconciliation between PFI and TIto identify Temporary and Permanent Differences B. Use the reconciliation as a basis for computing the desired year end balances in: 1. Income Tax Refund Receivable 2. Income Tax Payable 3. Deferred Tax Accounts (current and noncurrent) a. Deferred Tax Asset b. Allowance to Reduce DTA to Expected Realizable Value c. Deferred Tax Liability C.Compute the year end adjusting journal entry by differencing the desired and unadjusted G/L balances D. Compute the amount of deferred tax expense by differencing the beginning and ending deferred tax accounts