part six : accounting for enterprise income taxes
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Part Six : Accounting for Enterprise Income Taxes. Key Issues. Book (financial statement) vs. taxable income Permanent differences Effective vs. statutory tax rates Temporary (timing) differences Deferred taxes: Assets, Liabilities, Expense Possible cases and examples - PowerPoint PPT PresentationTRANSCRIPT
Part Six: Accounting for Enterprise Income Taxes
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Key Issues1. Book (financial statement) vs. taxable income2. Permanent differences3. Effective vs. statutory tax rates4. Temporary (timing) differences5. Deferred taxes: Assets, Liabilities, Expense6. Possible cases and examples7. Components of income tax expense (current vs
deferred) 8. Tax journal entries9. Originating vs reversing differences10. Asset, Liability (B/S) method vs I/S method11. NOL carryback and carryforward12. Deferred tax asset valuation allowance13. Footnote disclosures:
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3 Parts of Tax Disclosure1. 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.
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Key Identity Pre-tax book (accounting) income
± Permanent differences
± Temporary differences
= pre-tax taxable income
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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. interest income on municipal bonds)
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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
ex. E13-7, E13-8 (Kent)
tax expense
pre-tax (book) income
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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?
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4 Possible Types of Timing Differences
Revenues Expenses
recognize for books before taxes
1. Accrued (asset) revenue
3. Accrued (liab) expense
recognize for taxes before books
2. Deferred (unearned) revenue
4. Deferred (prepaid) expense
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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 CRCash 100 A/R 100 Cash 100 Rev
100
Note: total revenue is the same, just timing differs
period 1:
period 2:
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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 CRLiab 100 Rev 100 N/A
Note: total revenue is the same, just timing differs
period 1:
period 2:
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Ex. 3. accrued liability, payable
Books = accrual accounting Taxes = cash accounting DR CR DR CR Exp 100
Liab 100 N/A
DR CR DR CRLiab 100 Cash 100 Exp 100 Cash
100
Note: total expense is the same, just timing differs
period 1:
period 2:
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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 CRExp 100 Asset 100 N/A
Note: total expense is the same, just timing differs
period 1:
period 2:
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Timing Differences: Relation to Deferred Tax Assets, Liab.
Revenues Expenses
recognize for books before taxes
1. Deferred tax liability
3. Deferred tax asset
recognize for taxes before books
2. Deferred tax asset
4. Deferred tax liability
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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 expenseb CR Deferred tax asset/liability
b) Deferred tax expense =
net in deferred tax asset/liability
Assumes positive taxable income
1. current (pay now); and2. deferred (paid before or after)
can DR or CR deferred tax expense, depending on net deferred tax asset/liability
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Components of Tax Expense (cont’d)
Alternatively,3. DR total tax expensec
CR Deferred tax asset/liabilityCR Cash
c) Total tax expense = current + deferred
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Deferred Tax Accounting = Inter-period Tax Allocation
Total income tax expense =
Current (paid now) +Deferred (paid both before or after)
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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)
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Examples of Deferred Tax Assets/Liab1. 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 in a later period, when the receivable is actually written off.
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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.
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Calculation of Deferred Tax Expense, Asset, Liability: B/S Method1. deferred tax asset/liability = cumulative timing difference *
STR2. 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
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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.
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Intuition 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
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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)
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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.
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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
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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 expenseCR 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.
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
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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
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Financial Statement Disclosures (cont’d)
3a. components of deferred tax assets and liabilities
and/or3b. 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.)