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Accounting for corporate income taxes

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					Chapter 17: Accounting for corporate
income taxes

                     Motivation
         Temporary and permanent differences
                   Deferred taxes
         A. Future taxable amounts and deferred taxes
        B. Future deductible amounts and deferred taxes
          Accounting for net operating losses



                                                          1
Motivation

   differences between tax rules and financial reporting
   rules
      significant effects of corporate taxation on financial
      reporting matters
      basic understanding of corporate taxation in different
      countries needed to make comparisons

Financial income                            Taxable income
- determined according to         vs.       - tax rules are relevant
  financial reporting rules                 - income tax payable
- income tax expense

                    Accounting for income taxes
                    - determine taxes payable/refundable
                    - recognize deferred taxes
                                                                       2
   Example
             Big Orange Inc. - Financial reporting numbers

                                  2000         2001          2002       2003    Total

Revenues                      € 300.000    € 300.000   € 250.000    € 250.000
Expenses                       220.000      220.000      170.000     170.000
Pretax financial income        € 80.000     € 80.000    € 80.000     € 80.000   € 320.000

Income tax expense (35%)       € 28.000     € 28.000    € 28.000     € 28.000   € 112.000


             Big Orange Inc. - Tax reporting numbers

                                  2000         2001          2002       2003    Total

Revenues                      € 250.000    € 250.000   € 320.000    € 280.000
Expenses                       220.000      220.000      170.000     170.000
Taxable income                 € 30.000     € 30.000   € 150.000    € 110.000   € 320.000

Income tax payable (35%)       € 10.500     € 10.500    € 52.500     € 38.500   € 112.000

                                                                                        3
 Differences between income tax expenses and income
 taxes payable usually offset each other over time:

Comparison of income tax expenses and income taxes payable; Big Orange Inc.

                        2000        2001         2002        2003      Total

Income tax expense     28.000      28.000      28.000       28.000     112.000

Income taxes payable   10.500      10.500      52.500       38.500     112.000

Difference             17.500      17.500      -24.500     -10.500             0




     Offsetting property holds only if differences between
     financial income and taxable income are temporary.




                                                                               4
Temporary vs. permanent differences

 „difference“ between tax basis of an asset or liability
 and its reported (carrying or book) amount in the
 financial statements
    gives rise to differences between financial income and
    taxable income
    differences can be temporary or permanent
 Temporary difference
    difference is reversed over time
    results in taxable amounts or deductible amounts
    Taxable (deductible) amounts increase (decrease) future
    taxable income
 Permanent difference
    difference does not reverse over time; no deferred taxes

                                                               5
   Temporary vs. permanent differences
  Temporary differences
1 Revenues or gains are taxable after they are           3 Revenues or gains are taxable before
   recognized in financial income                           they are recognized in financial income
  - accounts receivable                                    - payments received in advance
  - investments (equity vs. cost method)
2 Expenses or losses are deductible after                4 Expenses or losses are deductible before
    they are recognized in financial income                  they are recognized in financial income
  - product warranty liabilities                           - tax depreciation faster than
  - litigation accruals                                          accounting depreciation
  - bad debt expense (allowance vs. direct                 - prepaid expenses
        write-off method)


  Permanent differences
1 Items are recognized for financial reporting           2 Items are recognized for tax purposes
    purposes but not for tax purposes                         but not for financial reporting purposes
  - interest received on state obligations                 - "percentage depletion" of natural resources
  - fines and expenses resulting from violation of law          in excess of their cost



                                                                                                           6
Deferred Taxes

 result from temporary differences between book
 basis and tax basis of an asset or liability
 accounting for deferred tax is the recognition of the
 tax implied by the valuation of the assets and
 liabilities included in the balance sheet
    it‘s not amounts of tax bills that the tax authorities have
    allowed the taxpayer to postpone or have asked for in
    advance




                                                                  7
               Asset                    Liability      Asset                    Liability



             tax value                 tax value     tax value                 tax value
                 >                         <             <                         >
              carrying                  carrying      carrying                  carrying
              amount                    amount        amount                    amount



Example:      Accounts                  Certain       Plant and                  Certain
           receivable, net            accruals and   equipment,                long-term
            of allowance               provisions        net                    liabilities



                         Deductible                              Taxable
                    temporary differences                  temporary differences



                       Deferred tax asset                  Deferred tax liabilitiy

                                                                                         8
Future taxable amounts and deferred tax
liabilities
A deferred tax liability represents the increase in taxes payable in future
years as a result of taxable temporary differences existing at the end of the
current year.


   taxable temporary difference
   deferred tax liability
   Computation of deferred tax liability
   1. book basis of asset – tax basis = cumulative temporary
      difference
      tax basis of liability – book basis = ctd
   2. cumulative temporary difference x enacted tax rate =
      deferred tax liability




                                                                                9
   Computation of income tax expenses

Total income tax expense            Income tax payable       +             Change in
                             =
         (benefit)                      (refundable)                 deferred income taxes

      two components of income tax expense
           Current tax expense (income tax payable for the period)
           Deferred tax expense (increase in the deferred tax liability account)
      example: Sutton, p. 558, problem 17.2

   Note, if permanent differences exist, we make a mistake if we want to
   deter-mine income tax expenses simply by applying the enacted tax
   rate to pretax financial income.
      Example for permanent difference: (Tax rate 40%)
                           Financial income                      taxable income
      Revenues                                100                         100
      Gen. Expenses                 50                                    50
      Fines                         10                                    --
                                    40                                    50
      Income tax                                                          20           10
B. Future deductible amounts and deferred
tax assets
A deferred tax asset represents the increase in taxes refundable (or saved) in
future years as a result of deductible temporary differences existing at the
end of the current year.
   deductible temporary difference
   deferred tax asset
   Computation of deferred tax asset
   1. book basis of liability – tax basis = cumulative temporary
      difference OR
      tax basis of asset – book basis = cumulative temporary
      difference
   2. cumulative temporary difference × enacted tax rate =
      deferred tax asset




                                                                                 11
Example – Assuming that a company has accounts receivable of €
  100.000 and has recorded an allowance for uncollectible accounts of €
  20.000 in 2001, the deferred tax asset is determined as follows:


            Tax basis of accounts receivable**                                    100.000
            Book basis of accounts receivable*                                     80.000

            Cumulative temporary difference at the end of 2001                     20.000
            Tax rate                                                               35,0%

            Deferred tax asset at the end of 2001                                   7.000


  ** tax basis: allowance for uncollectible accounts not included; *book basis: allowance included

Computation of income tax expenses
... same procedure as for deferred tax liabilities and therefore omitted
     here.


                                                                                                     12
Accounting for Net Operating Losses
  Net operating loss (NOL) for financial reporting
  purposes:
            revenues    <       expenses
  NOL for tax purposes:
      taxable revenues < tax-deductible expenses

  losses of one year can be used to offset profits of
  other years
    loss carry forward
    loss carry back
  to avoid inequitable tax burden


                                                        13
Loss Carryback and Loss Carryforward

   Loss carryback
         NOL is carried back two years [US-GAAP]              tax refund
           • loss is applied to earlier year first and then to the second
             year
         remaining losses may be carried forward
   Loss carryforward
         losses had been recorded in previous two years              no loss
         carryback, just loss carryforward

                          Net Operating Loss


2000         2001       2002      2003         2004        2005             2022

       Loss carryback                            Loss carryforward
       2 years back                              20 years forward

                                                                               14
International Differences in the Determination
of Taxable Income
  Loss Carryback/Carryforward

               Net operating loss relief
               Country             Carryback         Carryforward
               United Kingdom            1             no limit
               Netherlands               3             no limit
               France                    3                5
               Germany                   2             no limit
               USA                       2               20
               adapted from Alexander/Nobes, p.269

  Expenses
     UK ... expenses for entertainment, gifts to customers, and
     expensive cars are not deductible expenses
     France, Germany ... tax rules as the basis for deducting items for
     financial accounting


                                                                          15

				
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