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					INCOME TAXES
 Effect of Taxes on Financial Statements  Why Tax Expense  Tax Payable
 Temporary Differences  Modified Accelerated Cost Recovery (MACRS)

 Determination of Deferred Taxes  Disclosure of Tax Information
 American Standards  International Standards

 Analysis of Tax Impact  Net Operating Losses

EFFECT OF TAXES ON FINANCIAL STATEMENTS
Why is an understanding of taxes important?
 Taxes are one of the largest expenses on the income statement  Taxes payable can be a significant current liability  Deferred taxes can be a significant asset or liability  Tax strategies can significantly increase cash flow, but can be used to manipulate income  Many business decisions have tax consequences

Income Taxes 2

WHY TAX EXPENSE  TAX PAYABLE
Net income - determined by GAAP, on the basis of matching Taxable income - determined by the Internal Revenue Code

Net Income vs. Taxable Income
NET INCOME Measure Performance Generally Accepted Accounting Principles Income Statement TAXABLE INCOME Calculate an Obligation to the Government Internal Revenue Code

Purpose

Determined by

Reported on

Form 1120

Income Taxes 3

WHY TAX EXPENSE  TAX PAYABLE
Temporary Differences Temporary differences – differences resulting from timing of recognition. This causes NI  TI within periods but not over periods:
GAAP INCOME* > TAXABLE INCOME INFLOWS Installment Sales Effect: Taxed when collected Accelerated Depreciation Effect: Reduces taxable income early in asset life TAXABLE INCOME > GAAP INCOME* Advanced Rent Effect: Taxed when collected Warranty Expense, Retirement Benefits, Bad Debt Expense Effect: Deducted when paid

OUTFLOWS

* In this case, net income before taxes

IF, the company performed operations that caused $1,500,000 in taxes, BUT, the IRS requires a $1,100,000 payment, this year THEN, the following entry is made: Tax Expense Taxes Payable Deferred Taxes 1,500,000 1,100,000 400,000
In this case, deferred taxes are a liability.
4

Income Taxes

WHY TAX EXPENSE  TAX PAYABLE
Modified Accelerated Cost Recovery System
MACRS Applicable Percentage for Property Class
Recovery Year 3-Year Property 5-Year Property 7-Year Property 10-Year Property 15-Year Property 20-Year Property

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

33.33 44.45 14.81 * 7.41

20.00 32.00 19.20 11.52 * 11.52 5.76

14.29 24.49 17.49 12.49 8.93 * 8.92 8.93 4.46

10.00 18.00 14.40 11.52 9.22 7.37 6.55 * 6.55 6.56 6.55 3.28

5.00 9.50 8.55 7.70 6.93 6.23 5.90 * 5.90 5.91 5.90 5.91 5.90 5.91 5.90 5.91 2.95

3.750 7.219 6.677 6.177 5.713 5.285 4.888 4.522 4.462 * 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 2.231

Tools, Cars

Computers, Construction Equipment

Furniture, Railroad cars

Boats, Drilling Equipment

Factories

Sewers, Utility Plants

   

The 3-, 5-, 7-, and 10-year classes use 200% and the 15- and 20-year classes use 150% declining balance depreciation. All classes convert to straight-line depreciation in the optimal year, shown with an asterisk (*). A half-year depreciation is allowed in the first and last recovery years. If more than 40% of the year's MACRS property is placed in service in the last three months, then a midquarter convention must be used with depreciation tables that are not shown here.

Income Taxes 5

DETERMINING DEFERRED TAXES
Determining Timing Differences
Example:  $5,000 yearly revenue  One $6,000 machine, 4 year useful life for books, 3 year asset for tax, no salvage  Depreciation: Straight line for books, MACRS for taxes  40% tax rate Financial Statements
Year 1 2 3 4 Total
a b

Modified Accelerated Cost Recovery System (MACRS) Year Percent 1 33.33% 2 44.45% 3 14.81% 4 7.41%

Objective: Adhere to GAAP (Matching)
Income Before Taxes $3,500 3,500 3,500 3,500 $14,000 Tax Expenseb $1,400 1,400 1,400 1,400 $5,600 Net Incomec $2,100 2,100 2,100 2,100 $8,400

Revenue $5,000 5,000 5,000 5,000 $20,000

Operating Expensea $1,500 1,500 1,500 1,500 $6,000

Depreciation Expense = $6,000 / 3 = $2,000 / year Income Before Taxes * Tax Rate = $3,000 * .4 = $1,200 c Revenue – Operating Expense – Tax Expense = $5,000 – $2,000 – $1,200 = $1,800

Tax Return
Year 1 2 3 4 Total
a

Objective: Adhere to Internal Revenue Code
Deductions $2,000a 2,667 888 445 $6,000 Taxable Income $3,000 2,333 4,112 4,555 $14,000 Tax Payable $1,200 933 1,645 1,822 $5,600 Amount After Payable $1,800 1,400 2,467 2,733 $8,400

Revenue $5,000 5,000 5,000 5,000 $20,000

Depreciation Expense = Base * MACRS Rate = $6,000 * .333) = $2,000

Income Taxes 6

DETERMINING DEFERRED TAXES
Determining Timing Differences
Deferred Tax Liability- Due to Use of MACRS
Year Expense on Books Deduction for Taxes Temporary Difference
Cumulative Difference

Tax Rate

Cumulative Deferred Liability (Asset)

1 2 3 4

$1,500 $1,500 $1,500 $1,500 $6,000

$2,000 $2,667 $888 $445 $6,000

$500 $1,167 ($612) ($1,055) $0

$500 $1,667 ($1,055) 0 0

40% 40% 40% 40%

$200 $667 ($422) 0 0

The following amounts would be recognized in the financial statements:
Year 1 Year 2 Year 3 Year 4

Tax Expense (IS) Taxes Payable (BS) Deferred Tax Liability (BS) Deferred Tax Asset (BS)

1,200 1,200 200 0

1,200 933 667 0

1,200 1,645 0 422

2,000 1,822 0 0

Effect of a Tax Rate Change: If the enacted rate changed to 35% in Year 3, the deferred liability would be:
Expense on Books Deduction for Taxes Temporary Difference
Cumulative Difference
Cumulative Deferred Liability (Asset)

Year

Tax Rate

1 2 3 4

$1,500 $1,500 $1,500 $1,500 $6,000

$2,000 $2,667 $888 $445 $6,000

$500 $1,167 ($612) ($1,055) $0

$500 $1,667 ($1,055) 0 0

40% 40% 35%

$200 $667 ($369) 0 0

Income Taxes 7

DETERMINING DEFERRED TAXES
General Rules Deferred tax liabilities result from:
Source
Book revenue now (IS) Taxable revenue later (1120) Deduction now (1120) Expense later (IS)

Example
Installment sales Accelerated depreciation

Deferred tax assets result from:
Source
Taxable revenue now (1120) Book revenue later (IS) Expense now (IS) Deduction later (1120)

Example
Advanced rent Warranty expense, retirement benefits, bad debt expense

Discussion:
 Is it better to have deferred tax asset or deferred tax liability?  Are deferred tax liabilities a legal obligation at bankruptcy?

Income Taxes 8

DETERMINATION OF DEFERRED TAXES
How Are Deferred Taxes Liabilities Perceived?
Deferred taxes are debt:
Proponent: FASB Argument: Deferred taxes are measurable future obligations. Payment depends merely on the passage of time.

Deferred taxes may have some meaning:
Proponents: Some foreign accounting systems, some analysts Argument: Deferrals will reverse in the future. Why not take a present value of expected payments? (not allowed in US GAAP or IFRS)

Deferred taxes should be ignored:
Proponents: Creditors Argument: If the corporation went bankrupt, deferred taxes do not legally need to paid.

Deferred taxes are equity:
Proponents: Some analysts Argument: Deferred tax liabilities increase the value of the company. If deferred taxes are not recorded as a liability: (1) tax expense would be lower, (2) net income would be higher, and (3) retained earnings would be higher.

Income Taxes 9

DISCLOSURE OF TAX INFORMATION
On the Balance Sheet
1. Taxes Payable – amounts owed to taxing authorities within the year 2. Tax Refund Receivable – amounts to be returned within the year due to overpayment 3. Deferrals – Amounts resulting from differences in net income and taxable income. Current amounts are netted before disclosure. Noncurrent amounts are also netted before disclosure.  Net Current Tax Deferrals – deferrals that relate to current assets or current liabilities.  Net Non-Current Deferrals – deferrals that relate to non-current assets or liabilities.  Warning About Asset Overstatement Deferred tax assets should be
reduced if the probability of reversal is low. For example, if it becomes obvious that a warranty expense will not actually be paid, the deferred tax asset should be removed.

In the Notes:
 Current tax expense or benefit  Deferred tax expense or benefit  Investment tax credits  Operating loss carryforwards  Adjustments to deferred tax account resulting from tax rate changes  Reconciliation of statutory determined taxes to tax expense

 How does it look in the annual report?
Income Taxes 10

DISCLOSURE OF TAX INFORMATION
Tax Note of Wal Mart
The income tax provision consists of the following (in millions): Fiscal Year Ended January 31, Current: Federal State and local International Total current tax provision Deferred: Government Federal State and local International Total deferred tax provision Total provision for income taxes
Amount Paid to A tax “provision” is the same as a tax “expense”

2007 $4,871 522 883 6,276 (15) 4 100 89 $6,365

2006 $4,646 449 837 5,932 (62) 56 (123) (129) $5,803

2005 $4,116 640 570 5,326 311 (71) 23 263 $5,589
Expense on the Income Statement

Income before income taxes by jurisdiction is (in millions): Fiscal Year Ended January 31, United States Outside the United States Income before taxes 2007 $15,158 3,810 $18,968 2006 $14,447 3,088 $17,535 2005 $13,599 2,721 $16,320

Items that give rise to significant deferred tax accounts (in millions): January 31, Deferred tax liabilities Property and equipment Inventory Other Total deferred tax liabilities Deferred tax assets Net operating loss carryforwards Accrued for financial reporting not yet deductible Share-based compensation Other Total deferred tax assets Valuation allowance Total deferred tax assets, net of valuation allowance Net deferred tax liabilities 2007 $3,153 600 282 $4,035 $865 1,847 300 846 3,858 (921) $2,937 $1,098 2006 $2,816 551 392 $3,759 $892 1,668 248 737 3,545 (912) $2,633 $1,126

Liability on the Balance Sheet

Income Taxes 11

A reconciliation of the significant differences between the effective income tax rate and the federal statutory rate on pretax income is as follows: Fiscal Year Ended January 31, Statutory tax rate State income taxes Income taxes outside the United States Other Effective income tax rate 2007 35.00% 1.80% (1.84%) (1.40%) 33.56% 2006 35.00% 1.85% (2.09%) (1.67%) 33.09%
Effective Tax Rate

2005 35.00% 2.27% (2.21%) (0.81%) 34.25%

Income Taxes 12

DISCLOSURE OF TAX INFORMATION
Analysis of Deferrals
PROCTER AND GAMBLE
Deferred income tax assets and liabilities were comprised of the following: June 30 2008 2007 $1,132 723 560 439 183 249 161 — 95 85 1,119 (190) 4,556 $12,102 1,884 132 14,118
Stock allocated to employees expensed this period, but not deductible until employee takes possession. Hedge losses expensed this period, but not deductible until the hedge expires. Benefits earned by employees this period, but not deductible until paid at retirement. Cash received for goods to be delivered later. The amount has been taxed, but not recognized as revenue.

DEFERRED TAX ASSETS Stock-based compensation $1,082 Unrealized loss on financial transactions 1,274 Pension and postretirement benefits 633 Loss and other carryforwards 482 Advance payments 302 Goodwill and other intangible assets 267 Accrued marketing and promotion expense 125 Accrued interest and taxes 123 Inventory 114 Fixed assets 100 Other 1,048 Valuation allowances (173) TOTAL 5,377 DEFERRED TAX LIABILITIES Goodwill and other intangible assets Fixed assets Other TOTAL $12,371 1,847 151 14,369

P&G amortized $640 million in intangibles in 2008. Larger amounts were deducted for taxes. Accelerated depreciation is used for taxes; straight-line for the income statement.

Net operating loss carryforwards were $1,515 and $1,442 at June 30, 2008 and 2007, respectively. If unused, $629 will expire between 2009 and 2028. The remainder, totaling $886 at June 30, 2008, may be carried forward indefinitely.

Income Taxes

13

DISCLOSURE OF TAX INFORMATION International Standards
IFRS
Tax rates to calculate deferrals Deferred tax assets recognition Current/noncurrent Use tax rates that are enacted or substantively enacted. Recognize if probable (more likely than not) Classify net as noncurrent, with note identifying amount to be recovered within 12 months

US G A A P
Only enacted tax rates may be used. Recognize but reduce by a valuation allowance Based on classification of the related non-tax asset or liability for financial reporting.

Income Taxes 14

ANALYSIS OF TAX IMPACT
Impact of Deferred Taxes
Deferred Taxes to Total Liabilities

Company

Deferred Tax Liability

Total Liabilities

ExxonMobil Procter & Gamble UPS McDonalds Home Depot Johnson and Johnson Merck
For the 2006/7 fiscal year

20,851 12,015 2,529 1,057 1,416 1,319 446

105,171 71,254 17,728 13,566 27,233 31,238 27,010

19.8% 16.9% 14.3% 7.8% 5.2% 4.2% 1.7%

Income Taxes 15

ANALYSIS OF TAX IMPACT
Corporate Income Tax Rates

US Corporate Income Tax Rates--2009
Taxable income over $0 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 Not over $50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 Tax rate 15% 25% 34% 39% 34% 35% 38% 35%

Income Taxes 16

ANALYSIS OF TAX IMPACT
International Corporate Income Tax Rates
Average Corporate Tax Rates Country %
UAE Bulgaria Ireland Romania Hong Kong Hungary Russia China Greece Netherlands Vietnam Israel Poland South Korea Czech Republic Mexico Norway South Africa United Kingdom Australia Germany Spain Italy Canada Belgium Brazil France Argentina USA (TX) Japan India USA (IL) USA (NY) 0.0% 10.0% 13.0% 16.0% 16.5% 20.0% 24.0% 25.0% 25.0% 25.0% 25.0% 26.0% 26.5% 27.5% 28.0% 28.0% 28.0% 28.0% 28.0% 30.0% 30.0% 30.0% 32.4% 33.5% 34.0% 34.0% 34.4% 35.0% 36.0% 41.0% 42.0% 42.3% 46.2%

Source: Forbes 2008 (see http://www.forbes.com/global/2008/0407/060_2.html)

Income Taxes 17

ANALYSIS OF TAX IMPACT
Who Pays What in Taxes?
Largest American Oil Companies
Exxon Mobil
Effective Income Tax Rate Income Tax Expense Income Tax Paid Excise, duties and other taxes

Largest American Non-Oil Industrial Companies
General Electric 15.5% $2.8 billion $2.9 billion AT&T 34.4% $6.3 billion $4.0 billion Procter & Gamble 24.9% $4.0 billion $3.5 billion

Chevron 41.9% $13.5 billion $12.3 billion $22.3 billion

Conoco Phillips 48.9% $11.4 billion $11.3 billion $19.0 billion

41.8% $29.9 billion $26.3 billion $75.8 billion

Based on 2007 data Excise and import taxes are implemented by Federal, State, or local governments. Federal excise taxes on gasoline are 18.3 cents per gallon and on diesel fuel are 24.3 cents and 0.1 cents per gallon for the Leaking Underground Storage Tank Trust Fund. State taxes on gasoline vary from less than 10 cents per gallon to about 40 cents. Import taxes for oil, crude oil and fuel oils are 5.25 cents per barrel for heavier and 10.5 cents for lighter oils. Transportation fuels, such as gasoline and jet fuel, pay 52.5 cents per barrel, or 1.25 cents per gallon.

Income Taxes 18

NET OPERATING LOSSES (NOLs)
LOSS CARRY BACK (AND CARRY-FORWARD) ELECTION Taxable income in the past two years is offset. If the NOL is not totally absorbed, the remaining NOL can be used in the next 20 years. Treatment: show Tax Refund Receivable in the current asset section. LOSS CARRY FORWARD ELECTION Taxable income over the next 20 years may be offset by the NOL. Realized only if taxable income occurs. Treatment: show the NOL carry forward amount as a deferred tax asset
Let me get this straight. I lose money and the Feds send me a check, right?

Income Taxes 19

NOL Example
Get It Back, Corp. had the following taxable income data for the last four years: Year 2006 2007 2008 2009 2010 Taxable Income $500,000 $500,000 ($1,250,000) $600,000 $800,000 Tax Rate 40% 40% 40% 40% 40% Taxes Owed $200,000 $200,000 $0 ? ?

How much should GIB pay in taxes in 2009 and 2010? GIB Corp. has two options in 2008:  Carry back (and carry forward)  Carry forward only

Income Taxes 20

CB and CF: GIB applies for a refund of $400,000 ($200,000 + $200,000) for 2006 and 2007 taxes. No taxes are paid in 2008. Year 2006 2007 2008 2009 2010 Taxable Income $500,000 $500,000 ($1,250,000) $600,000 $800,000 Tax Rate 40% 40% 40% 40% 40% $0 $140,000 $320,000 Taxes Owed

In 2009, GIB applies the remaining $250,000 NOL and pays $140,000 in taxes [($600,000 - $250,000) * 40%]. In 2010, the tax will be $320,000 ($800,000 * 40%) CF Only: GIB has determined that the tax rate increase and would like to carry the benefit forward. GIB pays no taxes in 2008 and 2009. GIB may then apply a $650,000 ($1,250,000 - $600,000) offset to taxable income earned after 2009. Year 2006 2007 2008 2009 2010 Taxable Income $500,000 $500,000 ($1,250,000) $600,000 $800,000 Tax Rate 40% 40% 40% 45% 45% Taxes Owed

$200,000 $200,000
$0 $0 $67,500

In 2010, GIB has $650,000 ($1,250,000 - $600,000) in CF left. pays $67,500 in taxes [($800,000 - $650,000) * 45%].

Income Taxes 21

TAX NOTE
Continental Airlines
The reconciliations of income tax computed at the United States federal statutory tax rates to income tax provision for the years ended December 31, 1998, 1997 and 1996 are as follows (in millions):
Amount Percent 1998 Income tax provision at United States statutory rates $227 State income tax provision 10 Reorganization value not allocable to identifiable assets Meals and entertainment disallowance 10 Net operating loss not previously benefitted. Other 1 Income tax provision, net $248 1997 $224 9 4 9 (15) 6 $237 1996 $150 6 5 7 (88) 6 $ 86 1998 35.0 % 1.5 1.5 0.3 38.3 % 1997 35.0 % 1.4 0.6 1.4 (2.3) 1.0 37.1 % 1996 35.0 % 1.4 1.2 1.6 (20.5) 1.4 20.1 %

The significant component of the provision for income taxes for the year ended December 31, 1998, 1997 and 1996 was a deferred tax provision of $231 million, $220 million and $80 million, respectively. The provision for income taxes for the period ended December 31, 1998, 1997 and 1996 also reflects a current tax provision in the amount of $17 million, $17 million and $6 million, respectively, as the Company is in an alternative minimum tax position for federal income tax purposes and pays current state income tax. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the related amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1998 and 1997 are as follows (in millions):
Spare parts and supplies, fixed assets and intangibles Deferred gain Capital and safe harbor lease activity Other, net Gross deferred tax liabilities Accrued liabilities Revaluation of leases. Net operating loss carryforwards Investment tax credit carryforwards Minimum tax credit carryforward Gross deferred tax assets. Deferred tax assets valuation allowance Net deferred tax liability Less: current deferred tax (asset) liability Non-current deferred tax liability 1998 $ 536 57 46 39 678 (347) (2) (372) (45) (37) (803) 263 138 (234) $ 372 1997 $ 639 63 49 39 790 (370) (16) (631) (45) (21) (1,083) 617 324 (111) $ 435

Liabilities

Assets

Shown on the Balance Sheet

Income Taxes 22

At December 31, 1998, the Company had estimated NOLs of $1.1 billion for federal income tax purposes that will expire through 2009 and federal investment tax credit carryforwards of $45 million that will expire through 2001. As a result of the change in ownership of the Company on April 27, 1993, the ultimate utilization of the Company's net operating losses and investment tax credits could be limited. Reflecting this possible limitation, the Company has recorded a valuation allowance of $263 million at December 31, 1998. Continental had, as of December 31, 1998, deferred tax assets aggregating $803 million, including $372 million of NOLs and a valuation allowance of $263 million. During the first quarter of 1998, the Company consummated several transactions, the benefit of which resulted in the elimination of reorganization value in excess of amounts allocable to identifiable assets of $164 million. During the third and fourth quarters of 1998, the Company determined that additional NOLs of the Company's predecessor could be benefited and accordingly reduced the valuation allowance and routes, gates and slots by $190 million. To the extent the Company were to determine in the future that additional NOLs of the Company's predecessor could be recognized in the accompanying consolidated financial statements, such benefit would further reduce routes, gates and slots.

Discussion
 What are the implications of income tax expense structure of Continental Airlines (see amounts in paragraph form)?
Current Tax Expense Deferred Tax Expense Tax Expense 17 + 231 248

 If the company has NOLs of $1.1 billion, why do they recognize a deferred tax asset of only $372 million?
= NOL X Tax Rate = $1,100 million X .35  $385 million

Income Taxes 23

Sample Test Question

HOME DEPOT
NOTE 3 - INCOME TAXES
The provision for income taxes consisted of the following (in millions): FISCAL YEAR ENDED Current: U.S State Foreign Deferred: U.S State Foreign Total 2000 $ 1,209 228 45 1,482 9 (4) (3) 2 $ 1,484 1999 $ 823 150 20 993 46 (1) 2 47 $ 1,040 1998 $ 653 98 15 766 (31) 1 2 (28) $ 738

The Company's combined federal, state and foreign effective tax rates for fiscal years 2000, 1999 and 1998, net of offsets generated by federal, state and foreign tax incentive credits, were approximately 39.0%, 39.2% and 38.9%, respectively. A reconciliation of income tax expense at the federal statutory rate of 35% to actual tax expense for the applicable fiscal years follows (in millions): FISCAL YEAR ENDED Taxes at U.S. statutory rate State income taxes Foreign rate differences Other, net Total 2000 $1,331 145 2 6 $1,484 1999 $ 929 96 -15 $1,040 1998 $664 65 2 7 $738

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of January 30, 2000 and January 31, 1999 were as follows (in millions): 2000 Deferred Tax Assets: Accrued self-insurance liabilities Other accrued liabilities Total gross deferred tax assets Deferred Tax Liabilities: Accelerated depreciation Other Total gross deferred tax liabilities Net deferred tax liability $ 154 142 296 1999 $ 110 97 207

(321) (62) (383) $ (87)

(249) (43) (292) $ (85)

No valuation allowance was recorded against the deferred tax assets at January 30, 2000 or January 31,1999. Company management believes the existing net deductible temporary differences comprising the total gross deferred tax assets will reverse during periods in which the Company generates net taxable income.

Income Taxes 24

1. Home Depot’s federal statutory tax rate was 35% during 2000. The effective tax rate for Home Depot during 2000 was 39%. What is the primary reason for the difference between these percentages? State Income Taxes 2. How much should Home Depot pay to the Internal Revenue Service as a result of operations during for 2000? $ 1.209 billion 3. What was the tax expense recognized on the income statement by Home Depot for the year 2000? $ 1.484 billion 4. Designate whether the following statements are true or false: T F Home Depot’s tax deferrals should be stated on the balance sheet as a net asset of $209 million ($296 million - $87 million), instead of being shown separately as a gross asset and gross liability.
Answer: Home Depot should show a liability of $87million ($296 million – $383 million).

T F Home Depot has a practice of recognizing an insurance expense on the income statement that is not deductible for tax purposes. T F Home Depot uses a method for taxes that recognizes depreciation at a faster rate than the method used for financial reporting.
Home Depot has a deferred tax liability related to property, plant and equipment (which they show as accelerated depreciation of $321). This liability occurs because they recognized a smaller expense on the books than they did for a deduction on taxes. As their assets get older, the amount of deprecation recognized on the books will begin to equal the deprecation deducted for taxes and the liability will decrease.

General Rule:
An expense with no deduction results in a deferred tax asset. A deduction without an expense results in a deferred tax liability.
Income Taxes 25

Sample Test Question
NORTHWEST AIRLINES
Note 9—Income Taxes
Income tax expense (benefit) consisted of the following for the years ended December 31 (in millions): 2000 Current: Federal Foreign State Deferred: Federal Foreign State Total income tax expense (benefit) $57 1 6 64 110 (1) 6 115 $179 1999 $75 3 3 81 98 (2) 10 106 $187 1998 $(45) 3 1 (41) (90) (3) (11) (104) $(145)

Reconciliations of the statutory rate to the Company's income tax expense (benefit) for the years ended December 31 are as follows (in millions): Statutory rate applied State income tax Non-deductible meals, entertainment Adjustment to valuation allowance Other Total income tax expense (benefit) 2000 $152 7 11 5 4 $179 1999 $171 8 9 — (1) $187 1998 $(151) (6) 9 6 (3) $(145)

The net deferred tax liabilities listed below include a current net deferred tax asset of $108 million and $116 million and a long-term net deferred tax liability of $1.35 billion and $1.22 billion as of December 31, 2000 and 1999, respectively. Significant components of the Company's net deferred tax liability as of December 31 were as follows (in millions): 2000 Deferred tax assets: Expenses accelerated for financial reporting purposes Pension and postretirement benefits Gains from the sale-leaseback of aircraft Rent expense Travel award programs Leases capitalized for financial reporting purposes Alternative minimum and foreign tax credit carryforwards Total deferred tax assets $341 180 165 90 55 52 45 928 1999 $341 145 154 85 98 67 86 976

Income Taxes 26

Deferred tax liabilities: Accounting basis of assets in excess of tax basis Expenses other than accelerated depreciation and amortization Total deferred tax liabilities Net deferred tax liability

1,744 429 2,173 $1,245

1,724 358 2,082 $1,106

The Company has alternative minimum tax credits of approximately $43 million available for carryforward to future years' tax returns. The alternative minimum tax credits have an unlimited carryforward period. The Company generated and utilized $1 million of foreign tax credits for both regular and alternative minimum tax purposes during 2000. During 1999, the Company utilized all of its 1998 foreign tax credit carryforward and $1 million of the $3 million in foreign tax credits generated in 1999 for both regular and alternative minimum tax purposes. The remaining $2 million of foreign tax credits generated in 1999 is available for carryforward to years beyond 2000. Sections 382 and 383 of the Internal Revenue Code of 1986, as amended (the "Code"), and Treasury regulations limit the amounts of net operating loss carryforwards (NOLs), alternative minimum tax net operating loss carryforwards (AMTNOLs) and credits that can be used to offset taxable income (or used as a credit) in any single tax year if the corporation has more than a 50% ownership change (as defined in the Code) over a three-year testing period ending on the testing date. During 1994 and 1995, the Company utilized all of its regular NOLs and AMTNOLs. In August 2000, the Company and the Internal Revenue Service reached an agreement regarding the Company's NOLs that did not result in a material change in the utilization of the NOLs in any prior years.

Assume Northwest Airlines is a going concern. Designate whether the following statements are true or false:

1. T

F

As a result of operations that occurred during 1999, Northwest has recognized an expense of $81 million to governments in taxes. During 2000, Northwest performed operations that will cause $115 million of taxes to be paid in the future. Northwest Airlines has recognized pension expenses in their income statement that are not yet deductible for taxes. Northwest Airlines has recognized frequent flyer expenses in their income statement that are not yet deductible for taxes. Northwest Airlines uses a method for taxes that recognizes depreciation at a slower rate than the method used for financial reporting.

2. T

F

3. T

F

4. T

F

5. T

F

6. Northwest Airlines income before taxes was $435 million. What is their effective tax rate?

$ 179 / $435 = 41.1%

Income Taxes 27


				
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