Accounting for Income Taxes

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					Accounting for Income Taxes
Intraperiod tax allocation
Involves WHERE we present income tax expense during a single year. The "net of tax" items are generally the same items for which we present an EPS number plus any prior period adjustments.

Interperiod tax allocation
Related to temporary differences between accounting and taxable income Deferral approach to tax allocation (APB Opinion 11) Income tax expense = amount of taxes that would be paid if income statement numbers appeared on the current year's tax return. Deferred taxes was the plug figure (difference between taxes payable and tax expense). The effect of subsequent changes in tax rates on deferred tax account were essentially ignored. Liability approach to tax allocation (FASB 96, 109) Income tax expense = taxes currently payable plus change in deferred taxes. If tax rates change, the effect on deferred tax amounts affect income tax expense in the year the change is enacted. If there are no changes in tax rates, income tax expense should be approximately the same as under APB Opinion 11.

Permanent Differences Permanent differences affect both the computation of taxable income and income tax expense as reported on the income statement. Examples: Interest revenue on Municipal Bonds Life insurance premiums and proceeds when coporation is beneficiary Fines and penalties Dividend exclusion Statutory depletion Temporary Differences Temporary differences occur when an item appears on financial statements in one year and on the tax return in a different year. Taxable temporary differences give rise to deferred tax liabilities Deductible temporary differences give rise to deferred tax assets

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TEMPORARY DIFFERENCES Examples Taxable temporary differences
Revenues or gains that are taxable after they are recognized on books: Installment method for tax returns, accrual method for financial accounting purposes
Completed contract method for tax returns, percentage of completion method for financial accounting purposes (now uncommon)

Expenses or losses that are deductible before they are recognized on books: Accelerated depreciation for tax returns, straightline for financial accounting purposes Goodwill, deductable on tax return but not an expense for GAAP. However, impairment of goodwill, if it occurs, would cause the write-down of goodwill and a loss on GAAP financial statements Business combinations (goodwill): if assigned values of identifiable assets are higher than their tax basis, the difference is a taxable temporary difference and the related deferred tax liability would increase the goodwill to be recorded
A reduction in the tax basis of depreciable assets because of tax credits (under 1982 law, it was possible to get a larger investment tax credit if the depreciable basis of the assets were reduced),; similar result if we capitalize interest for book purposes but deduct it on tax return as paid.

Deductible temporary differences
Expenses or losses that are deductible after they are recognized on books: Warranty expenses accrued in year of sale according to GAAP, deductible on tax return only when paid Unrealized losses/gains on marketable securities (FASB 115), deductible on tax return only when the securities are actually sold (affects trading securities on income statement and available for sale securities on statement of comprehensive income). Losses related to contingent liabilities (compensated absenses, lawsuits, etc.) are deductible on tax return only when actually paid. Revenues or gains that are taxable before they are recognized on books: Subscription revenue recognized when earned per GAAP but taxable when collected. Rent revenue received in advance (deferred revenue under GAAP) is taxable when received.
Investment tax credits accounted for by the deferral method An increase in the tax basis of assets because of indexing whenever the local currency is the functional currency

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Net operating carrybacks and carryforwards Under current laws, a net operating loss in a particular year can be carried back for two years or forward for 20 years. The NOL would be handled as a deduction on the tax return of the year it is carried to. If you carry back an NOL, record "income tax refund receivable" using the tax rate in effect the year you are carrying to. If you elect to carryforward, you would use the current tax rate (or enacted future tax rate) and record a "deferred tax asset." Unused Tax credits may also be carried forward and would affect the amounts in the deferred tax accounts. Other temporary differences: Unremitted earnings of subsidiaries We report share of subsidiary's reported net income on parent company's books -- this is not a taxable item currently. However, if we collect dividends they are probably partially taxable (assuming 80% exclusion is in effect). Valuation Allowance for Deferred Tax Assets Deferred tax assets must be reduced by a valuation allowance (contra asset account) if it is more likely than not (50% probability) that they will not be realized. CLASSIFICATION OF DEFERRED TAXES Deferred tax assets and liabilities are classified as current or noncurrent as follows: If the amount is associated with a balance sheet account, the deferred taxes are classified the same way. For example, differences in depreciation methods would give rise to noncurrent deferred tax liability because accumulated depreciation is noncurrent account. If the amount is not associated with a balance sheet account, the deferred taxes are classified on the basis of when the difference is expected to reverse (if they reverse during next year, classify as current, otherwise as noncurrent).

Example Problems (get excel files from web page) First Place Place Inc. 2nd Best Corporation

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Intraperiod Tax Allocation Income Statement Income tax expense or benefit for the year shall be allocated among continuing operations, discontinued operations, extraordinary items, other comprehensive income, and items charged or credited directly to shareholders' equity (paragraph 36). FAS109, Par. 35 Balance Sheet (Owners Equity) or Statement of Retained Earnings a. b. Adjustments of the opening balance of retained earnings for certain changes in accounting principles or a correction of an error Gains and losses included in comprehensive income but excluded from net income (for example, translation adjustments under Statement 52 and changes in the unrealized holding gains and losses of securities classified as available-for-sale under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities) An increase or decrease in contributed capital (for example, deductible expenditures reported as a reduction of the proceeds from issuing capital stock)
An increase in the tax basis of assets acquired in a taxable business combination accounted for as a pooling of interests and for which a tax benefit is recognized at the date of the business combination

c.
d.

e.

Expenses for employee stock options recognized differently for financial reporting and tax purposes (refer to paragraphs 58-63 of FASB Statement No. 123 (revised 2004), Share-Based Payment)
Dividends that are paid on unallocated shares held by an ESOP and that are charged to retained earnings Deductible temporary differences and carryforwards that existed at the date of a quasi reorganization (except as set forth in paragraph 39).

f. g.

FAS109, Par. 36

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Deferred Tax Problems - worksheet
Pre-tax accounting income Permanent Differences: Book TI Temporary Differences:

Taxable Income Applicable Tax Rate Income taxes payable/(receivable) Inventory of TDs

Total net temporary differences Applicable tax rate Net ending balance (deferred tax accounts) Net balance fwd (deferred tax accounts) Change in net deferred taxes Taxes (payable)/receivable Income tax expense

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Deferred Tax Problems - worksheet
Pre-tax accounting income Permanent Differences: Book TI Temporary Differences:

Taxable Income Applicable Tax Rate Income taxes payable/(receivable) Inventory of TDs

Total net temporary differences Applicable tax rate Net ending balance (deferred tax accounts) Net balance fwd (deferred tax accounts) Change in net deferred taxes Taxes (payable)/receivable Income tax expense

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Deferred Tax Problems - worksheet
Pre-tax accounting income Permanent Differences: Book TI Temporary Differences:

Taxable Income Applicable Tax Rate Income taxes payable/(receivable) Inventory of TDs

Total net temporary differences Applicable tax rate Net ending balance (deferred tax accounts) Net balance fwd (deferred tax accounts) Change in net deferred taxes Taxes (payable)/receivable Income tax expense

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Partial Solution - First Place, Inc. – The “complicated method” If the current tax rate for 2005 is 34% and no new tax law has been enacted, we would make the following journal entry: 2005 Income tax expense (100,500 * .34) Deferred tax asset - current (10,000 * .34) Income taxes payable (80,500 * .34) Deferred tax liability - noncurrent (30,000 * .34) 34,170 3,400 27,370 10,200

If a new tax law is enacted in 2006 (36% tax rate) and no other rate changes have been enacted, we would make the following entry if we elect to carry the NOL back to 2000 when the tax rate was 34%: 2006 Income tax expense (plug figure) Income tax refund receivable (6,500 * .34) Deferred tax asset - current (1,000 * .36) Deferred tax liability - noncurrent (108,000 * .36) Deferred tax asset - current (10,000 * .02) Deferred tax liability - noncurrent (30,000 * .02) Alternate computation: Accumulated taxable TDs (30,000 + 108,000) * .36 = Accumulated deductible TDs (10,000 + 1,000) * .36 = Correct net amount for deferred taxes Currently on books (10,200 - 3,400) Change in deferred taxes Add taxes payble, subtract tax refunds Income tax expense for 1990 2006 Income tax expense [Book TI 100,500 * .36 = 36,180 + change in previousl recorded dfd tax (20,000 * .02)] Deferred tax asset - current (6,500 * .36) Deferred tax asset - current (1,000 * .36) Deferred tax asset - current (10,000 * .02) Deferred tax liability - noncurrent (108,000 * .36) Deferred tax liability - noncurrent (30,000 * .02) 49,680 - 3,960 45,720 6,800 38,920 -2,210 36,710 36,710 2,210 360 38,880 200 600

If we plan to carry the NOL forward, the entry would be: ($130 diff = 6,500 * .02) 36,580

2,340 360 200 38,880 600

As a practical matter, it may be easier to use just one account for "net deferred taxes" on the books and reclassify as asset/liability, current/noncurrent on the balance sheet when you do your external reporting. Using 4 accounts makes the entries look a lot more complicated!

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First Place, Inc. - continued If a new tax law is enacted 2007 which provides for 38% tax rates for 2007 and 40% thereafter, the journal entry would look like this: Accumulated taxable TDs (138,000 + 102,000) * .40 = Accumulated deductible TDs (11,000 + 0) * .40 = Correct net amount for deferred taxes Currently on books (10,200 + 38,880 + 600 - 3,400 -360 -200) Change in deferred taxes Add taxes payble, subtract tax refunds (1,500 * .34) Income tax expense for 1990 2007 Income tax expense (plug figure*) Income tax refund receivable Deferred tax asset - current (11,000 * .04) Deferred tax liability - noncurrent (102,000 * .40) Deferred tax liability - noncurrent (138,000 * .04) 96,000 - 4,400 91,600 45,720 45,880 - 510 45,370

45,370 510 440 40,800 5,520

*Approximately: 100,500 * .40 = 40,200 + change in deferred (138,000 - 11,000) * .04 = 5,080 (off $90 because carryback of NOL is at .34 rate instead of .40 {1,500 * .06})

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The “easier” method – First Place, Inc. To keep things simple, it is probably easier to do the “bookkeeping” using a single deferred income taxes account and then reclassify that balance for proper display on the balance sheet when financial statements are prepared. To illustrate: 2005 Income tax expense Deferred income taxes Income taxes payable 2006 Income tax expense Deferred income taxes Income tax refund receivable 2007 Income tax expense Deferred income taxes Income tax refund receivable 2008 Income tax expense Deferred income taxes Income taxes payable 2009 Income tax expense Deferred income taxes Income taxes payable Displayed on Balance Sheet: Deferred tax asset - current Deferred tax asset - noncurrent Deferred tax liability - current Deferred tax liability - noncurrent 12/31/05 3,400 34,170 6,800 27,370 36,710 38,920 2,210 45,370 45,880 510 40,200 57,600 97,800 40,200 34,000 74,200 12/31/06 3,960 12/31/07 4,400 12/31/08 14,000

(10,200) (6,800)

(49,680) (45,720)

(96,000) (91,600)

(48,000) (34,000)

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First Place, Inc. Pre-tax accounting income Permanent differences Book TI Temporary differences: Rent revenue Depreciation Warranty Applicable tax rate Income tax payable (recbl) Change in current year TDs Adj prior TDs for rate change Income tax expense Old deferral method expense: Difference related to rate change Inventory of TDs Rent revenue Depreciation Warranty Total temp differences Applicable tax rate Net balance - deferred taxes Net balance fwd Change in net deferred taxes Taxes (payable)/receivable Income tax expense

34% 2005 100,000 500 100,500 (30,000) 10,000 80,500 34% 27,370 6,800

36% 2006 100,000 500 100,500 (108,000) 1,000 (6,500) 34% (2,210) 38,520 400 36,710 36,180 530 12/31/06 (138,000) 11,000 (127,000) 36% (45,720) (6,800) (38,920) 2,210 36,710

38% 2007 100,000 500 100,500 (102,000) (1,500) 34% (510) 40,800 5,080 45,370 38,190 7,180 12/31/07 (240,000) 11,000 (229,000) 40% (91,600) (45,720) (45,880) 510 45,370

40% 2008 100,000 500 100,500 25,000 120,000 (1,000) 244,500 40% 97,800 (57,600) 4,580 44,780 40,200 4,580 12/31/08 25,000 (120,000) 10,000 (85,000) 40% (34,000) (91,600) 57,600 (97,800) 40,200

40% 2009 100,000 500 100,500 (25,000) 120,000 (10,000) 185,500 40% 74,200 (34,000) 40,200 40,200 12/31/09 40% (34,000) 34,000 (74,200) 40,200

34,170 34,170 12/31/05 (30,000) 10,000 (20,000) 34% (6,800) (6,800) (27,370) 34,170

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