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ACCOUNTING FOR DEFERRED INCOME TAXES

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ACCOUNTING FOR DEFERRED INCOME TAXES Powered By Docstoc
					FURTHER ISSUES IN ACCOUNTING FOR INCOME TAXES

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Extend your understanding of accounting for income taxes by incorporating the effects of changes in income tax rates and in the measurement of deferred tax assets.
U.S. GAAP and IFRS require firms measuring their income tax expense to incorporate the effects of temporary differences between the book basis and tax basis of assets and liabilities. Income tax expense each period equals 1. The income taxes payable for the current period based on taxable income, 2. Plus the income taxes that the firm expects to pay (as reflected in changes in deferred tax liabilities) and minus the income taxes the firm expects to save (as reflected in changes in deferred tax assets) in future periods when temporary differences reverse. Note on Terminology We find the correct term income before income taxes for financial reporting too cumbersome to use throughout this section. Instead, we use book income to refer to income before income taxes reported in the financial statements, and we use taxable income to refer to the amount reported in the income tax return. Similarly, the terms book purposes and tax purposes distinguish the financial statements from the tax return. We use the term pre-tax income to refer to an item on the financial statements and the term taxable income to refer to an item on the tax return. The illustration for Burns Corporation in the textbook showed that income tax expense each period equaled pre-tax book income for financial reporting times the income tax rate; in each year, income tax expense was $32,000 (= .40 × $80,000). Income tax expense also equaled income taxes currently payable plus the change in the Deferred Tax Liability account. For example, income tax expense for the first year equals income taxes currently payable of $30,400 plus the $1,600 increase in the Deferred Tax Liability account. Income tax expense for the fourth year equals income taxes currently payable of $34,240 minus the $2,240 decrease in the Deferred Tax Liability account. The Deferred Tax Liability account changed each year by the amount of the tax effect of the temporary difference between depreciation in the financial statements and on the tax return. EXTENSION OF INCOME TAX ACCOUNTING U.S. GAAP1 and IFRS2 require a more complex accounting for income taxes than is shown by the simple illustration for Burns Corporation in Chapter 11, for the following reasons: 1. The income tax rate that a firm uses to compute the amount of income taxes it will have to pay in the future might change, and if so, the amount in the Deferred Tax Liability account will not represent the amount of taxes that the firm must pay later. Temporary differences might create deferred tax assets instead of deferred tax liabilities. A deferred tax asset arises when a firm recognizes an expense earlier for financial reporting than for tax reporting. For example, a firm expenses an estimate of warranty costs in the year it sells the warranted product for book purposes, but it does not claim a tax deduction until later, when it makes actual expenditures for warranty repairs.

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Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes, “ 1998 (Codification Topic 740). 2 International Accounting Standards Board, International Accounting Standard 12, “Income Taxes,” 1996, 2001.

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Similarly, for financial reporting, a firm reports Bad Debt Expense in the year it makes a credit sale, but it does not claim a tax deduction until later, when it writes off specific uncollectible accounts. 3. U.S. GAAP requires firms to recognize a valuation allowance (similar in concept to an allowance for uncollectible accounts) to reduce the balance in the Deferred Tax Asset account to the amount the firm expects to realize in tax savings in the future. A firm with available future tax deductions for warranty costs or bad debts will not realize the benefits of these tax deductions if it cannot generate positive taxable income in the future. The valuation allowance adjusts downward the balance in Deferred Tax Assets for the uncertainty that the firm will realize these tax benefits. IFRS permits firms to recognize deferred tax assets only when it is probable that the firm will have sufficient taxable income in future periods against which it can deduct the deductible temporary differences. IFRS does not use the valuation allowance, but the amount of deferred tax assets under IFRS should equal the net amount under U.S. GAAP after subtracting the valuation allowance, in both cases reflecting the probable amount realizable. Deferred tax liabilities do not require a valuation allowance. Thus, the Deferred Tax Asset or Deferred Tax Liability accounts on the balance sheet can change each period because of temporary differences originating or reversing during the current period (illustrated in the Burns example in the textbook); 2. changes in income tax rates expected to apply in future periods when temporary differences reverse (illustrated in the next section); and 3. changes in the valuation allowance for Deferred Tax Assets under U.S. GAAP3 (illustrated in the next section). The illustration for Burns Corporation in Exhibit 11.11 in the textbook assumed that only the first of the three factors affected deferred income taxes each year. In such cases, we can measure income tax expense using pre-tax income amounts from the financial statements and plug the difference between income tax expense and income tax payable to deferred asset or liability accounts on the balance sheet. Because the second and third factors often occur, U.S. GAAP and IFRS instead require firms to measure income tax expense by first calculating the required balances in Deferred Tax Assets and Deferred Tax Liabilities at the beginning and the end of each year. Firms then compute income tax expense equal to income taxes currently payable plus (minus) credit (debit) changes in deferred tax accounts. The required balances in deferred tax accounts on the balance sheet include (1) cumulative temporary differences, (2) currently enacted tax rates applicable to future reversals of temporary differences, and (3) current valuation allowances for deferred tax assets under U.S. GAAP. Thus, any changes in these three items during a period affect the amount of income tax expense for that period. Example 1 Exhibit 1 continues the example for Burns Corporation. The top panel shows the computation of the required balance in the Deferred Tax Liability account at the end of each year: see column [6]. The required balance equals the difference between the tax basis and the financial reporting basis of the equipment times the tax rate expected to apply when the temporary differences reverse, a tax rate of 40 percent in this example. Columns [1] and [2] show the tax basis of the equipment using accelerated depreciation. Columns [3] and [4] show the financial reporting basis of the asset using straight-line depreciation. Column [5] shows the difference between the tax and the financial reporting bases at the end of each year. At the end of the first year, the book basis exceeds the tax basis by $4,000. Burns must report a balance of $1,600 (= .40 × $4,000) in its Deferred Tax Liability account for the extra income taxes it will pay in future years when b ook depreciation exceeds tax depreciation. At the end of the second year, the difference in the tax basis and the book basis of the equipment is $22,400, reflecting cumulative differences in depreciation for the two years. The required balance in the Deferred Tax Liability account is $8,960 (= .40 × $22,400). The lower panel of Exhibit 1 shows the computation of income tax expense. Income tax expense equals income taxes currently payable, column [10], plus (minus) the credit (debit) change in the Deferred Tax Liability account from column [11]. Example 2
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Assume that, during the second year, a legislative body changes the income tax rate

As the preceding discussion indicates, IFRS incorporates uncertainty about the realization of deferred tax assets in the recognition and measurement of deferred tax assets, whereas U.S. GAAP incorporates this uncertainty in the valuation allowance.

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applicable to the current and future years from 40 percent to 30 percent. The required balance in the Deferred Tax Liability account at the end of the second year is now $6,720 (= .30 × $22,400). The change in the balance in the Deferred Tax Liability account from the end of the first year to the end of the second year is $5,120 (= $6,720 – $1,600). Income tax payable for the second year is $18,480 (= .30 × $61,600). Thus, income tax expense is $23,600 (= $18,480 + $5,120). In the second year, we reduce the deferred income tax balance to reflect the expected lower future taxes; this reduces income tax expense for the second year from the amount it would otherwise have been. SUMMARY OF REQUIRED ACCOUNTING FOR INCOME TAXES This section summarizes the required accounting for income taxes under U.S. GAAP and IFRS. 1. 2. 3. 4. Identify at each balance sheet date all differences between the book basis and the tax basis of assets and liabilities. Eliminate step 1 differences that will have no future tax consequence (that is, eliminate permanent differences). Separate the remaining differences (temporary differences) into those that will result in future tax deductions and those that will result in future taxable income. Multiply temporary differences that will result in future taxable income by the enacted income tax rate expected to apply in the future period of the taxable income. Show the result as a deferred tax liability on the balance sheet. Multiply temporary differences that give rise to future tax deductions by the enacted income tax rate expected to apply in the future periods of the deductions. Under U.S. GAAP, include this item in deferred tax assets; see step 6, next. Under IFRS, include this item in deferred tax asset only if it is probable that the firm will be able to realize the benefit of the future tax deduction. Under U.S. GAAP, assess the likelihood that the firm will realize the benefits of deferred tax assets in the future. If the firm is “more likely than not” (that is, the probability exceeds 50 percent) to realize the benefits, then deferred tax assets equal the amount in step 5 above. If the firm has a realization probability of less than 50 percent, then the firm must reduce the deferred tax asset by a valuation allowance (similar in concept to an allowance for uncollectible accounts receivable). The deferred tax asset valuation allowance reduces the deferred tax asset to the amount the firm expects to realize in tax savings in the future.

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This six-step procedure results in a deferred tax asset and a deferred tax liability at each balance sheet date. To compute income tax expense each period, 1. 2. start with income taxes currently payable on taxable income (the amounts in column [10] of Exhibit 1), and add (or subtract) the credit (or debit) change in the deferred tax asset and the deferred tax liability between the beginning and the end of the period (the amount in column [11] of Exhibit 1). This second component of income tax expense includes temporary differences, changes in enacted income tax rates, and changes in the valuation allowance (under U.S. GAAP).

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PROBLEM FOR SELF-STUDY Computing income tax expense and deferred tax amounts. The book basis and the tax basis of the assets and liabilities of Coniff Corporation on December 31, 2009, 2010, and 2011, appear below.
Nature of Difference Date December 31, 2009 Assets ............................................. Liabilities.......................................... December 31, 2010 Assets ............................................. Liabilities.......................................... December 31, 2011 Assets ............................................. Liabilities.......................................... 1,500 880 1,150 880 90 — 260 — Book Basis Tax Basis Permanent Temporary

$1,000 600

$

800 600

$50 —

$150 —

1,200 700

950 700

60 —

190 —

Coniff Corporation’s taxable income was $400 for 2010 and $430 for 2011. It pays taxes at the rate of 40 percent of taxable income. Compute the amount of income tax expense for 2010 and for 2011.
SUGGESTED SOLUTION TO PROBLEM FOR SELF-STUDY

(Coniff Corporation; computing income tax expense and deferred tax amounts.)
2010 Income Tax Payable: .40 × $400 ...................................................................... Increase in Deferred Tax Liability: .40 × ($190 – $150) ..................................... Income Tax Expense ........................................................................................ $160 16 $176

2011 Income Tax Payable: .40 × $430 ....................................................................... Increase in Deferred Tax Liability: .40 × ($260 – $190)...................................... Income Tax Expense ......................................................................................... $172 28 $200

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E X HI B I T 1 BURNS CORPORATION Computation of Total Income Tax Expense over Life of Equipment Equipment Costs $120,000 and Has Six-Year Life

I nform a ti on from (o r Ba sed on ) Ta x Re tu rn s Depreciation Expense on Financial Statements [3] $ 20,000 20,000 20,000 20,000 20,000 20,000 $120,000

I nform ati on from (o r Based on ) F in an ci al S tatemen ts Financial Statement (Book) Basis of Asset at End of Year [4] $120,000 100,000 80,000 60,000 40,000 20,000 0 End-of-Year Excess of Book Basis over Tax Basis [5] $ 0 4,000 22,400 25,200 19,600 12,800 0 End-of-Year Required Credit (Debit) Balance in Deferred Income Tax Account [6] $ 0 1,600 8,960 10,080 7,840 5,120 0

Year 0 1 2 3 4 5 6 ... ... ... ... ... ... ...

Depreciation Deduction on Tax Return [1] $ 24,000 38,400 22,800 14,400 13,200 7,200 $120,000

Tax Basis of Asset at End of Year [2] $120,000 96,000 57,600 34,800 20,400 7,200 0

Totals ...

Com pu tation o f To ta l In com e Tax E xp en se fo r Fin anci al S tatem ents Debit (Credit) Change in Deferred Income Tax Account Equals 2nd Debit (Credit) to Income Tax Expense [11] $ 1,600 7,360 1,120 (2,240) (2,720) (5,120) $ 0

Year 0 1 2 3 4 5 6 Totals .... .... .... .... .... .... ..

Income before Depreciation and Taxes [7] $100,000 100,000 100,000 100,000 100,000 100,000

Depreciation Deduction on Tax Return [8] $ 24,000 38,400 22,800 14,400 13,200 7,200 $120,000

Taxable Income [9] $ 76,000 61,600 77,200 85,600 86,800 92,800 $480,000

Income Taxes Payable Equals 1st Debit to Income Tax Expense [10] $ 30,400 24,640 30,880 34,240 34,720 37,120 $192,000

Total Income Tax Expense for Year [12] $ 32,000 32,000 32,000 32,000 32,000 32,000 $192,000

[1] = Given [2] = [2] from end of last year – [1] this year [3] = $120,000/6 [4] = [4] from end of last year – [3] this year [5] = [4] – [2] [6] = [5] x (tax rate expected when timing differences reverse) = [5] x .40 in this example

[7] = Given [8] = [1] = Given [9] = [7] – [8] [10] = [9] x (actual tax rate this year) = [9] x .40 in this example [11] = [6] end of this year – [6] end of last year [12] = [10] + [11]

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PROBLEMS DEFTAX 1. Measuring income tax expense. The book basis and the tax basis of the assets and liabilities of Kleen Cleaners and the reasons for the differences appear below.
Reason for Difference Book Basis January 1, 2009 Assets ...................................... Liabilities.................................... December 31, 2009 Assets ....................................... Liabilities.................................... December 31, 2010 Assets ....................................... Liabilities.................................... 2,600 1,700 2,000 1,500 200 — 400 200 2,400 1,500 1,700 1,240 150 — 550 260 €2,000 1,200 €1,400 1,000 €100 — €500 200 Tax Basis Permanent Temporary

Taxable income was €600 in 2009 and €750 in 2010. The income tax rate is 40 percent. The firm expects to fully realize the tax benefits of deferred tax assets throughout 2009 and 2010. Prepare the journal entry to recognize income tax expense for 2009 and for 2010 under IFRS. DEFTAX 2. Measuring income tax expense. The book basis and the tax basis of the assets and liabilities of Computer Electronics Corporation and the reasons for the differences appear below.
Reason for Difference Book Basis January 1, 2009 Assets ....................................... Liabilities.................................... December 31, 2009 Assets ....................................... Liabilities.................................... December 31, 2010 Assets ....................................... Liabilities.................................... 6,000 4,800 4,200 3,900 550 — 1,250 900 5,300 4,100 3,700 3,300 400 — 1,200 800 $4,600 3,200 $3,400 2,600 $300 — $ 900 600 Tax Basis Permanent Temporary

Taxable income was $2,000 in 2009 and $2,400 in 2010. The income tax rate is 40 percent. The valuation allowance for deferred tax assets was $50 on January 1, 2009, $60 on December 31, 2009, and $75 on December 31, 2010. Prepare the journal entries to recognize income tax expense for 2009 and for 2010 under U.S. GAAP.


				
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