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Income Taxes

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Level I - Financial Reporting and Analysis

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 Contents
1. Introduction
2. Differences Between Accounting Profit and Taxable Income
3. Determining the Tax Base of Assets and Liabilities
4. Temporary and Permanent Differences between Taxable and
Accounting Profit
5. Unused Tax Losses and Tax Credits

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6. Recognition and Measurement of Current and Deferred Tax

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7. Presentation and Disclosure

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8. Comparison of U.S. GAAP and IFRS

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 1. Introduction

• Differences between how and when transactions are recognized for financial
reporting purposes relative to tax reporting

• Difficult reading; focus on the key concepts

• We will work with simple examples

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2. Differences between Accounting Profit and Taxable Income
Financial statements are prepared based on accounting standards; these standards
define the rules for computing accounting profit and hence the tax expense. The
calculation of income tax payable is based on tax laws.

Accounting Principles Tax Rules

Straight line depreciation Accelerated depreciation

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Revenue recognition rules Revenue based on cash received
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Matching principle for expenses Expenses based on cash paid
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 Accounting Profit and Taxable Income

Accounting profit is based on Taxable income is based on tax laws

accounting standards

Financial Reporting Tax Reporting

2011 2012 2011 2012
Revenue 100 100 Revenue 100 100

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Cash Expenses 50 50

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Cash Expenses 50 50
0

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Depreciation (SL) 25 25 Depreciation (Acc) 40 10

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Profit Before Tax 25 25 Taxable Income 10 40

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 Provision for Income Tax Expense and Tax Payable
Financial Reporting Tax Reporting
2011 2012 2011 2012
Revenue 100 100 Revenue 100 100
Cash Expenses 50 50 Cash Expenses 50 50
Depreciation (SL) 25 25 Depreciation (Acc) 40 10
Profit Before Tax 25 25 Taxable Income 10 40

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Tax rate is 40%. What is the income tax expense and tax payable for 2011.

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For 2011: Income tax expense = 40% of 25 = 10 and income tax payable is 40% of 10 = 4

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Income tax expense is shown on the income statement.

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Income tax payable is what is payable and is shown on the balance sheet.

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Income tax paid is the actual amount paid.

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 Deferred Tax Liabilities
Deferred tax liabilities (DTL) arise when income tax expense (income statement) is
temporarily greater than tax payable (tax return)
ƒ Revenue recognized on income statement before being included on tax return
ƒ Expenses tax deductible before being recognized on income statement

Financial Reporting Tax Reporting

2011 2012 2011 2012
Revenue 100 100 Revenue 100 100

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Cash Expenses 50 50 Cash Expenses 50 50

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Depreciation (SL) 25 25 Depreciation (Acc) 40 10
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Profit Before Tax 25 25 Taxable Income 10 40

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Tax Expense (40%) 10 10 Tax Payable (40%) 4 16

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Profit After Tax 15 15 Profit After Tax 6 24
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End of 2011 End of 2012

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DTL = 6 DTL is reversed
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 Deferred Tax Assets
Deferred tax assets (DTA) arise when tax payable is temporarily higher than income
tax expense
ƒ Revenue taxable before being recognized on income statement
ƒ Expense recognized before being tax deductible

Financial Reporting Tax Reporting

2011 2012 2011 2012
Revenue 100 100 Revenue 120 80
0

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Cash Expenses 50 50
0

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Cash Expenses 50 50

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Profit Before Tax 50 50 Taxable Income 70 30

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Tax Payable (40%) 28 12

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Tax Expense (40%) 20 20

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Profit After Tax 30 30 Profit After Tax 42
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 Tax Base of an Asset
Asset tax base is the value of an asset according to tax rules and is used to calculate tax
payable. Asset tax base is analogous to carrying amount (net book value).

Example: An asset is purchased for 50 and is depreciated over two years. On the
financial statements the depreciation is 25 and 25. According to tax rules the
depreciation is 40 and 10. Show the carrying amount and tax base at T=0, T=1 and T=2.

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 Link between Tax Base and DTL
Financial Reporting Tax Reporting
2011 2012 2011 2012
Revenue 100 100 Revenue 100 100
Cash Expenses 50 50 Cash Expenses 50 50
Depreciation (SL) 25 25 Depreciation (Acc) 40 10
Profit Before Tax 25 25 Taxable Income 10 40
Tax Expense (40%) 10 10 Tax Payable (40%) 4 16
Profit After Tax 15 15 Profit After Tax 6 24

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DTL = (Carrying Amount - Tax Base) x Tax Rate

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End of 2011: DTL = (25 – 10) x 0.4 = 6

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End of 2012: DTL = 0

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 Link Income Tax Expense, Tax Payable and DTL
Financial Reporting Tax Reporting
2011 2012 2011 2012
Profit Before Tax 25 25 Taxable Income 10 40
Tax Expense (40%) 10 10 Tax Payable (40%) 4 16
Profit After Tax 15 15 Profit After Tax 6 24

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DTL = (Carrying Amount - Tax Base) x Tax Rate ITE = ITP + Change in Net DTL

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End of 2011: DTL = (25 – 10) x 0.4 = 6 2011: ITE= 4 + (6 – 0) = 10

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End of 2012: DTL = 0 2012: ITE= 16 + (0 – 6) = 10

ITE = ITP + Change in DTL – Cha

Change
ge in DTA

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 Example
In 2012 the income tax payable is 100. During the year DTL increased from 20 to 25
and DTA increased from 0 to 10. What is the provision for income tax in 2012?

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 Example
Acme Inc. builds a factory which will be depreciated over 10 years for
accounting purposes. Tax rules allow depreciation over 5 years. Acme is likely
to record:
A. A deferred tax asset
B. A deferred tax liability
C. No deferred tax asset or liability

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 Example
Acme Inc. receives advance payments from customers that are immediately
taxable. The necessary service will be delivered next year. Acme is most likely
to record:
A. A deferred tax asset
B. A deferred tax liability
C. No deferred tax asset or liability

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3. Determining the Tax Base of Assets and Liabilities

• Determining the Tax Base of an Asset

• Determining the Tax Base of a Liability

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• Changes in Income Tax Rates

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 Determining the Tax Base of an Asset
Asset tax base is the amount that will be deductable for tax purposes in future periods
as the economic benefits become realized

Item Carrying Tax Base Temporary

Amount Difference
An asset is purchased for 50; for year 1 depreciation = 25 on income 25 10 15
statement and 40 for tax purposes
Capitalized development cost = 100 at the start of the year
During the year 30 was amortized

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For tax purposes only 25% amortization is allowed

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Research cost for the year = 100; entire cost was expensed

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Tax rules require cost to be spread over 4 years

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Gross accounts receivable = 100

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Provision for doubtful debt = 10%

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Tax authorities allow 20%

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 Determining the Tax Base of a Liability
The tax base of a liability is the carrying amount of the liability less any amounts that
will be deductable for tax purposes in the future.

Item Carrying Tax Base Temporary

Amount Difference
Customer payments received in advance = 50 50 0 50
Amount is taxable

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 Changes in Income Tax Rates
The measurement of deferred tax assets/liabilities is based on current tax law. If there
is a subsequent change in tax law or new income tax rates, then existing deferred tax
assets/liabilities must be adjusted for these changes.

DTL = (Carrying Amount - Tax Base) x Tax Rate

End of 2011: DTL = (25 – 10) x 0.4 = 6

What happens to DTL if tax rate is reduced to 30%?

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Decrease in tax rate reduces deferred tax liabilities and deferred tax assets

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Increase in tax rate increases deferred tax liabilities and deferred tax assets

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 Example
Firm A has a net deferred tax liability. The government announces a decrease in the
statutory tax rate. Will this change benefit the income statement and balance sheet?

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 4. Temporary and Permanent Differences

Permanent differences are differences between tax and financial reporting of

revenue (expenses) that will not be reversed at some future date. These
differences do not give rise to DTLs and DTAs. Examples include:
ƒ Income or expense items not allowed by tax legislation
ƒ Tax credits for some expenditures that directly reduce taxes

Permanent differences Æ Effective tax rate ≠ Statutory tax rate

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Reported effective tax rate = Income tax expense/Pretax income

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 Example
In 2012, Acme’s provision for income tax was 20 against EBT of 100. In the same year
the tax payable was 25 and taxable income was 110. What was Acme’s effective tax
rate for 2012?

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 Examples of Temporary Differences

Temporary differences between taxable and accounting profit arise from a

difference between the tax base and the carrying amount of assets and
liabilities. DTLs and DTAs are only created if there is temporary difference
which is expected to reverse in the future.

Balance Carrying Amount vs. Tax Base DTL or Example

Sheet Item DTA
Asset Carrying amount > tax base DTL SL deprecation for accounting profit

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Accelerated deprecation for taxable profit

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Asset Carrying amount < tax base DTA Research cost expensed for accountingg prof
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Amortized for tax

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Liability Carrying amount > tax base DTA Cash from customers before revenue
enue rrecog.
ecog.

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Cash from customers is taxed

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Liability Carrying amount < tax base DTL

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 5. Unused Tax Losses and Tax Credits
• Tax loss carry forward occurs when a company experiences a loss in a current
period that may be used to reduce future taxable income

• Tax credits reduce the actual amount of tax owed; governments may grant a tax
credit to promote a specific behavior

• IFRS allows recognition of unused tax losses and tax credits only to the extent that
it is probable that in the future there will be taxable income against which the

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unused tax losses and credits can be applied

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• Under U.S. GAAP, a deferred tax asset is recognized in full but is reduced
ed byy a

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valuation allowance if it is unlikely that the benefit will be realized

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 Assessing the Probability of Profitability
When assessing the probability that sufficient taxable profit will be generated in the
future, the following criteria can serve as a guide:
¾ If there is uncertainty as to the probability of future taxable profits, a deferred tax asset as
a result of unused tax losses or tax credits is only recognized to the extent of the available
taxable temporary difference;
¾ Assess the probability that the entity will in fact generate future taxable profits before the
unused tax losses and/or credits expire pursuant to tax rules regarding the carry forward of
the unused tax losses;

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¾ Determine whether the past tax losses were a result of specific circumstances that are

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unlikely to be repeated; and

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¾ Discover if tax planning opportunities are available to the entity that will resultt in fu

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profits. These might include changes in tax legislation that is phased in over more
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more financial period to the benefit of the entity.

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 Example
Acme Inc. incurs an expenditure which results in a tax credit. This tax credit
directly reduces taxes. Acme is likely to record:
A. A deferred tax asset
B. A deferred tax liability
C. No deferred tax asset or liability

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 6. Recognition and Measurement of Current and Deferred Tax
• Current taxes payable or recoverable are based on current tax rates; deferred taxes
should be measured at the tax rate that is expected to apply when the asset is
realized or the liability is settled.

• All unrecognized deferred tax assets and liabilities must be reassessed on the
appropriate balance sheet date and measured against their probable future
economic benefit.

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• If a DTL will not be reversed, analysts should treat it as equity

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• If there is uncertainty about the timing and amount of tax payments, an

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should treat DTLs and neither liabilities nor equity

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 Measurement of DTA and Valuation Allowance
• If DTA will not be realized because of insufficient future taxable income to recover
the tax asset then the DTA must be reduced

• Under U.S. GAAP, a DTA can be reduced by creating a valuation allowance; DTA can
be revalued upward by decreasing the valuation allowance which would increase
earnings

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 Example
Acme Inc. presents financial statements in accordance with U.S. GAAP. In 2012,
Acme discloses a DTA = 100 and valuation allowance = 10. In 2011, Acme
disclosed a valuation allowance of 15 against DTA of 95. The change in
valuation allowance most likely indicates:
A. Deferred tax liabilities were reduced in 2012
B. Expectations of future earning power has increased
C. Expectations of future earning power has decreased

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 7. Presentation and Disclosures
• Deferred tax assets and liabilities must be disclosed
• Under IFRS deferred tax assets or liabilities are classified as noncurrent
• Under U.S. GAAP the classification is based on the underlying asset or liability

Deferred tax assets:

Accrued expenses 10
Tax loss carry forward 11
Deferred tax assets 21
Valluation allowance -1

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Net deferred tax asset 20

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Deferred tax liabilities:

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Depreciation 30

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Retirement plans 15

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Deferred tax liabilities 45

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 8. Comparison of U.S. GAAP and IFRS
• Accounting treatment of income taxes under U.S.GAAP and IFRS are similar in most
respects

• Some differences:
ƒ Deferred tax recognition for goodwill
ƒ Deferred tax recognition with respect to investments in subsidiaries (both
foreign and domestic)
ƒ tax rate to be used for preparing numerical reconciliation

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ƒ Use of a valuation allowance

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• See Exhibit 5 for the full list

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 Summary
• Terminology

• Understand how DTLs and DTAs are created

• Tax base versus carrying amount

• DTL = (Carrying Amount – Tax Base) x Tax Rate

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• ITE = ITP + Change in DTL

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• Changes in income tax rate

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• Temporary versus permanent differences

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 Conclusion
• Read summary

• Review learning objectives

• Examples

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• Practice problems: good but not enough

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• Practice questions from other sources

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