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Income Tax

Reporting

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 13
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education

Learning objectives
1. The different objectives underlying income determination for
financial reporting (book) purposes versus tax purposes.
2. The distinction between temporary (timing) and permanent
differences, the items that cause these differences, and how each
affects book income versus taxable income.
3. The distortions created when the deferred tax effects of temporary
differences are ignored.
4. How tax expense is determined with interperiod tax allocation and
the relation between taxes payable, changes in deferred taxes
and tax expense.
5. Measuring and reporting valuation differences for deferred tax
assets.
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Learning objectives:
Concluded

6. How changes in tax rates are measured and recorded.


7. The reporting rules for net operating loss carrybacks and carryforwards.
8. How to read and interpret tax note disclosures and how these
footnotes can be used to enhance comparisons across firms.
9. Financial statement disclosures on uncertain tax positions.
10. How tax notes disclosures can be used to improve financial
statement analysis.
11. Key differences between IFRS and U.S. GAAP rules for reporting
of income taxes.
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Book income and taxable


income
Book Income:
Income computed for
financial reporting purposes

Taxable Income:
Income computed for
tax compliance purposes

Intended to reflect increases in


the firms well-offness.

Governed by the constructive


receipt/ability to pay doctrine.

Includes all earned inflows of


net assets, even when the
inflow is not immediately
convertible into cash.

The timing of taxation usually


(but not always) follows the
inflow of cash or equivalents.

Reflects expenses as they


accrue, not just when they are
paid.

Deductions generally are


allowed only when the
expenditures are made or
when a loss occurs.

Divergence complicates the way income


taxes are reflected in financial reports

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Understanding income tax


reporting:
Timing differences
Book Income

Timing
differences:

Depreciation expense
Bad debt expense
Installment sales
Revenues received in advance

Permanent
differences

Taxable Income

A timing difference results when a revenue (gain) or expense (loss) enters book
income in one period but affects taxable income in a different (earlier or later)
period.

Timing differences give rise to deferred tax assets and deferred tax liabilities
because they are temporary (they eventually reverse):
Book
income
Current period
Later period

Taxable
income

$100

$0

$0

$100

Type
Originating
Reversing

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Understanding income tax


reporting:
Permanent differences
Book Income

Taxable Income

Timing
differences:
Permanent
differences

Interest on state and municipal bonds.


Goodwill write-offs
Statutory depletion in excess of
cost-based depletion
Dividend received deduction

Permanent differences are caused by income items that:

Enter into book income but never affect taxable income.


Enter into taxable income but never affect book income.

Because permanent differences do not reverse, they do not give


rise to deferred tax assets or liabilities.

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Mitchell Corporation buys new equipment for $10,000 on January 1, 2014. The
asset has a five-year life and no salvage value. It will be depreciated using the
straight-line method for book purposes, but for tax purposes the sum-of-theyears-digits method will be used. (Technically, firms are required to use
MACRS depreciation for tax purposes.)

Straight-line

SYD method

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Understanding income tax


reporting:
Mitchells income tax payable

Assume for Mitchell Corporation that depreciation is the only book


versus tax difference.
If income before depreciation is expected to be $20,000 each year
over the next five years, and the statutory tax rate is 35%, then:

Taxes
Due

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Understanding income tax


reporting:
Mitchells temporary differences

Depreciation Expense

Income

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Understanding income tax


reporting:
The mismatch problem

If book income tax expense is set equal to actual taxes payable each
year, then:

Expense
increases with
taxes due

Book income
declines

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Understanding income tax


reporting:

A When
financial
reporting

book income
tax expense distortion
is set equal to the actual taxes
payable each year, there is a mismatch:
Figure 13.2
MITCHELL
CORPORATION
Tax Expense
without
Interperiod Tax
Allocation

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Understanding income tax


reporting:
The FASBs solution

Interperiod tax allocation overcomes


the mismatch problem.
$3,333
Tax
depreciation

$2,000
Book
depreciation

$1,333 of extra
depreciation
in year 1

The extra tax depreciation in early


years will be offset by lower tax
depreciation in later years.
The extra tax depreciation thus
generates a liability for future taxes.

Future tax liability


is $1,333 X 35%
or $467

Recording this deferred tax liability


as it accrues eliminates the
mismatch.

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Deferred income tax


accounting:
Interperiod tax allocation

FASB ASC Topic 740, Income Taxes, requires that the journal
entry for income taxes reflect both:

Taxes currently due


Any liability for future taxes arising from current period book-versustax differences that will reverse in later periods.

Originating

Reversing

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Deferred income tax


accounting:
Calculating tax expense
Relation between tax
expense, taxes payable,
and changes in deferred
tax liabilities

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Deferred income tax


accounting:

The mismatch is eliminated


Figure 13.4
MITCHELL
CORPORATION
Tax Expense with
Interperiod Tax
Allocation

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Deferred income tax assets:


Computing income tax expense

Relation between tax


expense, taxes payable, and
changes in deferred tax
assets and liabilities

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Deferred income tax assets:


Valuation allowances

The FASB requires firms with deferred tax assets to assess the
likelihood that those assets may not be fully realized in future
periods.
Realization depends on whether or not the firm has future taxable
income.
More likely than not
0%
DTA carrying value is
reduced until the new
amount falls within this
range

50%

100%

Probability that
DTA will NOT
be realized

Deferred tax asset (DTA)


valuation allowance is then
required

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Deferred income tax assets:


Valuation allowance example

Norman Corporation records a deferred tax asset in 2014 related to


accrued warranty expenses:

In early 2015, Norman determines that it is unlikely to earn enough


taxable income in future years to realize more than $200,000 of the
deferred tax asset. The entry made in 2015 is:

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Net operating losses:

Carrybacks and carryforwards example


Unfortunato Corporation experienced a $1 million pre-tax operating
loss in 2014. Under U.S. Income Tax Code, the company can either:
Figure 13.6
Illustration of Tax
Loss Carryback/
Carryforward
Provision

Figure 13.6
Illustration of Tax
Loss Carryforward
Provision

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Net operating losses:

Carryback and carryforward entries


Suppose Unfortunato had the following operating profit history:

=$750,000 x
35%

The following entry would be made to reflect the carryback:

If future pre-tax operating profits are expected to exceed $250,000, then the
carryforward entry would be :
$250,000
x 35%

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Deferred income tax


accounting:
When tax rates change

When tax rates change, the tax effects of reversals change as well.
Year 1

Year 2

$1,000

$1,000

Tax effect at 35%

350

350

at new 30%

300

300

Reversal
$700

Deferred tax liability

GAAP adopts the liability approach to measure deferred income taxes


in this situation. In any year current or future tax rates are changed:

The income tax expense number absorbs the full effect of the change
The relationship between that years tax expense and book income is
destroyed.

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Deferred income tax


accounting:
When tax rates change
$700

= ($1,333 +
$667) x .35

Deferred tax liability before


the tax rate change

$760

= ($1,333 +
$667) x .38

Deferred tax liability after


the tax rate change

Under the FASB ASC Topic 740, Income Taxes,liability approach,


income tax expense for 2016 would be:
2016

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Deferred income tax


accounting:
When tax rates change

Tax rate changes can inject one-shot (transitory) adjustments to


earnings. The earnings impact depends on:

Whether the tax rates are increased or decreased.


Whether the firm has net deferred tax assets or net deferred tax
liabilities.
The magnitude of the deferred tax balance.

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Understanding income tax


note disclosures:
Tax expense components

Taxes due

GAAP tax
expense
Due to temporary differences in revenue and expense items reported on Deeres 2012
GAAP income statement versus what was reported on its 2012 tax return.

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Global Vantage Point


Key differences between IFRS and U.S. GAAP
income tax accounting rules
Difference

GAAP

IFRS

Approach for recognizing


deferred tax assets

Uses a valuation account for


deferred tax asset if book basis is
different from the tax basis

No valuation account

Reconciliation of statutory and


effective tax rates

Uses the domestic federal


statutory rate

Uses a statutory rate

Reporting of deferred taxes on


the balance sheet

Classifies deferred tax assets and


liabilities as current or noncurrent
depending on the nature of the
temporary difference

Deferred tax assets and liabilities


are reported as noncurrent

Disclosure of income tax


amount recognized directly in
equity

Not required

Must disclose the aggregate


amount of current or deferred
income tax income or expense to
Other Comprehensive Income

Uncertain tax positions

Extensive guidance under FASB


ASC 740

No specific guidance. IAS 12 calls


for tax assets and liabilities to be
measured at the amount expected
to be paid

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Summary
The rules for computing income for financial reporting purposes
book incomediffer from those for computing income for tax
purposes.
The differences between book income and taxable income are
caused by both permanent and temporary (timing) differences in
the revenue and expense items reported on a companys books
versus its tax return.
Temporary differences give rise to both deferred tax assets and
deferred tax liabilities.
Deferred tax accounting allows firms to report tax costs (or benefits)
on the income statement in the same period as the related revenue
or expense items are reported (matching principle).
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Summary concluded
The income tax foot provides useful information for understanding
how much tax is paid and how much is deferred each year. Tax
notes also help explain why effective tax rates may differ from the
statutory rate.
Tax notes provide useful information that can be exploited to
improve interfirm comparability and evaluate firms earnings
quality.
GAAP disclosures are useful in assessing a firms uncertain tax
positions and whether the firm is aggressive or conservative in
recognizing the benefits associated with these positions.
There are a number of differences between IFRS and U.S. GAAP
rules for accounting for income taxes that you should be aware of.
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