StIce | StIce |Skousen

Income Taxes
Chapter 16

Intermediate Accounting
16E

Prepared by: Sarita Sheth | Santa Monica College

COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
 Learning Objectives
1. Understand the concept of deferred
taxes and the distinction between
permanent and temporary
differences.
2. Compute the amount of deferred tax
liabilities and assets.
3. Explain the provisions of tax loss
carrybacks and carryforwards, and
be able to account for these
provisions.
 Learning Objectives
4. Schedule future tax rates, and determine
the effect on tax assets and liabilities.
5. Determine appropriate financial
statement presentation and disclosure
associated with deferred tax assets and
liabilities.
6. Comply with income tax disclosure
requirements associated with the
statement of cash flows.
7. Describe how, with respect to deferred
income taxes, International Accounting
Standards have converged toward the
U.S. Treatment.
Overview
• The primary goal of
financial accounting is to
provide useful
information to
management,
stockholders, creditors,
and other properly
interested.
• The primary goal of the
income tax system is the
equitable collection of
revenue.
Deferred Income Tax Overview
Two basic considerations in U.S.
corporations computed net income.
1. How to account for revenues
and expenses that have
already been recognized and
reported to shareholders in a
company’s financial
statements but will not affect
taxable income until
subsequent years.
Deferred Income Tax Overview
Two basic considerations in U.S.
corporations computed net income.
2. How to account for revenues
and expenses that have
already been reported to the
IRS but will not be recognized
in the financial statements
until subsequent years.
 Simple Deferred Income Tax
Liability
• Examples:
– Revenues (or gains) taxable after they are
recognized for financial reporting, such as
receivables from installment sales.
– Expenses (or losses) deductible for tax
purposes before they are recognized for
financial reporting purposes, such as
accelerated tax depreciation.
Simple Deferred Tax Liability
In 2007, Hernandez Company earned
revenues of $30,000. Hernandez has no
expenses other than income taxes. In
this case, Hernandez is taxed on cash
received. The company received $10,000
in 2007 and $20,000 in 2008. The
income tax rate is 40% and it is expected
to remain the same into the foreseeable
future.
Simple Deferred Tax Liability
Income Tax Expense 12,000
Income Taxes Payable 4,000
Deferred Tax Liability 8,000
$30,000 x .40
$10,000 x .40
$20,000 x .40
Hernandez Company
Income Statement
For the Year Ended December 31, 2007
Revenues $30,000
Income tax expense:
Current $4,000
Deferred 8,000
Net income $18,000
 Simple Deferred Income Tax
Asset
• Examples:
– Expenses (or losses) that are deductible
for tax purposes after they are recognized
for financial reporting purposes, such as
warranty expenses.
– Revenues (or gains) that are taxable
before they are recognized for financial
reporting purposes, such as
subscriptions received in advance.
Simple Deferred Tax Asset
In 2007, Shah Corporation generated
service revenues totaling $60,000, all
taxable in 2007. No warranty claims
were made in 2007, but Gupta estimates
that in 2008 warranty costs of $10,000
will incurred for claims related to 2007
service revenues. Assume a 40% tax
rate.
 Simple Deferred Tax Asset
Income Tax Expense 20,000
Deferred Tax Asset 4,000
Income Taxes Payable 24,000
$30,000 x .40
Shah Company $10,000 x .40
Income Statement $20,000 x .40
For the Year Ended December 31, 2007
Revenues $60,000
Less: Warranty Expense 10,000
Income before taxes 50,000
Income tax expense:
Current $24,000
Deferred benefit (4,000) 20,000
Net income $30,000
 Temporary Differences
• Permanent Differences- Nondeductible
expenses or nontaxable revenues that are
recognized for financial reporting purposes
but are never part of taxable income.
• Temporary Differences- Differences between
pretax financial income and taxable income
arising from business events that are
recognized for both financial and tax
purposes, but in different time periods.
 Example of Permanent and
Temporary Differences
For the year ended December 31, 2007,
Monroe Corporation reported net
income before taxes of $420,000. This
amount includes $20,000 of
nontaxable revenues and $5,000 of
nondeductible expenses. The
depreciation method used for tax
purposes allowed a deduction that
exceeded the book approach by
$30,000.
 Example of Permanent and
Temporary Differences
Pretax income from income statement $420,000
Add (deduct) permanent differences:
Nontaxable revenues $(20,000)
Nondeductible expenses 5,000 (15,000)
Financial income subject to tax $405,000
Add (deduct) temporary differences:
Excess of tax depreciation over
book depreciation (30,000)
Taxable income $375,000

Tax on taxable income (income

taxes payable): $375,000 x .35 $131,250
Annual Computation of Deferred
Tax Liabilities & Assets
• Advantages of the asset and liability
method:
1. Assets and liabilities are recorded in
agreement with FASB definitions of
financial statement elements.
2. Method is flexible and recognizes
changes in circumstances and adjusts
the reported amounts accordingly.
3. Has better predictive value.
 Valuation Allowance for
Deferred Tax Asset

• Statement No. 109 stipulates that

both positive and negative
evidence be considered when
determining whether deferred tax
assets will be fully realized.
 Carryback and Carryforward of
Operating Losses

Carryback Election

Year Loss Year

-2 Year +20
Carryforward Election
 Net Operating Loss (NOL)
Carryback
Income Income
Year (Loss) Tax Rate Tax
2007 $10,000 35% $3,500
2008 14,000 30 4,200
2009 (19,000) 30 0

Journal Entry in 2009:

Income Tax Refund Receivable 6,200
Income Tax Benefit From NOL
Carryback 6,200
[$3,500 + (30% x $9,000)]
 Accounting for NOL
Carryforward
Continuing with the Prairie Company
illustration, assume that in 2010 the firm
incurred an operating loss of $35,000.
Income Income
Year (Loss) Tax Rate Tax
2009 $(19,000) 30% $0
20010 (35,000) 30% 0
The only loss remaining against which operating income
can be applied is $5,000 from 2008 ($14,000 – $9,000).
This leaves $30,000 to be carried forward from 2009 as
a future tax benefit of $9,000 ($30,000 x .30).
 Accounting for NOL
Carryforward
The journal entry for 2010 to
record the tax benefits :

Income Tax Refund Receivable 1,500

Deferred Tax Asset—NOL
Carryforward 9,000
Income Tax Benefit from NOL
Carryback 1,500
Income Tax Benefit from NOL
Carryforward 9,000
 Accounting for NOL
Carryforward
The firm reports a taxable income of $50,000
in 2011. The tax carryforward allows
management to deduct the carryforward from
the $15,000 tax ($50,000 x .30) that would be
due without the carryforward.

Journal Entry:
Income Tax Expense 15,000
Income Taxes Payable 6,000
Deferred Tax Asset—NOL
Carryforward 9,000
 Accounting for NOL
Carryforward
• If
Asmanagement believes
a result of this that
entry, thelosses will tax
deferred continue
asset
in the
is future and expected
zero—the the tax benefit will not
realizable be
value.
realized:
Journal Entry:
Income Tax Refund Receivable 1,500
Deferred Tax Asset—NOL
Carryforward 9,000
Income Tax Benefit from NOL
Carryback 1,500
Allowance to Reduce Deferred
Tax Assets to Realizable Value—
NOL Carryforward 9,000
Scheduling for Enacted Future
Tax Rates
• Proper recognition of deferred tax assets
and liabilities is required when future tax
rates are expected to differ from current tax
rates.
• The firm must determine the temporary
differences that will reverse.
• Statement No. 109 eliminates much of the
need for scheduling through the “more-
likely-than-not” criterion for future income.
 Financial Statement
Presentation and Disclosure
The following items must appear in the
income statement or an
accompanying note:

• Current tax expense or benefit

• Deferred tax expense or benefit
• Investment tax credits
• Government grants recognized as tax
reductions
 Financial Statement
Presentation and Disclosure
The following items must appear in the
income statement or an accompanying
note:
• Benefits of NOL carryforwards
• Adjustments of a deferred tax liability or
asset for enacted changes in tax laws or rates
or a change in the tax status of an enterprise
• Adjustments in beginning-of-the-year
valuation allowance because of a change in
circumstances
 Deferred Taxes and the
Statement of Cash Flows
Callazo Company had the following information
for 2007:
Revenue (all cash) $30,000
Income tax expense:
Current $10,300
Deferred 1,700 (12,000)
Net income $18,000
Cash paid for income taxes during 2007 totaled
$13,300.
 Deferred Taxes and the
Statement of Cash Flows
12/31/07 12/31/07
Income tax refund receivable $2,000 $ 0
Income taxes payable 0 1,000
Deferred tax liability 9,700 8,000

Analysis
Income Statement Adjustment SCF
Revenue (all cash),
$30,000 No adjustment $30,000 cash
collected from
customers
 Deferred Taxes and the
Statement of Cash Flows
Analysis
Income Statement Adjustment SCF
Income tax
expense—current –$2,000— $(13,300) Cash
$(10,300) Increase in paid for taxes
tax receivable
–$1,000—
Decrease in
taxes payable
 Deferred Taxes and the
Statement of Cash Flows
Analysis
Income Statement Adjustment SCF
Income tax
expense—deferred +$2,000— No effect
$(1,700) Increase in
deferred tax
liability
 Deferred Taxes and the
Statement of Cash Flows
Analysis
Income Statement Adjustment SCF
Net income, $18,000 –$1,300 $16,700 Cash
flow from
operations
Collazo Company
Statement of Cash Flows
(Direct Approach)

Cash collected from customers $30,000

Income taxes paid (13,300)
Cash provided by operating activities $16,700
 Deferred Taxes and the
Statement of Cash Flows
Collazo Company
Statement of Cash Flows
(Indirect Approach)
Net income

$18,000
Decrease in income tax refund receivable

(2,000)
Decrease in income taxes payable

(1,000)
Increase in deferred tax liability
 International Accounting for
Deferred Taxes
• No-Deferral Approach- Ignore the
differences and report income tax expense
equal to the amount of tax payable for the
year.
• Comprehensive Recognition Approach-
Deferred taxes are included in the
computation of income tax expense and
reported on the balance sheet.
• Partial Recognition Approach- A deferred tax
liability is recorded only to the extent that
the deferred taxes are actually expected to
be paid in the future.