CH16 - Income taxes

• Income Tax Accounting


  Reasons why Net Income for financial reporting (accounting income) is NOT EQUAL to Net Income for tax reporting (taxable income)
• Income Tax payment (in cash) to IRS is based on taxable income
• Income Tax Expense for financial reporting is a plug in the tax-related journal entry, not directly calculated
• Objectives of financial reporting and those of taxing authorities

  Not the same
• FASB


  Establishes financial accounting standards (GAAP) to provide useful information to investors and creditors
• Congress


  Establishes tax regulations to allow it to raise funds in a socially acceptable manner and based on tax payer's ability to pay (cash based)
• Sources for differences in the two incomes

  • Temporary differences
  • Permanent differences
  • Net Operating loss carryforwards
• Temporary Differences

  Driven by differences in GAAP and tax law regarding when revenues and expenses can be included in calculation of Net Income
• Temporary Differences


  Originate in one period and reverse, or turn around, in one or more subsequent periods
• Temporary Differences

  • Straight line depreciation for financial reporting vs. accelerated depreciation for tax reporting
• Deferred Tax Liability (DTL)

  Between origination and full reversal of the temporary differences, you will have a Deferred Tax Asset (DTA) or Deferred Tax Liability (DTL) on your balance sheet
• Deferred Tax Liabilities (DTL)

  Origination period: taxable income < pretax accounting income
• Items giving rise to a DTL

  • Tax revenue < FR revenue (e.g. trading securities)
  • Tax expense > FR expense (e.g. depreciation, prepaid expenses)
• Deferred Tax Assets (DTA)

  Origination period: taxable income > pretax accounting income
• Items giving rise to a DTA

  • Tax revenue > FR revenue (e.g. cash received in advance)
  • Tax expenses < FR expenses (e.g. warranties, bad debt)
• Valuation Allowance is needed if it is more likely than not that some portion or all of a deferred tax asset will not be realized
• Tax Rate Considerations


  Deferred tax liability = Temporary differences x Currently enacted tax rate effective in the year(s) the temporary difference reverses
• Any existing tax liability or asset must be adjusted to reflect a change in a tax law or rate immediately
• Permanent Differences

  Differences caused by transactions and events that under existing tax law will never affect taxable income or taxes payable
• Permanent Differences

  • Tax-free income (e.g. interest from municipal bonds)
  • Certain expenses that are not tax-deductible (e.g. fines and penalties)
• Permanent Differences


  Affect the effective tax rate, because they affect the relationship between tax expense and pretax accounting income
• Permanent differences do not create deferred tax assets or liabilities
• Multiple Temporary Differences

  • Future taxable amounts are multiplied by future tax rate(s) to determine the appropriate balance for the deferred tax liability
  • Future deductible amounts are multiplied by future tax rate(s) to determine the appropriate balance for the deferred tax asset
• Net Operating Losses (NOLs)


  Negative taxable income on the tax return, tax-deductible expenses exceed taxable revenues
• Tax laws permit an NOL to be used to reduce taxable income in future profitable years, creating a deferred tax asset
• Balance Sheet Classification


  • All deferred tax liabilities, deferred tax assets, and any valuation allowance against deferred tax assets are classified as noncurrent
  • If these deferred tax accounts relate to the same tax-paying component of the company and the same tax jurisdiction, they are netted against each other and shown as a single net number