Chapter 1515-1
16
Income Taxes
Overview
Financial accounting for income taxes is far more complicated then what you have experienced thus far. Previously, you probably saw income tax expense being simply recorded as “income before taxes” multiplied by a given rate. Unfortunately, accounting for income taxes isn’t quite that easy. Otherwise, an entire chapter—this chapter—would, obviously, not be needed.
Having already taken a tax course before this chapter can be useful, but it is not absolutely essential. This chapter will emphasize how financial accounting is affected by different kinds of tax adjustments, rather than your knowledge of specific tax rules and regulations.
Taxable income and financial income are almost always two different numbers. Hence, merely multiplying financial “income before taxes” by a constant rate every year would distort what is actually happening. Frequently, the differences between the two (financial and taxable income) are made up of numerous, even dozens, of different adjustments.
There are two different kinds of adjustments. One kind is called temporary because the adjustment will reverse itself in a different year. Temporary adjustments relate to timing differences. The tax law requires a different timetable for the recognition of some revenue and expense items. Over the life of a business, the total revenue and expenses are the same for financial and taxable income when it comes to temporary adjustments.
The other kind of adjustment is called permanent. Permanent differences result when an item of revenue or expense is never recorded for taxable income but is for financial income or vice versa.
When a company has higher taxable income now (due to more revenue or fewer expenses on a tax basis) relative to financial income, and it is due to temporary differences, that means the company will have lower taxable income later (again, relative to financial income). Lower taxable income and, hence,lower taxes later is a future economic benefit, and that sounds like our definition of an asset. Hence, a company in this situation will report a deferred tax asset.
If, on the other hand, a company has lower taxable income now, relative to financial income, it means the time to pay the piper will come later. Future obligations sound like liabilities, and indeed, that is the case here as well. Hence, a company in this situation will report a deferred tax liability.
That’s not so difficult, right? Well, the prior discussion begins to scratch the surface, but there is even more to it than that. We also have to consider changing tax rates, the effect of net operating losses getting carried back and forward to offset taxable income, and several other issues. Plus, most companies don’t have just one adjusting item, so things can get messy when there are many adjustments going different ways and on differing schedules. It’s time to roll up your sleeves because this topic takes more than a bit of common sense and skimming over to master.
Learning Objectives
Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered.
If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with.
The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.
Tips, Hints, and Things to Remember
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LO1 – Understand the concept of deferred taxes and the distinction between permanent and temporary differences.
How? There are three parts to a financial accounting entry dealing with income taxes. For academic purposes, you are usually given enough information to solve for two of the parts. The third is a plug to make the debits and credits equal. The two “fixed” parts are sometimes a debit to Income Tax Expense and a credit to Income Tax Payable. The third part is either a debit to Deferred Tax Asset or a credit to Deferred Tax Liability. The two fixed parts can also be the Income Tax Payable and either the Deferred Tax Asset or Deferred Tax Liability if that is the information provided. In that case, the Income Tax Expense is the plug.
If financial income before taxes is given, then that number multiplied by the tax rate (assuming the tax rate isn’t changing) will give you Income Tax Expense always. If taxable income is given, or can be solved for, then that number multiplied by the tax rate will give you Income Tax Payable. If the item that gives rise to the difference between financial and taxable income is given, then that number multiplied by the tax rate will give you your Deferred Tax Asset (Liability). If the tax rate is different in future years, then Income Tax Expense will always be the plug and can’t be as easily solved for.
LO2 – Compute the amount of deferred tax liabilities and assets including the use of a valuation allowance and the uncertainty of tax positions.
Why? What is the point of a valuation allowance? First, note that valuation allowances only apply to deferred tax assets. If it is thought that a deferred tax asset will not be used, or will only partially be used, then it shouldn’t be listed, or should only be partially listed, on the balance sheet. This is similar to the allowance for bad debts. The amount of accounts receivable listed as an asset should be the amount that is expected to turn into cash, not the full amount due.
When won’t a deferred tax asset be used? Perhaps the most common situation is when a company doesn’t have taxable income year after year. Without taxable income, the benefits of a deferred tax asset are no longer benefits. Many tax credits and losses that can carry forward to offset future taxable income expire. If it isn’t likely that the credits or losses will be used, because of expiration or because the company isn’t generating taxable income, then the deferred tax asset is reduced with a contra account, known as a valuation allowance.
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LO3 – Explain the provisions of tax loss carrybacks and carryforwards, and be able to account for these provisions.
How? When a loss is carried back and used, the calculation is as simple as multiplying the prior years’ rate(s) by the amount that was carried back and used. The entry is a debit to a receivable and a credit to an income tax benefit account, which serves to decrease (bring closer to zero) the current year loss that gave rise to the net operating loss.
When a loss is carried forward, either because an election was made, there was no prior income to offset, or because there wasn’t adequate income in prior years to fully absorb the entire current year loss, there is no immediate refund. Rather, an asset is created (for the tax benefits of the future use of the net operating loss). Deferred Tax Asset receives a credit and, similar to a carryback, an income tax benefit account receives a credit.
LO4 – Schedule future tax rates, and determine the effect on deferred tax assets and liabilities.
How? Future tax liabilities and tax assets should be based on future, not current, rates. If future, enacted rates change, then the current tax asset and/or liability need to be adjusted according to the new rates.
LO5 – Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities.
How? Classified balance sheets can have both current and noncurrent tax assets and/or liabilities. The classification of the deferred tax items are different than for others on the balance sheet. Other items are based on when they will be paid or when they will be collected. For tax assets and liabilities, however, it is based on what the asset or liability is that gives rise to the tax adjustment. Therefore, if depreciation, for instance, is going to be reversed (for book versus income tax purposes) in the coming year, it is not listed as current because it relates to “property, plant, and equipment,” which is a noncurrent asset.
Tax assets and liabilities can only offset each other if they are both of the same classification (i.e., both current or both noncurrent) and both for the same jurisdiction (i.e., both federal or both a single state’s taxes).
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LO6 – Comply with income tax disclosure requirements associated with the statement of cash flows.
How? Taxes will always be an operating activity. Usually, the amount of income taxes paid in a period will be different than the amount of income taxes accrued. Therefore, there is frequently an adjustment to net income, using the indirect method, to arrive at the correct cash flow from operating activities as it pertains to income taxes paid. The most common adjustment relative to net income is the change in the Income Taxes Payable account. If there are changes in the Deferred Tax Asset, Deferred Tax Liability, or Income TaxesReceivable accounts, then similar adjustments will need to be made for them as well. The adjustments relative to net income will move in the same directions as those for current assets (for receivables and deferred tax asset changes) and for current liabilities (for tax liability changes) as discussed back in Chapter 5.
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LO7 – Describe how, with respect to deferred income taxes, international accounting standards have converged toward the U.S. treatment.
Why? There is little to worry about here. The methods are nearly identical internationally when it comes to the financial accounting for income taxes (even though the tax laws and rates are very different in each country). It is doubtful that you will need to know the historical differences since they no longer apply.
The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format.
The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.
Multiple Choice
MC16-1 (LO1)The purpose of an interperiod income tax allocation is to
a. / show separately stated items net of tax.b. / allow reporting entities whose tax liabilities vary significantly from year to year to smooth payments to taxing agencies.
c. / amortize the deferred tax liability shown on the balance sheet.
d. / recognize an asset or liability for the tax consequences of temporary differences that exist at the balance sheet date.
MC16-2 (LO1)An example of a “deductible temporary difference” creating a deferred tax asset occurs when
a. / the installment sales method is used for income tax purposes, but the accrual method of recognizing sales revenue is used for financial reporting purposes.b. / accelerated depreciation is used for income tax purposes, but straight-line depreciation is used for accounting purposes.
c. / warranty expenses are recognized on the accrual basis for financial reporting purposes, but recognized as the warranty conditions are met for income tax purposes.
d. / the completed-contract method of recognizing construction revenue is used for income tax purposes, but the percentage-of-completion method is used for financial reporting purposes.
MC16-3 (LO2)The Wayne Static Company had taxable income of $12,000 during 2013. Wayne Static used accelerated depreciation for income tax purposes ($3,400) and straight-line depreciation for financial accounting purposes ($2,000). Assuming Wayne Static had no other temporary or permanent differences, what would the company's pretax financial accounting income be for 2013?
a. / $6,600b. / $10,600
c. / $13,400
d. / $17,400
MC16-4 (LO2)Monteblanco Corporation paid $20,000 in January 2013for premiums on a two-year life insurance policy which names the company as the beneficiary, an item that is never deductible for income tax purposes. Additionally, Monteblanco Corporation's financial statements for the year ended December 31, 2013, revealed the company paid $105,000 in nondeductible taxes during the year and also accrued estimated litigation losses of $200,000 which aren’t deductible until paid for income tax purposes. Assuming the lawsuit was resolved in February 2014(at which time a $200,000 loss was recognized for income tax purposes) and that Monteblanco’s tax rate is 30 percent for both 2013and 2014, what amount should Monteblanco report as asset for net deferred income taxes on its 2013balance sheet?
a. / $0b. / $57,000
c. / $60,000
d. / $66,000
MC16-5 (LO3)Recognizing tax benefits in a loss year due to a loss carryforward that will likely be used requires
a. / only a footnote disclosure.b. / creating a new carryforward for the next year.
c. / creating a deferred tax liability.
d. / creating a deferred tax asset.
MC16-6 (LO3)In 2013, Boothe Corporation reported $90,000 of income before income taxes. The tax rate for 2013was 30 percent. Boothe had an unused $60,000 net operating loss carryforward arising in 2012when the tax rate was 35 percent. The income tax payable Boothe would report for 2013would be
a. / $6,000.b. / $9,000.
c. / $10,500.
d. / $27,000.
MC16-7 (LO4)The following information is taken from Ibarra Corporation's 2013financial records:
Pretax accounting income / $1,500,000Excess tax depreciation / (45,000)
Taxable income / $1,455,000
Assume the taxable temporary difference was created entirely in 2013and will reverse in equal net taxable amounts in each of the next three years. If tax rates are 40 percent in 2013, 35 percent in 2014, 35 percent in 2015, and 30 percent in 2016, then the total deferred tax liability Ibarra should report on its December 31, 2013, balance sheet is
a. / $13,500.b. / $15,000.
c. / $15,750.
d. / $18,000.
MC16-8 (LO5)A deferred tax liability arising from the use of an accelerated method of depreciation for income tax purposes and the straight-line method for financial reporting purposes would be classified on the balance sheet as a(n)
a. / current liability.b. / noncurrent liability.
c. / current liability for the portion of the temporary difference reversing within a year and a noncurrent liability for the remainder.
d. / offset to the accumulated depreciation reported on the balance sheet.
MC16-9 (LO6)On the statement of cash flows using the indirect method, an increase in the deferred tax asset would be shown as a(n)
a. / addition to net income.b. / deduction from net income.
c. / increase in investing activities.
d. / increase in financing activities.
MC16-10 (LO7)International accounting standards currently are moving toward the
a. / no-deferral approach.b. / partial recognition approach.
c. / comprehensive recognition approach.
d. / discounted comprehensive recognition approach.
Matching
Matching16-1 (LO1)Listed below are the terms and associated definitions from the chapter for LO1. Match the correct definition letter with each term number.
___ 1.financial income / a.differences between financial and taxable income that result in future taxable amountsb.expected future benefits from tax deductions that have been recognized as expenses in the income statement but not yet deducted for income tax purposes
c.expected future income taxes to be paid on income that has been recognized in the income statement but not yet taxed
d.an accounting method that recognizes the tax effect of temporary differences between financial and taxable income in the financial statements rather than reporting as tax expense the actual tax liability in each year
e.income reported on the financial statements as opposed to income that is reported to taxing authorities in accordance with tax regulations
f.differences between financial and taxable income that will result in deductible amounts in future years
g.income as defined by income tax regulations as the basis for determining the income tax liability for a given entity
h.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; a common example is depreciation expense on equipment
i.nondeductible expenses or nontaxable revenues that are recognized for financial reporting purposes but that are never part of taxable income
___ 2.taxable income
___ 3.deferred income tax asset
___ 4.permanent differences
___ 5.temporary differences
___ 6.taxable temporary differences
___ 7.deductible temporary differences
___ 8.interperiod tax allocation
___ 9.deferred income tax liability
Matching16-2(LO2, LO3, LO5)Listed below are the terms and associated definitions from the chapter for LO2, LO3, and LO5. Match the correct definition letter with each term number.
___ 1.asset and liability method of interperiod tax allocation / a.the amount of operating loss that can be carried back and offset against the income of earlier profitable years to obtain a refund of previously paid income taxesb.rate computed by dividing reported income tax expense by earnings before income taxes
c.a method of income tax allocation that determines deferred tax assets or tax liabilities based on the expected future benefit or obligation associated with temporary difference reversals; if tax rates change, the asset or liability balances are adjusted to reflect the tax rates legislated to be in effect in the year when reversal is expected to occur
d.the amount of operating loss that can be carried forward and offset against income of future profitable years to reduce the tax liability for those years
e.a contra asset account that reduces an asset to its expected realizable value; this type of account can be used with accounts receivable and deferred tax assets
___ 2.valuation allowance
___ 3.net operating loss (NOL) carryback
___ 4.net operating loss (NOL) carryforward
___ 5.effective tax rate
Problems