Accounting for
Income Taxes
Interperiod, Intraperiod, operating loss
carryback/carryforward
2. Intraperiod Tax
Allocation
Accrued tax on current
period’s earnings/loss for
different categories of
income -continuing operations,
discontinued operations,
extraordinary item, net
income
taxes follow the income
1. Interperiod Tax allocation
• Accrue taxes each period
• Impacted by financial accounting book
income on income statement (US GAAP)
being different than IRS taxable income
(tax return)
Ignores permanent differences between financial accounting
book income (book NI) and IRS taxable income (tax NI) when creating
deferred tax asset/liability
Uses timing differences that reverse over time between book
NI and tax NI to create deferred tax asset/liability
3.
Carryback & Carryforward of
operating loss
Seeking refund on previous taxes
paid if sustain current operating loss
(carry back)
Seeking reduction in future taxes to
be paid if sustain current operating
loss (carry forward)
Comparison of records
U.S. GAAP Income Statement
Tax return
Tax return
Taxable revenues
XX
Deductible expenses
(XX)
Taxable income
XX
Times current tax rate
%
Tax payable
XX
Income Statement 1/1-12/31/XX
Revenues
XX
Sales revenue
XX
Interest revenue
XX
Service revenue
total
Expenses
(XX)
Depreciation expense
(XX)
Rent expense
(XX)
Insurance expense
(XX)
Warranty expense
Total
XX
(XX)
Income before tax
XX
Less: tax expense
Net Income
(XX)
XX
Interperiod tax allocation journal
entry results in:
• An increase to tax expense (debit) or tax credit (credit) as the “plug” figure of the
journal entry and impacting the Income Statement
• Deferred tax asset (current or long-term asset- depending on when it reverses) or
deferred tax liability (current or long-term liability – depending on when it reverses)
Also, need to know enacted future tax rates (if known) when item reverses. Impacts
the balance sheet.
• Tax payable – based on IRS rules and the taxable income on the tax return and
:
current tax rates.
• The entry can look like one of the journals below or a combination of the two:
Income tax expense
XX
Deferred tax liability
XX
Income tax payable
XX
Income tax expense
Deferred tax asset
Income tax payable
XX
XX
XX
Interperiod tax –differences in tax
and book
• Permanent differences-
• Temporary differences-
• Taxable income not changed by
income statement revenue or
expense, or taxable income
changed by revenue or expense not
reported on the income statement
• Taxable income changed by income
statement revenue or expense, but
not in the same time period
• Affects either reported pretax
income statement profits or taxable
income on tax return but never both
• Never triggers deferred tax asset or
liability, never reverses
• Ignored for Interperiod tax allocation
• Triggers deferred tax asset or liability,
reverses
• Difference between US GAAP
balance sheet assets/ liabilities versus
IRS tax basis assets/liabilities
• Affects both pretax income
statement profits and taxable
income on tax return
Reversing of deferred tax items
•
Example –Accrue taxes for 3 years, assuming depreciation is the only timing difference. New
equipment $9000, 3 year life, no salvage depreciated using double declining balance for taxes
and straight-line for books, assume pretax financial income is $10,000 every year, 20% tax rate.
STL=(cost-salvage)/useful life, DDB=(cost-accumulated depreciation) X 2/useful life). STL =
9000/3=3000 annually, DDB= year 1 (9000-0)*2/3=6000, year 2 (9000-6000)*2/3=2000, year 3 (90008000)*2/3 adjust to 1000. Notice the ending balance of the general ledger account “deferred
tax payable” becomes zero by the end of the 3rd year (and thus reversing liability balance
earlier).
Deferred tax payable
400
200
Yr.
1
600
0
Tax expense
2000
Deferred tax payable
Tax payable
600
1400
(deferred tax payable is (6000-3000) * .20=600, tax payable (10000(6000-3000)) *.20=1400, tax expense =plug figure or 10000* .20)
Yr.
2
Tax expense
Deferred tax payable
Tax payable
2000
200
2200
(deferred tax payable = (3000-2000) * .20, tax payable (10000+
(3000-2000) *.20=2200, tax expense plug or 10000*.20=2000
Yr.
3
Tax expense
Deferred tax payable
Tax payable
(deferred tax payable = (3000-1000)*.20=400, tax payable (10000+
(3000-1000)) *.20=2400, tax expense plug or 10000*.20=2000
2000
400
2400
Future taxable amounts create deferred tax payable
(in future, more taxable revenues or fewer tax deductions, raising future taxable income)
•
Tax rules, more on cash basis (taxable income increases when businesses taxed on cash collected from customers and
taxable income decreases for tax deductibles when cash paid for
•
Book rules, accrual basis (revenue recognized when earned, serving customers, etc., expensed when incurred (assets
used up, service received)
•
Results in deferred tax liability now (credited) and higher tax payable (versus book tax expense) in the future
•
Often elect tax rules currently that lower taxable income now by taking the largest tax deduction right away. Eventually
they catch up to you!
•
Examples of lower taxable income on tax return now compared to book pretax financial income this year (to reverse in
future)
–
Installment sales gross profit “point of sale” currently recognized completely in this period’s income statement, while taxed in the next
several years as cash is collected.
–
Revenues/expenses reported on US GAAP income statement using % of completion method for long-term projects, reported with
completed contract method on IRS tax return (profits taxed in future when project complete –versus some profits recognized each
period as work is done on each income statement)
–
Equity method --US GAAP income statement shows ownership % share of investment times company profits versus taxable income only
increased for dividends collected from investment.
–
Unrealized gains from holding trading securities immediately impact profits on income statement but only affect tax return when they
are sold later for a realized gain.
–
Accelerated tax depreciation versus non-accelerated book depreciation method (such as straight-line)
–
Interest expense capitalization currently on self-constructed assets for books (take away expense and add to asset—expensed through
depreciation in future) versus interest expense deducted from taxable income on tax return
–
Prepaid expenses deducted for tax purposes when paid are only expensed for books when expired/used
Future deductible amounts- create deferred tax assets
(in future, less taxable revenues or more tax deductions, lowering future taxable income)
•
Tax rules, more on cash basis (taxable income increases when businesses taxed on cash collected from customers and taxable income
decreases for tax deductibles when cash paid for
•
Book rules, accrual basis (revenue recognized when earned, serving customers, etc., expensed when incurred (assets used up, service
received)
•
Though often elect tax rules currently that lower taxable income now, sometimes this is not possible based on cash versus accrual accounting
•
Results in deferred tax asset now (debited) and lower tax payable (versus book tax expense) in the future
•
Examples of higher taxable income on tax return now compared to book pretax financial income this year (to reverse in future)
–
Cash from unearned revenue taxed when collected versus unearned revenue earned and recognized as revenue on the income
statement
–
Accrued expenses (interest, warranties, etc.) are deducted on US GAAP income statement when incurred as expenses and deducted
for taxes when cash is paid.
–
Assets not generating cash as planned (bad debt, losses on inventory, etc.) are deducted on US GAAP income statement as expenses
right away and deducted for taxes when cancelled or sold.
–
Compensatory stock option plans are expensed as incurred on the income statement but not deducted for taxes until options are
exercised.
–
Contingent loss may be expensed on income statement (if material, probable, estimateable) but not deducted for taxes until cash is
paid.
–
Unrealized loss from holding trading securities immediately impact profits on income statement but only affect tax return when they are
sold later for a realized loss.
Permanent federal income tax
differences-- examples
• Those that affect US GAAP income statement but not taxable
income on tax return:
– Interest earned on an investment in municipal bonds—generally not taxed
though reported as revenue on income statement
– Life insurance cash proceeds paid to company from death of insured
employee – generally not taxed (just as insurance premiums paid by
company can not be used as a tax deduction from taxable income on
the income tax return). US GAAP income statement can show cash
proceeds as a gain and insurance premiums paid as an expense.
Tax payable
• Current liability often accrued monthly
• Taxable income times current tax rate = income tax owed
• Follows IRS tax code – use tax rates for current period
• taxable income = taxable revenues less tax deductions
(expenses)
Valuation allowance may be needed if deferred
tax assets created (but not with deferred tax
payable)
• Deferred tax asset benefit only if sufficient future taxable income
to allow tax benefit from deferred tax asset to be used to lower
taxable income.
• A valuation allowance is a contra asset to reduce deferred tax
asset to estimated realizable value.
• If future income uncertain, then required to do an adjusting entry
as follows:
Income tax expense (or income tax benefit from operating loss
carryforward)
Allowance to reduce deferred tax asset to realizable value
XX
XX
•
Intraperiod Income Tax Allocation
Splitting up tax obligations (tax expense) between different categories of income (tax follows the incomecontinuing operations, discontinued operations, extraordinary items, net income)
•
Needed for Earnings per share for different categories of income
•
Accrue taxes example – 10% tax rate, before tax --continuing operations $200,000, discontinued operations –
($50,000), extraordinary loss ($10000). Assume no Interperiod tax allocation.
Income tax expense – continuing
operations
Income tax credit – discontinued
operations
Income tax credit – extraordinary
Income tax payable
Income statement
20000
5000
1000
14000
Income from continuing
operations before tax
Less: tax expense
Income from continuing
operations after tax
200,000
(20,000)
180,000
Earnings per share –
continuing operations
Discontinued operations
(net of $5000 tax credit)
(45000)
Earnings per share –
discontinued operations
Extraordinary loss (net of
$1000 tax credit)
(9000)
Earnings per share –
extraordinary loss
Net income
126000
EPS –net income
Operating loss impact on taxes
• Operating loss carrybacks
• Operating loss carryforwards
• Business reports operating loss
• Business reports operating loss
• Tax code allows refund of
previous tax payments, so
can offset loss against
previous taxed earnings (or
can wait until future earnings
to offset)
• Tax code allows current
operating loss to be offset
against future earnings (or
can offset against previous
earnings)
• If future tax rates higher and
future earnings likely, may just
elect carry forward
• Results in deferred tax asset
• If future earnings are not
likely, better to carryback first