Transcript Chapter 14 Deferred Taxes Mark Higgins

Chapter 14
Deferred Taxes
Mark Higgins
Nature Of Income Taxes
GAAP– The purpose of generally accepted
accounting principles (GAAP) is to produce
financial statements the underlying
economic activity of the entity.
TAP – The purpose of tax accounting
principles (TAP) is to raise revenue for the
government.
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Comparing GAAP with TAP
Gain on Sale of Marketable Securities – Under
GAAP income (loss) is recognized for securities
classified as trading securities. For TAP gain (loss)
is not recognized until the securities are sold.
Post Retirement Benefits Other Than Pensions –
For GAAP expense is recorded in the year the
benefits are earned. For TAP deduction is not until
the year the benefit is paid.
Transparency 14-3
Comparing GAAP with TAP
Asset Impairment – Under GAAP the value of the
asset is reduced and reflected in net income at the
time the impairment occurs. For TAP the deduction
for the impaired asset does not occur until the
asset is sold.
Warranties – For GAAP an expense is recorded in
the year of the sale to reflect estimated future
warranty obligations. For TAP a deduction for
warranties is not allowed until the year the
warranty benefit is paid.
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Net Operating Loss (NOL)
Carryforwards/Carrybacks
To provide equity for a company who has a
loss in one year and income in another year,
TAP allows a company to carryback its loss
in one year to offset the income it earned in
a prior year. Alternatively, it can carryforward
a loss from one year to offset its income in a
future year. A company can carryback
losses for 2 years and forward for 20 years.
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Net Operating Loss (NOL) Example
Assume Rhody has $10 million of income in
year 1 and has a loss of $2 million dollars in
year 2. Alternatively, Huskie Corporation has
$3 million of net income in year 1 and $5
million in year 2. The marginal tax rate for
both companies is 34%. What amount does
each company pay in taxes each year?
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Net Operating Loss (NOL) Example
Huskie would pay $1,020,000 ($3,000,000 x 34%) in
year 1 and $1,700,000 ($5,000,000 x 34%) in year 2.
A total of $2,720,000 in taxes over the two years.
Rhody would pay $3,4000,000 ($10,000,000 x 34%) in
year 1 and no taxes in year 2. However, Rhody can
carryback the $2,000,000 of loss to year 1 and receive
an tax refund of $680,000 ($2,000,000 x 34%). Note
that without the carryback provision Rhody’s income
tax, on the same total income would have been higher
than Huskies by $680,000 ($3,400,000 - $2,720,000).
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Comparing GAAP with TAP
Inventory – After considering the LIFO conformity
rule inventory is the same under under GAAP and
TAP. The only exception is if a company deducts
obsolete inventory for GAAP. This is not permitted
for TAP unless the inventory is actually disposed.
Warranties – For GAAP an expense is recorded in
the year of the sale to reflect estimated future
warranty obligations. For TAP a deduction for
warranties is not allowed until the year the
warranty benefit is paid.
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Permanent Differences
Permanent differences – Differences
between taxable income and book income
that will never reverse. For example interest
on municipal bonds is income for book
purposes but not income for tax purposes.
As a result, no asset/liability deferral is
required.
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Temporary Differences
Temporary differences– The differences
between taxable income and book income
that will reverse in later years. For example,
initially depreciation expense is higher for tax
purposes than for book purposes. However,
(on an assets by asset basis) this will
eventually reverse and the book expense
will be higher than tax expense.
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Deferred Taxes
Deferred taxes - Represent the difference
between the tax liability based on book
income and the tax liability based on
taxable income (i.e., the tax return).
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Deferred Tax Liability
Deferred tax liabilities – These represent an
obligation to pay more tax in later years. For
example for tax purposes an entity will depreciate
tangible personal property using the Modified
Cost Recovery System (MACRS). In essence,
this system depreciates the asset using a shorter
asset life and the double declining balance
method discussed previously.
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Deferred Tax Assets
Deferred tax assets– These represent taxes paid
due to taxable income being higher than book
income. Expenses like warranties are not
deductible for tax purposes until paid. Financial
accounting accrues and “matches” them to the
current period. The result is that taxable income is
higher now. In later years, when the warranty
expense is actually paid the taxable income will be
lower. As the authors suggest, deferred tax assets
should be thought of as “prepaid” items!
Transparency 14-13
Deferred Tax Liability
The effect is that in the early years of an
asset more depreciation is taken for tax
purposes than for book purposes. Thus
book income is greater than taxable income
As a result, a higher liability will be
incurred. In the later years, the opposite
occurs.
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Calculation of
Deferred Taxes
1. Find the temporary items that are treated
differently for tax and book. Multiply the total
difference by the current tax rate.
2. Compute tax liability (i.e., taxable income x
tax rate)
3. Difference between the two numbers is
Income tax expense (i.e., a plug)
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Example of
Deferred Taxes
For the current year Rhody’s has $300,000
more deductions (i.e., temporary differences
for tax purposes than for book purposes). Its
tax rate is 34% and its taxable income is
$3,500,000. Prepare the journal entry to
record the income tax expense for the
financial statements.
Transparency 14-16
Example of
Deferred Taxes
Deferred tax - $ 300,000 x 34%
= $102,000
Tax Liability - $3,500,000 x 34% = $1,190,000
Income Tax Expense 1,292,000
Deferred Taxes
Income Tax Payable
102,000
1,190,000
Transparency 14-17