Accounting for Income Taxes Flashcards
What are the two main objectives of accounting for income taxes?
To determine taxes payable/refundable for current year
To determine deferred tax liabilities/assets for future years
What is the first basic principle of accounting for income taxes?
Taxes payable/refundable for current year are recorded as “current tax liability/asset”
What is the second basic principle of accounting for income taxes?
Deferred tax liability/asset is estimated for future tax consequences on temporary differences and carryforwards
What is the third basic principle of accounting for income taxes?
Measurement of taxes is based on current tax law – never on anticipated tax laws
What is the fourth basic principle of accounting for income taxes?
Deferred tax assets are reduced by any tax benefits which are not expected to be realized
How much can net operating losses (NOLs) be carried back or carried forward?
Back 2 years
Forward 20 years
What happens if a NOL is carried back or forward?
It offsets taxable income for those years, thus reducing taxes
If done for previous years, it generates a tax refund for the taxes already paid on those profits
What are the two components of income tax expense?
Current tax expense and deferred tax expense
What does an ordinary tax JE look like?
Debit: Income Tax Expense – Current
Credit: Income Tax Payable
What are the JEs for loss carrybacks and carryforwards?
Carryback:
Debit: Income Tax Refund Receivable
Credit: Benefits of Loss Carryback
Carryforward:
Debit: Deferred Tax Asset
Credit: Benefits of Loss Carryforward
Both benefits would be reported in income statement against the net loss
What are the tax JEs for a year partially helped by a loss carryforward?
Debit: Income Tax Expense – Current ($X)
Debit: Income Tax Expense – Deferred ($Y)
Credit: Income Tax Payable ($X)
Credit: Deferred Tax Asset ($Y)
Notice that the deferred tax asset is removed with this entry
Both current and deferred expenses would count against income in income statement
What is the formula to reconcile pretax financial income and taxable income?
Pretax financial income
+ Taxable revenues over book revenues
- Deductible amounts over book expenses
= Taxable income
What is a temporary difference?
Difference between tax basis of an asset/liability and its book amount
Results in taxable or deductible amounts in the future, whenever the reported amount of the item is recovered (asset) or settled (liability)
What are the two kinds of temporary differences?
Taxable TDs – when assets are recovered
Deductible TDs – when liabilities are settled
When pretax financial income is less than taxable income, how is income tax expense recorded?
The difference between the two will be a deferred income tax expense
Debit: Income Tax Expense – current ($X)
Debit: Income Tax Expense – deferred ($Y)
Credit: Income Taxes Payable ($X)
Credit: Deferred Tax Liability ($Y)
What is a timing difference?
Occurs when rev/exp/gains/losses are book-recognized in one year but tax-recognized in another year
Count as temporary differences
What are examples of timing differences?
- earned income that will be paid in a future year (taxable when asset is recovered); unearned revenue (taxable before earned)
- loss contingencies (deductible when liability is settled); prepaid expenses (deductible before accrued)
Really, any difference resulting from accrual vs. cash accounting
What happens if revenue is received before being earned?
There is a tax liability that exceeds the book-revenue’s basis (of zero), and thus when it is earned, it will have a tax deduction
What happens if temporary differences are not linked with any particular assets or liabilities?
Will still result in taxable or deductible amounts for future years
E.g. if a company uses %-of-completion method for books and completed-contract method for taxes, the deferred income will become taxable when the contract is completed
What are permanent differences?
Revenues or expenses that simply aren’t taxed, and thus don’t create deferred tax assets/liabilities
What are examples of permanent differences from revenues?
Interest on municipal bonds
Proceeds from life insurance on an officer
Dividends subject to dividends-received deduction (70%, 80%, or 100%)
What are examples of permanent differences from expenses?
Expenses to generate tax-exempt income
Premiums paid for life insurance on officers
Fines, other costs due to violations of the law
What is an example of a permanent difference from a deduction?
Excess of percentage depletion over the cost of natural resources
What would be the income tax JE for a year with permanent differences in revenue and expenses?
A normal JE
Debit: Income Tax Expense – current
Credit: Income Taxes Payable
The permanent differences don’t affect other years, so there’s no deferred tax assets or liabilities
What is the effective tax rate?
The rate that is paid on pretax financial income
Can differ from 40% (or whatever the enacted rate is) if there are permanent differences, since the 40% rate will be applied towards the taxable income without any deferred taxes
How do you calculate net future taxable (or deductible) amounts?
Take all the temporary amounts, and add them in the opposite way that they affected pretax financial income
E.g. if an excess of warranty expense were recognized in the books over the tax amount, then that expense would be ADDED to pretax financial income to arrive at taxable income – but it would be SUBTRACTED to determine net future taxable (or deductible) amount
How do you calculate tax liabilities or assets from net future taxable (or deductible) amounts?
Net future taxable amount x tax rate = deferred tax liability
Net future deductible amount x tax rate = deferred tax asset
What are deferred tax expenses or benefits?
Changes during the year in deferred tax liabilities and assets
How do different levels of jurisdiction (federal, state, local, foreign) affect tax liabilities and assets?
Deferred tax liabilities and assets need to be reported separately for each jurisdiction, since they cannot offset each other
What is the role of valuation accounts for deferred tax assets?
If it is more likely than not (>50%) that any amount of a DTA will not be realized then the allowance account reduces the DTA by that amount
What are some assumptions about future taxable income rates?
If a taxable income is expected for a future year, then use that year’s enacted rate to calculate deferred tax liabilities/assets
If a NOL is expected for a future year, then use the enacted rate for the year to which the NOL is expected to carry forward or carry back
How do graduated tax rates affect the calculation of deferred tax liabilities/assets?
If graduated tax rates are used, then the entity should apply the average graduated tax rate for estimated taxable income to calculate deferred tax liabilities/assets
If there are temporary differences giving rise to deferred tax assets and liabilities, what should the JE be?
Debit: Income Tax Expense -- current Debit: Income Tax Expense -- deferred Debit: Deferred Tax Asset Credit: Income Taxes Payable Credit: Deferred Tax Liability
If the deferred tax liability at the end of year 1 is a given amount, and the total DTL at the end of year 2 is a greater amount, what should the JE be?
Debit: Income Tax Expense – current ($X)
Debit: Income Tax Expense – deferred ($Y)
Credit: Income Taxes Payable ($X)
Credit: Deferred Tax Liability ($Y)
“Y” will be the difference between yr. 1 and yr. 2 deferred tax liabilities
What is a key term when determining deferred tax assets/liabilities over given periods?
CUMULATIVE taxable (or deductible) temporary differences
Multiply the cumulative amount by the enacted rate to get the ending deferred tax asset/liability for that year, which can help determine the CHANGE in DTA/DTL from the previous year
What are the steps to calculate deferred tax expense (or benefit) for a given year?
Determine any changes in deferred tax assets – increases in DTA are deferred tax benefits
Do the same for deferred tax liabilities to get deferred tax expenses
Net deferred tax benefits and deferred tax expenses to get the total deferred tax expense (or benefit)
How do anticipated NOLs affect the calculation of deferred taxes?
They affect the applicable tax rate
The calculation of deferred tax liabilities/assets depends on the enacted tax rate for the year to which the tax is deferred, so use the rate from (e.g.) two years before the NOL, if it will be carried back
Do NOLs affect future taxable amounts or future deductible amounts?
Both – since there won’t be any taxes period, there will be none to deduct either
What kind of entries are deferred tax expenses and benefits?
Residual amounts, since they reflect the change in DTLs/DTAs for a given year
What must be reported if tax rates for future years are not uniform?
A schedule of future taxable/deductible amounts
If rates are uniform, aggregation is fine
What is the JE for a valuation allowance to decrease deferred tax assets?
It depends on what comprised the deferred tax asset. As an example:
Debit: Benefits of Loss Carryforward
Debit: Income Tax Expense – deferred
Credit: Allowance to Reduce DTA to Realizable Value
The Benefits entry decreases and the Expense entry increases, since the Deferred Tax Asset affects both
With a deductible temporary difference for a given year, how do you arrive at taxable income?
Pretax financial income
+ deductible temporary difference
= Taxable income
Remember that ADDING to taxable income is bad, so the future deduction (good) is offset
If a year has both (1) a NOL resulting in a carryforward and (2) a temporary difference resulting in a future deductible amount, how is the deferred tax asset reported?
As the sum of the two benefits
Debit: Deferred Tax Asset
Credit: Benefits of Loss Carryforward
Credit: Income Tax Expense – deferred
Make sure the two credited amounts are calculated using the right tax rates
If a deferred tax asset has a valuation account, and then the deferred tax asset is applied in a particular year, how is it reported?
The allowance is debited and the deferred tax asset is credited
Both are reduced/erased
For a tax benefit to be realized, what has to occur?
There has to be a period with taxable income against which the benefit can be applied
What are the three characteristics of tax-planning strategies?
- prudent and feasible
- something an entity would not normally take, but takes to prevent a carryforward from expiring
- results in usage of deferred tax assets
How do tax-planning strategies relate to the valuation allowance?
Expenses to perform the tax-planning strategy, and losses to recognize if it is performed (net of tax benefits) should be included in the valuation allowance
How does an entity determine whether a valuation allowance is needed?
By the preponderance of the evidence
Positive evidence – supporting that it is NOT needed
Negative evidence – denying that it’s not needed, i.e. supporting that it IS needed
What are some examples of “negative evidence” that valuation allowances are unneeded?
- history of carryforwards expiring unused
- losses expected in future years
- a brief carryback/carryforward period
What are some examples of “positive evidence” that valuation allowances are unneeded?
- existing sales indicate sufficient taxable income in the future
- the company’s assets are valued sufficiently higher than their tax basis
How should changes in valuation allowance be reported?
In income from continuing operations
This happens if circumstances have changed the company’s judgment on which deferred tax assets will be usable
If enacted tax laws are changed, how are deferred tax liabilities/assets affected?
They are adjusted accordingly for the period when the enacted laws changed
Difference (tax benefit/expense) is reported in income from continuing operations
If there is a change in enacted tax rates, how is it reported?
Deferred tax liabilities/assets are debited or credited accordingly, just as if they were being first recorded
What is a change in enterprise tax status?
When an enterprise changes how it is filed
E.g. partnership to corporation, S corporation to C corporation
Deferred tax liabilities/assets are either created or eliminated, depending on whether the entity becomes taxable or becomes nontaxable
How are deferred tax liabilities/assets reported on the balance sheet?
Recorded net of each other (i.e. liabilities offset assets)
Recorded in a net current and a net noncurrent amount
Recorded separately for different jurisdictions
How are deferred tax liabilities/assets classified as current or noncurrent?
Depending on the classification of the related taxable asset or liability
If there is no related asset/liability (e.g. carryforwards), then classified according to the expected reversal date
How are valuation allowances split between current and noncurrent deferred tax assets?
Pro rata
Regarding deferred tax liabilities/assets, what should be disclosed on the balance sheet?
- total of all DTLs and DTAs
- total valuation allowance
- net change in VA
- tax effect of each temporary difference or carryforward that gives rise to DTLs/DTAs
Permanent differences do NOT need to be disclosed
What is intraperiod tax allocation?
Allocating income tax expenses to different parts of the financial statements
Which income taxes are allocated to continuing operations?
Tax effects from:
- ordinary pretax income
- DTAs not expected to be realizable
- changes in tax laws
- changes in enterprise status
If a company has an operating loss and an extraordinary capital gain exceeding that loss, how is it reported?
The loss offsets the gain, and the excess is taxed at the gains rate
In the income statement, the tax benefit from the loss will be reported as the (loss) x (capital gains rate), since it offset the capital gains tax, not the income tax
Are benefits from carrybacks or carryforwards reported as ordinary operations, or something else?
They are reported as whatever type of income benefits from the credit – not by whatever type of income gave rise to the benefit historically
E.g. if discontinued operations caused a NOL in year 1, and if the carryforward offset taxable income from continuing operations in year 2, then the carryforward benefit would be classified as part of continuing operations
Can stockholders’ equity be charged/credited for income tax?
Yes
E.g. employee stock options recognized differently for GAAP and for tax
If a company acquires another company and then changes the valuation allowance for DTAs, how should it be recorded?
Adjustment to goodwill
If goodwill is 0, then any other decrease in VA should be recognized as a bargain purchase
When is the cost method used for recording investment in other companies?
When the investment does not amount to substantial control (20%) of the company
If it does, then use the equity method
What is the dividends-received deduction for cost-method investments?
Dividends received x deduction % (e.g. 70%) = taxable dividend income x effective tax rate = tax expense and liability
For this method, there can be no tax deferrals by definition
What tax effects are different for equity-method investments?
Dividend income is deducted as normal, but in addition the company records a temporary difference based on the ownership (equity) it has in the investment company’s undistributed income
How is undistributed income calculated for the equity method?
Net income - preferred stock x % of ownership = equity in company's income - dividends already paid to the investing company = undistributed income
How is the temporary taxable difference determined from undistributed income?
If UI is expected to be received as dividends, then the dividends-received deduction (80% or 100%) should be applied
If UI is expected to be received as a realized gain upon disposal, then it should not include the deduction
What is the distinction between the statutory tax rate and the effective tax rate?
- STR = percentage of a tax a company is legally required to pay on its taxable income
- ETR = percentage a company in fact pays
By definition, (pretax financial income) x (ETR) = total tax expense
When do the statutory tax rate and effective tax rate differ?
Only when there are permanent differences
Temporary differences cause a greater portion of the total tax expense to be deferred, but still result in the same total tax expense
