Lecture 14 Tax Flashcards
Why do we have to consider taxes differentlyfrom just GAAP?
Generally accepted accounting principles and tax laws usually specify different rules how to compute the profit of a business.
Hence, the net income before income taxes under GAAP typically differs from the taxable income computed according to the tax law.
What determines the amount and timing of taxes?
The matching principle implies that we should include in GAAP tax expense the tax on every income and expense item incurred in the current period, regardless whether the tax is payable to the tax authorities now, later, or earlier.
That means: the amount of the GAAP tax expense on income and expenses is given by the tax law, but the timing of its recognition is given by GAAP.
Why are different income and expense items taxed at different tax rates?
The main reasons are that:
- some income and expenses are incurred in different jurisdictions with different tax rates (multinational companies); and
- the law excludes certain income and expenses from taxation, so that, effectively, their tax rate is zero (and, conversely, sometimes subjects items to tax that are not part of GAAP income).
Differences between GAAP and tax-basis income arising from the second category are called permanent differences.
What are some examples of permanent differences between GAAP and tax-basis income?
Examples of permanent differences include:
- income from governmental subsidies (usually non-taxable);
- government-imposed fines for violations of the law (usually cannot be deducted from taxable income);
- compensation for executives (often non-deductible beyond a certain level);
- dividends received from affiliates (subject to income tax but do not constitute income under GAAP);
- actual stock-based compensation cost in excess of estimated value at grant date (the difference is tax-deductible but not a GAAP expense).
(The last two are example of the reverse case: the items are reported on tax returns but are not part of GAAP income.)
What is the effective tax rate?
The ratio of a company’s tax expense (also referred to as the provision for income taxes) to its pre-tax income is called the effective tax rate.
effective tax rate = income tax expense ÷ pre-tax income
Since not all items on the income statement are taxed at the same rate (e.g., because of permanent differences), the effective tax rate usually differs from the company’s nominal statutory tax rate.
In particular, since the tax on items excluded from taxable income is zero, the GAAP income tax expense is calculated excluding all items that give rise to permanent differences.
What are the GAAP-Tax timing differences?
Summary thus far: to calculate GAAP tax expense, always use the tax rate actually applicable to the item (not necessarily the statutory rate).
Tax amounts calculated for GAAP and tax reporting purposes are therefore always identical.
The timing of recognition may differ, i.e., income statement and tax return may recognize the item (or partial amounts thereof) in different periods.
Reason: GAAP rules follow the matching principle, but tax codes do not.
Differences between GAAP income and tax-basis income resulting from differences in the time of recognition are called temporary differences.
How do tax items create deferred taxes?
Items that give rise to temporary differences are included in the GAAP income tax expense calculation at their GAAP amounts.
This computation of tax expense on GAAP amounts results in a difference between the GAAP income tax expense and the current income tax payable to the tax authorities.
These differences are called deferred taxes and are accumulated as assets or liabilities on the balance sheet.
If the accumulated deferred amounts have a net debit balance, the total is shown on the balance sheet as a deferred tax asset.
If the accumulated deferred amounts have a net credit balance, the total is shown on the balance sheet as a deferred tax liability.
How do taxes apply to net operating losses?
If taxable income (according to tax accounting rules) is negative, companies can often deduct the loss from their pre-tax income in future (profitable) periods.
This future benefit is a deferred tax asset called a net operating loss (NOL) carryforward.
In addition, the company might be able to apply some of its current loss to prior (profitable) periods and receive an immediate tax refund.
This benefit is called a net operating loss carryback
What are some additional points to remember about deferred taxes?
In the long term, the aggregate tax expense according to GAAP and the aggregate actual taxes paid are the same. Hence, in the long term, any differences between the GAAP tax expense and the amount of taxes paid will reverse and offset.
Deferred tax assets and liabilities are the net amounts of the undiscounted aggregate future reversals. The notion of time value of money is not considered when computing deferred taxes.
Deferred tax assets and liabilities are computed separately if they relate to different items. For example, a company may have a deferred tax liability related to PP&E and a deferred tax asset related to its defined benefit pension plan.
When presenting these deferred tax items on the balance sheet, companies may net current (non-current) deferred tax assets with other current (non-current) deferred tax liabilities if the items relate to the same tax jurisdiction and the company has a legal right to settle them net.
What are some additional adjustments to the tax expense?
Companies often need to adjust deferred tax positions and tax payables created in the past. These adjustments are recognized as increases or decreases in the company’s current income tax expense.
Since these adjustments are not related to current-period income, they create differences between effective and statutory tax rates.
The main types of these adjustments are:
- revaluation of existing deferred tax assets and liabilities because a change in statutory tax rates has been passed into law;
- a valuation adjustment to existing deferred tax assets because the expected future tax benefit from the asset has changed; and
- additional tax payments or refunds related to prior years because tax authorities have adjusted the company’s previously filed returns.
What happens when the tax rate changes?
When tax rates change, deferred tax assets and liabilities must be revalued once the change in tax rates is (substantively) enacted.
How are valuation adjustments done for taxes?
Companies often face uncertainty whether a particular deferred tax asset will be realized.
For example, taking advantage of NOL carryforwards requires sufficiently high profits in the near future (which may not happen).
Companies may therefore only record deferred tax assets if it is “probable” (IFRS) or “more likely than not” (US GAAP) that the future tax savings will be realized.
If the estimated realized benefit changes in later periods, companies need to adjust the carrying amount of the deferred tax asset accordingly and recognize the adjustment in their current income tax expense.
