Part 9. Income Taxes

Question 1

Taxable income

Answer 1

• income subject to tax based on tax return.

Question 2

Taxes payable

Answer 2

The tax liability caused by taxable income, known as current tax expense, but not income tax expense.

Question 3

Income tax paid

Answer 3

The actual cash flow for income tax include payments or refund from other years.

Question 4

Tax loss carryforward

Answer 4

A current or past loss that can be used to reduce taxable income (thus taxes payable) in the future, which can result in deferred tax asset.

Question 5

Tax base

Answer 5

Net amount of an asset or liability used for tax reporting purposes.

Question 6

Accounting profit

Answer 6

The pre-tax financial income based on financial accounting standards, known as income before tax, and earnings before tax.

Question 7

Income tax expense

Answer 7

The expense recognised in income statement that includes taxes payable and changes in deferred tax assets and liabilities (DTA and DTL), the income tax equation is:

income tax expense = taxes payable + change in DTL - change in DTA

Question 8

Deferred tax liabilities

Answer 8

Balance sheet amounts result from an excess or income tax expense over taxes payable that are expected to result in future cash outflows.

Question 9

Deferred tax assets

Answer 9

Balance sheet amounts that result from an excess of taxes payable over income tax expense expected to be recovered from future operations, can also result from tax loss carryforwards.

Question 10

Valuation allowance

Answer 10

A reduction of deferred tax assets based on the likelihood the assets will not be realized.

Question 11

Carrying value

Answer 11

Net balance sheet value of an asset or liability.

Question 12

Permanent difference

Answer 12

A difference between taxable income (tax return) and pretax income (income statement) that will not reverse in the future.

Question 13

Temporary difference

Answer 13

A difference between the tax base and carrying value of an asset or liability will result in either taxable amounts or deductible amounts in the future.

Question 14

Differences between treatment of an accounting item for tax reporting and financial reporting occur when:

Answer 14

• Timing of revenue and expense recognition in the income statement and tax return differ.
• Certain revenues and expenses are recognised in income statement, but never on tax return and vice versa.
• Assets and/or liabilities have different carrying amounts and tax bases.
• Gain or loss recognition in income statement differs from tax return.
• Tax losses from prior periods may offset future taxable income.
• Financial statement adjustments may not affect tax return or may be recognised from different periods.

Question 15

Deferred tax liability

Answer 15

When income tax expense (income statement) is greater than taxes payable (tax return) due to temporary differences.

This occurs when:

• revenues (or gains) are recognized in income statements before they are included on the tax returns due to temporary differences.
• expenses (or losses) are tax-deductible before they are recognized in the income statement.
• They are expected to reverse, resulting in future cash outflows when taxes are paid.
• Most often created when an accelerated depreciation method is used on tax return and straight line depreciation is used on income statement.

Question 16

Deferred tax asset

Answer 16

This is created when taxes payable (tax return) are greater than income tax expense (income statement) due to temporary differences.

They occur when:

• revenues (or gains) are taxable before they are recognised in the income statement.
• expenses (or losses) are recognised in income statement before they are tax deductible.
• tax loss carryforwards are available to reduce future taxable income.
• Expected to reverse through future operations, but will provide future tax savings.
• Firm with taxable losses in excess of its taxable income can carry excess losses forward and use then to reduce taxable income in future periods.

e.g. post-employment benefits, warranty expenses, tax loss carryforwards

Question 17

Tax base

Answer 17

The amount that will be deducted on tax return in the future as economic benefits of asset are realised.

Question 18

Carrying value

Answer 18

The value of the asset reported on the financial statements, net of depreciation and amortisation.

Question 19

Depreciable equipment

Answer 19

• The cost of equipment is $100,000.
• In the income statement, depreciation expense of $10,000 is recognised each year for 10 years, where tax return of asset depreciated is $20,000 for 5 years.
• At the end of Q1, the tax base is $80,000 ($100,000 cost - $20,000 accumulated tax depreciation), with carrying value of $90,000 ($100,000 cost - $10,000 accumulated financial depreciation).
• Deferred tax liability ($10,000 x tax rate) is created to account for timing difference from different depreciation for tax and financial reporting.
  e. g. sale of machine for $100,000 results in a gain of $10,000 on income statement and gain of $20,000 on tax return - reversing tax liability.

Question 20

Research and development

Answer 20

• At beginning of tax year, $75,000 of R&D was expensed in income statement, on tax return capitalised and is amortised on straight line basis over 3 years.
• End of tax first year, the tax base is $50,000 ($75,000 cost - $25,000 accumulated tax amortisation) and asset has no carrying value (not appear on BS) as entire cost was expensed.
• Amortisation leads to deferred tax asset as earnings before tax are less than taxable income.

Question 21

Account receivable

Answer 21

• Gross receivables totaling $20,000 are outstanding at year end.
• As collection is uncertain, the firm recognised bad debt expense of $1,500 in income statement, where for tax purposes bad debt expense cannot be deducted until receivables are deemed worthless.
• In the end of the year, the tax base of receivables is $20,000 as no bad debt expense has been deducted on tax return, meaning carrying value is $18,500 ($20,000 - $1,500 bad debt expense).
• The result is deferred tax asset.

Question 22

Liability tax base

Answer 22

This is the carrying value of liability minus any amounts that will be deductible on tax return in the future, where the tax base of revenue received in advance is the carrying value minus the amount of revenue that will not be taxed in the future.

Question 23

Customer advance

Answer 23

• At year end, $10,000 was received from a customer for goods that will be shipped next year, on tax return revenue received in advance is taxable when collected.
• The carrying value of liability is $10,000, which will be reduced when goods shipped next year, with revenue received in advance, the tax base is equal to carrying value minus any amounts not taxed in the future.
• As customer advance has been taxed, $10,000 will not be taxed in the future, thus customer advance liability has a tax base of zero ($10,000 carrying value - $10,000 revenue not taxed in the future).
• Since, $10,000 has been taxed but not yet reported as revenue on income statement, a deferred tax asset is created.

Question 24

Warranty liability

Answer 24

• At year end, the firm estimates $5,000 of warranty expense required on goods already sold, on tax return warranty expense is not deductible until warranty work is actually performed next year.
• The carrying value of warranty liability is $5,000, with tax base equal to carrying value minus the amount deductible in the future.
• The warranty liability has a tax base of zero ($5,000 carrying value - $5,000 warranty expense deductible in the future).
• A delayed recognition of expense for tax results in deferred tax asset.

Question 25

Note payable

Answer 25

• The firm has outstanding promissory note with principle balance of $30,000, and interest accrues at 10% and is paid at end of each quarter.
• The promissory not is treated in same way on tax return and financial statements.
• The carrying value and tax base are both $30,000, with interest paid included in both pre-tax income on income statement, and in taxable income on tax return.
• No timing difference, no deferred tax items are created.

Question 26

Income tax rate changes

Answer 26

• This means DTA and DTL are adjusted to reflect the new rate, and adjustment can also affect income tax expense.

rise in tax rate = increase in DTA and DTL
fall in tax rate = decrease in DTA and DTL

• DTA and DTL must change on the balance sheet as new tax rate is the rate expected to be in force when associated reversals occur.
• rise (fall) in tax rate, when previously deferred income is recognised for tax, the tax due will be higher (lower), when expense items previously reported in FS are recognised for tax, the benefit will greater (less).

Question 27

Permanent Difference

Answer 27

The difference between taxable income and pre-tax income that will not reverse in the future.

This does not create:

• Do not create DTA or DTL
• Caused by revenue that is not taxable, expenses are not deductible or tax credits result in direct reduction of taxes.

e.g. in the US, interest received on municipal bonds is typically not taxable, and cost of life insurance on key company.

• This will cause the firms effective tax rate to differ from the statutory tax rate (the tax rate of jurisdiction where firm operates).
• The statutory and effective rate may also differ if firm is operating in more than one tax jurisdiction.

Question 28

Temporary difference

Answer 28

The difference between tax base and carrying value of an asset or liability that will result in taxable amounts or deductible amounts in the future.

This is expected to reverse in the future and balance sheet item is expected to provide future economic benefits, a DTA or DTL is created.

This can be:

• taxable temporary difference that result in expected future taxable income
• deductible temporary differences that result in expected future tax deductions

Question 29

Temporary difference on DTL:

Answer 29

• This can arise from an investment in another firm (e.g. subsidiaries, affiliates, branches, and joint ventures) when parent company recognises earnings from an investment before dividends are received.
• If parent company can control timing of future reversal, its probable temporary difference will not reverse, no DTL reported.

Question 30

Temporary difference on DTA:

Answer 30

• A temporary difference from an investment will result in DTA only if the temporary difference is expected to reverse in the future, and sufficient taxable profits are expected to exist when a reversal occurs.

Question 31

Valuation allowance

Answer 31

• A contra account that reduces the net balance sheet value of DTA, where if increases it will decrease the net balance sheet DTA, increasing income tax expense and decreasing net income.

US GAAP - its more likely than not some of all of DTA will not be realised, so DTA must be reduced by a valuation allowance.

IFRS - a similar calculation is made, but only the net amount of DTA is presented on the balance sheet, with amount of valuation allowance not separately disclosed.

Question 32

Use of valuation allowance:

Answer 32

• If the company has order backlogs or existing contracts which are expected to generate future taxable income, a valuation allowance may not be necessary.
• If company has cumulative losses over past few years or history of inability to use tax loss carryforwards, then company would need to use valuation allowance to reflect likelihood DTA will never be realised.

Fall in VA = rise in earnings
Rise in VA = fall in earnings

So, management can manipulate earnings by changing VA.

Question 33

Issues with measurement of deferred tax items:

Answer 33

• The appliable tax rate depends on how temporary difference will be settled, e.g. a tax jurisdiction which has capital gains tax rate lower than marginal tax rate. Given its tax base, the currently unrealised gains on asset is taxed at CGT rate when asset is disposed of, the rate should be used to calculate DTL.
• Another issue is that it is dependent on whether change in asset value recorded on statement or taken directly to equity.

e. g. revaluation gain taken directly from equity without affecting pretax income or taxes payable means balance sheet DTL is not affected.
- if the gain is taken directly to equity, the related future tax liability should be taken to equity too.
- adjustment to reduce amount of gain added to revaluation surplus by amount of future tax liability on revaluation gain.

• upward revaluation of asset on BS increases depreciation in subsequent periods, but not affect DTL, with tax liability increase in book value recognise rise in revaluation surplus.
• In subsequent periods, an amount equal to additional depreciation from upward revaluation of an asset, less tax liability on a portion of revaluation is transferred from revolution surplus to retained earnings.
• The unrealised gain in asset value realised over time through use of asset, the addition to retained earnings just offsets after-tax decrease in net income from add. depreciation from upward revalutaion of assets carrying value.

Question 34

Examples of temporary differences:

Answer 34

1. DTL results from accelerated depreciation for tax and SL depreciation for FS, where growth and capital spending considered when deciding whether difference will reverse.
2. Impairments - result in DTA as write down is recognised, and deduction on tax return is not allowed until asset is sold or disposed of.
3. Restructuring - generates DTA as costs recognised for financial reporting when restructuring is announced, not deducted for tax purpose until actually paid. Restructuring leads to cash outflows (net of tax savings) in years after restructuring costs are reported.
4. US firms use LIFO for FS and for tax purposes, so no temporary differences result, but in countries where this is not a requirement, TD can result from choice of inventory cost-flow method.
5. Post-employment benefits and deferred compensation are recognised for financial reporting when earned by employs bit deducted for tax purpose until paid, resulting in DTA reversed when benefits compensation are paid.
6. DTA is made to stockholders’ equity to reflect future tax impact of unrealised gains or losses on available for sale marketable securities taken directly to equity. No DTL added to BS for suture tax liability when gains/losses are realised.

Question 35

The following deferred tax information is disclosed:

Answer 35

• DTL, DTA, any valuation allowance, and net change in VA over the period.
• Any unrecognised DTL for undistributed earnings of subsidiaries and joint ventures.
• Current-year tax effect of each type of temporary difference.
• Components of income tax expense.
• Reconciliation of reported income tax expense and tax expense based on statutory rate.
• Tax loss carryforwards and credits.

Question 36

Difference in statutory tax rate to income tax:

Answer 36

• different tax rates in different tax jurisdictions (countries).
• permanent tax differences: tax credits, tax-exempt income, nondeductible expenses, and tax differences between capital gains and operating income.
• changes in tax rates and legislations
• deferred taxes provided on reinvested earnings of foreign and unconsolidated domestic affairs.
• tax holidays in some countries (watch special conditions i.e. termination dates for holiday or requirement to pay accumulated taxes at some point in future).