Reading 31 LOS's Flashcards
LOS 31a: Describe the differences between accounting profit and taxable income, and define key terms, including deferredtax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense
Taxes payable result in an outflow of cash from the firm, so firms try to minimize taxes payable and retain cash. This objective is achieved by recognizing higher expenses on the tax return, which leads to lower taxable income and consequently, lower taxes payable.
For financial reporting purposes, companies try to show healthy performance and profitability. This objective is achieved by recognizing lower expenses on the income statement, which lead to higher pretax income, and higher net income than on the tax return.
Depreciation expense is the source of discrepancy between taxable income and pretax income. This difference in amount of depreciation recognized on the two sets of statements also drives a difference in the tax base of the asset and the caryring value on the balance sheet.
LOS 31c: Calculate the tax base of a company’s assets and liabilites
The tax base of an asset or liability is the amount at which the asset or liability is value for tax purposes, while the carrying value is the amount recognized on the balance sheet for financial reporting purposes
Determing the Tax Base of an Asset
An asset’s tax base is the amount that will be expensed on the tax return in the future as economic benefits are realized from the asset. The tax base is the amount that will be depreciated in future periods as the asset is utilized over its remaining life.
Determing the Tax Base of a Liability
There are two types of liabilities that can result from accrual accounting - unearned revenues and accrued expenses. The rules for calculating the tax base of these liabilities are given below:
- Tax base of accrued expense liability = Carrying amount of the liability minus amounts that have not been expensed for tax purposes yet, but can be expensed in the future
- The tax base of unearned revenue liability = Carrying value of the liability minus the amount of revenue that has already been taxed and therefore will not be taxed in the future
Basically, the tax base of a liability is its carrying amoung, less any amounts that will be deductible for tax purposes in respect to that liability in future periods. For revenue received in advance, the tax base of the resulting liability is its carrying amount, less any amount of that revenue that will not be taxable in the future periods
LOS 31b: Explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis
LOS 31d: Calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilites, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate
Under US GAAP, a company can use a different depreciation method on its financial statements from the one it uses on its tax return. Taking advantage of this facility, firms try to record higher depreciation expense on their tax returns to minimize taxes payable, and recognize lower depreciation expense on their financial reports to maximize reported profits.
When the company pays less tax than it should, it creates a deferred tax liability (DTL). One way to calculate the value of the DTL balance sheet account is by adding the change in the DTL over the period to the previous year’s balance sheet value> OR you can use this formula:
- DTL= (carrying value of the asset - tax base) x Tax rate
Once the balance sheet DTL value has been calculated, the change in DTL over a given period can be calculated using the following:
- Change in DTL = Closing DTL balance - Opening DTL balance
The relationship between taxes payable (TP), changes in DTL, and income tax expense (ITE), is driven by the following formula:
- ITE= TP + Change in DTL
To summarize, a DTL usually arises when:
- Higher expenses are charged on the tax return compared to the financial statements
- Taxable income is lower than pretax or accounting profit
- Taxes payable are lower than income tax expense
- An asset’s tax base is lower than its carrying value
Accounting entries for an Increase in Deferred Tax Liabilities
- An increase in DTL increases total liabilities on the balance sheet
- The increase in DTL is added to taxes payable in the calculation of income tax expense, so it decreases net income, retained earnings, and owner’s equity
Deferred Tax Assets
DTAs usually arise when a company’s taxes payable exceed its income tax expense. The company pays more taxes based on its tax return than it should pay according to its financial statements. This is sort of a prepayment and therefore counts as an asset
DTA balances at a given balance sheet date can be calculated as:
- DTA= (carrying value of liability - Tax base of liability) x tax rate
The relationship between taxes payable, the change in DTA, and income tax expense is captured by the following formula:
- ITE = TP- Change in DTA
To summarize, a deferred tax asset arises when:
- Higher expenses are charged on the financial statement than on the tax return
- Taxable income is higher than pretax or accounting profit
- Taxes payable are greater than income tax expense
- a liability’s tax base is lower than its carrying value
Accounting Entries for an Increase in DTA
- An increase in DTA increases total assets on the balance sheet
- The increase in DTA is subtracted from taxes payable in the calculation of income tax expense, so it increases net income, retained earnings, and equity
LOS 31e: Evaluate the impact of tax rate changes on a company’s financial statements and ratios
When income tax rates change, the balances of DTA and DTLs on the balance sheet must be adjusted for the new tax rates. IF the tax rates rise, both DTA and DTL rise, and if the tax rate falls, they both fall.
- DTL or DTA change= (carrying value - tax base) x New tax rate
We can take away the following important conclusions:
- If a company has a net DTL (Excess DTL over DTA0 , a reduction in tax rates would reduce liabilities, reduce income tax expense, and increase equity
- If the company has a net DTA, a reduction in tax rates will reduce assets, increase income tax expense, and decrease equity
LOS 31f: Distinguish between temporary and permanent differences in pre-tax accounting income and taxable income
Temporary differences arise because of differencs between tax base and carrying value of assets and liabilities. Permanent differences on the toerh hand, arise as a result of expense or income items that can be recognized on one statement, but not the other. Examples are:
- Revenue items that are not taxable such as government grants
- Expense items that are not tax deductible such as fines and penalties
- Tax credits for some expenses that directly reduce taxes
The important thing to remember is that permanent difference do not result in deferred taxes. They result in differences between effective and statutory taxes and should be considered in the analysis of effictive tax rates. A firm’s reported effective tax rate is calculated as:
- Effective tax rate = Income tax expense/ Pretax income
Taxable temporary differences
these are DTLs
Deductible Temporary Differences
These are DTAs
Temporary Differences at Initial Recognition of Assets and Liabilities
When the difference is realized at recognition, a company cannot recognize DTAs or DTLs
Goodwill may be treated differently across differnt tax jurisdications, which may lead to differences in the carrying amount and tax base. However accountig standards do not permit the recognition of a DTL or DTA, upon its inital recognition
Business Combinations and Deferred Taxes
In a business combination, if the fair value of acquired intangible assets is different from their carrying values, deferred taxes can be recognized
Investments in Subsidiaries, Branches, Associates, and Joint Ventures
DTLs can be recognized here unless:
- The parent is in a position to control the timing of the future reversal of temporary difference and
- it is probably that the temporary difference will not reverse in the future
DTAs will only be recognized if:
- the temporary difference will reverse in the future and sufficient taxable profits exist against which the temporary difference can be used
Unused Losses and Tax Credits
Under IFRS, unused tax lossed and credits may only be recognized to the extent of probably future taxable income against which these can be applied. On the other hand, under US GAAP, DTAs are recognized in full and then reduced through a valuation allowing if they are unlikely to be recognized
Recognition and Measurement of Current and Deferred Tax
Even though DTAs and DTLs arise from temporary difference that are expected to reverse at some point in the future, present values are not used in determing the amounts to be recognized. Deferred taxes as well as income taxes should always be recognized unless they pertain to:
- taxes or deferred taxes charged directly to equity
- A possible provision for deferred taxes related to a business combination
Even if there has been no change in temporary difference during the current period, the carrying amount of DTA and DTL may change due to
- Changes in tax rates
- Reassessments of recoverability of DTA
- Change in expectations as to how the DTA or DTL will be realized
LOS 31g: Describe the valuation allowance for deferred tax assets - when it is required and what impact it has on financial statements
Recognition of a Valuation Allowance
DTAs must be evaluated at each balance sheet date to ensure that they will be recovered. If there are any doubts as to whether they will be realized, their carrying value should be reduced to the expected recoverable amount.
Under US GAAP, DTA are reduced by creating a contra-asset account know as the valuation allowance. An increase in this allowance reduces deferred tax assets. This results in an increase in income tax expense, which leads to lower net income, retained earnings, and equity
Since the timing and amount of any DTA is rather subjective in nature, analysts should carefully scrutinize these changes.
Recognitions of Current and Deferred Tax Charged Directly to equity
Under IFRS and US GAAP, DTA and DTLs should generally have the same accounting treatment as the assets and liabilities that give rise to them. If the item that gave rise to the DTA/DTL is taken directly to equity, the resulting deferred tax item should also be taken directly to equity
If a DTL is not expected to reverse it should be reduced, and the amount by which it is reduced should be taken directly to equity
LOS 31h: Compare a company’s deferred tax items
LOS 31i: Analyze disclosures relating to deferred tax items and the effective tax rate reconciliation, and explain how information included in these disclosures affects a company’s financial statements and financial ratios
LOS 31j: Identify the key provisions of and differences between income tax accounting under IFRS and US GAAP
