31. income taxes
A. Differences between accounting profit and taxable income and definition of key terms :
Tax return terminology
- Taxable income. Income subject to tax based on the tax return.
- Taxes payable. The tax liability on the balance sheet caused by taxable income. This is also known as current tax expense, but do not confuse with income tax expense.
- Income tax paid. The actual cash flow for income taxes including payments or refunds from other years.
- Tax loss carryforward. A current or past loss that can be used to reduce taxable income in the future. Can result in a deferred tax asset.
- Tax base. Net amount of an asset or liability used for tax reporting purposes.
Financial reporting terminology
- Accounting profit. Pretax financial income based on financial accounting standards. Also known as income before tax and earnings before tax.
- Income tax expense. Expense recognized in the income statement that includes taxes payable and changes in deferred tax assets and liabilities.
- Deferred tax liabilities. Balance sheet amounts that result from an excess of income tax expense over taxes payable that are expected to result in future cash outflows.
- Deferred tax assets. Balance sheet amounts that result from an excess of taxes payable over income tax expense that expected to be recovered from future operations.
- Valuation allowance. Reduction of deferred tax assets based on the likelihood the assets will not be realized.
- Carrying value. Net balance sheet value of an asset or liability.
- Permanent difference. A difference between taxable income (tax return) and pretax income (income statement) that will not be reverse in the future.
- Temporary difference. A difference between the tax base and the carrying value of an asset or liability that will result in either taxable amounts or deductible amounts in the future.
B. How deferred tax liabilities and assets are created and how they should be treated :
Differences between the treatment of an accounting item for tax reporting and financial reporting can occur when:
- The timing of revenue and expense recognition in the income statement and the tax return differ.
- Certain revenues and expenses are recognized in the income statement but never on the tax return or vice-versa.
- Assets and/or liabilities have different carrying amounts and tax bases.
- Gain or loss recognition in the income statement differs from the tax return.
- Tax losses from prior periods may offset future taxable income.
- Financial statement adjustments may not affect the tax return or may be recognized in different periods.
Deferred tax liabilities :
A deferred tax liability is created when income tax expense (income statement) is greater than taxes payable (tax return) due to temporary differences. Deferred tax liabilities occur when :
- Revenues are recognized in the income statement before they are included on the tax return due to temporary differences.
- Expenses are tax deductible before they are recognized in the income statement.
Deferred tax liabilities are expected to reverse and result in future cash outflows when the taxes are paid.
The most common way that deferred tax liabilities are created is when different depreciation methods are used on the tax return and the income statement.
Deferred tax assets :
A deferred tax asset is created when taxes payable (tax return) are greater than income tax expense (income statement) due to temporary differences. Deferred tax assets occur when :
- Revenues are taxable before they are recognized in the income statement.
- Expenses are recognized in the income statement before they are tax deductible.
- Tax loss carryforwards are available to reduce future taxable income.
Similar to deferred tax liabilities, deferred tax assets are expected to reverse through future operations. However, deferred tax assets are expected to provide future tax savings, while deferred tax liabilities are expected to result in future cash outflows.
C. Tax base of a company’s assets and liabilities :
Tax base of assets :
An asset’s tax base is the amount that will be deducted (expensed) on the tax return in the future as the economic benefits on the assets are realized. The carrying value of the asset reported on the financial statements, net of depreciation and amortization.
Following are a few examples of calculating the tax bases of various assets.
Depreciable equipment. The cost of equipment is $100,000. In the income statement, depreciation expense of $10,000 is recognized each year for ten years. On the tax return, the asset is depreciated at $20,000 per year for five years.
At the end of the first year, the tax base is $80,000 ($100,000 cost - $20,000 accumulated tax depreciation) and the carrying value is $90,000 ($100,000 cost - $10,000 accumulated financial depreciation). A deferred tax liability ($10,000 x tax rate) is created to account for the timing difference from different depreciation for tax and for financial reporting.
Research and development. At the beginning of this year, $75,000 of R&D was expensed in the income statement. On the tax return, the R&D was capitalized and is amortized on a straight-line basis over three years.
At the end of the first year, the tax base is $50,000 ($75,000 cost - $25,000 accumulated tax amortization) and the asset has no carrying value because the entire cost was expensed.
Accounts receivable. Gross receivables totaling $20,000 are outstanding at year-end. Because collection is uncertain, the firm recognizes bad debt expense $1,500 in the income statement. For tax purposes, bad debt expense cannot be deducted until the receivables are deemed worthless.
At the end of the year, the tax base of the receivables is $20,000 since no bad debt expense has been deducted on the tax return. The carrying value is $18,500 ($20,000 - $1,500 bad debt expense). Again, a deferred tax asset is the result.
Tax base of liabilities :
A liability’s tax base is the carrying value of the liability minus any amounts that be deductible on the tax return in the future. 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.
Following are a few examples of calculating the tax bases of various liabilities.
Customer advance. At year-end, $10,000 was received from a customer for goods that will be shipped next year. On the tax return, revenue received in advance is taxable when collected.
The carrying value of the liability is $10,000. The carrying value will be reduced when the goods are shipped next year. For revenue received in advance, the tax base is equal to the carrying value minus any amounts that will not be taxed in the future. Since the customer advance has already been taxed, $10,000 will not be taxed in the future. Thus, the customer advance liability has a tax base of zero. Since the $10,000 has been taxed but not yet reported as revenue on the income statement, a deferred tax asset is created.
Warranty liability. At year-end, a firm estimated that $5,000 of warranty expense will be required on goods already sold. On the tax return, warranty expense is not deductible until the warranty work is actually performed. The warranty work will be performed next year.
They carrying value of the warranty liability is $5,000. The tax base is equal to the carrying value minus the amount deductible in the future. Thus, the warranty liability has a tax base of zero ($5,000 carrying value - $5,000 warranty expense deductible in the future). Delayed recognition of this expense for tax results is a deferred tax asset.
D. Interpret the adjustments to the financial statements related to a change in the income tax rate :
If taxable income is less than pretax income and the cause of the difference is expected to reverse in future years, a deferred tax liability (DTL) is created. If taxable income is greater than pretax income and the difference is expected to reverse in future years, a deferred tax asset (DTA) is created.
The balance of the DTA or DTL is equal to the difference between the tax base and the carrying value of the asset or liability, multiplied by the tax rate.
Income tax expense and taxes payable are related through the change in the DTA and the change in the DTL : income tax expense = taxes payable + ΔDTL – ΔDTA.
E. Impact of tax rate changes on a company’s financial statements and ratios :
When the income tax rate changes, deferred tax assets and liabilities are adjusted to reflect the new rate. The adjustment can also affect income tax expense.
An increase in the tax rate will increase both deferred tax liabilities and deferred tax assets. A decrease in the tax rate will decrease both deferred tax liabilities and deferred tax assets.
Changes in the balance sheet values of DTLs and DTAs to account for a change in the tax rate will affect income tax expense in the current period.
income tax expense = taxes payables + ΔDTL – ΔDTA.
F. Temporary and permanent differences in pre-tax accounting income and taxable income :
A permanent difference is a difference between taxable income and pretax income that will not reverse in the future. Permanent differences do not create deferred tax assets or deferred tax liabilities. Permanent differences can be caused by revenue that is not taxable, expenses that are not deductible, or tax credits that result in a direct reduction of taxes.
Permanent differences will cause the firm’s effective tax rate to differ from the statutory tax rate. The statutory rate is the tax rate of the jurisdiction where the firm operates. The effective tax rate is derived from the income statement.
effective tax rate = income tax expense / pretax income
The statutory rate and effective rate may also differ if the firm is operating in more than one tax jurisdiction.
A temporary difference refers to a difference between the tax base and the carrying value of an asset or liability that will result in taxable amounts or deductible amounts in the future. If the temporary difference is expected to reverse in the future and the balance sheet item is expected to provide future economic benefits, a DTA or DTL is created.
Temporary differences can be taxable temporary differences that result in expected future taxable income or deductible temporary differences that result in expected future tax deductions.
G. Valuation allowance for deferred tax assets :
Although deferred taxes are created from temporary differences that are expected to reverse in the future, neither deferred tax assets nor deferred tax liabilities are carried on the balance sheet at their discounted present value. However, deferred tax assets are assessed at each balance sheet date to determine the likelihood of sufficient future taxable income to recover the tax assets. Without future taxable income, a DTA is worthless.
According to U.S. GAAP, if it is more likely than not that some or all of a DTA will not be realized, then the DTA must be reduced by a valuation allowance. The valuation allowance is a contra account that reduces the net balance sheet value of the DTA. Increasing the valuation allowance will decrease the net balance sheet DTA, increasing income tax expense and decreasing net income.
Because an increase (decrease) in the valuation allowance will decrease (increase) earnings, management can manipulate earnings by changing the valuation allowance.
Whenever a company reports substantial deferred tax assets, an analyst should review the company’s financial performance to determine the likelihood that those assets will be realized. Analysts should also scrutinize changes in the valuation allowance to determine whether those changes are economically justified.
H. Comparing a company’s deferred tax items :
Companies are required to disclose details on the source of the temporary differences that cause the deferred tax assets and liabilities reported on the balance sheet. Changes in those balance sheet accounts are reflected in income tax expense on the income statement. Here are some common examples of temporary differences you may encounter :
- A deferred tax liability results from using accelerated depreciation for tax purposes and straight-line depreciation for the financial statements.
- Impairments generally result in a deferred tax asset since the writedown is recognized immediately in the income statement, but the deduction on the tax return is generally not allowed until the asset is sold or disposed of.
- Restructuring generates a deferred tax asset because the costs are recognized for financial reporting purposes when the restructuring is announced, but not deducted for tax purposes until actually paid.
- In the United States, firms that use LIFO for their financial statements are required to use LIFO for tax purposes, so no temporary differences result. However, in countries where this is not a requirement, temporary differences can result from the choice of inventory cost-flow method.
- Post-employment benefits and deferred compensation are both recognized for financial reporting when earned by the employee but not deducted for tax purposes until actually paid. These can result in a deferred tax asset that will be reversed when the benefits or compensation are paid.
- A deferred tax adjustment is made to stockholders’ equity to reflect the future tax impact of unrealized gains or losses on available-for-sale marketable securities that are taken directly to equity. No DTL is added to the balance sheet for the future tax liability when gains/losses are realized.
I. Disclosures relating to deferred tax items and the effective tax rate reconciliation :
Typically, the following deferred tax information is disclosed :
- Deferred tax liabilities, deferred tax assets, any valuation allowance, and the net change in the valuation allowance over the period.
- Any unrecognized deferred tax liability for undistributed earnings of subsidiaries and joint ventures.
- Current-year tax effect of each type of temporary difference.
- Reconciliation of reported income tax expense and the tax expense based on the statutory rate.
- Tax loss carryforwards and credits.
Analyzing the effective tax rate reconciliation :
Some firms’ reported income tax expense differs from the amount based on the statutory income tax rate. Recall that the statutory rate is the tax rate of the jurisdiction where firm operates. The differences are generally the result of :
- Different tax rates in different tax jurisdictions.
- Permanent tax differences : tax credits, tax-exempt income, nondeductible expense, and tax differences between capital gains and operating income.
- Changes in tax rates and legislation.
- Deferred taxes provided on the reinvested earnings of foreign and unconsolidated domestic affiliates.
- Tax holidays in some countries.
Understanding the differences between reported income tax expense and the amount based on the statutory income tax rate will enable the analyst to better estimate future earnings and cash flow.
When estimating future earnings and cash flows, the analyst should understand each element of the reconciliation, including its relative impact, how it has changed with time, and how it is likely to change in the future.
J. Key provisions of and differences between income tax accounting under IFRS and U.S. GAAP :
The accounting treatment of income taxes under U.S. GAAP and their treatment under IFRS are similar in most respects. One major difference relates to the revaluation of fixed assets and intangible assets. U.S. GAAP prohibits upward revaluation, but they are permitted under IFRS and any resulting effects on deferred tax are recognized in equity.
Under IFRS, a tax rate that has been enacted or substantively enacted is used to measure deferred tax items. Under U.S. GAAP, only a tax rate that has actually been enacted can be used.
Under IFRS, deferred tax assets and liabilities are classified as noncurrent. Under U.S. GAAP, deferred tax items may be current or noncurrent, depending on how underlying asset or liability is classified.
Follow this link to next chapter 32. Non-current (long-term) liabilities.
Follow this link to Summary.
Follow this link to Summary.
|