ACCOUNTING FOR INCOME TAXES

A. Scope and Principle

SFAS 109 refers to some differences between the amount of taxable income and pretax financial income for a year as temporary differences. This statement requires that assets and liability method be used in accounting and reporting for temporary differences. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law. The effects of future changes in tax laws or rates are not anticipated.

B. Temporary and Permanent Differences

The circumstances that create an asset or a liability for deferred income taxes. - Accounting income measures the results of business operations in accordance with GAAP. Taxable income, on the other hand, measures the results of operations in accordance with the rules of tax law. So, the dollar amount of accounting income often differs from the amount of taxable income. The items causing this difference are classified as either permanent differences or temporary differences. Permanent difference - is an event that is recognized either in pretax financial income or in taxable income but never in the other. It does not result in a deferred tax asset or liability. Ex) State and municipal bond interest, Life insurance proceeds received on insurance policies for key executive Premiums paid for life insurance on officers when the enterprise is the beneficiary. Fines, penalties. Temporary differences - include differences that will result in taxable or deductible amounts in future years. a. Future deductible amount - warranty liability () subscriptions revenue received in advance () b. Future taxable amount - quicker depreciation for tax purpose () installment receivable for cash basis () Ex ) A corporation has pretax financial accounting(book) income of $146,000 in 1996. Additional information is as follows: 1. Municipal bond interest income is $35,000 2. Life insurance premium expense, where the corporation is the beneficiary, on books is $4,000. 3. Accelerated depreciation is used for tax purposes, while straight-line is used for books. Tax depreciation is $10,000; book depreciation is $5,000. 4. Estimated warranty expense of $500 is accrued for book purposes. When the tax rate is 30%, make an entry for income taxes Income tax expense 34,500 / Deferred tax asset 150 / Income tax payable 33,150 Deferred tax liability 1,500

C. Recognition and Measurement

Income tax expense = Income taxes payable + changes in deferred income taxes Enacted tax rate The tax rate that is used to measure deferred tax liabilities and deferred tax assets is the enacted tax rate(s) expected to apply to taxable income in the years that the liability is expected to be settled or the asset recovered. Ex) Bensons first year of operations is 1991. Benson has pretax financial income of $150,000 and taxable income of $50,000. Taxable income is expected in all future years. a. Tax rates enacted by the end of 1991 are as follows. 1991 40%, 1992 35%, 1993-1996 30%, 1997 25% b. Temporary differences existing at the end of 1991 are as follows. Installment sale difference (taxable in 1992) $30,000 Depreciation difference (taxable in 1993) 50,000 (taxable in 1994) 40,000 Estimated expenses (deductible in 1997) (20,000) Net temporary difference $100,000 Income tax expense Deferred tax asset 52,500 / Income tax payable 20,000 5,000 / Deferred tax liability 37,500

Valuation Allowances - Deferred tax assets are to be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that some portion of all of the deferred tax assets will not be realized.

D. Additional Issues
Revision of future tax rates - The effect is reported as an adjustment to income tax expense in the period of the change Ex) Assume that on December 10, 1996, a new income tax act is signed into law that lowers the corporate tax rate from 40% to 35%, effective January 1,1998. If Hostel Co. has one temporary difference at the beginning of 1996 related to $3 million of excess tax depreciation and if they reverse $1 million dollar every year from 1997, what entry should be made at the end of 1996? Deferred tax liability 100,000 / Income tax expense 100,000

Loss Carryback and Loss Carryforward Year 1994 1995 1996 1997 1998 Taxable Income or Loss $75,000 50,000 100,000 200,000 (500,000) Tax Rate 30% 35% 30% 40% Tax paid $22,500 17,500 30,000 80,000 -0-

If the company decides to use 2 years loss carryback and loss carryforward, what journal entry will be appropriate?

Income tax refund receivable Benefit due to loss carryback Deferred tax asset Benefit due to loss carryback Operating loss before income taxes Income tax benefit Benefit due to loss carryback Benefit due to loss carryforward Net loss

110,000 110,000 80,000 80,000 $(500,000) $110,000 80,000 190,000 $(310,000)

Financial Statement Presentation a. Whether an item is current or noncurrent depends on the classification of the related asset or liability. b. If a deferred tax item is not related to an asset or liability for financial reporting, it is classified based on the expected reversal date of the temporary differences.(e.g. a loss carryforward) c. Current deferred tax assets and liabilities are netted. Noncurrent deferred tax assets and liabilities are also offset and shown as a single amount.