Accounting for Income Taxes Accounting income is calculated through the application of generally accepted accounting principles.

Two important principles that influence the income calculation are the revenue recognition principle and the matching principle. The revenue recognition principle endeavors to report revenue in the period in which it is earned, and the matching principle endeavors to report expenses in the same accounting period as the revenues that they were incurred to generate. Taxable income is calculated by applying the provisions of the Income Tax Act. These provisions are not identical to GAAP and hence, taxable income and accounting income are often different figures. Accountants try to match income tax expense with the transactions that give rise to this expense. Thus, if a transaction occurs this period that will not be taxable until next year, GAAP requires that the tax effect be shown on the financial statements this year. Hence, Canada Revenue Agencys (CRAs) calculation of the annual tax liability usually does not tally with the tax liability shown on the balance sheet. We report the tax liability to CRA as the current liability income tax payable, and we report an additional tax liability calculated under GAAP under the heading of future income taxes. This latter amount may be either an asset or a liability, although it is usually the latter, and may be either short-term or long-term. We will define what circumstances dictate its classification as we proceed through this lecture note. Taxable Income The cheque a company writes to CRA to pay its income taxes is based on its taxable income. Taxable income is calculated by starting with income before tax, and adjusting for permanent and timing differences. Timing differences appear in the calculation of accounting and taxable income, but in different reporting periods. For example, imagine a revenue item that is taxable in 2001 when the cash is received, but included in income in 2002, when it is considered to be earned. This is a timing difference; it is included both in accounting and in taxable income but the timing of its inclusion differs in the two calculations. A permanent difference is either included in the calculation of accounting income and never in the calculation of taxable income, or in the calculation of taxable income and never in the calculation of accounting income. Examples of permanent differences and timing differences follow.

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Permanent differences Certain accounting expenses or revenues will never be taxable or deductible in the calculation of the companys taxable income. Conversely, certain items may be included in the calculation of taxable income that are never reported on the companys income statement. Examples of such permanent differences are provided below: Dividends: Dividends from taxable Canadian corporations are considered revenue for accounting purposes when the investment is accounted for by the cost method. They are excluded in the calculation of taxable income. Capital Gains: The entire amount of the gain is included in the calculation of accounting income; however, for tax purposes only one-half of the gain is included in taxable income. One half of the gain is a permanent difference between accounting and taxable income. Membership Dues: Dues paid for membership in most social clubs can be deducted from accounting income under GAAP. However, they cannot be deducted in the computation of taxable income. Meals and Entertainment Expense: For accounting purposes 100% of meals and entertainment expense is deducted in the calculation of net income. For tax purposes, 50% of such expenditures are deductible. Interest and Penalties on Unpaid Income Taxes: These are deductible for accounting purposes but never deductible for tax purposes.

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Timing Differences Amortization vs Capital Cost Allowance: For tax purposes fixed assets are assigned to classes. The capital cost allowance for the period is computed by applying the appropriate rate for the class to the unamortized capital cost (UCC) of the class. UCC is calculated as UCC at the beginning of the year plus one half of net additions (additions less disposals). Amortization for financial reporting purposes is calculated under the provisions of GAAP and is rarely equal to allowable capital cost allowance for the period. Capital cost allowance is an allowable deduction for tax purposes. Amortization is not. Pension Expense: Pension expense calculated under the provisions of GAAP is not tax deductible, whereas pension contributions (funding) are an allowable deduction. Non Deductible Accounting Reserves: Under GAAP, reserves (liabilities) are sometimes set up for items that cannot be deducted for tax purposes until the actual costs are incurred. An example would be an accounting reserve for warranties. Leases: When a lease is classified as a capital lease for accounting purposes and an operating lease for tax purposes, the total amount reported as expense for financial accounting purposes (interest expense and amortization) will be different from the allowable deduction for tax purposes (lease payment). All leases are now considered to be operating for tax purposes, unless the title transfers at the inception of the lease.

Calculation of Taxable Income - Example Assume we have the following information for ABC Co. 2001 Net Income Per Financial Statements Pension Expense Pension Funding Dividends From Taxable Canadian Corporations Amortization Expense CCA available Gain on Sales of Marketable Securities Carried at Cost Warranty Expense Warranties Paid Meals and Entertainment Expense $1,400,000 125,000 95,000 75,000 340,000 550,000 15,000 180,000 120,000 20,000

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Interest and Penalties on Unpaid Income Taxes Income Tax Rate - 2001 Reconciliation of Accounting Income to Taxable Income Accounting Income Accounting Income Per F/S Permanent Differences Dividends from Taxable Canadian Corporations Non - Taxable Gain on Sale of Marketable Sec. Non - Deductible Part of Meals and Entertainment. Exp. Interest on Unpaid Income Taxes Timing Differences Pension Expense Pension Funding Amortization Expense CCA Warranty Expense Warranty Paid 1,332,500 (7,500) 10,000 5,000 1,332,500 (7,500) 10,000 5,000 1,332,500 125,000 (95,000) 340,000 (550,000) 180,000 (120,000) 1,212,500 1,400,000 (75,000) Taxable Income 1,400,000 (75,000)

5,000 40%

Timing Differences

125,000 (95,000) 340,000 (550,000) 180,000 (120,000) (120,000)

Taxable income is $1,212,500, and income tax payable is $485,000 ($1,212,500*40%). The amount $485,000 is also considered to be the current portion of 1997 income tax expense. A corporation prepares a reconciliation between accounting income and taxable income as part of its corporate tax return that begins with net income per the financial statements and makes the necessary adjustments to arrive at income for tax purposes.

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Accounting for Income Taxes We will concentrate on the CICAs rules for the calculation of future income taxes, as set out in Section 3465 of the CICA Handbook. The Handbook requires that future income tax assets or liabilities be set up when the tax basis of an asset or liability differs from its book basis. This method also requires that future tax assets or liabilities be carried at the most recent tax rate enacted. The handbook identifies two types of difference between accounting and taxable income:

1. Temporary differences begin as current period transactions that will cause the taxable and accounting income of one or more future periods to differ. Temporary differences eventually reverse.

2. Other differences are differences between current period taxable and accounting income that will not cause differences between future taxable and accounting income. Future income taxes are based on temporary differences only. Other differences are added back to or deducted from accounting income in arriving at taxable income in a reconciliation of the format demonstrated on page 4 of these notes. Refer back to that example. The dividends from taxable Canadian corporations, the non-taxable gain on the sale of marketable securities, the non-deductible portion of meals and entertainment expense, and the interest on unpaid income taxes, are all categorized as other differences because these items will not cause future accounting and taxable income to diverge. You will note that this definition of other differences is equivalent to the definition of permanent differences employed by the Income Tax Act. The basic concept underlying temporary differences (which give rise to future income taxes) is the following: If a transaction occurs this period that has implication for taxes payable in a future period, those tax implications should be booked in the current period. Temporary differences are so called because they reverse themselves. That is, if we set up future income taxes in period one that cause total income tax expense to exceed income taxes currently payable, we do so because we expect that, in some future period, total income tax expense will be less than income taxes payable in that period with respect to that item. Temporary differences are based on the difference between the tax and the book bases of assets and liabilities. The book basis of these items is simply the amount at which they are carried on the balance sheet. The tax basis of an asset

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is the amount that could be deducted in the determination of taxable income if the asset were recovered for its carrying value. The tax basis of a liability is its carrying amount less any amount that will be deductible on the income tax return of a future period with respect to that liability. A simpler way to think of the tax basis for assets and liabilities is that the tax basis is the value CRA assigns to these items. Some examples should serve to clarify the definition of the tax basis of an asset or liability. We begin first with two asset examples:

Temporary Differences Related to Assets 1. A Future Tax Asset Assume that it is the first year of Ferret Co.s existence. Ferret Co. uses the weighted average method of inventory valuation for book purposes and the FIFO method of inventory valuation for tax purposes. Ending inventory is calculated at $100,000 using weighted average and $110,000 using FIFO. The corporate tax rate is 40%. The book basis of inventory is the $100,000 balance sheet amount, and the tax basis is $110,000, which represents the value at which the inventory is carried for tax purposes. The $110,000 tax basis of the inventory is the amount that will be deducted on the tax return when this inventory is expensed. The difference between the accounting and the tax bases of the inventory is $10,000. This $10,000, multiplied by the corporate tax rate, gives rise to a future tax asset of $4000. The $4000 is an asset because the corporation considers it has prepaid tax on the $10,000 inventory differential. Ending inventory reduces cost of goods sold, and therefore increases net income. Thus, current period taxable income is $10,000 higher than current period accounting income with respect to inventory. Next year, opening inventory will be $10,000 higher for tax purposes than for accounting purposes, and taxable income will be $10,000 lower than accounting income with respect to inventory. The corporation has, in effect, paid income tax on the $10,000 inventory differential one year in advance.

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2. A Future Tax Liability The most prevalent future income tax liability on a firms financial statements is related to the fixed asset account. In the early years of an assets life, the capital cost allowance deducted on the corporate tax return (which is usually calculated on a declining balance basis) tends to exceed amortization on the income statement (which is often calculated on a straight-line basis.) Over the entire life of a fixed asset, which costs $100,000, the firm, will deduct a total of $100,000 as amortization on its income statements, and a total of $100,000 as capital cost allowance on its corporate tax returns. Thus, to the extent that the firm starts out deducting more CCA than amortization (which causes accounting income to exceed taxable income), in the later years of the assets life, the firm will deduct more amortization than CCA (which will cause taxable income to exceed accounting income). Assume that Ferret Co. acquires a fixed asset at a cost of $100,000. It amortizes the asset straight-line over 10 years for accounting purposes, and uses the declining balance method at a 20% rate for tax purposes. Year 1 amortization is therefore $10,000, and year 1 CCA is $20,000. The book basis of the asset at year-end is its $90,000 net book value. The tax basis of the asset at year-end is its $80,000 unamortized capital cost, which is the cumulative amount that is available for deduction on future tax returns with respect to this asset. The $10,000 difference between the book basis and the tax basis gives rise to a future tax liability. If the corporate tax rate is 40%, the amount of the future tax liability is $4000. Current period taxable income is $10,000 less than current period accounting income with respect to the amortization/CCA differential. The $10,000 difference will reverse in the later years of the assets life, causing future taxable income to exceed future accounting income by $10,000. The corporation therefore considers that it has deferred the payment of taxes that relate to the current year to some future period, and hence sets up a future tax liability.

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Temporary Differences Related to Liabilities A Future Tax Asset Assume that Ferret Co. sells products under a two-year warranty. In its first year of operations, no warranty claims are made; However, Ferret Co. estimates that next year, warranty costs will be $5000 with respect to this years sales. The matching principle therefore dictates that $5000 of warranty expense, and a related $5000 warranty liability, be set up on Ferret Co.s first year financial statements. This $5000 reserve is not deductible for tax purposes, and will not be deductible until paid. The tax basis of the warranty liability account, which equals the book amount ($5000) less amounts deductible on future tax returns with respect to this liability ($5000), is therefore zero. Another way to think of this is that CRA uses cash basis accounting with respect to warranties, and therefore does not contemplate the use of balance sheet accrual accounts. Current period taxable income is $5000 higher than current period accounting income with respect to the warranties. When the $5000 warranty expense is actually paid, taxable income will be $5000 lower than accounting income with respect to these warranties. Using a tax rate of 40%, Ferret Co, in effect prepays $2000 of income tax with respect to the cost of warranties because the amount is not deductible for tax purposes until a later period than the one in which it is expensed for accounting purposes. Classification of Future Tax Assets / Liabilities Future tax assets / liabilities are classified in the balance sheet as short or long term, depending on the book assets / liabilities that gave rise to timing differences. In the above examples, future income tax assets related to inventory and warranty liabilities are short-term because the former is a current asset and the latter a current liability; future income tax liabilities related to fixed assets are long-term because fixed assets are long-term assets. A Caveat about Future Income Taxes A company that is growing and building up its asset base will build up a future income tax liability that is not expected to reverse in the foreseeable future. Considering capital assets alone, we can easily see that a growth company that is expanding its asset base year by year can build up a formidable reported tax liability, because CCA almost always exceeds amortization in the early years of an assets life. We do not employ discounting in accounting for future income taxes, so the financial statement impact of a future tax liability that is expected to reverse in 50 years is exactly the same as the financial statement impact of a future tax liability that is expected to reverse next year. Some accountants would like to see accounting rules changed to reflect partial income tax allocation, whereby we set up only those future tax liabilities that are expected to reverse in the near future. By excluding long term timing differences from the calculation of future taxes we would effectively be discounting them to zero, which might be a reasonable approximation of what discounting would accomplish if a comprehensive allocation basis was used with discounting.

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A Caveat about Future Income Taxes (continued) Big Rock Brewery Ltd. The 2002 balance sheet of Big Rock Brewery is shown on the following page. Note that future income taxes make up in excess of 1/3 of total liabilities. These future income taxes relate largely to difference between the book and tax bases of the capital assets. Big Rocks debt/equity ratio is 0.52 (total liabilities of 11.3 / total equity of 21.8). However, the future income tax differs from the other reported debts in that it is not a contractual liability. In fact, as long Big Rock continues to expand, future income taxes will not reverse, but will continue to increase. Thus, in order to assess how levered Big Rock is, we might want to look at the ratio of contractual debt/equity: (11.3 4.4 of FIT) / 21.8 = 0.32 Some users contend that reported future income taxes of a growing company really form part of the companys permanent capital, and add the amount to equity. This approach results in a debt equity ratio as follows: (11.3 4.4 of FIT) / (21.8 + 4.4 FIT) = 0.26 Note that the highest extreme of the debt/equity ratio calculated above is double that of the lowest extreme. Future incomes taxes should reverse in time, if the company continues to earn taxable income, so it may be overly optimistic to either treat them as equity or ignore them completely. However, they are far different in nature from liabilities for which a contractual obligation exists for repayment on schedule.

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Comprehensive Example Future Income Taxes Selected income statement information for ABC Co. is shown below. Note that 2001 income statement amounts are identical to those provided for the sample calculation of taxable income. 2000 2001 2002 Net Income Per Financial $1,400,000 $1,500,000 Statements Pension Expense 125,000 150,000 Pension Funding 95,000 175,000 Dividends From Taxable 75,000 75,000 Canadian Corporations Amortization Expense 340,000 340,000 CCA available 550,000 500,000 Gain on Sales of Marketable 15,000 N/A Securities Carried at Cost Warranty Expense 180,000 150,000 Warranties Paid 120,000 175,000 Meals and Entertainment 20,000 25,000 Expense Interest and Penalties on 5,000 N/A Unpaid Income Taxes Income tax rate 35% 40% 45% Selected balance sheet information is as follows: 2000 Current Assets Future Taxes (re Warranties) Non-Current Assets Fixed Assets (Net) Future Taxes (re Pensions) Current Liabilities Warranty Liability Long-term Liabilities Accrued Pension Cost Future Taxes (re Fixed Assets)

2001

2002

$ 35,000

1,540,000 105,000

1,200,000 ?

1,610,000 ?

100,000

160,000

135,000

300,000 175,000

330,000 ?

305,000 ?

Other Information: Unamortized Capital Cost (UCC) of fixed assets was $1,040,000 at the end of 2000. No fixed assets were sold during 2001 or 2002. Fixed assets in the amount of $750,000 were acquired during 2002. At the end of each fiscal year, the next years tax rate has not yet been enacted.

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Calculations Related to Income Tax Accounting We will use the above information to complete ABC Co.s accounting for income taxes for the fiscal years 2001 and 2002. The current portion of income tax expense is equal to taxable income multiplied by the current tax rate. 2001 taxable income is equal to the $1,212,500 calculated on page 4 of this note. Future income taxes are calculated by comparing the accounting and tax bases of balance sheet amounts. Book bases for 2001 and 2002 fixed assets, warranty liability, and accrued pension costs are the amounts reported on the balance sheets. Tax bases for these items are as follows: 2001 490,000 -0-02002 740,000 -0-0-

Fixed Assets (see Note A) Warranty Liability (see Note B) Accrued pension costs (see Note C)

Note A: Fixed Assets and Capital Cost Allowance The tax basis of the fixed assets is their unamortized capital cost (UCC), which is CRAs equivalent to net book value. Schedules of UCC and NBV, and the temporary differences associated with them, are shown below: UCC 2000 closing balance 2001 CCA/amortization 2001 closing balance 2002 additions 2002 CCA/amortization 2002 closing balance $1,040,000 (550,000) $490,000 750,000 (500,000) $740,000 NBV $1,540,000 (340,000) $1,200,000 750,000 (340,000) $1,610,000 Temporary Differences $(500,000) (210,000) (710,000) -0(160,000) $(870,000)

Note B: Warranty Liability Warranty liabilities have a tax basis of zero because no amounts will be deductible for tax purposes with respect to these liabilities. Warranties are deductible for tax purposes when paid, not when accrued. Note C: Accrued Pension Costs The accrued pension liability has a tax basis of zero for the same rationale applied to the warranty liability; pension payments are deductible for tax purposes when paid, not when accrued.

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The future income tax accounts on each years balance sheet are equal to the difference between the book and the tax bases of the underlying assets, multiplied by the most recent tax rate available. A future income tax liability arises when transactions have occurred that will cause future taxable income to exceed future accounting income. A future income tax asset arises when transactions have occurred that will cause future accounting income to exceed future taxable income. The following schedule calculates the 2001 journal entry required with respect to future income tax assets and liabilities. The required balance in the 2001 Future Income Taxes account is calculated by multiplying the difference between the tax and the book bases of relevant assets and liabilities by 40%, the 2001 income tax rate. (Note that the 2002 tax rate has not yet been enacted.) The figures for the journal entry represent the amounts required to update the FIT accounts from the 2000 closing balances to the required balances at the end of 2001.
Item Book Basis 2001 1,200,000 160,000 330,000 Tax Basis 2001 490,000 -0-0Difference DR (CR)* (710,000) 160,000 330,000 2001 FIT Balance** (284,000) 64,000 132,000 (88,000) 2000 FIT Balance*** (175,000) 35,000 105,000 (35,000) Journal Entry Required (109,000) 29,000 27,000 (53,000)

Fixed Assets Warranty Liability Accrued Pension Totals

* A DR denotes an excess of DRs on the tax basis over the book basis, or an excess of CRs on the book basis over the tax basis. This convention is observed because it allows us to complete the table identifying necessary adjustments to the FIT balance as debits or credits. ** The 2001 Future Income Tax (FIT) balance equals the difference column multiplies by the current tax rate (40%). *** 2000 FIT balances are as reported on the 2000 balance sheet.

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2001 Journal Entries Provision for income tax - current Income Tax Payable $1,212,500 * 40% (see calculation of taxable income , p.4)

485,000 485,000

Provision for income tax - future FIT current asset (re warranties) FIT long-term asset (re pensions) FIT long-term liability (re fixed assets)

53,000 29,000 27,000 109,000

The following schedule calculates the 2002 journal entry required with respect to future income tax assets and liabilities.
Item Book Basis 2002 1,610,000 135,000 305,000 Tax Basis 2002 740,000 -0-0Difference DR (CR)* (870,000) 135,000 305,000 2002 FIT Balance** (391,500) 60,750 137,250 (193,500) 2001 FIT Balance*** (284,000) 64,000 132,000 (88,000) Journal Entry Required (107,500) (3250) 5250 (105,500)

Fixed Assets Warranty Liability Accrued Pension Totals

* A DR denotes an excess of DRs on the tax basis over the book basis, or an excess of credits on the book basis over the tax basis. ** The 2002 Future Income Tax (FIT) balance equals the difference column multiplies by the current tax rate (45%). *** 2001 FIT balances are as reported on the 2001 balance sheet. 2002 Journal Entries Provision for income tax - current 552,375 Income Tax Payable 2002 taxable income of $1,227,500 (see next page)* 45% Provision for income tax - future FIT long-term asset (re pensions) FIT current asset (re warranties) FIT long-term liability (re fixed assets) 105,500 5,250 3,250 107,500

552,375

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Reconciliation of Accounting Income to Taxable Income Accounting Income Accounting Income Per F/S Permanent Differences Dividends from Taxable Canadian Corporations Non - Deductible Part of Meals and Entertainment. Exp. Timing Differences Pension Expense Pension Funding Amortization Expense CCA Warranty Expense Warranty Paid 1,437,500 1,500,000 (75,000) 12,500 1,437,500 Taxable Income 1,500,000 (75,000) 12,500 1,437,500 150,000 (175,000) 340,000 (500,000) 150,000 (175,000) 1,227,500 150,000 (175,000) 340,000 (500,000) 150,000 (175,000) (210,000) Timing Differences

Taxable income is $ 1,227,500 and income tax payable is $552,375 (1,232,500*45%). The amount is also considered to be the current portion of 2002 income tax expense.

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Note Disclosures We will use the example of Big Rock Brewerys 2002 annual report again to examine note disclosures related to future income taxes (see the following page). The first thing we notice is a reconciliation between income tax expense calculated at the statutory corporate income tax rate ($858,000) and the income tax expense calculated at the effective rate ($751,000). It is the latter amount that is reported on the face of the income statement. There are a variety of reasons for these differences, and all the specific causes in Big Rocks case are listed in their note. Focusing on the second item (non-deductible expenses), these are examples of the permanent differences we examined in this note: accounting expenses that are never deductible for tax purposes. This portion of the note disclosure enables us to understand why reported income tax expense is not simply equal to income before tax the statutory tax rate. Next, focus on the breakdown of the $4,416,400 liability reported on the balance sheet. This breakdown tells us the individual categories of items making up the temporary differences. We might use this to help us estimate future cash flows associated with income taxes. In Big Rocks case, the majority of the future income tax liability relates to capital assets. As long as Big Rock continues to expand, this future tax liability will only increase. Big Rock next discloses the amount of non-capital (i.e. operating) losses available for carryforward. This amount totals $364,000 in 2002. Big Rock can earn up to $364,000 in future taxable income without paying any income tax because it can carry this loss forward to apply against future income. Finally, Big Rock discloses the amount of cash income tax paid annually to CRA.

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Loss Carryforwards and Carrybacks For income tax purposes, corporations are permitted to carry non-capital (i.e. operating) losses back three years to be applied against prior years' taxable income, and forward twenty years to be applied against future years' taxable income. Tax loss carrybacks are first applied to the earliest year available. To the extent that sufficient taxable income exists in the past three years to offset a company's current-year loss for tax purposes, there is no doubt that the company will attain the tax benefit of the loss in the form of a tax refund. To the extent that sufficient taxable income does not exist in the three years' prior to the loss for tax purposes to cover the loss, the company will realize the tax benefit of the loss only to the extent that its taxable income over the next twenty years is sufficient to cover the loss. We can recognize a future tax asset associated with a loss carryforward in circumstances where it is "more likely than not" (CICA Handbook, section 3465) that the benefit associated with the loss will be attained. More likely than not is interpreted as a greater than 50% probability that the tax benefit will be realized. To the extent that a tax loss carryforward can be used to reduce taxable income of the next twenty years, the loss carryforward is a deductible temporary difference. Note that significant judgment is involved in the decision as to whether or not it is "likely" that a tax benefit arises from a loss for tax purposes. A strong earnings history is evidence that a current period loss is an anomaly, whereas a history of losses raises doubt that the company will be able to apply the loss against the taxable income of a future year. The lack of clear-cut guidelines for when a future income tax asset can be set up as a result of a loss carryforward may provide firms with an opportunity for earnings management.

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Example 1 The following example illustrates a situation in which, after the tax loss is carried back, the future tax benefit associated with the reminder of the loss is recognized as a future tax asset in the period of the loss, and applied against the taxable income of the next three years. Recall that, in order to set up a future income tax asset associated with the loss, we must be confident that it is more likely than not that the benefit associated with the loss will be attained. 1999 Taxable income (loss) Tax rate $ 100,000 38% 2000 $(660,000) 40% 2001 $ 290,000 43% 2002 $ 600,000 41%

For simplicity, assume that there is no taxable income against which the 2000 loss can be deducted prior to 1999. Assume also that taxable income equals accounting income in each of the four years presented. Finally, assume that the next year's tax rate has not been enacted by year-end. 1999 Tax expense - current Taxes payable $100,000*38%

38,000 38,000

2000, loss year Record the loss carryback at the tax rate in the carryback year, 1999 Tax refund receivable Tax benefit - current $100,000*38% 38,000 38,000

Record the tax benefit of the remaining loss at the 2000 tax rate (Note: If the 2001 tax rate had been enacted at the time of preparation of this entry, we would set up the loss carryforward benefit at the 2001 tax rate.) Future income tax asset Future income tax benefit ($660,000 - $100,000)*40% 224,000 224,000

2001, year subsequent to loss year Update the future income tax asset to the 2001 tax rate Future income tax asset Future income tax expense $560,000*(43%-40%) 16,800 16,800

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Record 2001 tax expense, ignoring the loss carryforward Tax expense - current Taxes payable $290,000*43% 124,700 124,700

Record the use of the loss carryforward to reduce 2001 taxable income Taxes payable Tax expense - current 124,700 124,700

Record the draw down of the FIT asset Future income tax expense Future income tax asset Remaining loss carryforward Carried back to 1999 Applied to 2001 taxable income Available for carryforward to 2002 2002 Update the future income tax asset to the 2002 tax rate Future income tax expense 5,400 Future income tax asset 5,400 $270,000*(41%-43%) (Note that that FIT asset has become less valuable because the tax rate decreased.) Record 2002 tax expense, ignoring the loss carryforward Tax expense - current 246,000 Taxes payable $600,000*41% 124,700 124,700 $ 660,000 (100,000) (290,000) $ 270,000

246,000

Record the use of the loss carryforward to reduce 2002 taxable income Taxes payable Tax expense - current $270,000*41% Record the draw down of the FIT asset Future income tax expense Future income tax asset 110,700 110,700

110,700 110,700

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Note that that tax loss carryforward has been applied in its entirety against the taxable income of past and future years:

Original loss carryforward Carried back to 1999 Applied to 2001 taxable income Applied to 2002 taxable income Remaining balance

$ 660,000 (100,000) (290,000) (270,000) $ -0-

Example 2 Assume those same facts as in Example 1 with the following exception: In 2000, the loss year, the company's accountant does not believe that it is more likely than not that the company will have sufficient taxable income against which to offset the loss. However, in 2001, when the company earns a profit, the accountant decides that it is now appropriate to recognize the entire tax benefit of the loss carryforward because it is more likely than not that that benefit will be realized. Note that the future income tax asset associated with the loss carryforward benefit is initially set up at the 2001 tax rate because the asset is first recognized in that year. In other respects, the journal entries are similar to those used in Example 1. 1999 Tax expense - current Taxes payable $100,000*38% 38,000 38,000

2000, loss year Record the loss carryback at the tax rate in the carryback year, 1999 Tax refund receivable Tax benefit - current $100,000*38% 38,000 38,000

2001, year subsequent to loss year Record the tax benefit of the loss carryforward at the 2001 tax rate (Note: If the 2001 tax rate had been enacted at the time of preparation of this entry, we would set up the loss carryforward benefit at the 2001 tax rate.) Future income tax asset Future income tax benefit ($660,000 - $100,000)*43% 240,800 240,800

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Record 2001 tax expense, ignoring the loss carryforward Tax expense - current Taxes payable $290,000*43% 124,700 124,700

Record the use of the loss carryforward to reduce 2001 taxable income Taxes payable Tax expense - current 124,700 124,700

Record the draw down of the FIT asset Future income tax expense Future income tax asset Remaining loss carryforward Carried back to 1999 Applied to 2001 taxable income Available for carryforward to 2002 2002 Update the future income tax asset to the 2002 tax rate Future income tax expense 5,400 Future income tax asset 5,400 $270,000*(41%-43%) (Note that that FIT asset has become less valuable because the tax rate decreased.) Record 2002 tax expense, ignoring the loss carryforward Tax expense - current 246,000 Taxes payable $600,000*41% 124,700 124,700 $ 660,000 (100,000) (290,000) $ 270,000

246,000

Record the use of the loss carryforward to reduce 2002 taxable income Taxes payable Tax expense - current $270,000*41% 110,700 110,700

Record the use of the loss carryforward to reduce 2002 taxable income Future income tax expense 110,700 Future income tax asset 110,700

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Note that that tax loss carryforward has been applied in its entirety against the taxable income of past and future years:

Original loss carryforward Carried back to 1999 Applied to 2001 taxable income Applied to 2002 taxable income Remaining balance

$ 660,000 (100,000) (290,000) (270,000) $ -0-

Update to International GAAP International accounting standards use the term deferred income taxes in the same manner as Canadian GAAP use future income taxes. Whereas Canadian GAAP classifies future income tax assets and liabilities as current or non-current based on the classification of the underlying asset or liability, International accounting standards do not permit classification of deferred tax assets or liabilities as current.

Accounting for Income Taxes/accounting 610/wier

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