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CHAPTER 12

ACCOUNTING FOR
INCOME TAXES
Introduction
Income taxes are an
expense
Consistent with
The proprietary theory
Definition of comprehensive income

Accounting for income taxes is a controversial


issue
Historical Perspective
Income taxes first became a significant
issue because of the emerging facilities
exception during World War II
ARB No. 23
Required the allocation of some deferred income taxes

Did not provide clear measurement guidelines

The allocation of income taxes to the periods impacted is termed


interperiod tax allocation
APB Opinion No. 11
Extended interperiod tax allocation to all timing differences

Criticism because resulting balance sheet items did not reflect future tax
consequences
Result
FASB Statement No. 96
Later FASB Statement No. 109 (See FASB ASC 740)
The Income Tax Allocation Issue

The objective of Provide information about the


financial accounting amount and timing of future
cash flows
SFAC No. 1

Most economic events have tax cash flow consequences


These cash consequences are reported on tax returns in
accordance with the Internal Revenue Code (IRC)
The Income Tax Allocation Issue

The goal of the IRC is to raise revenue to run the government


and in some cases to regulate the economy

These same economic events are reported for financial


accounting purposes under GAAP
The Income Tax Allocation Issue
The goals of the IRC and GAAP sometimes result in reporting
revenues and expenses in different accounting periods creating
an originating difference
In subsequent years these differences will reverse creating a
reversing difference
This issue is termed the income tax allocation issue

Revenue Expense

2010 2011
Permanent Differences

Permanent differences are differences between taxable


income and financial accounting that will never reverse
Federal economic policy
Or to alleviate a provision
of the IRC that falls too
heavily on one segment
of the economy

Financial Taxable
income income
Permanent Differences
Occur because provisions
of the IRC
Exempt certain types of
revenue from taxation
Financial Or prohibit the deduction of
income Taxable
income
certain expenses
Types of Permanent Differences

Revenue recognized for Financial Taxable


financial accounting income income
purposes that is never
taxable
Interest on municipal bonds
Expenses recognized for financial accounting purposes
that are never deductible for tax purposes
Life insurance premiums
Income tax deductions that do not qualify as expenses
under GAAP
Temporary Differences

Temporary differences
Will reverse in a subsequent period
Some temporary differences are timing differences
Others occur because of different measurement bases
Temporary Differences

Create timing differences


Result in assets and liabilities
having differing bases for financial accounting
and taxation purposes
Originating differences when they reverse
create
Taxable amounts
Deductible amounts
Temporary Differences

Categories of timing differences


Current financial accounting income exceeds
current taxable income
Current financial accounting income is less
than current taxable income
Additional Temporary Differences

1 Reduction in the tax basis of depreciable assets


because of tax credits
2 The ITC accounted for by the deferred method
3 Foreign operations for which the reporting currency is
the functional currency
4 An increase in the tax basis of assets because of
indexing for inflation
5 Business combinations accounted for by the
purchase method
Net Operating Losses
Occurs when tax deductions are
greater than taxable income in a
period
IRC allows for these losses to be
carried back two years and
forward twenty years
Should the benefits of NOLs be
recognized?
Conceptual Issues
Allocation versus Nonallocation
Comprehensive versus Partial allocation
Discounting deferred taxes
Alternative Interperiod Tax
Allocation Methods

Deferred method
Uses rates in effect when
difference originates
Asset/liability method
Uses rates expected to be in effect when the difference reverses
Net of tax method
Use one of the above methods to adjust balance sheet items that
caused the temporary difference
e. g. depreciable assets
FASB Dissatisfaction With the
Deferred Method

APB Opinion No. 11 required the use of


the deferred method
Did not meet SFAS No. 6 definition of
assets and liabilities
Measurement and Reporting
Under SFAS No. 96
Required the asset/liability approach
to allocation
Deferred tax liability
Deferred tax asset
SFAS No. 96
Limited the recognition of deferred tax assets
created by NOLs
Zero future income assumption
Business Dissatisfaction With
SFAS No. 96
The cost of scheduling necessary under its
provision
Loss of deferred tax assets under zero future
income assumption
SFAS No. 109

Board remained committed to the asset/liability


method
Allowed for the separate recognition and
measurement of deferred tax assets and liabilities
without regard to future income considerations
More likely than not criteria for deferred tax assets
rather than zero future income assumption
Determining Deferred Asset and
Liability Balances
1 Identify temporary differences, NOL
carryforwards, and unused tax credits
2 Measure the total deferred tax liability by
applying the expected tax rate to the future
taxable amount
3 Measure the total deferred tax asset by
applying the expected future rate to future
deductible amounts and NOL carryforwards
4 Measure deferred tax assets for each type of
unused tax credit
5 Measure the valuation allowance based on
the more likely than not criterion
The Valuation Allowance

There may be insufficient future


taxable income to derive the
benefit from a deferred tax asset
Use allowance to reduce the
deferred tax asset to amount
expected to be realized under the
more likely than not criterion
Do Assets and Liabilities Created by SFAS No.
109 Meet the Definitions in SFAC No. 6?

Deferred tax liability - meets the three


characteristics of liabilities
Deferred tax asset - meets the three
characteristics of assets
Financial Statement Disclosures
Income statement
Balance sheet
SEC disclosure requirements
FIN No. 48 (ASC 740): Accounting for
Uncertainty in Income Taxes an
Interpretation of FASB Stmt No. 109
Tax contingencies too flexible
Used to manipulate earnings
Reporting & disclosure of tax positions
lacked transparency
FIN 48 establishes proper
accounting treatment for uncertain
tax positions.
FIN No. 48: Accounting for Uncertainty in
Income Taxes an Interpretation of FASB
Stmt No. 109
Evaluation of tax position is a 2-step
process
Recognition
Measurement
Financial Analysis of Income Taxes

Disclosure requirements allow


financial statement users to make
better decisions including:
1 Assessing the quality of earnings
2 Assessing future cash flows
3 Calculation of actual tax rates
Financial Analysis of Income Taxes

The footnotes provide information on:


1 Information on the amount of taxes that would be
paid at the federal statutory rate and the amount
actually paid
2 Changes in the deferred tax asset and liability
accounts
3 Information concerning income tax carrybacks and
carryforwards
Financial Analysis of Income Taxes
The earnings conservatism ratio
Pretax accounting incomea
Taxable income
aIn the event a company reports material permanent income tax
differences, the amount of these differences adjusts the numerator.
Financial Analysis of Income Taxes

Earnings conservatism ratios for Hershey and Tootsie

1.20

1.00
1.00 1.00 1.00 1.00
0.80 1.00
1.00
0.60

0.40

0.20

0.00
2009 2010 2011
Hershey Tootsie Roll
IAS No. 12:
Accounting for Taxes on Income
Amended in 1996 to require the liability
(asset/liability) method
Quite similar to U.S. GAAP, as outlined in
SFAS No. 109
Considering other issues:
1 Do tax consequences of recovery amounts of assets and
liabilities depend on the manner of recovery?
2 Disclosure of reconciliation between income tax expense
and accounting profit
March 2009: Exposure draft of revised IAS
No. 12
Attempt to alleviate differences
At present the income tax project is inactive.
End of Chapter 12

Prepared by Kathryn Yarbrough, MBA

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