ACC422 Final Exam

Why/When do Deferred Taxes Arise

Income tax EXPENSE differs from income tax LIABILITY

Where is Tax Expense Determined

Under GAAP

Where is income tax liability determined?

Under the IRC (Internal Revenue Code)

• Authored by CONGRESS

What is the BASIS difference between temporary and permanent differences?

Temporary

• Reverse over time

Permanent

• Do not reverse

Examples of Permanent Differences

• Items recognized for financial accounting purposes, but not for income tax purposes

  • Interest Income received on tax exempt securities

  • Fines and Expenses from violations of the law

  • Premiums paid for life insurance on key officers/employees

Permanent Differences: Interest Income Received on Tax Exempt Securities

• Congress puts value on certain investments such as churches and schools to encourage investment

• This would lower taxable income

• Lower Taxable Income is more beneficial

Permanent Differences: Fines and Expenses from violating the law

• Train wreck that caused a lot of damage will NOT have tax deductions

• They add back to taxable income

• Civil rights violations, discrimination, pollution

Permanent Differences: Premiums for life insurance on key officers/employees

Court says it is LEGAL but not tax deductible, like Steve Jobs policy

• Added back to taxable income

Deferred Tax Asset: Source

Arises due to net DEDUCTIBLE amounts in the future

Deferred Tax Liability: Source

Arises due to net Taxable AMOUNTS in the future

Deductible Temporary Differences: Examples

(Assets) Warranty Expense, Unearned Revenue

Taxable Temporary Differences: Examples

(Liabilities): Depreciation, Installment Sales

Deferred Tax Rates: Applying Tax Rates

• Basic Rule: Apply the yearly tax rate to calculate deferred tax effects

• If future tax rates change: Use the enacted tax rate expected to apply in future year

• If not enacted, use current tax rate

Enacted

Congress votes on it

Effective Income Tax Rate Equation

Income Tax Expense / GAAP NI = %

NOLs Rules of Application

• The NOL of one year can be applied to offset taxable income of other years, possibly resulting in tax refunds

NOLs Historically: Carryback option and Carryforward only

• Carryback Option

  • Carried back 2 years and carried forward 20 years

• Carryforward Only

  • ONLY Carriedforward 20 years

Major Change in NOL rules

NOL Carrybacks no longer allowed

If NOLs are carried back 2 years and carried forward 20 years

• Remaining NOLs are applied to following 20 year period

• Any tax refunds are reported in the year of the original NOL

NOL JEs: Carrybacks

WHEN ALLOWABLE

• DR: Income Tax Refund Receivable

  • Benefit on Carryback

NOL JEs: Carryforwards

• DR: Deferred Tax Asset

  • Benefit on Carryforward

Income Tax Expense JE

• DR: Income Tax Expense (Plug)

• DR: Deferred Tax Asset (Future)

  • CR: Deferred Tax Liability (Future)

  • CR: Income Tax Payable (Today)

Steps for Deferred Tax Analysis

• Start at GAAP NI

• Analyze Permanent Differences (Individually)

• Analyze Temporary Differences

  • Taxable → DTL

  • Deductible → DTA

• Arrive at Taxable Income

• Multiply by current tax rate to arrive at income tax expense (DR)

Income Tax Expense FS Effects

• Income Taxes Payable Current Liability

• Deferred Tax Liability Non-Current Liability

• Both CURRENT and DEFERRED tax are summed, and then subtracted from “Income before Income Taxes” to arrive at Net Income

When do taxable temp. differences appear?

Taxable Income is LESS THAN Financial Income

• Revenues or gains are taxable after they are recognized in financial income

  • AR and Investments

• Expenses or losses are deductible before they are recognized in financial income

  • Depreciation and Prepaid Expenses

When do deductible temp. differences appear?

Taxable income is GREATER THAN financial income

• Revenues or gains are taxable before they are recognized in financial income

  • Subscriptions and rental pmts received in advance

• Expenses or losses are deductible after they are recognized in financial income

  • Warranty Liabilities

  • Litigation Accruals

What are the 2 broad categories of differences that we discuss (Deferred Tax)

• Permanent and Temporary

How many permanent differences did we talk about in class?

3

• Interest income received on tax exempt securities

• Fines and expenses resulting from violating the law

• Premiums paid for life insurance on key offiers/employees

What is the most common permanent difference that is a deduction

Tax Exempt Bonds (Lower Taxable Income)

2 Subcategories of Temporary Differences

• Taxable and Deductible

  • NOT DTA AND DTL

What does a taxable difference create on the BS

Liability

What does a deductible difference create on the BS

Asset

One common taxable temporary difference

• Depreciation

• Installment Sales (AR)

One common deductible temporary difference

Warranties

If an event says reversible in deferred taxes it is…

A Temporary Difference

Depreciation (Deferred Taxes)

Temporary Difference

• Taxable (NEVER DEDUCTIBLE)

• CREATES A DTL

• We are choosing to recognize it at a later date

Rent (Deferred Taxes)

• Unearned Revenue because they earned more cash that was not earned

• Owe more tax today, but less in the future

• Temporary Deductible Difference

• If rent collected was LOWER than EARNED revenue, it would be TAXABLE

What does deferred taxes aim to do?

• Reconcile GAAP Revenue and Expenses

What is the new standard for Accounting for Pension Plans

ASC715

Defined Contribution Plans

• Employer contributions are defined

• Retirees benefit depends on the fund performance

• Retiree bears the investment risk

Defined Benefit Plans

• Retiree benefits are a fixed amount

• Employer contributions to the plan depend on promised benefits to retirees

• Employer bears the investment risk

If contributions made to pension are LESS THAN pension expense what does the employer record

Accrued Liability

• UNDERFUNDED PLAN

If contributions to pension are GREATER THAN pension expense, what does the employer record

Accrued Benefit

• OVERFUNDED PLAN

What do pension calculations involve

Actuarial Assumptions (They are estimates)

What are the assumptions behind pension calculations

• Mortality Rates

• Employee Turnover

• Future Salaries

• Rates of Return

What are the components of pension cost

• Service Cost

• Interest Cost

• Return on Plan Assets

• Gains and Losses

• Amortization of Unrecognized Prior Service Cost

How is service cost incurred (Pensions)

• Increase in PBO payable to employees because services rendered during the current year

What is PBO (Pension)

Projected Benefit Obligation

INCREASES COST

What is Interest Cost (Pensions)

• Promised employee benefits are a liability to the company

• Company pays interest on the beginning balance of the PBO

• Settlement rate determines the interest expense

• INCREASES COST

What is Return on Assets (Pensions)

• Assuming a positive return, it LOWERS pension expense

• Can be heavily manipulated by “optimistic” assumptions

• One of the largest sources of gains and losses in pension plans is the differences between expected and actual returns

What are amortized unrecognized Gains & Losses (Pensions)

• Unrecognized G/L are deviations of actual amounts from estimated amounts

• Amortize the Unrgnzd G/L only if they Exceed 10% of

  • The greater of PBO OR MARKET RELATED VALUE (Both at start of year)

• Amortize over the REMAINING SERVICE LIFE of active employees

• SUBJECT TO MATERIALITY TEST

• GAINS LOWER EXPENSE

• LOSSES INCREASE EXPENSE

What are unrecognized prior service costs (UPSC) (Pensions)

• Results only when a plan has been changed

• The UPSC is allocated to pension expense based on the remaining service years of the concerned employees

• UNAMORTIZED UPSC is shown in the OCI

• INCREASES EXPENSE

What changes did ASC 715 make

• Use of OCI account for

  • PSC and G/L

    • NOT A PART OF NET INCOME

• No longer based on ABO

Recognition of Pension Funding Asset or Liability JE

• DR: Pension Expense

• DR: Pension Asset

  • CR: Pension Liability

  • CR: Cash

What was the problem w pensions?

Companies made promises with pensions but never accounted for them

Companies and states were/are running at surpluses

Why can Defined BENEFIT plans be considered worse?

• If company goes bankrupt pension is gone

• Vesting Periods can be very long

What type of relationship does ROA have on Pension Expense (Cost)

Inverse or negative

• During positive years it lowers expense

If we have $1M in PBO and $1.2M in Assets

200,000 overfunded plan

When to debit and credit for OCI

• DR: ONLY FOR AMORTIZATION GAINS

  • CR: Amortization of PSC and LOSSES

For pensions, do we use market/FV or cost

ALWAYS MARKET/FAIR VALUE, NEVER COST

3 Methods to find ROA

• Given

• Beginning FV (Assets) * ERR (Expected Return)

• Solve w T-Chart/Equation

  • Beginning Balance + Contribution = Ending (DEBIT)

  • Paid Benefits (CREDIT)

What is the materiality test for G/L Called?

Corridor Test

• Does G/L Exist?

• Take PBO & Assets

  • Take bigger of two, and multiply by 10%

• Take Excess and divide it by service years

What if there are 2 losses back to back (Pensions)

• We carryover the UNRECOGNIZED LOSS to the next year

What is a Lease, and what are Lessor’s and Lessee’s

Contractual agreement between the lessor and lessee

• Lessee is the party that is making payments, has rights, and will have to move out

• Lessor is the true owner

Taxes, Insurance, and maintenance may be assumed by either party

Advantages of Leasing

• May not require any money down

• Payments often fixed

• Reduces risk of obsolescence to the lessee

• May have less restrictive covenants

• May be less costly

• May not add existing debt on the BS

Conceptual Nature of a Lease

• Lease transferring substantially all benefits and risks of ownership should be capitalized

• Transfer of ownership can be assumed is the lease is non-cancelable

• Leases that do not substantially transfer benefits and risks are operating leases

What are the 4 criteria in Group 1 for identifying finance leases (Lessee)

• Transfer of Ownership

• Bargain Purchase

• Lease w terms equal to 75% or more of the economic life “MAJOR PART”

• Leases where PV of lease payments is equal to 90% or more of FMV “SUBSTANTIALLY ALL”

Classifications of Leases: Lessor

• Operating Lease

• Financing Lease

  • Most popular

  • NO GROSS PROFIT, Interest is the “profit”

• Sales-Type Lease

What are the group 2 criteria for a lease to be finance type (Lessor)

• Collectibility must be reasonably assured (Revenue Recognition)

• Lessors Performance must be substantially complete (Rev. Recognition)

• Assets FV MUST BE EQUAL to lessor’s BV

What information is in the Lease Receivable for the lessor

• Minimum Lease Payments

• Any residual value at the end of the lease term

Sales Lease: Lessor (JE)

• DR: Lease Receivable

• DR: COGS (Equal to Asset BV)

  • CR: Sales (Equal to L.R)

  • CR: Inventory (Asset Book Value)

What are residual values?

• Estimated FV of asset at the end of the lease term

• May be Guaranteed or Not Guaranteed

• Can affect calculation only for LESSEE

What is the "New” Asset Category used for leases

Right of Use Asset

What do we record for leases that are cancellable?

NO ENTRY

What “Life” are Lease JE’s based on

Lease life, NOT USEFUL LIFE

If the accountant mixes up who the lessee and lessor is, how does this affect FS?

• Assets would be the same, just classified wrong

• Liabilities would be understated

• Revenues would be understated

Who is responsible for depreciation and amortization on a lease?

• ONLY THE LESSEE

• Payments affect liability

• ROU Affected by Amortization

What was the old standard for leases, as well as the new one?

• Old

  • SFAS 13, ASC 840

• New

  • BAAP; ASC 842

What were the major changes in the new Leasing Accounting Standard?

• “Capital” Lease changed to “Finance”

• Changed the 75% and 90% rules to Major Part and Substantially All

• Right of Use Asset Category

Describe the behavior (Add or Subtract) of the 3 permanent differences discussed in class

• Tax Exempt Bonds (SUBTRACT)

• Fines (ADD)

• Life Insurance Policies (ADD)

Most common taxable and deductible difference

Taxable

• Depreciation

Deductible

• Warranties

Deferred Taxes; Unearned vs. Installment Treatment

• Installment

  • TAXABLE, we collect the money in the future

• Unearned

  • DEDUCTIBLE, we get cash and earn it later

What rates do we use for Income Tax Payable? DTA/DTL (If applicable)

• Income Tax Payable

  • Current Rate

• DTA/DTL

  • If there is a future rate ENACTED, we use it

What do we do to DTA and DTL in reversals

• DTA; CREDIT

• DTL; DEBIT

What is a lag measure, for G/L

We do not recognize the G/L until the NEXT year