ACCT 400B Exam 2 - Accounting for Income Taxes

Goals of FASB

Accuracy and Reliability

Goals of Tax Code

• Generate revenues for government

• Influence tax payer behavior → incentivize with lower rates, tax deductions when you donate

Recognized/Incurred

Items in Net income for GAAP/Books

Taxable/Deductible

items included in current periods income tax return

Pretax Book Income

Contains only items recognized/incurred in that period

Taxable Income

• Contains items that are taxable/deductible in that period

• Just the items that will affect this years tax period

Book-Tax Difference

The difference between Pretax Book Income and Taxable Income

Permanent Differences

• items that are different and will always be different

• never affect tax

• account for before getting Taxable book income

Temporary Differences

• different right now but won’t always be different, over time will be the same

• DTA or DTL

Deferred Tax Assets (DTA)

• defer tax benefits

• something that will lower our taxes in the future

Deferred Tax Liabilities (DTL)

• defer tax payments

• future tax payment is expected

Revenues/Gains Taxable AFTER Recognized for Books

(ex: A/R and Installment Sales)

• Now = more revenues recognized and less revenues taxable

• Later = more revenues taxable and more taxes owed

• DTL

Expenses/Losses Deductible AFTER Incurred

(ex: accrued liabilities, A/P, Contingent Losses, Stock Compensation)

• Now = More expenses incurred, less tax deductibles

• Less = More tax deductibles, less taxes paid

• DTA

Revenues/Gains Taxable BEFORE Recognized

(ex: deferred/unearned revenue)

• Now = More taxes owed

• Later = Less Taxes owed

• DTA

Expenses/Losses Deductible BEFORE Incurred

(ex: prepaid expenses, accelerated depreciation)

• Now = More tax deductions

• Later = Less tax deductions, more taxes owed

• DTL

Example of Chart

Pretax Book Income

+Permanent Differences

=Taxable Book Income

+DTA

-DTL

=Taxable Income

Tax Provision Journal Entry

Dr. Income Tax Expense (Taxable Book Income x %)

Dr. DTA (Amount of DTA’s x %)

Cr. DTL (Amount of DTL’s x %)

Cr. Income Tax Payable (Taxable Income x %)

ETR (effective tax rate)

• Equation?

• What does it tell us?

• Benchmark?

• What stakeholders care?

• Income Tax Expense / Pretax Book Income

• Tells us what % of this years tax income will be taxable someday , Tax Avoidance

• Benchmark vs. Statuary Rate → if higher = non favorable ; if lower = more favorable, the better the company avoids tax

• Equity investors care because top is net income, tax expense affects Net Income

Cash ETR

• Equation?

• What does it tell us?

• Benchmark?

• What stakeholders care?

• Income Tax Payable / Prebook Tax Income

• Tax deferral

• Benchmark vs. ETR → the lower the better

• Creditors care because cash is liquidity

Goals of Tax for Company

1. Tax Avoidance

2. Defer as much tax possible

What items effect avoidance/ETR?

ONLY permanent items

How to Improve Avoidance/Decrease ETR?

• Seek out sources of revenues you would never have to pay taxes on

• Avoid non-deductible expenses

How to Improve Cash ETR?

• seek items out that give us more deductions now

• invest in items that will give you favorable deductions now

Valuation Allowance

• Contra-Asset which reduces DTA

• assess the likelihood the DTAs won’t be realized

Why might we not be able to take deductions?

• Because we need to have future taxable income (we can’t have zero taxes)

Why do we only have a valuation allowance for DTA and not DTLs?

Because of conservatism

Journal Entry for Valuation Allowance

Dr. Income Tax Expense

. Cr. Valuation Allowance on DTA’s

Debiting income tax expense because its an increase in taxes we expect to pay overtime

Record VA - ETR and Cash ETR effects

• Increase ETR which decreases net income because expenses are higher

• No effect on cash ETR

Release VA - ETR and Cash ETR effects

• Decrease ETR which means higher Net Income because we are paying less in expenses

• Higher audit risk and higher burden of proof

• No effect on Cash ETR

Net Operating Loss (NOLs)

• negative taxable income on tax return

• no taxes are paid in that year

• NOLs can be used to offset taxable net income in future periods (Carry Forward)

Journal Entry for Years with NOL

Dr. DTA (Amount x Tax Rate)

Cr. Income Tax Expense

We are crediting income tax expense because it is a tax benefit we will receive one day

Year of NOL Originate - ETR and Cash ETR effect?

• Decreases ETR because decreases expenses which increases NI

• Cash ETR - No effect

Journal Entry for NOLs applied to Taxable income

Dr. Income Tax Expense (Amount for year x tax rate)

Cr. DTA (Amount for year x .80 x tax rate)

Cr. Income Tax Payable (Amount for year x .20 x tax rate)

Year of NOL Applied - ETR and Cash ETR Effect?

• ETR - no effect

• Cash ETR Decreases