Accounting for Income Taxes

Accounting for Income Taxes

Overview of Accounting for Income Taxes

• Revenues and expenses (including gains and losses) on tax returns may differ from those reported on the company’s income statement for the same year.

• Reasons for these differences:

  • Objectives of financial reporting differ from those of taxing authorities:

  • Financial accounting standards aim to provide useful information to investors and creditors and are generally free from political influence.

  • Tax regulations established by Congress serve three main objectives:

    • Raise funds for public goods and services.

    • Influence taxpayer behavior (e.g., high taxes on smoking).

Temporary Differences

• Definition: Temporary differences arise when pretax accounting income differs from taxable income recognized in different periods.

• These differences relate to:

  • Amounts of assets or liabilities reported in financial statements versus tax basis included in tax records.

  • They originate in one period and reverse or turn around in one or more subsequent periods.

Examples of Temporary Differences

1. **Installment Sales: **

   • Income from selling properties on an installment basis is:

     • Reported in the year of sale for financial purposes.

     • Reported when installment payments are received for tax purposes.

   • Temporary Difference:

     • Originates when the installment sales are made.

     • Reverses in future periods when installments are collected.

2. Depreciation:

   • Comparisons between MACRS (Modified Accelerated Cost Recovery System) and straight-line methods.

   • IRS 946: Standard for MACRS.

   • Allowance for Doubtful Accounts:

     • No allowance for tax purposes; expenses are recorded when receivables are written off.

Deferred Tax Assets (DTAs) and Deferred Tax Liabilities (DTLs)

• Deferred Tax Assets (DTAs):

  • Arise when GAAP income is less than income reported to taxing authorities. This can happen due to:

  • Warranties on products (GAAP income < Tax Income).

  • When the transaction giving rise to a DTA reverses, accountants will reduce the DTA.

• Deferred Tax Liabilities (DTLs):

  • Arise when GAAP income is greater than income reported for tax purposes. This can occur with:

  • Accelerated depreciation for tax purposes (GAAP income > Tax Income).

  • When the transaction gets reversed, DTL is reduced.

DTL Example - Watson Associates

1. Equipment Purchase:

   • Watson purchased $60,000 of computer equipment.

   • Estimated useful life: 3 years.

   • Straight-line depreciation for financial reporting: $20,000 annually.

   • Tax deductibility: Full amount deducted in 2022.

2. Income before Tax and Depreciation:

   • Overview (Thousands):

   • Yearly Income Before Tax: $120

   • Depreciation:

     • On tax return: 2022 - ($60,000), 2023 - ($0), 2024 - ($0).

   • Taxable Income: $60, $120, $120 (in respective years).

   • Tax Rates Applied: 25% leading to tax payable of $15, $30, $30 (in respective years).

3. Pretax Accounting Income:

   • For all three years cumulative: Stays at $300, with individual yearly amounts of $100.

4. Taxable vs Pretax Difference:

   • In 2022, DTL created by ($60,000 - $20,000 = $40,000).

   • This reverses in subsequent years as Watson modifies its depreciation.

GAAP Tax Expense

• Tax Expense:

  • Each year’s tax expense includes:

  • Current portion related to tax payable in the current year.

  • Deferred portion which involves changes in DTAs and DTLs.

The 4-Step Process for Tax Expense Calculation

1. Calculate tax payable:

   • Amount of tax currently payable based on the current year’s tax return.

2. Calculate ending DTAs and DTLs:

   • Determine appropriate ending balances for DTAs and DTLs.

3. Calculate change in DTAs and DTLs:

   • Determine change (debit or credit) needed to move to new balances.

4. Plug tax expense:

   • Combine tax payable from Step 1 and changes from Step 3 to find total income tax expense.

Additional DTL Examples

Watson Associates - Continuing Example

• Tracking changes in DTL over three years:

  • 2022: Starting balance of $0, ending balance $10, with a journal entry showing income tax expense details and the classification as such.

  • Continued entries confirm yearly calculations adjusting for current amounts.

Temporary Differences from Installment Sales

• Kent Land Management Example:

  • Reported pretax accounting income of $180 million including $80 million from installment sales. Comparison made against tax return times.

Deferred Tax Liability Recap

• Final table summarizing information based on taxable amounts and tax applicable for each year.

  • Ongoing adjustments per enacted tax rates yielding balances that determine journal entries.

Valuation Allowance for DTA

• Any deferred tax assets must be reduced if it's more likely than not that portions will not be realized due to insufficient future taxable income.

• Ties into broader accounts receivable scenarios where uncollectibles are anticipated.

Permanent Differences

• Introduced as differences between GAAP and tax that are not reverted, like municipal bond interest which is tax-exempt.