978-0078025679 Chapter 13 Lecture Note

Unlock access to all the studying documents.

View Full Document

Financial Reporting and Analysis 6e Income Tax Reporting

CHAPTER 13

INCOME TAX REPORTING

CHAPTER OVERVIEW

The rules for computing income for financial reporting purposes—book income—differ from the

rules for computing income for tax purposes. The differences between book income and taxable income

are caused both by permanent and temporary (timing) differences in the revenue and expense items

reported on a company’s book versus its tax return. Temporary differences give rise to either a

deferred tax asset or a deferred tax liability. Deferred tax accounting generally requires firms to report

tax costs (or benefits) on the income statement in the period in which the related revenue and expense

items are recognized for book purposes irrespective of when these amounts were reported on the tax

return.

The income tax footnote provides useful information for understanding how much of the current

period’s tax provision (expense) is actually payable to the federal, state, and foreign governments, and

how much is deferred. Tax footnotes allow users to understand why firms’ effective tax rates may

differ from the statutory rate. GAAP disclosures are useful in assessing a firm’s uncertain tax positions

and whether the firm is aggressive or conservative in recognizing the benefits associated with these

positions. Finally, tax footnotes provide information that can be exploited to improve interfirm

comparability and evaluate firms’ earnings quality.

There are a number of differences between IFRS and U.S. GAAP rules for accounting for income

taxes that you should be aware of as you analyze financial statements across countries. IFRS and US

GAAP income tax rules largely overlap but differ in several subtle but important ways. A recent IASB

exposure draft proposes to narrow the differences.

CHAPTER OUTLINE

I. UNDERSTANDING INCOME TAX REPORTING – Temporary and Permanent Differences

Between Book Income and Taxable Income

A. In the U.S., as in many industrialized countries, the rules for computing GAAP income for

financial reporting purposes (book income) do not correspond to rules for computing income for

taxation purposes (taxable income).

1. This divergence is allowable and makes sense because of the different objectives

underlying book income and taxable income.

a. Book income is intended to reflect increases in a firm’s “well-offness” – to

include all changes in net assets except from/with owners.

b. Book income includes all earned inflows of net assets, even inflows not

immediately convertible into cash, and it reflects expenses as they accrue, not

just when they are paid.

c. In contrast, taxable income is governed by the “constructive receipt/ability to pay”

doctrine, meaning that taxation usually (but not always) follows the inflow of cash

or cash equivalents.

2. This divergence complicates the way that income taxes are reflected in financial reports.

B. The differences that result from determining income reported in external financial statements

and determining taxable income for tax purposes fall into two broad categories:

1. A temporary or timing difference results when a revenue (gain) or expense (loss) enters

into the determination of book income in one period but affects taxable income in a

Financial Reporting and Analysis 6e Income Tax Reporting

different earlier or later period.

a. Timing differences are considered “temporary” because a revenue (or expense) item

that causes book income to be greater than (less than) taxable income when it is

initially recorded (called an originating temporary difference) will eventually

reverse.

b. These reversals cause book income to be less than (greater than) taxable income in

future periods and are called reversing temporary differences.

c. Temporary differences that will cause taxable income to be higher than book income

in future periods give rise to a deferred tax liability.

d. Conversely, temporary differences that will cause taxable income to be lower than

book income in future periods when those differences reverse give rise to a deferred

tax asset.

b. See Exhibit 13.1 in the text for examples of temporary (timing) differences.

c. Timing differences result in a journal entry on the books of the corporation for the

difference between the tax liability for the year and book income times the

applicable tax rate for the corporation.

C. Problems Caused by Temporary Differences

1. Interperiod tax allocation refers to the allocation of income tax expense across periods

when there are differences between book and tax income.

2. Depreciation expense is the most prevalent temporary book/tax timing difference.

a. For tax purposes, profit-maximizing firms try to minimize the discounted present

value of their future tax payments by using accelerated depreciation for tax purposes.

b. Many of these same firms use straight–line depreciation for financial reporting

purposes, causing a temporary difference between book income and taxable

income.

c. Treating actual cash taxes paid as income tax expense would not reflect the true

economics of the situation.

i. This approach would mismatch tax expense with pre-tax book income, resulting

in an increasing effective (book) tax rate even when the pre-tax book income

and the statutory tax rate are stable over time.

ii. The effective (book) tax rate is the tax expense divided by pre-tax income that is

reported on the GAAP income statement.

iii. Continuing with the depreciation expense temporary difference, this approach

also ignores the future tax liability that results.

d. Therefore, tax expense must be adjusted for temporary differences between book and

tax items in order to reflect the true economics of the situation.

D. Deferred Income Tax Accounting: Interperiod Tax Allocation:

To avoid these drawbacks, income tax accounting does not simply equate tax expense

with current taxes paid (or payable).

1. Instead, the journal entry for income taxes expense reflects all tax payments related

to current period pre-tax income regardless of when the payments will occur. It calls

for recognizing deferred tax liability, reflecting future tax payments.

a. The debit to income tax expense, when tax rates are constant and there are no

permanent book/tax differences, equals the tax rate times pre–tax book income.

b. The credit to income tax payable is the tax rate times the taxable income per the tax

return.

c. The debit/credit to the deferred income taxes line is the tax rate times the net of all

temporary differences.

d. The text illustrates that the debit to income tax expense is a plug number, which

represents the combination of current taxes payable and any change in the deferred

Financial Reporting and Analysis 6e Income Tax Reporting

tax balance.

2. As summarized in Figure 13.5 in the text, income tax expense equals taxes payable plus

increases in the deferred tax liability minus decreases in the deferred tax liability.

a. Increases in the deferred tax asset decrease the income tax expense.

b. Decreases in the deferred tax asset increase the income tax expense.

3. When tax rates do not change from year to year, the entry described above

simultaneously overcomes both of the drawbacks that would exist if we simply

measured tax expense as cash taxes paid.

a. The liability for future taxes is explicitly recognized.

b. The reported tax expense is exactly the same percentage of the pre-tax book income

(provided there are no permanent book/tax differences).

c. This matching disappears in any year that Congress changes the U.S. tax rates, since

the current GAAP focuses on the liability for future taxes, which changes as tax

rates change.

Teaching Tip: At any point in time, the balance in the deferred tax liability (asset) equals the

cumulative dollar amount of temporary difference(s) between book and tax income times the tax

rate.

E. When Congress changes tax rates, the tax effects of the reversals change as well.

1. In any year that current or future tax rates are changed, the income tax expense number

absorbs the full effect of the change, and the relationship between that year’s tax expense

and book income is destroyed.

2. Assume a deferred tax liability position that is attributable to depreciation.

a. As tax rates increase, the liability for future taxes will be larger than the amount

currently reported.

b. As tax rates decrease, the liability for future taxes will be less than the amount

currently reported.

c. Therefore, the future liability represents the cumulative excess of tax over book

depreciation multiplied by the new tax rate that will be in effect.

d. Under the liability approach of the current U.S. GAAP (FASB Topic 740 for

Income Taxes), the full change in the amount of future liability for income taxes is

recognized as an increase or decrease in income tax expense in the year that the tax

rate change becomes known.

e. This accounting injects a transitory adjustment to earnings in the year that Congress

passes new tax rates. This effect on bottom-line earnings can vary depending on:

i. Whether tax rates are increasing or decreasing.

ii. Whether the firm has net deferred tax assets or net deferred tax

liabilities.

iii. The magnitude of the deferred tax balance.

F. Deferred Tax Assets result when taxable income initially exceeds pre-tax income.

1. Temporary differences that result in deferred tax assets (liabilities) are called future

deductible (taxable) amounts since future tax return income will be lower (higher) than

future book income when these amounts reverse (all other factors being equal).

a. Increases in deferred tax assets are subtracted from income tax payable to arrive at

income tax expense.

b. Decreases in deferred tax assets are added to income tax payable to arrive at income

tax expense.

2. Deferred Tax Asset Valuation Allowances: It is always possible that a firm that has

recognized deferred income tax assets may not receive tax payment reductions in future

Financial Reporting and Analysis 6e Income Tax Reporting

years.

a. For this reason, the FASB requires firms with deferred tax assets to assess the

likelihood that these assets may not be fully realized in future periods.

b. If management believes that the probability of future taxable income is greater than

50%, deferred income tax assets can be recognized (without adjustment) in their

entirety.

c. However, if this assessment indicates that it is more likely than not that some

portion of the benefit will not be realized in its entirety:

i. Then a deferred tax asset valuation allowance is required to “reduce

deferred tax asset to the amount that is more likely than not to be

realized.” (FASB ASC Paragraph 740-10-30-5e)

ii. The creation of this allowance requires a debit to income tax expense.

iii. Future adjustments to this allowance are also adjustments to the income

tax expense account.

d. There is some evidence that managers use the valuation allowance to manage

earnings.

e. Valuation Allowances at Profitable Companies: It may seem counterintuitive

to see a valuation allowance at a profitable company. If a firm has deferred tax

assets in a particular jurisdiction, it will have to generate taxable income in that

jurisdiction to realize the value of the deferred tax assets.

f. Subjectivity of Valuation Allowances: Potential for abuse of valuation

allowances exist since there are no readily observable criteria for the decision to

establish a deferred tax asset valuation allowance.

g. There is compelling evidence that managers take advantage of the discretion

associated with setting the deferred tax asset valuation allowance to manage

earnings in both a positive and a negative direction.

G. Firms reporting operating losses may offset those losses against either past or future tax

payments.

1. A firm may carry back the operating loss and offset it against taxable income in the

previous two years offsetting the earliest year first.

2. If the loss exceeds the total taxable income for the two-year period, then the remaining

loss can be carried forward and offset against future taxable income in the ensuing 20

years.

3. A firm can elect to only carry the loss forward against taxable profits in the next 20

years.

a. In this case the firm would for go an immediate refund if there was taxable income

in the previous two years.

b. Most firms elect the carryback option in order to maximize the present value of the

benefit.

c. Firms may elect the carry forward option if they believe that future rates will be

much higher than past rates.

4. Any income tax refund receivable is immediately credited to income tax expense.

5. The loss in excess of the combined prior two-years’ profits will result in future tax

benefits.

a. The firm recognizes a deferred tax asset for an amount equal to the carry forward

times the tax rate.

b. Income tax expense is credited.

c. The firm must determine whether any portion of the asset needs to be offset with a

valuation allowance.

H. Classification of Deferred Tax Assets and Deferred Tax Liabilities

Financial Reporting and Analysis 6e Income Tax Reporting

A. The disclosures contained in a typical income tax footnote provide information

that enable financial statement users to extract useful insights about a firm’s past

performance future prospects, and tax planning strategies.

1. GAAP requires firms to classify deferred tax assets or deferred tax liabilities as

current or noncurrent based on the related asset’s classification.

2. The disclosure typically shows the tax expense provision for three years.

a. This includes the portion currently payable to the IRS and the portion that is

deferred taxes.

b. Within each category, separate amounts for U.S. federal, foreign, and state and

local taxes are typically disclosed.

3. For tax-paying components of an entity, all current deferred tax assets and liabilities

can be netted and presented as a single amount.

4. Noncurrent deferred tax assets and liabilities can be netted and presented as a single

amount.

5. Firms are not allowed to net deferred tax liabilities and assets attributable to

different tax-paying components or to different tax jurisdictions.

I. Deferred Income Tax Accounting When Tax Rates Change

A. GAAP uses the liability approach whereby deferred tax assets and liabilities are

always valued at the enacted tax rate expected to be in effect when the related temporary

differences reverse.

1. In any year that current or future tax rates change, the income tax expense

number absorbs the full effect of the change, and the usual relationship

between that year’s income tax expense and book income is destroyed.

2. Under the liability approach of Topic 740: Income Taxes, the full charge in the

amount of future liability for income taxes is recognized as an increase or

decrease in income tax expense in the year the tax rate change is enacted.

3. Analysts must be alert to recognize how tax rate changes can inject one–time

(transitory) shocks to earnings in the year a taxing authority adopts new tax

rates.

J. Permanent Differences: A permanent difference between taxable income and book

income is caused by income items that:

a. Enter into the determination of accounting income but never affect taxable income

and vice versa.

b. Because permanent differences between book income and taxable income do not

reverse and are not offset by corresponding differences in subsequent periods, they

`do not give rise to deferred tax assets or liabilities.

c. Exhibit 13.2 in the text provides examples of permanent differences.

II. UNDERSTANDING INCOME TAX NOTE DISCLOSURES

A. The disclosures contained in a typical income tax footnote provide information that enable

financial statement users to extract useful insights about a firm’s past performance future prospects,

and tax planning strategies.

1. GAAP requires firms to disclose separately the current and deferred portion of the current

period’s income tax provision.

2. Reconciliation of Statutory and Effective Tax Rates: The required reconciliation

disclosure typically explains why the debit to income tax expense differs from the U.S.

statutory corporate tax rate multiplied by pre-tax book income.

a. Divergence between the statutory rate and the effective rate is attributable to

tax credits and permanent differences.

Financial Reporting and Analysis 6e Income Tax Reporting

b. This divergence between statutory tax rate and the effective tax rate is useful to

analysts because it provides information on the firm’s tax policy decisions related

to:

i. Permanent difference items that are not taxed or are not tax deductible but

are included in book income.

ii. State and local taxes.

iii. Changes in the valuation allowance.

iv. Differential tax rates in foreign jurisdictions in which the firm operates.

v. Various tax credits offered by the federal government.

4. Details on the Sources of Deferred Tax Assets and Liabilities: This disclosure typically

contains major components of the net deferred asset and net deferred liability accounts.

a. The change in the net deferred liability (asset) position may or may not be the credit

(debit) to the deferred taxes line in the income tax journal entry.

b. There may be a change in the deferred tax asset valuation account that affects this

analysis.

c. Tax effects arising from discontinued operations, extraordinary items, direct charges

or credits to stockholders’ equity for prior period adjustments or other comprehensive

income items are not included in the journal entry that relates to income from

continuing operation.

d. Deferred tax assets and liabilities changes not seen in the deferred tax provision is

acquisitions.

e. GAAP require that the amounts and expiration dates of net operating loss and tax

credit carryforwards for which tax benefits have not been recognized be disclosed in

the income tax note.

5. Why Don’t Company’s Deferred Tax Assets and Liabilities Seem to

Reverse? Even though individual deferred tax assets and liabilities reverse, they

are replaced by new deferred tax assets and liabilities that arise.

6. Deferred Taxes and Cash Flow: The company’s tax strategy, not whether a

deferred tax liability is created, affects cash flow. Using tax accounting methods

that accelerate deductions or delay income recognition increases cash flow at least

in the early years.

III. MEASURING AND REPORTING OF UNCERTAIN TAX POSITIONS

A. The basis for this section is FASB Accounting Standards Codification under Topic

740 (FASB Interpretation No. 48 (FIN 48) in the pre-Codification period) which defines a

tax position as a position in a previously filed tax return or a position expected to be

taken in a future tax return that is reflected in measuring current taxes payable or deferred

income tax assets and liabilities for interim or annual periods.

1. GAAP procedures require a two-step process to determine how much benefit to

recognize from an uncertain tax position and how much a firm should recognize

in its tax contingency reserve as a liability for unrecognized tax benefits.

2. Step 1 involves a recognition threshold where a firm must determine whether the

uncertain tax position meets the test of “more likely than not” that it will be able to

sustain the tax return position based solely on technical merits.

a. The term “more likely than not” means a likelihood of more than 50%.

3. If the recognition threshold is met, then the firm moves to step 2.

4. Step 2 measures the tax benefit as the largest amount of benefit that is

cumulatively greater than 50% likely of being realized.

5. The difference between the tax benefit as shown on the tax return and the tax

Financial Reporting and Analysis 6e Income Tax Reporting

benefit determined under the two-step approach is recorded as an increase in the

tax contingency reserve (or liability for unrecognized tax benefits).

6. Increases or decreases into the tax contingency reserve resulting from permanent

differences affect a firm’s current tax provision.

7. An uncertain tax position relating to a temporary difference also gives rise to

book-tax basis differences that create a deferred tax asset or deferred tax liability.

8. GAAP forbids the use of a valuation allowance in place of a contingency reserve.

B. Recording Uncertain Tax Position Related to Timing of Deductibility: Changes or

resolution of uncertain tax positions in subsequent years or if the

uncertain tax position is settled with the taxing authority, appropriate adjustments

are made to the tax contingency reserve with offsetting adjustments to tax expense

or cash.

IV. EXTRACTING ANALYTICAL INSIGHTS FROM NOTE DISCLOSURES

A. Information about deferred tax assets and liabilities can help assess earnings quality and

enhance interfirm comparisons. Firms will generally select policies that minimize the

present value of their tax payments, even though their financial reporting choices might

differ substantially.

B. Using Deferred Tax Notes to Assess Earnings Quality

1. Companies must disclose details about individual temporary differences that give rise to

the deferred tax asset and deferred tax liability balances on the balance sheet.

2. Since materiality guidelines are subjective, careful scrutiny of the income tax note

provides analysts a way to detect subtle changes in accounting estimates that affect

bottom-line earnings but are not separately disclosed.

3. A detailed examination of deferred income tax balances provides auditors evidence for

evaluating management candor.

C. Using Tax Notes to Improve Interfirm Comparability

1. The deferred tax portion of the income tax note can be used to undo differences in

financial reporting choices across firms and thus to improve interfirm comparisons.

V. GLOBAL VANTAGE POINT

A. Even though IFRS and U.S. GAAP rules for accounting for income taxes largely overlap,

there are important but subtle areas of difference to note:

1. Approach for recognizing deferred tax assets

2. Reconciliation of statutory and effective tax rates

3. Reporting of deferred taxes on the balance sheet

4. Disclosure of income tax amounts recognized directly in equity

5. Uncertain tax positions.

B. Approach for Recognizing Deferred Tax Assets

1. Set forth in IAS 12, “Income Taxes,” IFRS rules, like U.S. GAAP, take an assets-liability

approach to accounting for income taxes intended to recognize, in the balance sheet, the

future tax consequences of events that are recognized on the financial statements and tax

return in different periods (temporary difference) – both record an deferred tax asset

(liability).

2. For U.S. GAAP, the applicable tax rate is the enacted tax rate passed by Congress. IFRS

allows firms to use either the enacted tax rate or substantively enacted tax rates.

3. No valuation account is used for deferred tax assets under IFRS. Firms use a one-step

approach that provides for recognition of deferred tax assets only to the extent it is deemed

Financial Reporting and Analysis 6e Income Tax Reporting

probable that they will be realized.

4. Attempts to manage earnings through adjustments to deferred tax assets are more difficult to

detect under current IFRS reporting.

C. Reconciliation of Statutory and Effective Tax Rates

1. Both IFRS and US GAAP require a numerical reconciliation that explains the differences

between statutory and effective tax rates. US GAAP requires the domestic federal statutory rate

be used as a starting point. While IFRS allows firms to use this rate also, it offers the alternative

of using a statutory rate that aggregates domestic rates in various jurisdictions in which a firm

operates to be used.

D. Reporting Deferred Taxes in the Balance Sheet

1. US GAAP requires firms to classify deferred tax assets and liabilities as current or non-

current depending on the classification of the event, giving rise to the temporary difference.

2. IFRS does not give consideration to the classification of the underlying asset or liability but

rather deferred tax assets and liabilities are reported as non-current in a classified balance sheet.

3. US GAAP requires netting of deferred tax assets and liabilities (both current and non–

current) on the face of the balance sheet if they relate to the same tax-paying component and

same tax authority of an entity. IFRS allows netting (offsetting) if, and only if,

i. entity has a legally enforceable right to set off current tax assets against current tax liabilities

ii. deferred tax assets and liabilities relate to income taxes levied by the same taxing authority

on either the same taxable entity or different taxable entities which intend to settle taxes on a net

basis or realize assets and settle liabilities simultaneously

4. Practically, these stringent requirements result in deferred tax assets and liabilities being

reported separately by firms following IFRS rules.

E. Disclosure of Income Tax Amounts Recognized Directly in Equity (Other Comprehensive

Income)

1. IFRS requires a disclosure of aggregate amount of current and deferred tax expense or

income flowing directly through Other Comprehensive Income. US GAAP does not currently require

such disclosure.

F. Uncertain Tax Positions

1. While FASB provides extensive guidance on measurement and recognition of continent

liabilities related firms’ uncertain tax positions, the IFRS has no such specific guidance but

rather calls for tax assets and liabilities to be measured at the amount expected to be paid.

G. IASB Exposure Draft on Income Taxes: In March 2009, the IASB issued an exposure draft that

would eliminate many of the current differences existing between IFRS and US GAAP among which

are the following four:

1. As in US GAAP firms would recognize a valuation account against deferred tax assets.

2. Firms would recognize tax expense (or benefits) arising at the time of the transactions and

other events in the same component of comprehensive income or equity in which it recognizes

the related event or transaction.

3. Firms would be required to disaggregate deferred tax assets and liabilities into current and

non- current amounts based on the classification of the related asset or liability.

4. As to the uncertainty of whether the tax authority would accept the amounts reported to it,

the draft proposes the deferred tax assets and liabilities be measured at the probability-weighted average

of all possible outcomes.

5. IASB is planning a fundamental review of accounting for income taxes.

Financial Reporting and Analysis 6e Income Tax Reporting

CHAPTER QUIZ

1. A firm purchases a machine costing $6,000 with a three-year estimated service life and no

salvage value. For financial reporting purposes, the firm uses straight-line depreciation with a

three-year life. For income tax reporting, the machine is depreciated with a two-year life. The

machine is used to manufacture a product that will generate annual revenue of $5,000 for three years.

Warranty expenses are estimated at 10% of revenues each year; all repairs are provided in Year 3.

The tax rate is 40% in all three years. Calculate the deferred tax asset and liability balances at the end

of Year 2.

Asset Liability

a. $200 $400

b. $400 $800

c. $800 $800

d. $1,000 $800

2. Assume the same facts as in #1 above, except that the income tax rate is 40% in Year 1 and 35% in

Years 2 and 3. Calculate the Year 1 income tax expense assuming the Year 2 tax-rate change is enacted

in Year 1.

a. $750.

b. $800.

c. $975.

d. $1,000.

3. What circumstances lead to the recognition of a deferred tax asset?

a. A deferred tax asset results when a transaction originates a difference that causes financial

income to be less than taxable income.

b. A deferred tax asset results when a transaction originates a difference that causes taxable

income to be less than financial income.

c. A deferred tax asset results when a transaction reverses a difference, causing financial income to

be less than taxable income.

d. A deferred tax asset results when a transaction reverses a difference, causing taxable income to

be less than financial income.

4. How are tax loss carryforwards and credits classified on the balance sheet?

a. Tax loss carryforwards and credits are classified on the balance sheet as current assets.

b. Tax loss carryforwards and credits are classified on the balance sheet as long-term assets.

c. Tax loss carryforwards and credits are classified on the balance sheet in the same manner as the

asset or liability that gives rise to the difference.

d. Tax loss carryforwards and credits are classified on the balance sheet based on their expected

reversal date.

5. Which of the following best characterizes how impairments and restructuring costs affect the

accounting for income taxes?

a. For impairments, the financial reporting write-downs generate tax deductions when the loss is

recognized.

b. Restructuring costs usually become tax deductible when they are paid rather than when they are

accrued.

c. Impairments and restructuring costs do not affect the volatility of deferred tax assets.

d. Neither cost results in deferred tax assets.

Financial Reporting and Analysis 6e Income Tax Reporting

6. An increase in the age of long-term assets increases ROA. How does this increase in age

generally affect deferred taxes?

a. Deferred tax liabilities associated with the depreciation of long–term assets start to reverse as

long-term assets age.

b. Deferred tax liabilities associated with the depreciation of long-term assets continue to

originate as long-term assets reach the final years of their useful lives.

c. Deferred tax assets associated with the depreciation of long-term assets originate as long-term

assets age.

d. Deferred tax liabilities associated with the depreciation of long-term assets are maintained as

long-term assets age.

7. Deferred tax assets related to postretirement benefits other than pensions are $582 million in 2015

and $625 million in 2016. Calculate the incremental difference between benefits accrued

and amounts deducted for taxes in 2016. Assume a 35% tax rate.

a. $66 million.

b. $123 million.

c. $1,663 million.

d. $1,786 million.

8. The balance in the deferred tax asset valuation allowance was $23 million in 2015 and $16

million in 2016. What effect did the change in this allowance have on the 2016 income statement?

a. Decreases in the allowance suggest that the firm does not expect to realize future sources

of taxable income.

b. The decline in the valuation allowance is recognized as nonoperating income on the

income statement.

c. The decline in the valuation allowance is recognized as an increase in income from

continuing operations because of lower income tax expense.

d. The decline in the valuation allowance does not affect the income statement since it is offset

by a lower deferred tax asset amount.

9. What effect does a decline in the deferred tax asset valuation allowance have on cash flows?

a. Cash flows decline in the year that the decline in the valuation allowance was recorded.

b. Cash flows increase in the year that the decline in the valuation allowance was recorded.

c. The increase in the asset balance has no effect on cash from operations in the future since

deferred tax assets are “noncash” items.

d. The increase in the asset balance will lead to higher cash from operations in the future since

tax payments will decline when the additional assets are realized.

10. Which of the following best characterizes why changes in accounting principles rarely have an

impact on cash flows?

a. A change in assumed inventory cost flow methods does not alter the amount of cash required

to acquire the inventory, so the accounting method is inconsequential to cash flows.

b. A change to the LIFO method from the FIFO method is the only accounting change that

impacts cash flows.

c. Cash flows are not affected by financial reporting changes unless the firm also changes

methods on its tax return.

d. Deferred taxes offset the change in the taxes payable, so income tax expense remains

unchanged.

Financial Reporting and Analysis 6e Income Tax Reporting

QUIZ ANSWERS:

1. b. Income Statement: Tax Return:

Pretax Tax Pretax Tax

Yr. Rev. Exp. Income Exp. NI Rev. Exp. Income Payable NI

1 5,000 2,500 2,500 1,000 1,500 5,000 3,000 2,000 800 1,200

2 5,000 2,500 2,500 1,000 1,500 5,000 3,000 2,000 800 1,200

3 5,000 2,500 2,500 1,000 1,500 5,000 1,500 3,500 1,400 2,100

7,500 4,500 7,500 4,500

Depreciation expense: 6,000 ÷ 3 = 2,000 6,000 ÷ 2 = 3,000 in years 1 and 2

Warranty Expense: 5,000 x 10% = 500 1,500 in year 3

Total expenses, years 1-3 2,500

Years 1 and 2 journal entries:

Tax Expense 1,000

Deferred Tax Asset 200 (500 x 40%)

Deferred Tax Liability 400 (1,000 x 40%)

Income Taxes Payable 800

Year 3 journal entry:

Tax Expense 1,000

Deferred Tax Liability 800 (2,000 x 40%)

Deferred Tax Asset 400 (1,000 x 40%)

Income Taxes Payable 800

At the end of year 1 there is a current deferred tax asset of $200 and a long-term deferred tax

liability of $400. At the end of year 2 there is a current deferred tax asset of $400 and a long-term

deferred tax liability of $800. These amounts are originating differences in both of these years. In

year 3, they completely reverse, so there is no deferred tax balance at the end of year 3. (In other

words, the cumulative financial reporting income and tax income return income before tax is the

same).

Financial Reporting and Analysis 6e Income Tax Reporting

McGraw-Hill Education.

the financial statements, but they decrease by large amounts in subsequent periods as the assets are

sold or the amounts are paid.

6. a. Deferred tax liabilities associated with the depreciation of long-term assets start to reverse as

assets age. In other words, as the age of the assets increases, firms reach a point where book

depreciation starts to exceed tax depreciation, resulting in the reversal of the previously recorded

deferred tax liability.

7. b. The cumulative difference between the benefits accrued and amounts deducted for taxes in

2015-2016 are:

2015: $582-s-35% = $1,663

2016: $625-s-35% = $1,786

It is evident that in both years the firm has cumulatively deducted more on its financial statements

than on its tax returns. The incremental difference between benefits accrued and amounts

deducted for taxes in 2016 is:

2016: 1,786–1,663 = 123

8. c. Decreases in the allowance suggest that the firm expects to realize future sources of taxable

income, thereby realizing the deferred tax asset. The decline in the valuation account is recognized

as an increase in income from continuing operations because of lower income tax expense.

9. d. There is no effect on cash flows in the year that the decline in the valuation allowance was

recorded. However, the increases in the asset balance will lead to higher cash from operations in

the future since tax payments will decline when the additional assets are realized.

10. c. Cash flows are not affected by financial reporting changes unless the firm also changes methods

on its tax return. Deferred taxes offset the change in the income tax expense, so income tax

payable expense remains unchanged. The only accounting change that has a cash flow impact is a

change from the LIFO method of inventory accounting.

RECOMMENDED EXHIBITS

Exhibit 13.1—Examples of Temporary Differences Between Book Income and Taxable Income.

Exhibit 13.2—Examples of Permanent Differences Between Book Income and Taxable Income.

Exhibit 13.6—Computation of Income Tax Expense with Interperiod Tax Allocation.

Figure 13.5— Relations Among Income Tax expense, Taxes Payable, and Changes in Deferred

Tax Assets and Liabilities.

Figure 13.7—Overview of Interperiod Tax Allocation.