978-1259722660 Chapter 16 Lecture Note Part 1

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CHAPTER 16

ACCOUNTING FOR INCOME TAXES

Overview

In this chapter we explore financial accounting and reporting for the effects of income taxes. The

discussion defines and illustrates temporary differences, which are the basis for recognizing deferred

tax assets and deferred tax liabilities, as well as permanent differences, which have no deferred tax

consequences. You will learn how to adjust deferred tax assets and deferred tax liabilities when tax

laws or rates change. We also discuss accounting for operating loss carrybacks and carryforwards

and intraperiod tax allocation.

Learning Objectives

After studying this chapter, you should be able to:

LO16–1 Describe the types of temporary differences that cause deferred tax liabilities and

determine the amounts needed to record periodic income taxes.

LO16–2 Describe the types of temporary differences that cause deferred tax assets and determine

the amounts needed to record periodic income taxes.

LO16–3 Describe when and how a valuation allowance is recorded for deferred tax assets.

LO16–4 Explain why permanent differences have no deferred tax consequences.

LO16–5 Explain how a change in tax rates affects the measurement of deferred tax amounts.

LO16–6 Determine income tax amounts when multiple temporary differences exist.

LO16–7 Describe when and how a net operating loss carryforward and a net operating loss

carryback are recognized in the financial statements.

LO16–8 Explain how deferred tax assets and deferred tax liabilities are reported in a classified

balance sheet and describe related disclosures.

LO16–9 Demonstrate how to account for uncertainty in income tax decisions.

LO16–10 Explain intraperiod tax allocation.

LO16–11 Discuss the primary differences between U.S. GAAP and IFRS with respect to

accounting for income taxes.

Lecture Outline

Part A: Deferred Tax Assets and Deferred Tax Liabilities

I. Conceptual Underpinning

A. Revenues and expenses included on a company’s income tax return usually are the same

as those reported on the company’s income statement for the same period.

II. Temporary Differences

A. If GAAP and tax rules differ, tax payments might occur in years different from when the

revenues and expenses that cause the taxes are generated. This would produce a

difference between pretax accounting income and taxable income and, consequently,

between the reported amount of an asset or liability in the financial statements and its tax

basis.

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B. The difference is a temporary difference if it originates in one period and reverses, or

turns around, in one or more later periods.

C. Income tax expense includes both the current and deferred tax consequences of the

activities of the reporting period.

III. Deferred Tax Liabilities

A. A temporary difference causes a future taxable amount if the taxable income will be

increased relative to accounting income in the year(s) when the difference reverses.

B. Such differences create deferred tax liabilities for the taxes to be paid on the future

taxable amounts.

1. Revenues or gains reported on the tax return after the income statement.

2. Expenses or losses reported on the tax return before the income statement.

C. Another perspective starts with the balance sheet effect.

1. An assumption underlying a balance sheet is that assets will be recovered (used or

sold to produce cash) and liabilities will be settled (typically paid with cash). So, for

example, receivables will be collected,

2. Before that occurs, there is a temporary difference between the book value (also

called the carrying value or carrying amount) of those assets and liabilities on the

balance sheet and the tax basis of those assets and liabilities for the tax return.

3. The tax basis of an asset or liability is its original value for tax purposes reduced by

any amounts included to date on tax returns.

D. We can calculate the related deferred tax asset or liability balance by multiplying the

temporary book-tax difference by the applicable tax rate.

IV. Deferred Tax Assets

A. A temporary difference causes a future deductible amount if the taxable income will be

decreased relative to accounting income in the year(s) when the difference reverses.

B. Such differences create deferred tax assets for the taxes to be paid on the future taxable

amounts.

1. Expenses or losses reported on the tax return after the income statement.

2. Revenue or gains reported on the tax return before the income statement.

V. Valuation Allowance

A. Deferred tax assets are recognized for all deductible temporary differences.

B. A deferred tax asset is then reduced by a valuation allowance if it is “more likely than

not” that some portion or all of the deferred tax asset will not be realized.

VI. Disclosures Linking Tax Expense with Changes in Deferred Tax Assets and Liabilities

A. Illustration 16–7A shows Shoe Carnival’s tax note and 16–7B shows the company’s

deferred tax assets, valuation allowance, and deferred tax liabilities. Use the illustrations

to demonstrate how a tax expense journal entry ties to the changes in deferred tax assets,

liabilities, and valuation allowance.

VII. Permanent Differences

A. Permanent differences are those caused by transactions and events that under existing tax

law will never affect taxable income or taxes payable.

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B. Permanent differences are disregarded when determining both the tax payable currently

and the deferred tax effect.

Part B: Other Tax Accounting Issues

I. Tax Rate Considerations

A. A deferred tax liability or asset is calculated using currently enacted tax rates and laws

rather than anticipated tax rates. If a phased-in change in rates is scheduled to occur, the

specific tax rates of each future year are multiplied by the amounts reversing in each of

those years. The total tax effect is the deferred tax liability or asset.

B. When a change in a tax law or rate occurs, we adjust the deferred tax liability or asset to

reflect the change in the amount to be paid or recovered. The effect of the adjustment is

reported in operating income in the year of the tax law or rate changes.

C. Although differences in the specific IFRS and U.S. GAAP guidance in several areas

account for many of the disparities, the principal reason is that a great many of the

non-tax differences between IFRS and U.S. GAAP affect deferred taxes.

II. Multiple Temporary Differences

A. A company usually has several temporary differences, both originating and reversing, in

any particular year.

B. This doesn’t change our approach. We multiply the total of the future taxable amounts by

the future tax rate to determine the appropriate balance for the deferred tax liability, and

the total of the future deductible amounts by the future tax rate to determine the

appropriate balance for the deferred tax asset.

III. Net Operating Losses

A. A net operating loss (NOL) can be used to reduce taxable income in other, profitable

years by either:

1. A carryback of the NOL to the previous two years or

2. A carryforward of the NOL to later years (up to 20).

B. The income tax benefit of both an NOL carryback and an NOL carryforward are

recognized for accounting purposes in the year the NOL occurs.

IV. Financial Statement Presentation

A. In the balance sheet, all deferred tax liabilities, deferred tax assets, and any valuation

allowance against deferred tax assets are classified as noncurrent. If they relate to the

same tax-paying component of the company and the same tax jurisdiction, they are netted

against each other and shown as a single net number in the balance sheet. However,

deferred tax amounts that relate to components of a company that are separate for tax

purposes, or that relate to different tax jurisdictions, should not be offset.

B. Additional relevant information needed for full disclosure pertaining to deferred tax

amounts is reported in disclosure notes, including the components of income tax expense

and available operating loss carryforwards.

V. Coping with Uncertainty in Income Taxes

A. The means of dealing with uncertainty in tax decisions is prescribed by FASB ASC 740:

Income Taxes–Overall (previously “Accounting for Uncertainty in Income Taxes, an

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Interpretation of FASB Statement No. 109,” FASB Interpretation No. 48 (Norwalk,

Conn.: FASB, June 2008)), commonly called FIN 48. This guidance allows companies to

recognize in the financial statements the tax benefit of a position it takes only if it is

“more likely than not” (greater than 50% chance) to be sustained if challenged. Guidance

also prescribes how to measure the amount to be recognized. The decision, then, is a

“two-step” process.

B. Step 1. A tax benefit may be reflected in the financial statements only if it is “more

likely than not” that the company will be able to sustain the tax return position,

based on its technical merits.

Step 2. A tax benefit should be measured as the largest amount of benefit that is

“cumulatively greater than 50 percent likely to be realized” (demonstrated

later).

VI. Intraperiod Tax Allocation

A. Intraperiod tax allocation means the total income tax expense for a reporting period is

allocated among the financial statement items that gave rise to it.

B. Each of the following income statement items is reported net of its respective income tax

effects.

1. Income (or loss) from continuing operations

2. Discontinued operations

Decision Makers’ Perspective

A. One of the most important aspects of most business decisions is the tax effect.

B. Income tax is one of the largest expenditures many firms incur.

C. Investors, creditors, and managers should be alert to choices that minimize or delay taxes

and to disclosures that indicate potential tax expenditures.

1. Investments in buildings and equipment can signify deferred tax liabilities from

temporary differences in depreciation.

2. New investments that cause the level of depreciable assets to at least remain

constant over time can effectively delay that deferred tax liability indefinitely.

3. Impending plant closings suggest declining levels of depreciable assets and

therefore might cause material paydowns of that deferred tax liability.

D. Deferred tax assets represent future tax savings.

1. An operating loss carryforward is a deferred tax asset that often reflects sizable

future tax deductions.

2. Operating loss carryforwards indicate potential future tax benefits because they

allow large amounts of future income to be earned tax-free.

E. Because deferred tax liabilities increase debt, deferred tax liabilities increase risk as

measured by the debt to equity ratio.

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PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter,

but they can be easily edited to allow instructors to change numbers and content

in illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

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