Accounting for Income Taxes

Question 1

What are the two main objectives of accounting for income taxes?

Answer 1

To determine taxes payable/refundable for current year

To determine deferred tax liabilities/assets for future years

Question 2

What is the first basic principle of accounting for income taxes?

Answer 2

Taxes payable/refundable for current year are recorded as “current tax liability/asset”

Question 3

What is the second basic principle of accounting for income taxes?

Answer 3

Deferred tax liability/asset is estimated for future tax consequences on temporary differences and carryforwards

Question 4

What is the third basic principle of accounting for income taxes?

Answer 4

Measurement of taxes is based on current tax law – never on anticipated tax laws

Question 5

What is the fourth basic principle of accounting for income taxes?

Answer 5

Deferred tax assets are reduced by any tax benefits which are not expected to be realized

Question 6

How much can net operating losses (NOLs) be carried back or carried forward?

Answer 6

Back 2 years

Forward 20 years

Question 7

What happens if a NOL is carried back or forward?

Answer 7

It offsets taxable income for those years, thus reducing taxes

If done for previous years, it generates a tax refund for the taxes already paid on those profits

Question 8

What are the two components of income tax expense?

Answer 8

Current tax expense and deferred tax expense

Question 9

What does an ordinary tax JE look like?

Answer 9

Debit: Income Tax Expense – Current

Credit: Income Tax Payable

Question 10

What are the JEs for loss carrybacks and carryforwards?

Answer 10

Carryback:
Debit: Income Tax Refund Receivable
Credit: Benefits of Loss Carryback

Carryforward:
Debit: Deferred Tax Asset
Credit: Benefits of Loss Carryforward

Both benefits would be reported in income statement against the net loss

Question 11

What are the tax JEs for a year partially helped by a loss carryforward?

Answer 11

Debit: Income Tax Expense – Current ($X)
Debit: Income Tax Expense – Deferred ($Y)
Credit: Income Tax Payable ($X)
Credit: Deferred Tax Asset ($Y)

Notice that the deferred tax asset is removed with this entry

Both current and deferred expenses would count against income in income statement

Question 12

What is the formula to reconcile pretax financial income and taxable income?

Answer 12

Pretax financial income
+ Taxable revenues over book revenues
- Deductible amounts over book expenses
= Taxable income

Question 13

What is a temporary difference?

Answer 13

Difference between tax basis of an asset/liability and its book amount

Results in taxable or deductible amounts in the future, whenever the reported amount of the item is recovered (asset) or settled (liability)

Question 14

What are the two kinds of temporary differences?

Answer 14

Taxable TDs – when assets are recovered

Deductible TDs – when liabilities are settled

Question 15

When pretax financial income is less than taxable income, how is income tax expense recorded?

Answer 15

The difference between the two will be a deferred income tax expense

Debit: Income Tax Expense – current ($X)
Debit: Income Tax Expense – deferred ($Y)
Credit: Income Taxes Payable ($X)
Credit: Deferred Tax Liability ($Y)

Question 16

What is a timing difference?

Answer 16

Occurs when rev/exp/gains/losses are book-recognized in one year but tax-recognized in another year

Count as temporary differences

Question 17

What are examples of timing differences?

Answer 17

• earned income that will be paid in a future year (taxable when asset is recovered); unearned revenue (taxable before earned)
• loss contingencies (deductible when liability is settled); prepaid expenses (deductible before accrued)

Really, any difference resulting from accrual vs. cash accounting

Question 18

What happens if revenue is received before being earned?

Answer 18

There is a tax liability that exceeds the book-revenue’s basis (of zero), and thus when it is earned, it will have a tax deduction

Question 19

What happens if temporary differences are not linked with any particular assets or liabilities?

Answer 19

Will still result in taxable or deductible amounts for future years

E.g. if a company uses %-of-completion method for books and completed-contract method for taxes, the deferred income will become taxable when the contract is completed

Question 20

What are permanent differences?

Answer 20

Revenues or expenses that simply aren’t taxed, and thus don’t create deferred tax assets/liabilities

Question 21

What are examples of permanent differences from revenues?

Answer 21

Interest on municipal bonds

Proceeds from life insurance on an officer

Dividends subject to dividends-received deduction (70%, 80%, or 100%)

Question 22

What are examples of permanent differences from expenses?

Answer 22

Expenses to generate tax-exempt income

Premiums paid for life insurance on officers

Fines, other costs due to violations of the law

Question 23

What is an example of a permanent difference from a deduction?

Answer 23

Excess of percentage depletion over the cost of natural resources

Question 24

What would be the income tax JE for a year with permanent differences in revenue and expenses?

Answer 24

A normal JE

Debit: Income Tax Expense – current
Credit: Income Taxes Payable

The permanent differences don’t affect other years, so there’s no deferred tax assets or liabilities

Question 25

What is the effective tax rate?

Answer 25

The rate that is paid on pretax financial income Can differ from 40% (or whatever the enacted rate is) if there are permanent differences, since the 40% rate will be applied towards the taxable income without any deferred taxes

Question 26

How do you calculate net future taxable (or deductible) amounts?

Answer 26

Take all the temporary amounts, and add them in the opposite way that they affected pretax financial income E.g. if an excess of warranty expense were recognized in the books over the tax amount, then that expense would be ADDED to pretax financial income to arrive at taxable income -- but it would be SUBTRACTED to determine net future taxable (or deductible) amount

Question 27

How do you calculate tax liabilities or assets from net future taxable (or deductible) amounts?

Answer 27

Net future taxable amount x tax rate = deferred tax liability Net future deductible amount x tax rate = deferred tax asset

Question 28

What are deferred tax expenses or benefits?

Answer 28

Changes during the year in deferred tax liabilities and assets

Question 29

How do different levels of jurisdiction (federal, state, local, foreign) affect tax liabilities and assets?

Answer 29

Deferred tax liabilities and assets need to be reported separately for each jurisdiction, since they cannot offset each other

Question 30

What is the role of valuation accounts for deferred tax assets?

Answer 30

If it is more likely than not (>50%) that any amount of a DTA will not be realized then the allowance account reduces the DTA by that amount

Question 31

What are some assumptions about future taxable income rates?

Answer 31

If a taxable income is expected for a future year, then use that year's enacted rate to calculate deferred tax liabilities/assets If a NOL is expected for a future year, then use the enacted rate for the year to which the NOL is expected to carry forward or carry back

Question 32

How do graduated tax rates affect the calculation of deferred tax liabilities/assets?

Answer 32

If graduated tax rates are used, then the entity should apply the *average graduated tax rate* for estimated taxable income to calculate deferred tax liabilities/assets

Question 33

If there are temporary differences giving rise to deferred tax assets and liabilities, what should the JE be?

Answer 33

``` Debit: Income Tax Expense -- current Debit: Income Tax Expense -- deferred Debit: Deferred Tax Asset Credit: Income Taxes Payable Credit: Deferred Tax Liability ```

Question 34

If the deferred tax liability at the end of year 1 is a given amount, and the total DTL at the end of year 2 is a greater amount, what should the JE be?

Answer 34

Debit: Income Tax Expense -- current ($X) Debit: Income Tax Expense -- deferred ($Y) Credit: Income Taxes Payable ($X) Credit: Deferred Tax Liability ($Y) "Y" will be the *difference* between yr. 1 and yr. 2 deferred tax liabilities

Question 35

What is a key term when determining deferred tax assets/liabilities over given periods?

Answer 35

CUMULATIVE taxable (or deductible) temporary differences Multiply the cumulative amount by the enacted rate to get the ending deferred tax asset/liability for that year, which can help determine the CHANGE in DTA/DTL from the previous year

Question 36

What are the steps to calculate deferred tax expense (or benefit) for a given year?

Answer 36

Determine any changes in deferred tax assets -- increases in DTA are deferred tax benefits Do the same for deferred tax liabilities to get deferred tax expenses Net deferred tax benefits and deferred tax expenses to get the total deferred tax expense (or benefit)

Question 37

How do anticipated NOLs affect the calculation of deferred taxes?

Answer 37

They affect the applicable tax rate The calculation of deferred tax liabilities/assets depends on the enacted tax rate for the year to which the tax is deferred, so use the rate from (e.g.) two years before the NOL, if it will be carried back

Question 38

Do NOLs affect future taxable amounts or future deductible amounts?

Answer 38

Both -- since there won't be any taxes period, there will be none to deduct either

Question 39

What kind of entries are deferred tax expenses and benefits?

Answer 39

Residual amounts, since they reflect the change in DTLs/DTAs for a given year

Question 40

What must be reported if tax rates for future years are not uniform?

Answer 40

A schedule of future taxable/deductible amounts If rates are uniform, aggregation is fine

Question 41

What is the JE for a valuation allowance to decrease deferred tax assets?

Answer 41

It depends on what comprised the deferred tax asset. As an example: Debit: Benefits of Loss Carryforward Debit: Income Tax Expense -- deferred Credit: Allowance to Reduce DTA to Realizable Value The Benefits entry decreases and the Expense entry increases, since the Deferred Tax Asset affects both

Question 42

With a deductible temporary difference for a given year, how do you arrive at taxable income?

Answer 42

Pretax financial income + deductible temporary difference = Taxable income Remember that ADDING to taxable income is bad, so the future deduction (good) is offset

Question 43

If a year has both (1) a NOL resulting in a carryforward and (2) a temporary difference resulting in a future deductible amount, how is the deferred tax asset reported?

Answer 43

As the sum of the two benefits Debit: Deferred Tax Asset Credit: Benefits of Loss Carryforward Credit: Income Tax Expense -- deferred Make sure the two credited amounts are calculated using the right tax rates

Question 44

If a deferred tax asset has a valuation account, and then the deferred tax asset is applied in a particular year, how is it reported?

Answer 44

The allowance is debited and the deferred tax asset is credited Both are reduced/erased

Question 45

For a tax benefit to be realized, what has to occur?

Answer 45

There has to be a period with taxable income against which the benefit can be applied

Question 46

What are the three characteristics of tax-planning strategies?

Answer 46

- prudent and feasible - something an entity would not normally take, but takes to prevent a carryforward from expiring - results in usage of deferred tax assets

Question 47

How do tax-planning strategies relate to the valuation allowance?

Answer 47

Expenses to perform the tax-planning strategy, and losses to recognize if it is performed (net of tax benefits) should be included in the valuation allowance

Question 48

How does an entity determine whether a valuation allowance is needed?

Answer 48

By the preponderance of the evidence Positive evidence -- supporting that it is NOT needed Negative evidence -- denying that it's not needed, i.e. supporting that it IS needed

Question 49

What are some examples of "negative evidence" that valuation allowances are unneeded?

Answer 49

- history of carryforwards expiring unused - losses expected in future years - a brief carryback/carryforward period

Question 50

What are some examples of "positive evidence" that valuation allowances are unneeded?

Answer 50

- existing sales indicate sufficient taxable income in the future - the company's assets are valued sufficiently higher than their tax basis

Question 51

How should changes in valuation allowance be reported?

Answer 51

In income from continuing operations This happens if circumstances have changed the company's judgment on which deferred tax assets will be usable

Question 52

If enacted tax laws are changed, how are deferred tax liabilities/assets affected?

Answer 52

They are adjusted accordingly for the period when the enacted laws changed Difference (tax benefit/expense) is reported in income from continuing operations

Question 53

If there is a change in enacted tax rates, how is it reported?

Answer 53

Deferred tax liabilities/assets are debited or credited accordingly, just as if they were being first recorded

Question 54

What is a change in enterprise tax status?

Answer 54

When an enterprise changes how it is filed E.g. partnership to corporation, S corporation to C corporation Deferred tax liabilities/assets are either created or eliminated, depending on whether the entity becomes taxable or becomes nontaxable

Question 55

How are deferred tax liabilities/assets reported on the balance sheet?

Answer 55

Recorded net of each other (i.e. liabilities offset assets) Recorded in a net current and a net noncurrent amount Recorded separately for different jurisdictions

Question 56

How are deferred tax liabilities/assets classified as current or noncurrent?

Answer 56

Depending on the classification of the related taxable asset or liability If there is no related asset/liability (e.g. carryforwards), then classified according to the expected reversal date

Question 57

How are valuation allowances split between current and noncurrent deferred tax assets?

Answer 57

Pro rata

Question 58

Regarding deferred tax liabilities/assets, what should be disclosed on the balance sheet?

Answer 58

- total of all DTLs and DTAs - total valuation allowance - net change in VA - tax effect of each temporary difference or carryforward that gives rise to DTLs/DTAs Permanent differences do NOT need to be disclosed

Question 59

What is intraperiod tax allocation?

Answer 59

Allocating income tax expenses to different parts of the financial statements

Question 60

Which income taxes are allocated to continuing operations?

Answer 60

Tax effects from: - ordinary pretax income - DTAs not expected to be realizable - changes in tax laws - changes in enterprise status

Question 61

If a company has an operating loss and an extraordinary capital gain exceeding that loss, how is it reported?

Answer 61

The loss offsets the gain, and the excess is taxed at the gains rate In the income statement, the tax benefit from the loss will be reported as the (loss) x (capital gains rate), since it offset the capital gains tax, not the income tax

Question 62

Are benefits from carrybacks or carryforwards reported as ordinary operations, or something else?

Answer 62

They are reported as whatever type of income benefits from the credit -- not by whatever type of income gave rise to the benefit historically E.g. if discontinued operations caused a NOL in year 1, and if the carryforward offset taxable income from continuing operations in year 2, then the carryforward benefit would be classified as part of continuing operations

Question 63

Can stockholders' equity be charged/credited for income tax?

Answer 63

Yes E.g. employee stock options recognized differently for GAAP and for tax

Question 64

If a company acquires another company and then changes the valuation allowance for DTAs, how should it be recorded?

Answer 64

Adjustment to goodwill If goodwill is 0, then any other decrease in VA should be recognized as a bargain purchase

Question 65

When is the cost method used for recording investment in other companies?

Answer 65

When the investment does not amount to substantial control (20%) of the company If it does, then use the equity method

Question 66

What is the dividends-received deduction for cost-method investments?

Answer 66

``` Dividends received x deduction % (e.g. 70%) = taxable dividend income x effective tax rate = tax expense and liability ``` For this method, there can be no tax deferrals by definition

Question 67

What tax effects are different for equity-method investments?

Answer 67

Dividend income is deducted as normal, but in addition the company records a temporary difference based on the ownership (equity) it has in the investment company's undistributed income

Question 68

How is undistributed income calculated for the equity method?

Answer 68

``` Net income - preferred stock x % of ownership = equity in company's income - dividends already paid to the investing company = undistributed income ```

Question 69

How is the temporary taxable difference determined from undistributed income?

Answer 69

If UI is expected to be received as dividends, then the dividends-received deduction (80% or 100%) should be applied If UI is expected to be received as a realized gain upon disposal, then it should not include the deduction

Question 70

What is the distinction between the statutory tax rate and the effective tax rate?

Answer 70

- STR = percentage of a tax a company is legally required to pay on its taxable income - ETR = percentage a company in fact pays By definition, (pretax financial income) x (ETR) = total tax expense

Question 71

When do the statutory tax rate and effective tax rate differ?

Answer 71

Only when there are permanent differences Temporary differences cause a greater portion of the total tax expense to be deferred, but still result in the same total tax expense