Accounting for Income Taxes

Overview
In this chapter we explore the financial accounting and reporting standards 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 nontemporary differences, which have no deferred tax
consequences. You also will learn how to adjust deferred tax assets and deferred tax liabilities when tax laws or
rates change. We also discuss accounting for loss carrybacks and carryforwards and intraperiod tax allocation.

Lecture Outline
Part A: Deferred Tax Assets and Deferred Tax Liabilities
I. Temporary Differences
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.
B. If IFRS 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 base.
1. The tax base of an asset is the “amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of
the asset.”
2. A deferred tax liability (or asset) is the tax effect of the temporary difference between the
financial statement carrying amount of an asset or liability and its tax base.
3. A deferred tax asset or liability may not be related to a specific asset or liability.
C. The difference is a temporary difference if it originates in one period and reverses, or “turns
around,” in one or more later periods.
D. Income tax expense includes both the current and deferred tax consequences of the activities of the
reporting period.

II. 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.
1. The future taxable amount is referred to as a taxable temporary difference.
2. A taxable temporary difference will result in future taxable income when the carrying amount
of the related asset or liability is recovered or settled.
B. Therefore, 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. If an item is nontaxable, the tax base of that asset is equivalent to the carrying amount.
1. So, if income is tax-exempt, the amount that will be deductible when said income is received is
the entire balance.

III. 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.
C. Deferred tax assets are recognized for all deductible temporary differences to the extent that it is
probable that the deferred tax assets will be utilized to offset future taxable income.
1. “Probable” is not defined in IAS No. 12 although it is typically considered to be more
conservative than the term “more likely than not” under US GAAP.
2. Deferred tax assets may not be utilized if there is no taxable income to be reduced when the
future deduction becomes available.
D. At the end of each reporting period, the deferred tax asset is reevaluated. The appropriate balance is
decided on and the balance is adjusted.
E. Under International Financial Reporting Standards, deferred tax assets are recorded only if
realization of the tax benefit is “probable.” But under US GAAP, we recognize all deferred tax
assets (unless the future deductible amounts are uncertain), but record a valuation allowance unless
realization is “more likely than not.”

IV. Nontemporary Differences

A. Nontemporary differences, or permanent differences, are those caused by transactions, and events
that under existing tax law will never affect taxable income or taxes payable.
B. Permanent differences are disregarded when determining both the tax payable currently and the
deferred tax effect.
C. Companies typically report a comparison (or reconciliation) between the statutory and effective tax
rate.
D. The term “permanent differences” does not appear in IAS No. 12 but the concept applies in the
determination of tax expense. However, IAS No. 12 specifically prohibits
1. the recognition of certain temporary differences that arise on initial recognition when the
underlying transaction is not a business combination and that “affects neither accounting profit
nor taxable profit (tax loss)” on initial recognition;
2. the recognition of a deferred tax liability on goodwill.

Part B: Other Tax Accounting Issues

I. Change in Tax Rates

A. A deferred tax liability or asset is calculated using current 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 income in
the year of the tax law or rate changes.
C. Under IFRS, deferred taxes are based on “substantially enacted” rates, meaning whatever rate is
“virtually certain” to apply. Under US GAAP, however, deferred taxes are based on currently
enacted tax rates.
D. Although differences in the specific IFRS and US GAAP guidance in several areas account for many
of the disparities, the principal reason is that a great many of the nontax differences between IFRS
and US GAAP affect net income and shareholders’ equity and therefore have consequential effects
on 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. Tax Losses

A. A loss (negative taxable income) can be used to reduce taxable income in other, profitable years by
either:
1. a carryforward of the loss to later years,
2. a carryback of the loss to the prior years, or
B. A tax loss is recognized in the year the tax loss occurs (if there is evidence of probable future profit
against which the loss may be used to offset to reduce future taxable income).
1. Otherwise, the tax loss is recognized as a tax benefit only in the year when the loss is used to
offset actual taxable income.
2. If a company has both tax losses (a deductible temporary difference) and taxable temporary
difference, a deferred tax asset may be recognized to set off against the taxable temporary
difference in the future.
C. The income tax benefit of both a loss carryback and a loss carryforward is recognized for accounting
purposes in the year the operating loss occurs.

IV. Financial Statement Presentation

A. On the statement of financial position, deferred tax assets and deferred tax liabilities are classified as
noncurrent, but are not discounted.
B. Deferred tax assets and liabilities should not be reported individually but should be offset against
each other if the company has a right to legally set off current tax assets against current tax
liabilities.
1. Deferred tax assets and liabilities should relate to the same taxable entity and to taxes levied by
the same taxation authority.
2. The resulting net amount is then reported as either a noncurrent asset (if deferred tax assets
exceed deferred tax liabilities) or noncurrent liability (if deferred tax liabilities exceed deferred
tax assets).
C. Relevant detailed 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.
D. Under US GAAP, deferred tax liabilities and deferred tax assets are classified in the statement of
financial position as current and noncurrent based on the classification of the underlying asset or
liability. Under IFRS, though, they always are classified as noncurrent.

V. Dealing with Uncertainty

A. When there is uncertainty with respect to the assessment on current tax, IAS No. 12 does not
prescribe specific accounting requirements. In the absence of specific guidelines in IAS No. 12, we
fall back on the principles in IAS No. 37 Provisions, Contingent Assets and Contingent Liabilities.
B. If the uncertainty relates to the tax liability, we consider the following questions:
1. Does the company have a present obligation to tax authorities arising from a past event?
2. Is there a probable outflow of resources to tax authorities?
3. Is the amount of the liability reliably estimable?
C. If the answer is yes to all three questions, we recognize the uncertain tax liability as a provision. If
the likelihood of the outflow is only possible (and not probable), we disclose the contingent liability
in the footnotes.
D. Uncertain tax refunds are contingent assets, which we do not recognize until the benefit becomes
virtually certain. If the gain is probable, we disclose the gain in the footnotes.
E. US GAAP provides more explicit guidelines than the IFRS on how companies should deal with
uncertainty relating to tax liabilities. The means of dealing with uncertainty in tax decisions is
 prescribed by FASB Interpretation No. 48 (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 percent 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.
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.

VI. Intraperiod Tax Allocation

A. Intraperiod tax allocation means the total income tax expense for a reporting period is allocated
among the financial statement, specifically income, items that gave rise to it.
B. As items are either charged to other comprehensive income (OCI) or taken directly to equity. Tax
attributed to such items is recognized in the corresponding component of the financial statement by
measuring the items on a “net of tax” basis
C. 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
3. Other comprehensive income
4. Items recognized in other comprehensive income include:
1) revaluation of property, plant, and equipment;
2) foreign currency gains or losses arising on the translation of a foreign operation’s financial
statements.
5. Items recognized directly in equity include:
1) prior period adjustments for change in accounting policy or correction of error;
2) “initial recognition of the equity component of a compound financial instrument.”

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 paydown of that deferred tax liability.
D. Deferred tax assets represent future tax savings.
1. A loss carryforward is a deferred tax asset that often reflects sizable future tax deductions.
2. 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.