The Statement of Cash Flow 2

Accounting for Income Taxes Objectives: • Understand the differences between tax accounting and financial accounting ƒTiming: temporary differences ƒScope: permanent differences • Understand the effects of events on income taxes ƒNet operating losses ƒValuation allowances ƒChanges in tax rates • Interpret income tax disclosures Source: Treasury Acting Assistant Secretary for Tax Policy Jonathan Talisman, Testimony before the Senate Committee on Finance, March 8, 2000 GAAP vs. Tax Code Examples of differences: Revenue Recognition: rental fees collected in advance ƒ GAAP : Rent revenue recognized when earned (passage of time) ƒ Tax Code: Rent collections considered as taxable income Matching principle: depreciation of fixed assets ƒ GAAP: Different depreciation methods allowed, e.g. straight line ƒ Tax Code: MACRS (accelerated); no residual value Other items: Revenue from municipal bonds ƒ GAAP: Revenue recognized as interest is earned (passage of time) ƒ Tax Code: Interest revenue exempt from federal taxes What factors cause differences in accounting rules for GAAP and the Tax Code? Two Methods of Accounting for Timing Differences Japan, Germany: ??? = part of income tax expense ƒ Essentially, GAAP = Tax Code ƒ Tax expense = taxes currently owed, thus deferred taxes do not arise United States: ??? = recognize as "deferred tax liability" ƒ Tax expense is based on the pre-tax GAAP income. ƒ Deferred taxes arise because tax expense ≠ taxes currently owed Income tax expense = Current tax expense + Deferred tax expense (NI) (Taxes payable) (Deferred Tax Liability) Deferred tax expense = Timing difference x statutory tax rate = Deferred Tax Liability Deferred Taxes over Time Deferred taxes caused by timing differences are temporary, because they reverse over time. Year Year 2003 2004 2005 disposal Financial Tax Depreciation Deferred Acc. Depr reporting reporting difference Tax Difference, depreciation depreciation Expense (EB) 30,000 60,000 30,000 9,000 30,000 30,000 40,000 10,000 3,000 40,000 30,000 (30,000) (9,000) 10,000 10,000 - (10,000) (3,000) - •Timing differences that create / increase deferred taxes over time are called originating differences •Timing differences that remove / decrease deferred taxes over time are called reversing differences Def Tax Liability (EB) 9,000 12,000 3,000 - Deferred Tax Liability: Summary Deferred tax liabilities arise/increase when a timing difference leads to: (IRS) (GAAP) Current Taxable income < Pretax Income ! GAAP recognizes more revenue than the Tax Code # Revenue recognition before cash collection (e.g., unremitted earnings of foreign subsidiaries) ! GAAP matches less expenses than the Tax Code # Expenses matched in the Tax Code are accelerated relative to GAAP (e.g., MACRS vs. straight line) Deferred tax liabilities decrease (to zero) when the above events reverse in the future. Deferred Tax Liability: Summary Deferred tax liabilities arise/increase when a timing difference leads to: (IRS) (GAAP) Current Taxable income < Pretax Income ! GAAP recognizes more revenue than the Tax Code # Revenue recognition before cash collection (e.g., unremitted earnings of foreign subsidiaries) ! GAAP matches less expenses than the Tax Code # Expenses matched in the Tax Code are accelerated relative to GAAP (e.g., MACRS vs. straight line) Deferred tax liabilities decrease (to zero) when the above events reverse in the future. In future, IRS income > GAAP income Increased taxes will be paid (liability) Deferred Tax Asset: Illustration Suppose that total rent collected in 2003 was $100,000, of which $50,000 was rent paid in advance for 2004. Tax rate is 30%. NI before taxes Tax Payable Tax Expense Financial reporting 50,000 Tax reporting 100,000 30,000 15,000 Tax Expense = Taxes Payable -Deferred Tax Asset 15,000 = 30,000 - 15,000 A deferred tax asset of $15,000 was created in 2003. The reversal occurs in 2004 when the (financial) revenue for 2004 is recognized. Tax Effects of Marketable Securities Suppose the value of stock you own goes up by $100. Are you $100 richer? In the U.S., capital gains and losses are not recognized for tax purposes unless realized. We will soon see that unrealized gains and losses from certain securities are recognized in the financial statements. These unrealized gains and losses carry with them an obligation to pay more or less in future taxes, i.e. deferred liabilities or assets. Consider GE Capital (1999, $ in millions) Net deferred tax liability (asset) Net unrealized gains on securities 1999 1998 <95> 665 Permanent Differences: Summary ! Permanent differences are never expected to reverse (e.g., income that is never taxable) ! Permanent differences do not create deferred taxes. However, they do change the effective tax rate, because the basis of income tax expense is adjusted for permanent differences. P Tax-exempt revenues (e.g. interest income from state and local bonds) decreases the effective tax rate P Non-tax deductible expenses (e.g. government fines) increases the effective tax rate Income tax expense =(Pretax income -Tax-exempt revenues + Nondeductible expense) x statutory tax rate Effective tax rate = Income tax expense / Pretax GAAP income Tax Deductions from Net Operating Losses (NOL) ! Net operating loss carryback: generates a refund of income taxes paid from two years back, in the order of years, starting with the earliest year. A = Income tax refund receviable = L + E -(- Income tax expense) ! Net operating loss carryforward: reduces taxable income in subsequent years, up to a maximum of 20 years. Leftover NOL carryback may be carried forward, but once an NOL is carried forward, it can no longer be carried back. NOL carryforwards are recorded as deferred tax assets. A Deferred tax asset = = L + E -(-Income tax expense) Valuation Allowance If the benefits of a deferred tax asset are not likely to be realized, the value of the deferred tax asset balance should be reduced by a "valuation account". ! Conservatism: no symmetric adjustment for deferred tax liabilities, except when future tax rates decrease ! Application of judgement: "likely" means more than 50% probability of occuring. ! Bad signal: implies that management believes not enough earnings in the future ! Valuation allowance increases the effective tax rate when recognized (because it increases income tax expense). Changes in Tax Rates When tax rates change, deferred tax assets and liabilities are readjusted to reflect the taxes that will be incurred when the reversals occur (proper matching). ! The new tax rate is used for timing differences as soon as the law instituting the tax change is enacted, even if the law is not yet officially in force. ! Adjustments to previous balances are disclosed as additions or reductions in the deferred tax component of income tax expense. ! Changes in tax rates affect the effective tax rates from the year new tax rates are enacted until the new tax rates are in effect. Income tax expense = Current tax expense + Deferred tax expense + DTA/L adj. (future rate) (future-current) (current rate) In 1993, Congress increased the federal tax rate for corporations, from 34% to 35%. Ford reported a decrease in income taxes of $199 million in 1993 due to the rate adjustment. Why did the tax rate increase boost Ford’s income? (Answer: Ford had a deferred tax asset.) Disclosure Rules ! Income statement < Separate Income tax expense = current tax expense + deferred tax expense (May be done in the footnotes) ! Footnotes < Components of income tax expense < Components of deferred tax expense P Timing differences for the period P NOL credits P Effects of changes in tax rate P Changes in valuation allowance < Components of deferred tax assets and deferred tax liabilities < Reconciliation of statutory federal tax rate with effective tax rate ! Balance sheet < Current and non-current components of deferred tax assets and liabilities netted out. ! SCF < Deferred tax expense added back to net income in operating section