Advanced Financial Accounting Unit 9 Review: Income Taxes & Deferred Tax Accounting

Key Concepts and Definitions

• Income tax expense represents the sum of taxes payable for the current period and the tax consequences of items reported in different periods for financial reporting and tax purposes (deferred taxes)
• Taxable income refers to the amount used to compute income taxes payable under the tax code
• Pretax financial income is the income reported on the income statement before deducting income tax expense
• Deferred tax assets arise when taxable income is greater than pretax financial income, resulting in future deductible amounts
  • Examples include rent collected in advance and estimated expenses (warranty costs, bad debts)
• Deferred tax liabilities occur when pretax financial income is greater than taxable income, resulting in future taxable amounts
  • Examples include accelerated depreciation for tax purposes and installment sales

Tax Accounting vs. Financial Accounting

• Tax accounting focuses on complying with tax laws and regulations to determine taxable income and income taxes payable
• Financial accounting aims to provide useful information to investors, creditors, and other users of financial statements following Generally Accepted Accounting Principles (GAAP)
• Differences between tax accounting and financial accounting lead to deferred tax assets and liabilities
  • Temporary differences result in future taxable or deductible amounts when the related asset is recovered or the liability is settled
  • Permanent differences do not create deferred tax assets or liabilities (municipal bond interest, fines and penalties)
• Tax accounting uses the cash basis or modified cash basis, while financial accounting primarily uses the accrual basis
• The objectives and users of the information differ between tax accounting (tax authorities) and financial accounting (investors, creditors)

Income Tax Expense Components

• Current tax expense (benefit) is the amount of income taxes payable (refundable) for the period
• Deferred tax expense (benefit) represents the change in deferred tax assets and liabilities during the period
• Total income tax expense is the sum of current tax expense and deferred tax expense
  • Reported on the income statement and reconciled to the amount computed by applying the federal statutory tax rate to pretax financial income
• Changes in deferred tax assets and liabilities are included in income tax expense, except for those related to business combinations or items charged directly to equity
• The components of income tax expense are disclosed in the financial statement notes, along with a reconciliation of reported income tax expense to the statutory amount

Temporary vs. Permanent Differences

• Temporary differences arise when the tax basis of an asset or liability differs from its reported amount in the financial statements
  • Result in taxable or deductible amounts in future years (depreciation, warranty costs, rent collected in advance)
  • Create deferred tax assets or liabilities
• Permanent differences result from items included in financial reporting income but never in taxable income, or vice versa
  • Do not create deferred tax assets or liabilities (municipal bond interest, fines and penalties)
• Temporary differences reverse over time as the related assets are recovered or liabilities are settled
  • Depreciation differences reverse as the asset is depreciated for financial reporting purposes
  • Warranty expense differences reverse when actual warranty costs are incurred and deducted for tax purposes
• Identifying temporary and permanent differences is crucial for determining deferred tax assets, deferred tax liabilities, and income tax expense

Deferred Tax Assets and Liabilities

• Deferred tax assets represent future deductible amounts that will result in a reduction of future income taxes payable
  • Arise when taxable income is greater than pretax financial income (rent collected in advance, estimated expenses)
  • Measured using the applicable tax rate and provisions of the enacted tax law
• Deferred tax liabilities represent future taxable amounts that will result in an increase in future income taxes payable
  • Occur when pretax financial income is greater than taxable income (accelerated depreciation for tax purposes, installment sales)
  • Measured using the applicable tax rate and provisions of the enacted tax law
• Changes in deferred tax assets and liabilities are included in income tax expense, except for those related to business combinations or items charged directly to equity
• Deferred tax assets and liabilities are classified as current or noncurrent based on the classification of the related asset or liability for financial reporting

Valuation Allowances

• A valuation allowance is recorded to reduce deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized
• The need for a valuation allowance is assessed at each balance sheet date
  • Based on available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, and tax planning strategies
• Changes in the valuation allowance are included in income tax expense in the period of the change
• The amount of and reasons for the valuation allowance are disclosed in the financial statement notes
• Valuation allowances do not affect deferred tax liabilities

Tax Rate Changes and Effects

• Deferred tax assets and liabilities are adjusted for the effect of changes in tax laws or rates in the period that includes the enactment date
  • The effect is included in income tax expense from continuing operations
• Changes in tax rates or laws may also affect taxes payable for prior years
  • The effect is included in income tax expense in the period of the change
• Retroactive changes in tax rates or laws are accounted for in the period of enactment
  • May require an adjustment to deferred tax assets and liabilities and taxes payable for prior years
• The effects of tax rate changes on deferred tax assets and liabilities are disclosed in the financial statement notes

Disclosure Requirements and Financial Statement Presentation

• The components of income tax expense (current and deferred) are disclosed in the financial statement notes
• A reconciliation of reported income tax expense to the statutory amount is provided, showing the effect of permanent differences and other items
• The significant components of deferred tax assets and liabilities are disclosed, along with the related valuation allowance
  • Classified as current or noncurrent based on the classification of the related asset or liability
• The effect of changes in tax rates or laws on deferred tax assets and liabilities is disclosed
• The amount and expiration dates of operating loss and tax credit carryforwards are disclosed
• The aggregate amount of temporary differences associated with investments in subsidiaries and joint ventures for which deferred tax liabilities have not been recognized is disclosed
• The income tax expense or benefit allocated to continuing operations, discontinued operations, extraordinary items, and other comprehensive income is disclosed