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Int. Acc. FA LECT 7: CH 19 part 3: Accounting for income taxes (Apply…
Int. Acc. FA LECT 7: CH 19 part 3: Accounting for income taxes
Describe various permanent differences.
Temporary differences:
Until now, we discussed temporary differences that will reverse during the following years. Examples:
Investments accounted for under the equity method for financial reporting purposes and under the cost method for tax purposes.
Gain on involuntary conversion of non-monetary asset which is recognized for financial reporting purposes but deferred for tax purposes.
Contracts accounted for under the percentage-of-completion method for financial reporting purposes and the cost-recovery method (zero-profit method) for tax purposes.
Unrealized holding gains for financial reporting purposes (including use of the fair value option) but deferred for tax purposes.
Sales accounted for on the accrual basis for financial reporting purposes and on the installment (cash) basis for tax purposes.
Permanent differences
There can also be permanent differences:
Enter into taxable income but never into pretax financial income.
Affect only the period in which they occur.
Enter into pretax financial income but never into taxable income or
Do not give rise to future taxable or deductible amounts.
Examples
Tax-exempt interest received on government bonds
Limited deductibility of specific expenses
Fines and expenses resulting from violation of law
changes in future tax rates
But: tax rates can change in the future. If we know that tax rate changes are virtually certain (substantially enacted),
we use these future tax rates to calculate deferred tax liabilities/assets.
Example E19-13
So far, tax rates have remained constant throughout the years.
Apply accounting procedures for a loss carryback and a loss carryforward.
Net operating loss (NOL) = expenses exceed revenues for tax purposes
Inequitable tax burden if companies were taxed during profitable periods without receiving any tax reliefs during periods of NOLs
What happens to income tax expense and taxes payable when a company does not make a profit?
Tax laws allow companies to use losses in one year to offset profits in other years
How does this affect the accounting?
Accounting for losses
Loss Carryback
Back 2 years and forward 20 years.
Losses must be applied to earliest year first.
Loss Carryforward
May elect to forgo loss carryback and
Carryforward losses 20 years.
Accounting for losses-carryforward
Because future taxable income is offset, the tax effect of a loss carryforward represents future tax savings
Realization of the future tax benefit depends on future earnings -->
Uncertain!
If a carryback fails to fully absorb a loss or if a company chooses not to carry back, it may carry the loss forward
If it is “probable” that a company may not realize the entire NOL carryforward in future periods, it does not recognize a deferred tax asset because it is probable that the the carryforward will not be realized (see p. 973-974!)
Accounting for loss carryforward is controversial
Very subjective: what does “probable” mean?
Gives companies the opportunity to “manage” the numbers
High uncertainty
Or: if the deferred tax asset has already been recognized, it may be necessary to write down the deferred tax asset
§ As in the Freddie Mac and Sony examples
Presentation in financial statements
: Why are these tax disclosures important
Enable better predictions of future cash flows.
Predict future cash flows for operating loss carryforwards.
Assess earnings quality.