Tax Reporting vs.

Financial Reporting
Income Tax Expense on the income statement is based on pre-tax income computed using GAAP (or IFRS) Financial Statements (Books): Pre-tax income (per GAAP rules) x Effective tax rate . = Income Tax Expense Income Tax Payable (or paid in cash) is based on Taxable Income using tax code rules Tax Return: Taxable income (per IRS rules) x Statutory tax rate = Income Tax Payable

The two tax amounts can be DIFFERENT!

Permanent differences Temporary differences
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Tax Reporting vs. Financial Reporting

Examples Interest income from municipal bonds Cash advances from customers (unearned revenue) Bad debt expense Depreciation GAAP Interest revenue increases pre-tax income Revenue recognized when earned (in future) Expense recognized when sale is made (now) Depreciation method chosen by firm Tax Code Does not affect taxable income (tax-exempt) Revenue recognized when cash collected (now) Expense when account is written-off (in future) Depreciation schedule from tax authority

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Example
Books 2011 EBITDA 50,000 2012 50,000 EBITDA Tax Return 2011 50,000 2012 50,000

EBITDA in this example is Earnings before depreciation, municipal bond interest revenue, and taxes

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Example: Permanent Differences

Books 2011 EBITDA Muni Interest Revenue 50,000 1,000 2012 50,000 EBITDA 1,000 Muni Interest Revenue Tax Return 2011 50,000 0 2012 50,000 0

Permanent Differences
Revenues that are never included in taxable income and expenses that are never deductible for tax purposes
Examples: Interest on tax-exempt municipal bonds, tax penalties and tax credits, state and foreign taxes

Do not reverse over time Cause the Effective Tax Rate to not equal the Statutory Tax Rate

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Example: Temporary Differences

Books 2011 EBITDA Muni Interest Revenue Depreciation 50,000 1,000 2012 50,000 EBITDA 1,000 Muni Interest Revenue Tax Return 2011 50,000 0 (15,000) 2012 50,000 0 (5,000)

(10,000) (10,000) Depreciation

Temporary Differences
Revenues or expenses recognized in a different period for tax purposes than for financial reporting purposes
Examples: book vs. tax depreciation, bad debt expense, unearned revenue

Reverse over time Stored up in Deferred Tax Assets and Liabilities

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Example: Pre-tax Income vs. Taxable Income

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income 50,000 1,000 41,000 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income Tax Return 2011 50,000 0 (15,000) 35,000 2012 50,000 0 (5,000) 45,000

(10,000) (10,000) Depreciation

Pre-Tax Income: Earnings before taxes under GAAP Taxable Income: Earnings before taxes under tax rules
Differences between pre-tax income and taxable income arise from permanent and temporary differences

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Example: Income Tax Payable

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income 50,000 1,000 41,000 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income X Statutory rate Income Tax Payable Tax Return 2011 50,000 0 (15,000) 35,000 0.35 12,250 2012 50,000 0 (5,000) 45,000 0.35 15,750

(10,000) (10,000) Depreciation

Statutory rate: Tax rate set by the government Income Tax Payable: Taxes owed to the government
Taxable income x statutory rate

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Example: Adjusted Pre-Tax Income

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income Remove Perm Diff Adj. Pre-tax Income 50,000 1,000 41,000 (1,000) 40,000 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income (1,000) X Statutory rate 40,000 Income Tax Payable Tax Return 2011 50,000 0 (15,000) 35,000 0.35 12,250 2012 50,000 0 (5,000) 45,000 0.35 15,750

(10,000) (10,000) Depreciation

Adjusted Pre-Tax Income

Used to compute Income Tax Expense for financial reporting purposes Pre-tax income adjusted for permanent tax differences

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Example: Income Tax Expense

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income Remove Perm Diff Adj. Pre-tax Income X Statutory rate Income Tax Expense 50,000 1,000 41,000 (1,000) 40,000 0.35 14,000 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income (1,000) X Statutory rate 40,000 Income Tax Payable 0.35 14,000 Tax Return 2011 50,000 0 (15,000) 35,000 0.35 12,250 2012 50,000 0 (5,000) 45,000 0.35 15,750

(10,000) (10,000) Depreciation

Income Tax Expense

Number reported on the income statement Adjusted Pre-Tax Income x Statutory rate Differs from Income Tax Payable due to Temporary Differences
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Example: Income Tax Expense vs. Income Tax Payable

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income Remove Perm Diff Adj. Pre-tax Income X Statutory rate Income Tax Expense IncTaxExpIncTaxPay 50,000 1,000 41,000 (1,000) 40,000 0.35 14,000 1,750 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income (1,000) X Statutory rate 40,000 Income Tax Payable 0.35 14,000 (1,750) Tax Return 2011 50,000 0 (15,000) 35,000 0.35 12,250 2012 50,000 0 (5,000) 45,000 0.35 15,750

(10,000) (10,000) Depreciation

KNOWLEDGE FOR ACTION

Example: Income Tax Expense vs. Income Tax Payable

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income Remove Perm Diff Adj. Pre-tax Income X Statutory rate Income Tax Expense IncTaxExp IncTaxPay 50,000 1,000 41,000 (1,000) 40,000 0.35 14,000 1,750 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income (1,000) X Statutory rate 40,000 Income Tax Payable 0.35 14,000 Book Depr-Tax Depr (1,750) 5000 (5000) Tax Return 2011 50,000 0 (15,000) 35,000 0.35 12,250 2012 50,000 0 (5,000) 45,000 0.35 15,750

(10,000) (10,000) Depreciation

KNOWLEDGE FOR ACTION

Example: Income Tax Expense vs. Income Tax Payable

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income Remove Perm Diff Adj. Pre-tax Income X Statutory rate Income Tax Expense IncTaxExp IncTaxPay 50,000 1,000 41,000 (1,000) 40,000 0.35 14,000 1,750 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income (1,000) X Statutory rate 40,000 Income Tax Payable 0.35 14,000 Book Depr-Tax Depr (1,750) Tax Effect @ 35% 5000 1,750 (5000) (1,750) Tax Return 2011 50,000 0 (15,000) 35,000 0.35 12,250 2012 50,000 0 (5,000) 45,000 0.35 15,750

(10,000) (10,000) Depreciation

Temporary Differences reverse over time!

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Example: Effective Tax Rate

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income Remove Perm Diff Adj. Pre-tax Income X Statutory rate Income Tax Expense Effective Tax Rate 50,000 1,000 41,000 (1,000) 40,000 0.35 14,000 34.1% 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income (1,000) X Statutory rate 40,000 Income Tax Payable 0.35 14,000 34.1% Tax Return 2011 50,000 0 (15,000) 35,000 0.35 12,250 2012 50,000 0 (5,000) 45,000 0.35 15,750

(10,000) (10,000) Depreciation

Effective Tax Rate = Income Tax Expense / Pre-Tax Income

Does not equal 35% (Statutory Rate) because of Permanent Differences Does not reverse
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Tax Expense Calculation: Summary

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income Income Tax Expense Pre-Tax Income +/- Permanent Diff Adjusted Pre-Tax Inc X Statutory rate = Income Tax Expense +/- Temporary Diff Taxable Income X Statutory rate = Income Tax Payable 50,000 1,000 41,000 14,000 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income 14,000 Income Tax Payable 41,000 - 1,000 40,000 -5,000 35,000 X 0.35 = 12,250 X 0.35 = 14,000 Tax Return 2011 50,000 0 (15,000) 35,000 12,250 2012 50,000 0 (5,000) 45,000 15,750 2011

(10,000) (10,000) Depreciation

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Tax Expense Calculation: Summary

Books 2011 EBITDA Muni Interest Revenue Depreciation Pre-tax Income Income Tax Expense Pre-Tax Income +/- Permanent Diff Adjusted Pre-Tax Inc X Statutory rate = Income Tax Expense +/- Temporary Diff Taxable Income X Statutory rate = Income Tax Payable 50,000 1,000 41,000 14,000 2012 50,000 EBITDA 1,000 Muni Interest Revenue 41,000 Taxable income 14,000 Income Tax Payable 41,000 - 1,000 40,000 +5,000 45,000 X 0.35 = 15,750 X 0.35 = 14,000 Tax Return 2011 50,000 0 (15,000) 35,000 12,250 2012 50,000 0 (5,000) 45,000 15,750 2012

(10,000) (10,000) Depreciation

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Temporary Differences
Differences between Income Tax Expense on the financial statements and Income Tax Payable to the government that will reverse over time Income Tax Expense = Adjusted Pre-tax income x statutory tax rate
Adjusted Pre-tax income based on GAAP rules and excludes permanent differences For convenience, I will say Pre-Tax Income instead of Adjusted Pre-Tax Income Expense on income statement

Income Tax Payable = Taxable income x statutory tax rate

Taxable income based on tax code rules Paid to the government

Temporary Differences are stored in Deferred Tax Assets and Liabilities We will use 35% as the statutory tax rate in all calculations unless otherwise noted
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Deferred Tax Liabilities

Arise from temporary differences where, initially, tax rules require bigger expenses or smaller revenues than GAAP
Pre-tax income > Taxable income Income tax expense > Income tax payable

In the future, GAAP will require bigger expenses or smaller revenues than tax rules
Pre-tax income < Taxable income Income tax expense < Income taxes payable

The Deferred Tax Liability represents the obligation to make higher tax payments in the future

KNOWLEDGE FOR ACTION

Deferred Tax Liabilities

Arise from temporary differences where, initially, tax rules require bigger expenses or smaller revenues than GAAP
Pre-tax income > Taxable income Income tax expense > Income tax payable

In the future, GAAP will require bigger expenses or smaller revenues than tax rules
Pre-tax income < Taxable income Income tax expense < Income taxes payable

The Deferred Tax Liability represents the obligation to make higher tax payments in the future
Today Dr. Income Tax Expense (+E) 100 Cr. Deferred Tax Liability (+L) 10 Cr. Income Tax Payable (+L) 90

KNOWLEDGE FOR ACTION

Deferred Tax Liabilities

Arise from temporary differences where, initially, tax rules require bigger expenses or smaller revenues than GAAP
Pre-tax income > Taxable income Income tax expense > Income tax payable

In the future, GAAP will require bigger expenses or smaller revenues than tax rules
Pre-tax income < Taxable income Income tax expense < Income tax payable

The Deferred Tax Liability represents the obligation to make higher tax payments in the future
Today Dr. Income Tax Expense (+E) 100 Cr. Deferred Tax Liability (+L) 10 Cr. Income Tax Payable (+L) 90

KNOWLEDGE FOR ACTION

Deferred Tax Liabilities

Arise from temporary differences where, initially, tax rules require bigger expenses or smaller revenues than GAAP
Pre-tax income > Taxable income Income tax expense > Income tax payable

In the future, GAAP will require bigger expenses or smaller revenues than tax rules
Pre-tax income < Taxable income Income tax expense < Income tax payable

The Deferred Tax Liability represents the obligation to make higher tax payments in the future
Today Dr. Income Tax Expense (+E) 100 Cr. Deferred Tax Liability (+L) 10 Cr. Income Tax Payable (+L) 90 Future Dr. Income Tax Expense (+E) 90 Dr. Deferred Tax Liability (-L) 10 Cr. Income Tax Payable (+L) 100

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Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000
Deferred Tax Liab. (L) 14,000 10

2010 Journal entry Dr. Income Tax Expense (+E) Cr. Deferred Tax Liability (+L) Cr. Income Tax Payable (+L)

21,000 14,000 7,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 2011 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 2011 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000 100,000 27,000 73,000 25,550

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 2011 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000 100,000 27,000 73,000 25,550
Deferred Tax Liab. (L) 14,000 10

2011 Journal entry Dr. Income Tax Expense (+E) Dr. Deferred Tax Liability (-L) Cr. Income Tax Payable (+L)
KNOWLEDGE FOR ACTION

21,000 4,550 25,550

11

4,550

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 2011 2012 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000 100,000 27,000 73,000 25,550

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 2011 2012 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax Exp. Income Pay. 80,000 20,000 7,000 27,000 73,000 25,550 13,000 87,000 30,450

EBTDA 100,000 100,000 100,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 2011 2012 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax Exp. Income Pay. 80,000 20,000 7,000 27,000 73,000 25,550 13,000 87,000 30,450
Deferred Tax Liab. (L) 14,000 10

EBTDA 100,000 100,000 100,000

2012 Journal entry Dr. Income Tax Expense (+E) Dr. Deferred Tax Liability (-L) Cr. Income Tax Payable (+L)
KNOWLEDGE FOR ACTION

21,000 9,450 30,450

11 12

4,550 9,450 0

Example: Deferred Tax Liabilities

Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
Year 2010 2011 2012 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 120,000 63,000 MACRS Method (tax) Depr. Taxable Inc. Tax Exp. Income Pay. 80,000 20,000 7,000 27,000 73,000 25,550 13,000 87,000 30,450 120,000 63,000

EBTDA 100,000 100,000 100,000

Temporary difference:
Timing of depreciation expense and tax expense is shifted across time But totals are the same between books and taxes
KNOWLEDGE FOR ACTION

Deferred Tax Assets

Arise from temporary differences where, initially, tax rules require smaller expenses or bigger revenues than GAAP
Pre-tax income < Taxable income Income tax expense < Income tax payable

In the future, GAAP will require smaller expenses or bigger revenues than tax rules
Pre-tax income > Taxable income Income tax expense > Income tax payable

The Deferred Tax Asset represents the benefit of tax savings in the future
Today Dr. Income Tax Expense (+E) Dr. Deferred Tax Asset (+A) Cr. Income Tax Payable (+L) 90 10 100 Future Dr. Income Tax Expense (+E) Cr. Deferred Tax Asset (-A) Cr. Income Tax Payable (+L) 100 10 90

KNOWLEDGE FOR ACTION

Example: Deferred Tax Assets

Brey Co. recognizes $80,000 of bad debt expense on 2010 sales. There are no write-offs of those sales in 2010. In 2011, Brey wrote-off $30,000 of accounts. In 2012, Brey wrote off $50,000 of accounts.
Allowance Method (books) Bad Debt Pre-tax Inc. Tax Income EBTBD Exp. Exp. 100,000 80,000 20,000 7,000 Direct Write-off Method (tax) Bad Debt Taxable Inc. Tax EBTBD Exp. Income Pay. 100,000 0 100,000 35,000

Year 2010

2010 Journal entry Dr. Income Tax Expense (+E) Dr. Deferred Tax Asset (+A) Cr. Income Tax Payable (+L)

Deferred Tax Asset (A)

7,000 28,000 35,000

10

28,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Assets

Brey Co. recognizes $80,000 of bad debt expense on 2010 sales. There are no write-offs of those sales in 2010. In 2011, Brey wrote-off $30,000 of accounts. In 2012, Brey wrote off $50,000 of accounts.
Allowance Method (books) Bad Debt Pre-tax Inc. Tax Income EBTBD Exp. Exp. 100,000 80,000 20,000 7,000 100,000 0 100,000 35,000 Direct Write-off Method (tax) Bad Debt Taxable Inc. Tax EBTBD Exp. Income Pay. 100,000 0 100,000 35,000 100,000 30,000 70,000 24,500
Deferred Tax Asset (A) 10 28,000 10,500 11

Year 2010 2011

2011 Journal entry Dr. Income Tax Expense (+E) Cr. Deferred Tax Asset (-A) Cr. Income Tax Payable (+L)
KNOWLEDGE FOR ACTION

35,000 10,500 24,500

Example: Deferred Tax Assets

Brey Co. recognizes $80,000 of bad debt expense on 2010 sales. There are no write-offs of those sales in 2010. In 2011, Brey wrote-off $30,000 of accounts. In 2012, Brey wrote off $50,000 of accounts.
Allowance Method (books) Bad Debt Pre-tax Inc. Tax Income EBTBD Exp. Exp. 100,000 80,000 20,000 7,000 100,000 0 100,000 35,000 100,000 0 100,000 35,000 Direct Write-off Method (tax) Bad Debt Taxable Inc. Tax EBTBD Exp. Income Pay. 100,000 0 100,000 35,000 100,000 30,000 70,000 24,500 100,000 50,000 50,000 17,500
Deferred Tax Asset (A) 10 28,000 10,500 17,500 0 11 12

Year 2010 2011 2012

2012 Journal entry Dr. Income Tax Expense (+E) Cr. Deferred Tax Asset (-A) Cr. Income Tax Payable (+L)
KNOWLEDGE FOR ACTION

35,000 17,500 17,500

Example: Deferred Tax Assets

Brey Co. recognizes $80,000 of bad debt expense on 2010 sales. There are no write-offs of those sales in 2010. In 2011, Brey wrote-off $30,000 of accounts. In 2012, Brey wrote off $50,000 of accounts.
Allowance Method (books) Bad Debt Pre-tax Inc. Tax Income EBTBD Exp. Exp. 100,000 80,000 20,000 7,000 100,000 0 100,000 35,000 100,000 0 100,000 35,000 80,000 77,000 Direct Write-off Method (tax) Bad Debt Taxable Inc. Tax EBTBD Exp. Income Pay. 100,000 0 100,000 35,000 100,000 30,000 70,000 24,500 100,000 50,000 50,000 17,500 80,000 77,000

Year 2010 2011 2012

Temporary difference:
Timing of bad debt expense and tax expense is shifted across time But totals are the same between books and taxes
KNOWLEDGE FOR ACTION

Changes in Future Tax Rates

Deferred tax assets and liabilities must be based on expected future tax rates
Generally, assume that current tax rate will continue into the future

If the government changes the statutory tax rate, the balances in DTA and DTL must be adjusted to reflect the new rate, with the adjustment running through Income Tax Expense
Tax rate increase:
DTAs increase -> Dr. Deferred Tax Asset (+A), Cr. Income Tax Expense (-E) DTLs increase -> Dr. Income Tax Expense (+E), Cr. Deferred Tax Liability (+L)

Tax rate decrease:

DTAs decrease -> Dr. Income Tax Expense (+E), Cr. Deferred Tax Asset (-A) DTLs decrease -> Dr. Deferred Tax Liability (-L), Cr. Income Tax Expense (-E)

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities and Change in Tax Rates

At the end of 2011, the government increases the tax rate to 40%
Year 2010 2011 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000 100,000 27,000 73,000 25,550
Deferred Tax Liab. (L)

Balance in DTL is $9,450 (under 35% rate)

11 4,550

14,000

10

9,450

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities and Change in Tax Rates

At the end of 2011, the government increases the tax rate to 40%
Year 2010 2011 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 80,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000 100,000 27,000 73,000 25,550 107,000
Deferred Tax Liab. (L) 14,000 11 4,550 9,450 10

Balance in DTL is $9,450 (under 35% rate) Pre-tax Difference = $9,450 / 0.35 = $27,000
Note: this is the difference in Accumulated Depreciation (107,000 80,000)

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities and Change in Tax Rates

At the end of 2011, the government increases the tax rate to 40%
Year 2010 2011 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 80,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000 100,000 27,000 73,000 25,550 107,000
Deferred Tax Liab. (L) 14,000 11 4,550 10,800 10

Balance in DTL is $9,450 (under 35% rate) Pre-tax Difference = $9,450 / 0.35 = $27,000 DTL at new rate = $27,000 x 0.40 = $10,800

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities and Change in Tax Rates

At the end of 2011, the government increases the tax rate to 40%
Year 2010 2011 Straight Line Method (books) Depr. Pre-tax Inc. Tax Income EBTDA Exp. Exp. 100,000 40,000 60,000 21,000 100,000 40,000 60,000 21,000 80,000 MACRS Method (tax) Depr. Taxable Inc. Tax EBTDA Exp. Income Pay. 100,000 80,000 20,000 7,000 100,000 27,000 73,000 25,550 107,000
Deferred Tax Liab. (L) 14,000 11 4,550 1,350 10,800 Adj. 10

Balance in DTL is $9,450 (under 35% rate) Pre-tax Difference = $9,450 / 0.35 = $27,000 DTL at new rate = $27,000 x 0.40 = $10,800 Required increase in DTL = $10,800 - $9,450 = $1,350 Dr. Income Tax Expense (+E) 1,350 Cr. Deferred Tax Liability (+L) 1,350
KNOWLEDGE FOR ACTION

Example: Deferred Tax Assets and Change in Tax Rates

At the end of 2011, the government increases the tax rate to 40%
Year 2010 2011 Allowance Method (books) Bad Debt Pre-tax Inc. Tax Income EBTBD Exp. Exp. 100,000 80,000 20,000 7,000 100,000 0 100,000 35,000 Direct Write-off Method (tax) Bad Debt Taxable Inc. Tax EBTBD Exp. Income Pay. 100,000 0 100,000 35,000 100,000 30,000 70,000 24,500
Deferred Tax Asset (A) 10 28,000 10,500 17,500 11

Balance in DTA is $17,500 (under 35% rate)

KNOWLEDGE FOR ACTION

Example: Deferred Tax Assets and Change in Tax Rates

At the end of 2011, the government increases the tax rate to 40%
Year 2010 2011 Allowance Method (books) Bad Debt Pre-tax Inc. Tax Income EBTBD Exp. Exp. 100,000 80,000 20,000 7,000 100,000 0 100,000 35,000 80,000 Direct Write-off Method (tax) Bad Debt Taxable Inc. Tax EBTBD Exp. Income Pay. 100,000 0 100,000 35,000 100,000 30,000 70,000 24,500 30,000
Deferred Tax Asset (A) 10 28,000 10,500 17,500 11

Balance in DTA is $17,500 (under 35% rate) Pre-tax Difference = $17,500 / 0.35 = $50,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Assets and Change in Tax Rates

At the end of 2011, the government increases the tax rate to 40%
Year 2010 2011 Allowance Method (books) Bad Debt Pre-tax Inc. Tax Income EBTBD Exp. Exp. 100,000 80,000 20,000 7,000 100,000 0 100,000 35,000 80,000 Direct Write-off Method (tax) Bad Debt Taxable Inc. Tax EBTBD Exp. Income Pay. 100,000 0 100,000 35,000 100,000 30,000 70,000 24,500 30,000
Deferred Tax Asset (A) 10 28,000 10,500 20,000 11

Balance in DTA is $17,500 (under 35% rate) Pre-tax Difference = $17,500 / 0.35 = $50,000 DTA at new rate = $50,000 x 0.40 = $20,000

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Example: Deferred Tax Assets and Change in Tax Rates

At the end of 2011, the government increases the tax rate to 40%
Year 2010 2011 Allowance Method (books) Bad Debt Pre-tax Inc. Tax Income EBTBD Exp. Exp. 100,000 80,000 20,000 7,000 100,000 0 100,000 35,000 80,000 Direct Write-off Method (tax) Bad Debt Taxable Inc. Tax EBTBD Exp. Income Pay. 100,000 0 100,000 35,000 100,000 30,000 70,000 24,500 30,000
Deferred Tax Asset (A) 10 Adj. 28,000 10,500 2,500 20,000 11

Balance in DTA is $17,500 (under 35% rate) Pre-tax Difference = $17,500 / 0.35 = $50,000 DTA at new rate = $50,000 x 0.40 = $20,000 Required increase in DTA = $20,000 - $17,500 = $2,500 Dr. Deferred Tax Asset (+A) 2,500 Cr. Income Tax Expense (-E) 2,500
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Valuation Allowance
Deferred Tax Assets represent future tax savings; i.e. a reduction in future cash outflows But, companies can only realize tax savings if they are profitable
DTA reduces taxes paid, but will not produce a refund if the company does not have to pay taxes
Companies do not have to pay taxes when they have negative taxable income

Must have positive taxable income and positive income tax payable

Companies can only report a Deferred Tax Asset if it is more likely than not the firm will be profitable enough in the future to take advantage of the tax savings If it is not more likely than not, companies must reduce the DTA using a Valuation Allowance (XA)
Works just like Allowance for Doubtful Accounts

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Net Operating Losses (NOLs)

A net operating loss occurs in a year when taxable income is negative Federal tax law permits taxpayers to use an NOL to offset the profits of prior and future years First, carry the NOL back 2 years and receive refunds for income taxes that have already been paid in those years Any loss remaining after the 2-year carryback can be carried forward up to 20 years to offset future taxable income Create a Deferred Tax Asset for the amount of tax savings due to NOL Carryforwards

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Example: NOLs
In 2011, Noll International Inc. experienced an $80,000 net operating loss (i.e. negative taxable income) in its US subsidiary, and a $150,000 net operating loss in its Liechtenstein subsidiary Noll did not pay taxes in 2009-2010 in either jurisdiction, so it cannot carry the loss back to get a refund Noll expects it is more likely than not to be able to use NOL carryforwards in 2014 in both countries
US tax rate is expected to be 35%. The US DTA is $80,000 x .35 = $28,000 Liechtenstein tax rate is expected to be 15%. The LI DTA is $150,000 x .15 = $22,500

Journal entry: Dr. Deferred Tax Asset (+A) Cr. Income Tax Expense (-E)
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50,500 50,500

Example: NOL Carryforwards and Valuation Allowance

In June 2012, Noll is preparing its quarterly reports and has serious doubts about the future profitability of its Liechtenstein subsidiary Noll decides that it is not more likely than not to be able to use NOL carryforwards in Liechtenstein before they expire
Recall, the LI DTA is $150,000 x .15 = $22,500

Journal entry: Dr. Income Tax Expense (+E) Cr. Valuation Allowance (+XA) Disclosure presentation:
Deferred Tax Assets DTA: NOL Carryforwards Less Valuation Allowance Net Deferred Tax Assets
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22,500 22,500

50,500 (22,500) 28,000

Example: NOL Carryforwards and Valuation Allowance

In December 2012, Noll is preparing its annual report and is now very optimistic about the future profitability of its Liechtenstein subsidiary Noll decides that it is more likely than not to be able to use NOL carryforwards in Liechtenstein by 2014
Recall, the LI DTA is $150,000 x .15 = $22,500

Journal entry: Dr. Valuation Allowance (-XA) 22,500 Cr. Income Tax Expense (-E) 22,500 Note that this entry will increase Net Income by $22,500
Such valuation allowance reductions could be used for last chance earnings manipulation

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Deferred Tax Footnotes

Components of Income before Tax
Domestic vs. Foreign

Components of Income Tax Expense

Currently payable vs. Deferred

Reconciliation from Statutory to Effective Income Tax Rates

Permanent differences

Components of Deferred Tax Assets and Liabilities

Temporary differences and Valuation Allowance

Differences between Footnote and Balance Sheet

Deferred tax assets and liabilities may be netted by jurisdiction on the balance sheet Deferred tax assets and liabilities may be split into current and noncurrent portions

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Disclosure Example
Moth Inc. manufactures construction equipment Questions to answer from Moths Income Tax footnote:
What is the effect of Moths non-US subsidiaries on its 2012 effective tax rate? Provide a summary journal entry for 2012 Income Tax Expense Provide the journal entry for the change in valuation allowance during 2011. Why did Moth make this entry? What effect does this entry have on net income? Was Moths warranty expense for tax purposes higher or lower than its warranty expense for book purposes in 2012? Was Moths depreciation expense for tax purposes higher or lower than its depreciation expense for book purposes in 2012?

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Footnote 6: Income Taxes

Reconciliation of the U.S. federal statutory rate to effective rate: U.S. statutory rate (Decreases) increases in taxes from: Net operating loss carryforwards Benefit of Foreign Sales Corp. Non-U.S. subsidiaries taxed at other than 35% Other-net Provision for income taxes Year ended Dec. 31 2012 2011 2010 35.0% 35.0% 35.0% (0.4) (4.4) (2.1) (3.2) (1.0) (2.8)

Effect of non-US subsidiaries on 2012 ETR

Increased ETR by 1.9% Represents extra tax on the same pre-tax income Permanent difference

1.9 (0.5) 1.4 1.4 0.4 (0.1) 32.0% 30.6% 33.0%

We paid income taxes of $306, $714, and $709 in 2012, 2011, and 2010, respectively.

For tax calculations, we will use statutory rate: 35%

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Footnote 6: Income Taxes

(millions) Profit before taxes: U.S. Non-U.S. Year ended December 31 2012 2011 2010 $1,050 $1,880 $2,071 371 294 342 $1,421 $2,174 $2,413 Provision for income taxes: Current tax provision: U.S. Federal $179 $471 $571 Non-U.S. 190 102 103 State (U.S.) 21 45 54 390 618 728 Deferred tax provision (credit): U.S. Federal 81 93 60 Non-U.S. (25) (55) 7 State (U.S.) 9 9 1 65 47 68 Total provision $455 $665 $796
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Journal entry for 2012 Income Tax Expense

Dr. Income Tax Expense Cr. Deferred Taxes Cr. Income Tax Payable 455 65 390

Footnote 6: Income Taxes

(millions) Profit before taxes: U.S. Non-U.S. Year ended December 31 2012 2011 2010 $1,050 $1,880 $2,071 371 294 342 $1,421 $2,174 $2,413 Provision for income taxes: Current tax provision: U.S. Federal $179 $471 $571 Non-U.S. 190 102 103 State (U.S.) 21 45 54 390 618 728 Deferred tax provision (credit): U.S. Federal 81 93 60 Non-U.S. (25) (55) 7 State (U.S.) 9 9 1 65 47 68 Total provision $455 $665 $796
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Journal entry for 2012 Income Tax Expense

Dr. Income Tax Expense Cr. Deferred Taxes Cr. Income Tax Payable 455 65 390 455

More detail?
Dr. Income Tax Expense

Footnote 6: Income Taxes

(millions) Deferred tax assets and liabilities: Deferred tax assets: Postemployment benefits Warranty reserves Unrealized profit Net operating loss carryforwards Inventory valuation method Other Deferred tax liabilities: Capital assets Pension Valuation allowance for DTAs Deferred taxes net December 31, 2012 2011 2010 $1,044 $1,032 $1,107 237 194 159 167 179 201 170 83 76 93 78 62 205 230 233 1,916 1,796 1,838 (383) (263) (177) (138) (83) (99) (521) (346) (276) (72) (61) (129) $1,323 $1,389 $1,433

Deferred Tax Assets

Debit of 120
(1916 1796)

Deferred Tax Liab.

Credit of 175
(521 346)

Valuation Allowance
Credit of 11
(72 61)

Cr. Def Taxes 65 =

Dr. DTA 120 Cr. DTL 175 Cr. Val Allow 10

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Footnote 6: Income Taxes

(millions) Profit before taxes: U.S. Non-U.S. Year ended December 31 2012 2011 2010 $1,050 $1,880 $2,071 371 294 342 $1,421 $2,174 $2,413 Provision for income taxes: Current tax provision: U.S. Federal $179 $471 $571 Non-U.S. 190 102 103 State (U.S.) 21 45 54 390 618 728 Deferred tax provision (credit): U.S. Federal 81 93 60 Non-U.S. (25) (55) 7 State (U.S.) 9 9 1 65 47 68 Total provision $455 $665 $796
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Journal entry for 2012 Income Tax Expense

Dr. Income Tax Expense Cr. Deferred Taxes Cr. Income Tax Payable 455 65 390 455 120 175 10

More detail?
Dr. Income Tax Expense Dr. Deferred Tax Assets

Cr. Deferred Tax Liabilities Cr. Valuation Allowance

Footnote 6: Income Taxes

Reconciliation of the U.S. federal statutory rate to effective rate: U.S. statutory rate (Decreases) increases in taxes from: Net operating loss carryforwards Benefit of Foreign Sales Corp. Non-U.S. subsidiaries taxed at other than 35% Other-net Provision for income taxes Year ended Dec. 31 2012 2011 2010 35.0% 35.0% 35.0% (0.4) (4.4) (2.1) (3.2) (1.0) (2.8)

Cash paid for income taxes

$306 in 2012

Cr. Income Tax Payable 390 =

Cr. Cash 306 Cr. Inc Tax Pay 84
(390 306)

1.9 (0.5) 1.4 1.4 0.4 (0.1) 32.0% 30.6% 33.0%

We paid income taxes of $306, $714, and $709 in 2012, 2011, and 2010, respectively.

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Footnote 6: Income Taxes

(millions) Profit before taxes: U.S. Non-U.S. Year ended December 31 2012 2011 2010 $1,050 $1,880 $2,071 371 294 342 $1,421 $2,174 $2,413 Provision for income taxes: Current tax provision: U.S. Federal $179 $471 $571 Non-U.S. 190 102 103 State (U.S.) 21 45 54 390 618 728 Deferred tax provision (credit): U.S. Federal 81 93 60 Non-U.S. (25) (55) 7 State (U.S.) 9 9 1 65 47 68 Total provision $455 $665 $796
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Journal entry for 2012 Income Tax Expense

Dr. Income Tax Expense Cr. Deferred Taxes Cr. Income Tax Payable 455 65 390 455 120 175 10 84 306

More detail?
Dr. Income Tax Expense Dr. Deferred Tax Assets

Cr. Deferred Tax Liabilities Cr. Valuation Allowance Cr. Income Tax Payable Cr. Cash

Footnote 6: Income Taxes

(millions) Deferred tax assets and liabilities: Deferred tax assets: Postemployment benefits Warranty reserves Unrealized profit Net operating loss carryforwards Inventory valuation method Other Deferred tax liabilities: Capital assets Pension Valuation allowance for DTAs Deferred taxes net

Journal entry for 2011 change in valuation allowance $1,044 $1,032 $1,107
237 167 170 93 205 1,916 194 179 83 78 230 1,796 159 201 76 62 233 1,838 Decrease of $68 (61 129) Dr. Val. Allow. (-XA) 68 Cr. Inc. Tax Exp. (-E) 68

December 31, 2012 2011 2010

(383) (263) (138) (83) (521) (346) (276) (72) (61) (129) $1,323 $1,389 $1,433

Increases Net Income by $68 (177) Why did the Valuation (99) Allowance decrease?

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Footnote 6: Income Taxes

As of December 31, 2012, amounts and expiration dates of net operating loss carryforwards in various non-U.S. taxing jurisdictions were: Beyond 2013 2014 2015 2016 2017 2018 2019 2019 Total $1 $4 $8 $18 $15 $45 $45 $482 $618 A valuation allowance has been recorded at certain non-U.S. subsidiaries that have not yet demonstrated consistent and/or sustainable profitability to support the recognition of net deferred tax assets. Circumstances could change in the future which would allow us to reduce the remaining valuation allowance and recognize additional net deferred tax assets. In 2011, circumstances changed at certain of our European subsidiaries which allowed us to reduce the valuation allowance and recognize additional net deferred tax assets.

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Footnote 6: Income Taxes

(millions) Deferred tax assets and liabilities: Deferred tax assets: Postemployment benefits Warranty reserves Unrealized profit Net operating loss carryforwards Inventory valuation method Other Deferred tax liabilities: Capital assets Pension Valuation allowance for DTAs Deferred taxes net

Journal entry for 2011 change in valuation allowance $1,044 $1,032 $1,107
237 167 170 93 205 1,916 194 179 83 78 230 1,796 159 201 76 62 233 1,838 Decrease of $68 (61 129) Dr. Valuation Allow. 68 Cr. Income Tax Exp. 68

December 31, 2012 2011 2010

(383) (263) (138) (83) (521) (346) (276) (72) (61) (129) $1,323 $1,389 $1,433

Increases Net Income by $68 (177) Why did the Valuation (99) Allowance decrease?
circumstances changed at certain of our European subsidiaries

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Footnote 6: Income Taxes

(millions) Deferred tax assets and liabilities: Deferred tax assets: Postemployment benefits Warranty reserves Unrealized profit Net operating loss carryforwards Inventory valuation method Other Deferred tax liabilities: Capital assets Pension Valuation allowance for DTAs Deferred taxes net December 31, 2012 2011 2010 $1,044 $1,032 $1,107 237 194 159 167 179 201 170 83 76 93 78 62 205 230 233 1,916 1,796 1,838 (383) (263) (177) (138) (83) (99) (521) (346) (276) (72) (61) (129) $1,323 $1,389 $1,433

2012 difference in Warranty Expense

Warranty DTA increased by $43 (237 194) Dr. Income Tax Exp Dr. Deferred Tax Asset 43 Cr. Income Tax Payable Income Tax Exp < Income Tax Payable for Warranty

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Footnote 6: Income Taxes

(millions) Deferred tax assets and liabilities: Deferred tax assets: Postemployment benefits Warranty reserves Unrealized profit Net operating loss carryforwards Inventory valuation method Other December 31, 2012 2011 2010 $1,044 $1,032 $1,107 237 194 159 167 179 201 170 83 76 93 78 62 205 230 233 1,916 1,796 1,838

2012 difference in Warranty Expense

Warranty DTA increased by $43 (237 194) Dr. Income Tax Exp Dr. Deferred Tax Asset 43 Cr. Income Tax Payable Income Tax Exp < Income Tax Payable for Warranty

Income Tax Expense < Income Tax Payable by $43 for Warranty Pre-tax Income < Taxable Income by $123 (43 / 0.35) Book Warranty Expense > Tax Warranty Expense by $123

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Footnote 6: Income Taxes

(millions) Deferred tax assets and liabilities: Deferred tax assets: Postemployment benefits Warranty reserves Unrealized profit Net operating loss carryforwards Inventory valuation method Other Deferred tax liabilities: Capital assets Pension Valuation allowance for DTAs Deferred taxes net December 31, 2012 2011 2010 $1,044 $1,032 $1,107 237 194 159 167 179 201 170 83 76 93 78 62 205 230 233 1,916 1,796 1,838 (383) (263) (177) (138) (83) (99) (521) (346) (276) (72) (61) (129) $1,323 $1,389 $1,433

2012 difference in Depreciation Expense

Capital Assets DTL increased by $120 (383 263) Dr. Income Tax Exp Cr. Def Tax Liab Cr. Income Tax Pay 120

Income Tax Exp > Income Tax Pay for Depreciation

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Footnote 6: Income Taxes

(millions) Deferred tax assets and liabilities: Deferred tax liabilities: Capital assets Pension Valuation allowance for DTAs Deferred taxes net December 31, 2012 2011 2010 (383) (263) (177) (138) (83) (99) (521) (346) (276) (72) (61) (129) $1,323 $1,389 $1,433

2012 difference in Depreciation Expense

Capital Assets DTL increased by $120 (383 263) Dr. Income Tax Exp Cr. Def Tax Liab Cr. Income Tax Pay 120

Income Tax Exp > Income Tax Pay for Depreciation

Income Tax Expense > Income Tax Payable by $120 for Depreciation Pre-tax Income > Taxable Income by $343 (120 / 0.35) Book Depreciation Expense < Tax Depreciation Expense by $343

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Taxes and the Statement of Cash Flows

All operating activity line items on the SCF are shown pre-tax
($000's) Year ended Dec. 31: 2009 2010 Net Income 1,470 3,028 Depreciation 2,372 4,537 Doubtful Accts. 12 48 Changes in: Accounts Receivable 4,594 (7,357) Inventories 1,481 (13,179) Deferred Taxes 8 178 Prepaid, other (1) 179 Accounts Payable (3,927) 5,084 Accrued Wages 99 708 Other Current Liabs. 110 464 Taxes Payable (502) 816 Cash Flow from Operations 5,716 (5,494)
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2011 5,071 7,191 48 (660) (7,872) 587 14 86 232 (23) 278 4,952

All tax effects are reflected in:

Changes in Deferred Taxes Changes in Income Tax Payable

Taxes and the SCF: Example

Company increases book Depreciation Expense by $100 in 2011
Pre-tax income down by $100
Income Tax Expense down by $35 (100 x .35) Net Income down by $65 (100 35)

Tax Depreciation is unaffected

Taxable Income unaffected; Income Tax Payable unaffected

Balance these differences with a reduction in Deferred Tax Liability of $35

Journal entries Dr. Depreciation Expense (+E) 100 Cr. Accumulated Depreciation (+XA) 100 Dr. Deferred Tax Liability (-L) 35 Cr. Income Tax Expense (-E) 35 (100 x .35)

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SCF: Cash Flows from Operating Activities

($000's) Year ended Dec. 31: Net Income Depreciation Doubtful Accts. Changes in: Accounts Receivable Inventories Deferred Taxes Prepaid, other Accounts Payable Accrued Wages Other Current Liabs. Taxes Payable Cash Flow from Operations 2009 1,470 2,372 12 2010 3,028 4,537 48 Old 2011 5,071 7,191 48 New 2011 5,006 7,291 48 Chg. (65) 100

4,594 (7,357) (660) (660) 1,481 (13,179) (7,872) (7,872) 8 178 587 552 (1) 179 14 14 (3,927) 5,084 86 86 99 708 232 232 110 464 (23) (23) (502) 816 278 278 5,716 (5,494) 4,952 4,952

(35)

0 0

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Taxes and Marketable Securities

Gains or losses on Marketable Securities are taxed only when sold
Tax is based on the difference between the sales price and the purchase price

Trading Securities
Unrealized gains/losses from mark-to-market are carried on the Income Statement
Create a Deferred Tax Asset or Liability

Available for Sale Securities

Unrealized gains/losses for AFS securities are stored up in AOCI Accumulated Other Comprehensive Income must be carried on an after-tax basis
Create a DTA or DTL to reflect the tax effect of the unrealized gains/losses in AOCI

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Example: Mark-to-market on balance sheet date - Trading

At quarter end, Bott Banks investment in TK stock is now worth $129 (Bott bought the stock for $100) Journal entries: Dr. Marketable Securities (+A) Cr. Gain on Investments (+R) Dr. Income Tax Expense (+E) Cr. Deferred Tax Liability (+L)

29 29 10 10 (29 x 0.35)

Note: No Income Tax Payable because taxes are only paid when the security is sold

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Example: Sale of investment - Trading

After quarter end, Bott Bank sells its TK stock for $109 Journal entries: Dr. Cash (+A) 109 Dr. Loss on investment (+E) 20 Cr. Marketable Securities (-A) 129 Dr. Deferred Tax Liability (-L) 10 Cr. Income Tax Expense (-E) 7 (20 x 0.35) Cr. Income Tax Payable (+L) 3 ((109-100) x 0.35) Note: Income Tax Payable is based on the Realized Gain computed using the original cost (109 100)

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Example: Mark-to-market on balance sheet date - AFS

At quarter end, Meyer Co.s investment in TK stock is now worth $129 (Meyer bought the stock for $100) Journal entries: Dr. Marketable Securities (+A) Cr. AOCI (+SE) Dr. AOCI (-SE) Cr. Deferred Tax Liability (+L)

29 29 10 10
DTL eff

AOCI (SE) 10 29 Qtr end

19

Note: Instead of debiting Income Tax Expense, as we would if this went on the Income Statement, we debit AOCI

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Example: Sale of investment - AFS

After quarter end, Meyer Co. sells its TK stock for $109 Journal entries: Dr. Cash (+A) 109 Tax eff Dr. AOCI (-SE) 29 Sale Cr. Gain on investment (+R, +SE) 9 Cr. Marketable Securities (-A) 129 Dr. Income Tax Expense (+E) 3 (9 x 0.35) Cr. Income Tax Payable (+L) 3 Dr. Deferred Tax Liability (-L) 10 Cr. AOCI (+SE) 10

AOCI (SE) 10 29 29 10 0 Qtr end Sale Tx

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