Understanding Income Taxes: Key Concepts and Calculations

School

University of Manitoba**We aren't endorsed by this school

Course

ACC 3120

Subject

Accounting

Date

Dec 11, 2024

Pages

Uploaded by DrPheasant3606

Intermediate AccountingChapter 18Income Taxes

Chapter 18: Income TaxesAfter studying this chapter, you should be able to:1.Understand the importance of income taxes from a business perspective.2.Explain the difference between accounting income and taxable income, and calculate taxable income and current income taxes.3.Explain what a taxable temporary difference is, determine its amount, and calculate deferred tax liabilities and deferred assets.4.Prepare analyses of deferred tax balances and record deferred tax expense.5.Explain the effect of multiple tax rates and tax rate changes on income tax accounts, and calculate current and deferred tax amounts when there is a change in substantively enacted tax rates.6.Account for tax loss carryover benefits, including any note disclosures.7.Explain why the Deferred Tax Asset account is reassessed at the statement of financial position date, and account for the deferred tax asset with and without a valuation allowance account.8.Identify and apply the presentation and disclosure requirements for income tax assets and liabilities, and apply intraperiod tax allocation.9.Identify the major differences between ASPE and IFRS for income taxes.2Copyright ©2019 John Wiley & Sons Canada, Ltd.

Learning Objective 1: Income Taxes from a Business Perspective•Our main focus in this chapter is on financial reporting by companies once they have determined the amount of taxes that they owe.•Corporations file income tax returns following the Income Tax Act (administered by the Canada Revenue Agency) and related provincial legislation•GAAP methods differ from tax legislation; pre-tax accounting income (under IFRS or ASPE) is not the same as taxable income•Although under ASPE, companies have an option of using the taxes payable approach where income tax expense would typically equal taxes payableLO13Copyright ©2019 John Wiley & Sons Canada, Ltd.

Learning Objective 2:Explain the difference between accounting income and taxable income, and calculate taxable income and current income taxes.•Accounting income—also known as “income before taxes”, “income for financial reporting purposes” or “accounting profit”—is a pre-tax conceptoDetermined according to IFRS or ASPEoObjective is to provide useful information to users of the financial statements•Taxable income—also known as “income for tax purposes” or “taxable profit”.It indicates the amount on which income tax payable is calculated.•Different objectives: accounting income and taxable income usually differLO24Copyright ©2019 John Wiley & Sons Canada, Ltd.

Calculation of Taxable Income•To calculate taxable income, companies prepare a reconciliation (schedule) that begins with accounting income and then adjusts for differences to arrive at taxable income•The main reasons for differences:oTemporary differences/timing/Reversing differences1.Revenues or gains are taxable before/after being recognized in accounting income2.Expenses or losses are deductible for tax purposes before/after they are recognized in accounting incomeoPermanent differences3.Items included in accounting income that are never included in taxable incomeLO25Copyright ©2019 John Wiley & Sons Canada, Ltd.

Calculation of Taxable Income1.Revenues or gains are taxable after they are recognized in accounting income.•Income recognized on the accrual basis for financial reporting purposes and on the instalment or cash basis for tax purpose Examples:•Instalment sales that are recognized when the sale takes place for financial reporting purposes and on the cash basis for tax purposes•Contracts that are accounted for under the percentage-of-completion method for financial reporting purposes and the completed contract or zero-profit basis for tax purposes, resulting in some or all of the related gross profit being deferred for tax purposes•Unrealized holding gains that are recognized in income or in OCI on investments or other assets carried at fair value, but that are not taxable until the assets are sold and the gains realized (or become realizable as an account receivable)LO26Copyright ©2019 John Wiley & Sons Canada, Ltd.

Calculation of Taxable IncomeLO27Copyright ©2019 John Wiley & Sons Canada, Ltd. 2.Expenses or losses are deductible for tax purposes after they are recognizedin accounting incomeFor financial statement purposes, an expense may have to be accrued, but for taxpurposes it may not be deductible as an expense until it is paid.Examples:•Product warranty liabilities

8Copyright ©2019 John Wiley & Sons Canada, Ltd. Calculation of Taxable Income3. Revenues or gains are taxable before they are recognized in accounting income•For tax purposes, the advance payment may have to be included in taxable income when the cash is received. •When the entity recognizes this revenue on the income statement in later yearswhen the goods or services are provided to customers, this revenue can bededucted in calculating taxable income.•Examples include the following: •Subscriptions, royalties, and rentals received in advance

9Copyright ©2019 John Wiley & Sons Canada, Ltd. Calculation of Taxable Income4.Expenses or losses are deductible before they are recognized in accounting income•The cost of assets such as equipment, for example, is deducted for financial Statement purposes according to whichever depreciation method the company uses for financial statement purposes. •For tax purposes, the capital cost allowance (CCA) method must be used.•Therefore, depending on which accounting method was chosen, the asset's cost may be deducted faster for tax purposes than it is expensed for financial reporting purposes.

Calculation of Taxable Income(1) are included in accounting income but never in taxable income. Examples of items that are included in accounting income but never in taxable income are: •Non–tax-deductible expenses such as fines and penalties, golf and social club dues, and expenses related to the earning of non-taxable revenue•Non-taxable revenue, such as dividends from taxable Canadian corporations, and proceeds on life insurance policies carried by the company on key officers or employees10Copyright ©2019 John Wiley & Sons Canada, Ltd. 5. Permanent differences are caused by items that

Temporary difference must be classified as1)Deferred tax liability: if when the diff is reversed, the company will more taxesReverse # are positive (+) = liability2)Deferred tax asset: If when the diff is reversed, tax saving will happen (pay less tax)Reverse # are negative (-) = asset12Copyright ©2019 John Wiley & Sons Canada, Ltd.

Two accounting Method to income tax exp1) Tax payable method- only ASPE-Ignore the deferred tax (don’t record temp. difference-It record only current income tax exp2) Temporary diff (ASPE & IFRS)-record current income tax & deferred tax.13Copyright ©2019 John Wiley & Sons Canada, Ltd.

Calculation of Current Income Tax •Two methods for determining current income taxes1) Taxes payable methodCurrent rate of tax applied company’s taxable incomeChoice under ASPE2) Temporary difference approach (Asset-liability approach)Adjusts current income taxes for effects of changes in deferred tax assets and deferred tax liabilities and recognizes them under deferred tax expense Conceptually better, income tax should be directly related to accounting incomeRequired under IFRS; choice under ASPELO214Copyright ©2019 John Wiley & Sons Canada, Ltd.

Calculation of Current Income Tax •Temporary difference approach—same process under IFRS and ASPE, but different terminologyIFRSASPETemporary difference approachFuture income taxes methodDeferred tax assetsFuture income tax assetsDeferred tax liabilitiesFuture income tax liabilitiesDeferred tax expenseFuture income tax expense•Objectives: recognize the amount of taxes payable (refundable) for the current year; recognize tax assets/liabilities for future tax consequencesLO215Copyright ©2019 John Wiley & Sons Canada, Ltd.

16Copyright ©2019 John Wiley & Sons Canada, Ltd. •A deferred tax liability or future income tax liability is the future tax consequence of a taxable temporary difference •Increase in taxes payable in future years as a result of a taxable temporary difference at the end of the current yearDeferred Tax Liabilities

•A deferred tax asset or future income tax asset is the future tax consequence of a deductible temporary difference •It represents the reduction in taxes payable or the increase in taxes refundable in future years as a result of a deductible temporary difference at the end of the yearLO317Copyright ©2019 John Wiley & Sons Canada, Ltd.

Explain the effect of multiple tax rates and tax rate changes on income tax accounts and calculate current and deferred tax amounts when there is a change in substantively enacted tax rates.What happens if tax rates (or tax laws) are different for future years?•Accounting standards—use the income tax rates that are expected to apply when the tax liabilities are settled, or tax assets are realized•Sometimes a substantively enacted rate or tax law is more appropriateoFor ASPE, this means drafted and tabled in Parliament*oFor IFRS, government announcements have the effect of actual* enactment•The effect of a change in the tax rate should be recorded immediatelyas an adjustment to income tax expense in the period of the changeLO519Copyright ©2019 John Wiley & Sons Canada, Ltd.

If the tax rate changed-When we record current income tax exp – Current year tax rate- when we record deferred tax exp – future tax rateIf the company wasn’t aware of change in tax rate 7 recorded deferred tax using current rateOnce it is aware, an adj entry is need to adjust deferred tax to new tax rate20Copyright ©2019 John Wiley & Sons Canada, Ltd.

Account for tax loss carryover benefits, including any note disclosures.•A loss for income tax purposes or tax loss occurs when the year's tax-deductible expenses and losses exceed the company's taxable revenues and gains. •Tax laws permit taxpayers to use a tax loss of one year to offset taxable income of other years oLoss carryback: carry a tax loss back against taxable income of the immediately preceding 3 yearsoLoss carryforward: carry losses forward to the 20 years immediately following the lossoIf full amount of loss cannot be absorbed by carrybacks, then it can be carried forwardLO622Copyright ©2019 John Wiley & Sons Canada, Ltd.

Account for tax loss carryover benefits, including any note disclosures.•Decision on how to use a tax loss depends on which factors management sees as the greatest tax advantageLO623Copyright ©2019 John Wiley & Sons Canada, Ltd. Carryback:•If a loss is carried back, it is usually applied against the earliest available income—2017 •The tax returns for the 2017,2018 and 2019 years are refiled:•the current-year tax loss (2020) is deducted from the previously reported taxable income, and a revised amount of income tax payable is determined for each year.•This figure is then compared with the taxes that were actually paid for each of the preceding years, and the government is asked to refund the difference.

Account for tax loss carryover benefits, including any note disclosures.LO624Copyright ©2019 John Wiley & Sons Canada, Ltd. •If the full amount of the loss could not be absorbed in the carryback period, the tax loss can be used to offset taxable income in the future so that taxes for those future years are reduced or eliminated.

Income Tax Loss Carryover Benefits •If it appears (“more likely than not”) there will be income in the future to offset the loss carryforward, the benefits should be recognized in the period of the lossoAs a deferred tax benefit in the income statementoAs a deferred tax asset on the statement of financial positionoASPE (not IFRS) allows a contra valuation allowance account •If it appears there will be no future income, the benefits are not recognized in the financial statements•But, disclosure is required of the amounts of tax loss carryforwards and their expiry dates•If previously unrecorded tax losses are used to benefit a future period, the benefit is recognized in that periodLO625Copyright ©2019 John Wiley & Sons Canada, Ltd.

Tax Loss Carryforward•If a net operating loss is not fully absorbed through a carryback or if the company decides not to carry the loss back, the loss can be carried forward for up to 20 years•When a company carries a tax loss forward, a deferred tax asset should be established for the benefits of future tax savings to the extent they are more likely than not to be realized. •The benefit, once again, is recognized in the year of the loss.•If, in the year of the loss, it is considered more likely than not that the benefits of the tax loss will not be realized, the benefit is notrecognized; instead, the existence of the available tax losses is reported in a note to the financial statements.•If the company does benefit from these losses in a future year, the benefit of the loss is recognized as a reduction of tax expense in that future year.27Copyright ©2019 John Wiley & Sons Canada, Ltd.

Carryforward with Valuation Allowance•In the previous example , we assumed that company.'s future was uncertain, and that there was not enough evidence that it would be able to benefit from the remaining $150,000 of 2021 tax losses available to be carried forward. As a result, no deferred tax asset was recognized in 2021. •There is an alternative recognition approach to this situation•A deferred tax asset is recognized for the full amount of the tax effect on the $150,000 loss carryforward, along with an offsetting valuation allowance, a contra account to the Deferred Tax Asset account•Financial statements would be the same if the allowance method Is not used•This valuation allowance approach is permitted under ASPE. 29Copyright ©2019 John Wiley & Sons Canada, Ltd.

Explain why the Deferred Tax Asset account is reassessed at the statement of financial position date, and account for the deferred tax asset with and without a valuation allowance account.•Like all assets, the Deferred Tax Asset must be reviewed at year end to ensure that the carrying amounts are appropriate based on existing conditions at the SFP date•This depends on whether taxable income will be earned in the future against which temporary differences can be deducted•If it is unlikely that sufficient taxable income will be generated, the income tax asset may have to be written down•The deferred tax asset account is also reviewed to determine if it may now be reasonable to recognize a deferred tax asset that was previously unrecognizedLO731Copyright ©2019 John Wiley & Sons Canada, Ltd.

Identify and apply the presentation and disclosure requirements for income tax assets and liabilities, and apply intraperiod tax allocationIncome taxes Receivable/Payable (current)•Under all methods, current income taxes payable or receivable are reported separately from deferred or future tax assets and liabilities •If there is a debit balance in the payable account from instalment payments, reported as Prepaid Income Tax or Income Tax Receivable•Income tax refund from a loss carryback is reported as an income tax receivable and as a current assetLO833Copyright ©2019 John Wiley & Sons Canada, Ltd.

Statement of Financial Position PresentationDeferred Tax Assets/Liabilities•IFRS requiresall deferred tax assets/liabilities be reported as non-currentitems•Under ASPE, future income tax assets/liabilities are segregated into current/non-current based on the underlying temporary difference•If not related to asset/liability, future income taxes classified according to the expected date of reversal or realization•Under IFRS and ASPE, deferred tax assets/liabilities cannot be netted unless they relate to the same taxable entity and authority; there is a right to settle or realize at the same time LO834Copyright ©2019 John Wiley & Sons Canada, Ltd.

Disclosure Requirements•ASPE calls for limited disclosures •IFRS has more extensive disclosure requirements oSources of both current and deferred taxesoAmount of current and deferred tax recognized in equityoReconciliation of effective and statutory tax ratesoInformation about unrecognized deferred tax assetsoInformation about each type of temporary difference and deferred tax asset or liability recognized on statement of financial positionLO835Copyright ©2019 John Wiley & Sons Canada, Ltd.

Analysis•Assessment of quality of earnings—accounting for deferred taxes is an area that requires considerable judgement and may be open to abuse•Profits that are improved by a favourable tax effect should be examined very carefully•Better predictions of future cash flows—based on upcoming reductions in future income tax liabilities, and additional cash required for tax payments•Data analytics has impacted how CRA checks non-compliance—e.g. monitoring Facebook, Twitter, and using text miningLO836Copyright ©2019 John Wiley & Sons Canada, Ltd.

Comparison of IFRS and ASPE•ASPE allows an accounting policy choice—either the taxes payable method or the future income taxes method•IFRS requires the use of the temporary difference approach (same as future income taxes method)•Main differences relate tooTerminologyoClassification of deferred/future tax assets and liabilities on the statement of financial positionoUse of a valuation allowanceoExtent of the disclosureLO937Copyright ©2019 John Wiley & Sons Canada, Ltd.