�OVERVIEW OF TAXES�COLUMBIA CORE ACCOUNTING�REVIEW SESSION��ANTHONY LE�

TAX TERMINOLOGY

TAX TERMINOLOGY

• Examples of common Permanent Differences:
• Interest received on municipal bonds (not taxable for IRS income, but recognized as income under GAAP)
• Government-imposed fines for violations (not deductible for IRS income, but deductible from income under GAAP)
• Dividends received from affiliates (taxed by IRS, but not income under GAAP)

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• Examples of common Temporary Differences:
• Different depreciation methods under GAAP and IRS tax code
• Differences in revenue recognition (rent sales generally included in IRS tax code income when collected but included in GAAP income when earned)
• Differences in expense recognition: warranty and bad debt expenses are generally only deductible from taxable�income when an actual claim or write-off occurs; under GAAP, the losses are estimated and�recognized at the time of sale

A few other key terms (Deferred Tax Assets, Deferred Tax Liability, Valuation Allowance) that we’ll get to later!

EXAMPLE OF TEMPORARY DIFFERENCE

• Examples of common Temporary Differences:
• Different depreciation methods under GAAP and IRS tax code
• Differences in revenue recognition (rent sales generally included in IRS tax code income when collected but included in GAAP income when earned)
• Differences in expense recognition: warranty and bad debt expenses are generally only deductible from taxable�income when an actual claim or write-off occurs; under GAAP, the losses are estimated and�recognized at the time of sale

Suppose we have an asset that is worth $200 and it depreciates fully over 4 years. We use the straight line method to come to our GAAP income, but we use the accelerated method for our tax-code income (shown below). Calculate the taxable income under U.S. GAAP and the IRS tax-code for each year, and record each of the entries we would make for the income tax expenses for each individual year.

Notice that over the four years, the total IRS income adds up to $300 (40 + 50 + 90 + 120 = 300)

Notice that over the four years, the total GAAP income adds up to $300 (90 + 70 + 60 + 80 = 300)

Notice that over the four years, the total GAAP depreciation adds up to $200 (50 + 50 + 50 + 50 = 200)

Notice that over the four years, the total IRS depreciation adds up to $200 (100 + 80 + 20 + 10 = 200)

The fact that these reconcile after the four years is precisely what makes depreciation a “temporary difference”

EXAMPLE OF TEMPORARY DIFFERENCE

Suppose we have an asset that is worth $200 and it depreciates fully over 4 years. We use the straight line method to come to our GAAP income, but we use the accelerated method for our tax-code income (shown below). Calculate the taxable income under U.S. GAAP and the IRS tax-code for each year, and record each of the entries we would make for the income tax expenses for each individual year.

Now we can talk about what a deferred tax asset/deferred tax liability is: is it the differences in taxes between the IRS tax code income and the GAAP income for temporary differences. For the example above, lets say the tax rate is 25%. What is the deferred tax asset/liability each year?

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*NOTE: We have a Deferred Tax Asset (DTA) when the GAAP Income < IRS Income and a Deferred Tax Liability when GAAP Income > IRS Income.

EXAMPLE OF TEMPORARY DIFFERENCE

Suppose we have an asset that is worth $200 and it depreciates fully over 4 years. We use the straight line method to come to our GAAP income, but we use the accelerated method for our tax-code income (shown below). Calculate the taxable income under U.S. GAAP and the IRS tax-code for each year, and record each of the entries we would make for the income tax expenses for each individual year.

Eventually we want this to have a balance of zero, to reflect that at the end of year 4, there are no longer any differences between the taxes recognized under GAAP and the taxes paid to the IRS

First way to calculate DTL (i.e., differences in income * tax rates), second way on next slide

EXAMPLE OF TEMPORARY DIFFERENCE

Suppose we have an asset that is worth $200 and it depreciates fully over 4 years. We use the straight line method to come to our GAAP income, but we use the accelerated method for our tax-code income (shown below). Calculate the taxable income under U.S. GAAP and the IRS tax-code for each year, and record each of the entries we would make for the income tax expenses for each individual year.

Second way to calculate DTL: find taxes owed and tax expense first, and just take difference

EXAMPLE OF TEMPORARY DIFFERENCE

Suppose we have an asset that is worth $200 and it depreciates fully over 4 years. We use the straight line method to come to our GAAP income, but we use the accelerated method for our tax-code income (shown below). Calculate the taxable income under U.S. GAAP and the IRS tax-code for each year, and record each of the entries we would make for the income tax expenses for each individual year.

Second way to calculate DTL: find taxes owed and tax expense first, and just take difference

EXAMPLE OF PERMANENT DIFFERENCE

A fine paid to the Government is recorded in our GAAP income as aN Expense or related item. That means that:

Recall that a loss is included as an loss for GAAP, but is never allowed to be deducted for the IRS tax-code income

We get 35 (taxes owed to IRS) by doing 140 * 0.25 = $35. We get 30 (tax expense measured by GAAP) by doing 120 * 0.25 = $30. Note that this is WRONG and is only shown here for illustrative purposes

We get 35 (taxes owed to IRS) by doing 140 * 0.25 = $35. We get 35 (tax expense measured by GAAP) by doing (120 + 20) * 0.25 = $35. Note that this is the CORRECT adjustment to make (add back the loss to the GAAP income, since it is never allowed to be deducted for IRS income)

HOW THE TAX CONCEPTS CONNECT

EXAMPLE: DOMINIAK CASE

a) What were the temporary differences for 2015?

Temporary Differences = Taxable IRS Income – Taxable GAAP Income��Income Tax Expense = Taxable GAAP Income * 0.4 �Income Tax Payable = Taxable IRS Income * 0.4��36,000 = Taxable GAAP Income *0.4 🡪 Taxable GAAP Income = 90,000�24,000 = Taxable IRS Income * 0.4 🡪 Taxable IRS Income = 60,000

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Temporary Differences = 60,000– 90,000 = (30,000)

EXAMPLE: DOMINIAK CASE

b) What was the depreciation expense in the Tax return?

GAAP Depreciation = 270,000

Temporary Differences = 30,000

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IRS Tax Code Depreciation = 300,000

EXAMPLE: DOMINIAK CASE

c) Did the temporary differences create a deferred tax asset or a deferred tax liability?

The book depreciation is 270,000 while the tax depreciation is 300,000. Since depreciation is an expense, this means that Taxable Income < "Book" Income.

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Dr Income Tax Expense 36,000

Cr Income Tax Payable 24,000

Cr Deferred Tax Liability 12,000

EXAMPLE: DOMINIAK CASE

d) What were the permanent differences for 2015?

Taxable GAAP Income = 90,000

Pre-Tax Income = 100,000

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Permanent Differences = Pre-Tax Income – Taxable GAAP Income = 100,000 – 90,000 = 10,000

EXAMPLE: DOMINIAK CASE

e) Did the permanent differences create a deferred tax asset or a deferred tax liability?

Neither – only temporary differences create a DTA/DTL.

VALUATION ALLOWANCE

• Valuation Allowances are tied to the concept of Deferred Tax Asset:
• A DTA is essentially an item on your balance sheet that represents you’ve recognized more taxes in your income state (i.e., income tax expense) than you’ve paid to the IRS – so the balance in DTA can be allocated to cover a portion of future taxes��
• If a company is profitable, they will expect to use their DTA’s in the future – but what if they expect to make losses? Then the DTA will go to waste
• Thus, we need to set up an account called “Valuation Allowance” that recognizes the amount of DTA the company expects to not be able to use because they expect to make losses in the future (and thus, will lose out on those DTA benefits)��
• An increase (decrease) in valuation allowance will increase (reduce) tax expense and hence reduce (increase) net income --> although very subjective, we can say that an increase in valuation allowance might signal that the company has negative expectations about their future profitability because they are estimating that a larger amount of their DTA’s will not be collected