Taxes and their Impact for Financial Analysis

Taxes and their Impact for Financial Analysis - Taxes and...

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Taxes and their Impact for Financial Analysis Introduction Taxable income is computed in accordance with prescribed tax regulations and rules, whereas accounting income is measured in accordance with generally accepted accounting principles. Unfortunately for accountants, tax regulations and accounting principles are not always in agreement. Due to the fact that tax regulations and generally accepted accounting principles differ in many ways, taxable income and financial income frequently differ. The following represent examples of events that can result in such differences: (a) depreciation computed on a straight-line basis for financial reporting purposes and on an accelerated basis for tax purposes, (b) income recognized on the accrual basis for financial reporting purposes and on the installment basis for tax purposes, and (c) warranty costs recognized in the period incurred for financial reporting purposes and when they are paid for tax purposes. The items discussed in the paragraph above can result in temporary differences between the amounts reported for book purposes and those reported for tax purposes. A temporary difference is the difference between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable amounts (increase in taxable income) or deductible amounts (decrease in taxable income) in future years when the reported amount of the asset is recovered or when the reported amount of the liability is settled. When the book amount of an asset or liability differs from the tax basis as a result of a temporary difference, the future tax effects on taxable income must be reported in the current financial statements. Deferred Tax Liability A deferred tax liability is the amount of deferred tax consequence attributable to the temporary differences that will result in net taxable amounts (taxable amounts less deductible amounts) in future years. The liability is the amount of taxes payable on these net taxable amounts in future years based on existing provisions of the tax law. The following example is presented to demonstrate the deferred tax liability concept. Assume that Bobbie Company earns $50,000 of net operating income before depreciation for each of five consecutive years. The company depreciates its fixed assets using the straight-line method for accounting purposes and an acceptable accelerated method for tax purposes over this five-year period. The following schedule shows taxable income, income tax payable, accounting income, and income tax expense for the five-year period assuming a 40% tax rate. 1
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Income Income Taxable Tax Accounting Tax Year Income Payable Income Expense 1 $ 40,000 $16,000 $ 44,000 $17,600 2 42,000 16,800 44,000 17,600 3 44,000 17,600 44,000 17,600 4 46,000 18,400 44,000 17,600 5 48,000 19,200 44,000 17,600 Totals $220,000 $88,000 $220,000 $88,000 At the end of year one the entry to recognize the tax expense and the tax liability is: Income Tax Expense
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This note was uploaded on 10/07/2010 for the course FIN 3162N taught by Professor Spencer during the Spring '10 term at Dowling.

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Taxes and their Impact for Financial Analysis - Taxes and...

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