Income Taxes - II - NBA 500: Intermediate Accounting Mark...

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Unformatted text preview: NBA 500: Intermediate Accounting Mark W. Nelson INCOME TAXES II 1. IDX(a): Interpreting temporary differences (including N OLs). “Accounting Issues: President Obama and Congress...:” example of a change in N 0L carryback provisions designed to produce economic stimulus (note: much is just borrowing from the future, but can have big effects on current-period cash flow and tax expense). “GM’s Latest Incentive Plan” highlights how valuable NOL carryforwards can be. 2. IDX(b-d): reconciling tax entry from operations with non-operations tax effects. The approach taught in the schematic does not always appear to have been applied by firms, because firms have other tax effects besides continuing operations. These include tax effects of items disclosed below income from continuing operations (like extraordinary items and discontinued operations) and items that affect comprehensive income but not net income (like unrealized gains and losses on available-for—sale securities). 3. IDX(e): Valuation allowances. These are contra to DTAs, valuing the DTA down to the amount the firm believes they will be able to realize in future periods. Firms must assess whether they will have enough taxable income in future periods to soak up the tax deductions arising from the DTA. As noted on the schematic, sources of taxable income in future periods include taxable income generated from ordinary operations, reversal of DTLs that increase taxable income, and carry backs and carry forwards of any remaining future loss (i.e., NOLs). Illustration of Double Big Bath highlights that the dependence of valuation allowances on income projections allows for a potential for earnings management. For example, consider the illustration of a “double big bath” included in your course packet. We normally think of “big baths” (e.g., large writeoffs and restructuring charges) as reducing net-of—tax earnings in the year the bath is taken. However, the vague “more likely than not” criterion allows a “double big bath,” where a firm recognizes a big expense, decides it isn’t “more likely than not” that sufficient future income will be earned to allow the future tax benefits of the expense to be realized, and so sets up a big valuation allowance which offsets the DTA, and increases tax expense. The result of a double big bath is that earnings are reduced by the gross amount of the restructuring charge in the year the charge is taken, and future year earnings can be inflated by decreases in the valuation allowance that reduce future tax expense. 4. IDXU): effective tax rates are effected by permanent differences, as well as by valuation allowances and other limitations on firms’ ability to realize tax benefits. Therefore, it is not typically a very good proxy of the marginal tax rate that would apply to a particular transaction, so we focus on “federal + incremental state”. “Unexploded Ordnance”: example of a (potentially impermanent) permanent difference. US companies pay tax at the US rate on worldwide earnings, but only when they repatriate the earnings. They can avoid accruing tax expense (i.e., avoid debiting tax expense and crediting a DTL) if they can provide sufficient evidence that they have or will reinvest the earnings indefinitely in the foreign operations, such that US tax will never be payable. This shows up as a “permanent difference” and lowers the effective tax rate (because the before-tax income from the foreign earnings is included in the firm’s before-tax income, but no tax expense is recognized on the firm’s tax expense line). However, if the firm eventually chooses to repatriate the earnings (i.e., via payments of dividends from a foreign subsidiary to a US parent), there is an effect on tax payable and therefore tax expense, which increases the effective tax rate (because the amount is included in tax expense, but there may be no foreign earnings included in the firm’s before—tax income). Note: research (Krull, Accounting Review 2004) suggests that firms time repatriation to manage earnings. 5. IDX(g): Under SFAS No. 109, if tax rates increase (decrease), deferred tax assets and liabilities increase (decrease). Tax expense is always a plug, so the effect of tax rate changes flow through income in the year of the change. These income effects can be anticipated by watching changes in enacted tax rates. IDX Systems Corporation: Solution a) For each of the following items in lDX’s listing of “significant components of the Company’s deferred tax assets," determine (1) whether the item is a DTA or DTL, and (2) whether the item results in a future taxable amount or future deductible amount. Also speculate as to the underlying accounting event that would create this timing difference. 1) Allowances and accruals of $5026: DTA, future deductible amount. This would be caused by expenses being accrued for accounting purposes but not yet deductible for tax purposes (e.g., inventory writedowns), such that future taxable income will be lower than accounting income when the firm can take the tax deduction. 2) Deferred revenue of $1805: DTA, future deductible amount. This would be caused by receiving cash that is included in taxable income and is associated with revenue that has not yet been earned, such that accounting income is lower than taxable income in the period in which the timing difference arises. 3) Depreciation of $35 10: DTL, future taxable amount. This would be caused by taking faster depreciation deductions for tax purposes than the expense taken for accounting purposes, such that future taxable income will be higher than future accounting income. 4) Net operating loss carry forwards: DTA, future deductible amount. This would be caused by the firm having a loss on their tax return in a prior year. NOL (“net operating loss”) carry back or carry forward is allowed by the government to not penalize volatile earnings streams. Typically firms are allowed to carry back NOLs 2 years (thus obtaining an irmnediate tax refund) and/or carry forward NOLs 20 years (thus offsetting future taxable income with the loss). Carry backs result in an immediate tax refund (essentially reducing prior taxable income, and therefore prior taxes), while carry forwards result in a DTA (reducing future taxable income). Normally firms choose a carry back, because they get an immediate tax refund, but if tax rates are higher in the near future firms may choose carry forward. In the year the NOL arises, the firm will recognize a tax refund receivable (if carrying some NOL back) and/or a DTA (if carryng some NOL forward), and will plug for tax benefit (a credit, opposite of tax expense because this is the tax benefit that accompanies a loss). Tax refund receivable (= amount of NOL carried back * applicable tax rates) DTA (= amount of NOL carried forward * applicable tax rates) Tax expense (plug, acts as “negative tax expense”, reducing loss on US) 5) Research and experimentation credits: DTA, future deduetible amount. This is a tax credit (reduction of taxes payable) that the firm gets for expenditures associated with qualifying technological research. Typically we would expect this to run through the firm’s statutory rate reconciliation as a permanent difference, but there appears to have been some cap on the amount of credit IDX could take in prior years, such that they can only take those as a reduction of fiiture taxes. Therefore, given that these amounts will reduce future taxes payable, they are viewed as DTAs. b. From IDX’s summary of the provision (benefit) for income taxes, write a journal entry that records IDX’s’s income tax expense associated with continuing operations during 2003, making any entry involving deferred taxes to “net deferred taxes.” Net deferred Taxes 10,967 Tax Payable 10,529 Tax expense/benefit 438 c. Regarding IDX’s deferred tax balances: 1) What is the net deferred tax balance as of 12/31/03, and where is that balance disclosed on the balance sheet? $17,303, disclosed as $5899 net current DTA and $11,404 net non-current DTA. 2) What is the net deferred tax balance as of 12/31/02, and where is that balance disclosed on the balance sheet? $3 603, disclosed as $2033 net current DTA and $1570 net non-current DTA. 3) Compare IDX’s net deferred tax balance between year-end 03 and 02. Why doesn’t the change in deferred tax balances equal the entry to net deferred taxes in your answer to question 13‘? Change in deferred taxes of $17,303 — $3603 = $13,700 is $2733 higher than the $10,967 included in answer to question b. This occurs because question b addressed only income taxes fi'Om continuing operations, but the deferred tax accounts would also be affected by (1) “below the tax line” items reported on the income statement, and (2) “comprehensive income” items that circumvent the income statement and are reported directly (net of tax) in owner’s equity. In the case of IDX, it appears that the difference is driven by the discontinued operation reported on the income statement. d. Write a journal entry that recognizes tax expense associated with IDX’s discontinued operation during 2003. Note: for this problem, ignore any “comprehensive income" items that [DX reports in owner’s equity. (6 points) IDX’s total net deferred tax asset increased during 2003 by $17,303 — 3603 = $13,700. Deferred Tax 2733 ($13,700 — 10,967) Tax Payable 117 (plug) Tax expense/benefit 2616 (from reconciliation of tax expense; also equal to $2733 — 117 in note 2) Note: could also view as two separate journal entries: Deferred Tax 2733 Tax expense 2733 Tax expense 1 17 Tax payable 1 17 e) [DX decreased their valuation allowance by $19,100 - $6,033 = $13,067 during 2003. (Note: if you need a tax rate during this problem, use t = 40%.) 1) What effect did that have on 2003 net income? (state “increase”, “decrease”, or “no change”, and indicate the amount of the change) Can View as making the journal entry: Valuation Allowance 13,067 Tax expense 13,067 Decreased tax expense by $13,067, so increased net income by $13,067. 2) To be able to decrease their valuation allowance by $13,067 during 2003, how much additional fiiture taxable income must IDX have concluded during 2003 is “more likely than not” to be realized? $13,067 / .4 = $32,667.50. 4 3) On what did IDX base their conclusion that future income will be more likely than not? Do you believe their basis is adequate? "This reversal is primarily due to the Company’s expectation that future taxable income will be sufficient to recover its deferred tax assets, except for certain state items discussed below. The company has generated on a cumulative basis pre-tax income from continuing operations for the three years ended December 31, 2003.” 4) Could IDX manipulate net income in 2003 using their valuation allowance and their future income projections? Yes, in whatever period they conclude that future income is “more likely than not,” IDX can decrease tax expense and increase income. 5) As of year-end 2003, IDX retains a valuation allowance of $6033. They justify this valuation allowance as follows: “The company believes that the available objective evidence creates sufficient uncertainty regarding the realization of certain deferred tax assets such that a partial valuation allowance has been recorded. Management believes it is more likely than not that the deferred tax asset will be realized.” Given your understanding of SFAS No. 109, do these statements contradict each other? Explain briefly. Yes. If it is more likely than not that the deferred tax asset will be realized, no valuation allowance should be recognized. f. Regarding lDX’s reconciliation of the federal statutory rate to the effective income tax rate fi'om continuing operations, 1) What is lDX’s effective tax rate in 2003? Calculate that rate fi'om information on the income statement. (438)/31,237 = -1 4% 2) How would the effective tax rate be affected by a permanent difference whereby revenue is recognized for financial accounting purposes but never taxable? View before-tax accounting income as the constant. Such non-taxable revenue would make taxable income lower than before-tax accounting income. The low taxable income would result in low tax payable, and (since there are no deferred-tax implications for a permanent difference), we would plug for lower tax expense. In other words, we can view this permanent difference as having the effect of the following journal entry: Tax payable x Tax expense x (plug) Since tax expense is decreased, the permanent difference would serve to decrease the effective tax rate that is computed by dividing (lower) tax expense by (constant) before-tax accounting income. More generally, permanent differences that decrease taxable income relative to accounting income serve to decrease the effective tax rate; permanent differences that increase taxable income relative to accounting income serve to increase the effective tax rate. It appears that IDX has “other, ne ” permanent differences whereby taxable income is higher than accounting income, increasing the effective tax rate by 1.6%. 3) Why was the effective tax rate decreased by a decrease in valuation allowance? When there is no valuation allowance, deferred tax assets and liabilities change in a way that matches tax effects to the period in which the related expense or revenue is shown on the income statement. Thus, holding everything else constant, DTLs and DTAs provide a tax expense equivalent to that which would be obtained fiom applying the relevant marginal tax rate to before-tax net income. When a valuation allowance increases, that valuation allowance prevents the tax benefit from future deductions from being matched against the related revenue or expense, so tax expense is higher. As a result, tax expense is a higher proportion of before-tax net income, and the effective tax rate is higher than would be implied by the relevant marginal tax rate. Tax expense x (plug) Val allowance x When a valuation allowance decreases, the opposite is true. In this case, tax expense is decreased, so tax expense is a lower proportion of before-tax net income, and the effective tax rate is lower than would be implied by the relevant marginal tax rate. Val allowance x Tax expense X (plug) More generally, increases in valuation allowance serve to increase the effective tax rate, and decreases in the valuation allowance serve to decrease the effective tax rate. 4) (challenging — think of this one as a stretch problem!) Why was the effective tax rate decreased by “Utilization of previously reserved net operating losses and current year research and experimentation credits”? I am inferring that this really mixes together two things. The first part is “utilization of previously reserved NOLs.” This implies that, in previous years the firm had recognized a DTA for NOLs, and also set up a valuation allowance that offset that DTA. Normally, setting up a DTA would reduce tax expense, but the valuation allowance offset the DTA such that there was no effect on tax expense: DTA x Valuation allowance x Now the firm is using up that DTA to reduce tax payable. They therefore also need to reduce the related valuation allowance: Tax payable x DTA x Valuation allowance x Tax expense x Note that using up the DTA doesn’t affect the effective tax rate, but as indicated in the answer to e(3) above, reducing the valuation allowance decreases the effective tax rate by reducing the numerator (tax expense) but not the denominator (BTNI). The second part is “utilization of current year research and experimentation credits.” Given that these are described as “current year," I believe that they are new credits that are permanent differences, so they reduce the effective tax rate by reducing tax payable and therefore tax expense in the current year: Tax payable y Tax expense y 5) Estimate the marginal tax rate that would apply to an ordinary sale made during 2003. (3 points) 35% federal + 4.4% incremental state = 39.4%. g) Assume that, on 12/31/03, Congress enacts a law that immediately reduces the federal tax rate that applies to 2004 and all subsequent years from 35% to 30%. Write a journal entry that records the effect of that rate change on tax exPense and “net deferred taxes.” How will the tax rate change affect net income? General appro ach: 01d DTA = (told)(net future deductible amount), so net future deductible amount = old DTA / told new DTA = (tnew)(net future deductible amount) new DTA = (tnew)(old DTA / told) = (old DTA) (tnew / told) New net DTA = ((30 + .044)/(.35 + .044))($17,303) = $15,107. DTA needs to decrease by $17,303 - $15,107 = $2,196. Tax expense 2196 Net deferred taxes 2196 Net income will decrease by 2196. ...
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This note was uploaded on 05/18/2011 for the course NBA 5000 taught by Professor Nelson,mark during the Spring '11 term at Cornell University (Engineering School).

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Income Taxes - II - NBA 500: Intermediate Accounting Mark...

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