Financial Income Tax Reporting

Financial Income Tax Reporting - FINANCIAL INCOME TAX...

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Unformatted text preview: FINANCIAL INCOME TAX REPORTING Introduction The objective of financial income tax reporting is to best depict the underlying economics experienced by a Company regarding its income taxes. In contrast, the objective in preparing the tax report required by Revenue Canada is to minimize a Company's tax liability while complying with their mandated rules and procedures. Historically, a company selected from one of the following two fundamental approaches available for the financial reporting of income taxes, namely, the Taxes Payable Method and the Interperiod Tax Allocation - Deferral Method. Another interperiod tax allocation approach also available, the Accrual Method, is a variant of the Deferral Method and is discussed later. 98 Definitions of Terms and Methods Prior to the release of Handbook Section 3465 the following terms and methods were used in reporting for taxes. Accounting Income (AI). Income reported in the financial report before the provision for taxes, but after excluding any permanent differences. Taxable Income (TI). Income reported to Revenue Canada and used to determine a company‘s tax liability. Permanent Difference. A difference between accounting and taxable incomes caused by a revenue or expense item being included in the computation of one of the two incomes that will never be included in the computation of the other. Timing Difference. A difference between accounting and taxable incomes for a period caused by a revenue or expense item being included in the computation of one of the two incomes that will not be included in the other until some later period. Tax Liability. Taxes owed to Revenue Canada which is derived by taking the product of taxable income and the tax rate and then subtracting any available tax credits such as those provided by tax loss carryovers. Tax Provision (Expense). Tax reported in the financial statements. The term provision is a good choice given the various views held on what a tax represents, namely, expense, distribution, or confiscation. Taxes Payable Method. A method where the tax provision is equal to the taxes payable. Assuming no tax credits are available, the tax provision equals taxable income times the tax rate (TI x t). 99 Deferral Method. A method where the (ideal) tax provision is equal to accounting income times the tax rate (Al x t). Deferred Taxes (D/I‘). The product of the difference between accounting and taxable incomes and the tax rate. Algebraically, Dfl‘ = [AI-TI] x t where t is the tax rate. Uniform Reporting In 1968, the CICA decided that the financial reporting of taxes should be uniform. All firms would thereafter be required to use the mandated method for reporting taxes. Selecting among the methods available, the CICA used the attribute of comparability in making their policy choice. This attribute is meant to assist a user in comparing the performance of one firm with itself over time or the performances of different firms at one point in time. Although the resulting uniformity, might in itself, enhance comparability; it was the Ideal Tax Line which relates pretax income (A1) with after tax income (Al - Tax Provision) that the Institute used in assessing each method‘s ability to provide comparability. Letting}; denote the tax‘rate, this Ideal Tax Line can be expressed algebraically as After-tax Income = (l - t) Pre-Tax Income 100 and is depicted graphically as Afiw’l‘ax Imam: where the slope of the line is H In the positive quadrant, pretax income is greater than after tax income, whereas, in the negative quadrant, the pretax income is less than after tax income. To satisfy this ideal, it would be necessary for the gOVernment to not only tax profits, but also subsidize losses. Assuming this standard is achieved, a Company reporting twice the pretax income in one year as compared to another will report twice the after-tax income. Similarly, if two or more companies report the same prevtaxwincome in one year, they will all report the same after—tax income. This comparability standard, in essence, eliminates the effect of taxes on assessing the company‘s relative performance. In other words, comparing a Company‘s after—tax income performance with itself or some other company results in the same relative comparison as if the pre—tax income performance was used. Once adopted to ascertain the relative merits of the competing Taxes Payable and Deferral Methods, this standard results in a fait accompli. That is, any simple hypothetical example can be contrived to demonstrate the superiority of the Deferral Method in meeting this standard. For example, given the following data: 101 Year 1 2 3 4 5 Accommng Income 500 500 500 500 500 Plus Depreciation 1 00 l 00 100 l 00 l 00 Less Capital Cost Allowmxce ‘ 92002 g 1501 1 100! L591 L01 'l‘axable Income 49$} M 500 £50 603 karate-«50% ‘ Capital Cost Allowance is depreciation for tax reportmg. Total 2,500 500 $500[ The entries for both methods, definitions used to calculate amounts, the Deferred Taxes account, and summations are as follows: Entries (All Recorded at Year End): XE; Taxes Payable Methg 1 Tax Provision 200 250 Taxes Payable 200 Deferred Taxes 2 Tax Provision 225 250 Taxes Payable 225 Delened Taxes 3 Tax Provision 250 250 Taxes Payable 250 Deferred Taxes 4 Tax Provision 275 250 Taxes Payable E275 Deferred Taxes 5 Tax Provision 300 250 Tmces Payable 300 Delerred Taxes W 275 (25) ' 300 (50) ' 102 ' Brackets indicate a debit in this context. Definitions Employed: Tax Liability: Taxes Payable 2 TI x t Taxes Payable Method: Tax Provision = TI x t Deferral Method: Tax Provision = Al x t Deferred Taxes = (Al « TI) x t Note: In year 4, the timing difference depicted by the Deferred Taxes account reverses itself. Deferred Taxes [Cumulative (AI - TI) x tave] Year 1 balance Year 2 balance Year 3 balance Year 4 balance Year 5 balance 103 Recapitulation of Methods Taxes Payable Method Yeant .1. .2. 9. 1 Income before Taxes 500 500 500 500 Less Tax Provision 29,9 22; gig _2_7_5_ Net Income M Q ggg g3; Deferral Method Year .1. .2. .3: .4 Income before Taxes 500 500 500 500 Less Tax Provision go go go 259 Net Income 241.0 .2320 Q0 32.1.2 I EEI§§M I'll EE All 2,500 1,250 hill For the Deferral Method, all points (x = pro-tax income, y = after—tax income) fall on the Ideal Tax Line, whereas, for the Taxes Payable Method all points except one fall above or below the line. Therefore, the Deferral Method was the anointed winner and became, at that time, the CICA mandated method (see Handbook Section 3470 Recommendations). located in Superseded Accounting 104 CICA Tax Reporting Requirements The new CICA reporting requirement (see Handbook Section 3465) for accounting for income taxes emphasizes the Balance Sheet through the use of future income tax liabilities and assets and forces {the Income Statement to articulate with it. Under the replaced requirement (see Handbook Section 34 70) the emphasis was just the opposite. New terminology which is discussed below has been introduced to accommodate this Balance Sheet emphasis. However, the only substantive change has been to replace the deferral with the accrual method of accounting for taxes. New Terminology Under the new method, the Tax Expense (Benefit) formerly called Tax Provision is equal to the Current Tax Expense plus Future Tax Expense where the Current Tax Expense equals Taxable Income times the current tax rate (T I x a) and the Future Tax Expense equals the change in the Net Taxable (Deductible) Difference times the current tax rate plus the Net Taxable Difference beginning balance times the changes in the tax rates (Leno — t”). The Tax Basis of an Asset, although not defined by the CICA, is, in general, any amount relating to the asset that will be deductible for income tax purposes in future periods. The Tax Basis of 3 Liability is its carrying amount less any amount relating to the liability that will be deductible for income tax purposes in future periods. Temporary Differences are differences between the tax basis of an asset or liability and its carrying amount in the balance sheet. Temporary differences may be either: 105 (i) Deductible Temporary Differences, which are temporary differences that will result in deductible amounts in determining taxable income of future periods when the carrying amount of the asset or liability is recovered or settled; or (ii) Taxable Temporary Difl’erences, which are temporary differences that will result in taxable amounts in determining taxable income of future periods when the carrying amount of the asset or liability is recovered or settled. Future Income Tax Assets are the amounts of income tax benefits arising from: (i) deductible temporary differences; (ii) the carryforward of unused tax losses; and (iii) the carryforward of unused income tax reductions, except for investment tax credits. Future Income Tax Liabilities are the amounts of income taxes arising from taxable temporary differences. The Tax Shield is any amounts relating to an asset or liability that will be deductible for income tax purposes in future periods. It, in essence, shields income from being taxed. Tax Basis of an Asset Clarified The carrying value of an asset can be viewed as a future taxable income stream which from a tax point of View results in a future disbenefit, namely, the tax. Associated with the asset is a tax shield, that is, unused tax deductions which when deducted in the future will provide tax relief, a future tax benefit. The tax basis of an asset is deemed to be its shield. 106 Temporary differences for an asset arise when there is a difference between the carrying value and the tax basis. If the carrying value exceeds the tax basis (i.e., future taxable income exceeds future tax deductions) then this difference times the tax rate will result in a tax being owed, thus a future tax liability. On the other hand, if the tax basis exceeds the carrying value this difference times the tax rate will result in a future tax credit, thus a future tax asset. Algebraically, Temporary Difference: Carrying Value - Tax Basis = Carrying Value - Shield Case of Two Assets - 40% Tax Rate: Assume, there are two physically identical assets each with a carrying value of $1,000; one has a tax basis of $1,000, whereas, the other has a zero tax basis. Furthermore, assume both assets Can generate, in the future, taxable income equal to their carrying values. The asset with the $1,000 tax basis will provide a tax shield such that the future after tax benefit of the asset is equal to its carrying value of $1,000. In comparison, the unshielded asset will be taxed $400, providing an after tax benefit of only $600, an amount less than its carrying value. Since the future after tax benefits differ, a future tax liability is recognized in the unshielded asset case to account for the difference. Tax Basis of a Liability Clarified The carrying value of a liability can be viewed as the maximum amount that can be deducted for tax purposes over the life of the liability, whereas, its tax shield represents the unused deductions to date. Recall, unused tax deductions result in future tax relief, thus the tax shield provides a future benefit. The tax basis of a liability is defined as the diflerence between its carrying value and its shield and is equal to the expired (used) deductions to date which is exactly opposite of the tax basis of an asset. 107 Temporary differences for a liability arise when there is a difference between the carrying value and the tax basis. Algebraically, Temporary Difference = Carrying Value - Tax Basis = Carrying Value - (Carrying Value - Tax Shield) = Tax Shield or Temporary Difference = Maximum Deductions - (Maximum Deductions ~ Unused Deductions) 2 Maximum Deductions - Used Deductions = Unused Deductions Thus, this difference times the tax rate provides future tax relief, a benefit, resulting in a future tax asset. Case of Two liabilities - 40% Tax Rate: Assume, there are two liabilities each with a carrying value of $1,000; one has a tax basis of $1,000 and thus a zero tax shield, whereas, the other has a zero tax basis and thus a $1,000 tax shield. Each will require a $1,000 cash outflow, a disbenefit, to extinguish the debt when it comes due. The liability with the $1000 tax basis will not provide any future tax relief. Accordingly, its after tax disbenefit is equal to its carrying value. In comparison, the liability with the zero tax basis will shield future taxable income by $1,000, reducing the taxes owed by $400. Thus, the future tax relief inherent in this liability results in an after tax disbenefit of $600, an amount less than its carrying value. Since the future after tax benefits differ, a future tax asset is recognized in the shielded liability case to account for the difference. 108 Example: The following comprehensive example illustrates the new approach while comparing it with both the Deferral and Accrual Methods of accounting for intenperiod tax allocations. Plant assets are depreciated for accounting purposes at 10% a year on a straight—line basis and at 20% a year on a declining balance basis for tax purposes subject to the "half year rule" in the year of acquisition. For other transactions assume for financial reporting the Sales—Accrual Method is used, whereas, for tax reporting assume the cash basis is used. Also assume a tax rate of 40% in year 1 and a 50% tax rate in year 2. YEAR 1 Pre—tax Entries: Cash 12,000 Capital received from stockholders 12,000 Equipment 10,000 Cash 10,000 Accounts Receivable 10,000 Sales 10,000 Cash 8,000 Accounts Receivable 8,000 Inventory 8,000 Accounts Payable 8,000 Accounts Payable 5,000 Cash 5,000 Wage Expense 2,000 Wage Payable 2,000 Wages Payable 1,800 Cash 1,800 CGS-Ex 6,000 Inventory 6,000 Depreciation Expense 1,000 Accumulated Depreciation 1,000 100 Deferral and Accrual Methods Financial Reporting ' Tax Reporting Sales $10,000 Cash Collected $ 8,000 Less Expenses: Less Cash Paid: CGS (6,000) Inventory (5,000) Wage (2,000) Wages (1,800) Depreciation (1,000) Capital Cost Allowance _(_LQO_Q_) Accounting Income fl Taxable Income LM Under both the Deferral and Accrual Methods the Ideal Tax Provision equals Accounting Income times the current tax rate (i.e., Al x ti). Departures from the ideal can arise when the tax rates change over time. The two methods differ in how they account for these changes in rates. With Deferral, the Deferred Taxes balance is equal to the cumulative difi’erence between accounting and taxable incomes times the weighted average of the tax rates used during accumulation, whereas, with Accrual, the balance is equal to the cumulative difi‘erence between accounting and taxable incomes times the current tax rate. Specifically, each year, during the period of deferred tax accumulation, the Deferral Method uses the current tax rate in determining the amount of increase to the Deferred Taxes account. Moreover, no adjustment is made to the beginning Deferred Taxes balance to reflect rate changes in those years they occur. Thus the Ideal Tax Provision is achieved and the Deferred Taxes balance is equal to the cumulative difference between accounting and taxable incomes times the weighted average of the rates used during accumulation. However, when a timing reversal occurs the balance must be drawn down at the average rate rather than the rate current for that year which, in turn, causes the reported tax provision to depart from the ideal. In contrast, the Accrual Method does make an adjustment to the beginning Deferred Taxes balance to reflect rate changes when they occur. Although the adjustment results in the balance always being equal to the difference between cumulative accounting and taxable incomes times the current tax rate, it also causes the reported tax provision to depart from the ideal at that time. HO T ax Provision ($1,000 x .40) 400 Taxes Payable ($200 x .40) 80 Deferred Taxes ($1,000 — 200) x .40 320 Taxes Payable 80 Cash 80 Deferral ” Accrual Cumulative (AI - TI) x tWe Cumulative (AI - TI) x tt Deferred Taxes Deferred Taxes 320 320 New Method Taxable (Deductible) Am 92mm mass m Cash $ 3,120 NA. NA. Accounts Receivable 2,000 0 2,000.» Inventory 2,000 0 2,000“ Equipment (Net) 9,000 9,000 0 a W $290 Accounts Payable $ (3,000) 0 0 (3,000)“ Wages Payable (200) 0 (200)“ Net Future Income Tax Liability (320)' NA. NA. Capital Received (12,000) N .A. N .A. Retained Eanungs £6 2 NA. Edi: £13,420; m (1) When the Accounts Receivable is written off, the proceeds will be included in taxable income, but no portion of the carrying amount will be tax deductible, thus creating this Taxable Temporary Difference. 111 (2) When the Inventory is written off through sale and the proceeds are collected, those proceeds will be included in taxable income, but no portion of the carrying amount will be tax deductible, thus creating this Taxable Temporary Difference. (3) In year 1 the depreciation and capital cost allowance are the same, thus the carrying value and the unused capital cost are equal. (4) 14 When both the Accounts and Wages Payable are written off upon payment, the payment will be tax deductible, thus creating this Deductible Temporary Difference. * Taxable Temporary Difference $4,000 Deductible Temporary Difference (3,200) Net Taxable Temporary Difference 800 , x .40 Net Future Tax Liability £43224) After all of this effort in understanding the new terminology one discovers that the Net Taxable Temporary Difference is equal to AI vTI. Accordingly, taxes reported under both the New and Accrual Methods are the same. Surely, this pronouncement has to be the accountants full employment guarantee. Current Tax Ex. (200 x .4) 80 Future BX. (800 x .4) 320 Taxes Payable (200 x 7.4) 80 Net Future Tax Liability from Temporary Difference (800 x .4) 320 Taxes Payable 80 Cash 80 Cumulative Net Taxable Temporary Difference x tt Net Future Tax Liability From Temporary Difference 320 112 YEARZ Recall, the year 2 tax rate is 50%. Pre—tax Entries: Accounts Receivable ‘fiales Cash Accounts Receivable Inventory Accounts Payable Accounts Payable Cash Wage Expense Wages Payable Wages Payable Cash CGS—EX Inventory Depreciation Expense p ‘ Accumulated Depreciation Financial Reporting Sales $ 11,000 Less Expenses: CGS (7,000) Wage (2,000) Depreciation 1 1 ,0001 Accounting Income 141$ 1 1,000 1 1,000 12,000 12,000 9,000 9,000 10,000 10,000 2,000 2,000 2,200 2,200 7,000 7,000 1,000 1,000 Tax Reporting Cash Collected SS 12,000 Less Cash Paid: Inventory (10,000) Wages (2,200) Capital Cost Allowance (1,8001 Taxable Income M 113 The Taxable Loss creates a potential tax benefit, that is, a credit of ($1,000) which is equal to the taxable loss times the tax rate [($2,000) x .5]. This credit can be carried back and forward over the carryover period. Deferral Method Taxes Receivable* (200 x .4) 80 Tax Provision (Loss) (200 x (.4 ~ 5)) 20 Future Tax Benefit (200 x .5) 100 Future Tax Benefit** 02,000 x .5) 1,000 Tax Provision (1,000 x .5) 500 Deferred Taxes ((1,000 — (—2,000)) x .5) 1,500 *Taxes Receivable is that portion of the potential tax benefit which is carried back and immediately realized. **Future Tax Benefit is that portion of the potential tax benefit which is carried forward and deemed to be realizable. Note: Since the tax rate is lower in the carryback period than it is in the loss period that portion of the tax benefit carried back cannot be realized in full. This results in a loss causing the Tax Provision to depart from the ideal by $20. Cumulative (AI - TI) tm Future Tax Benefit Deferred Taxes l ,000 100 320 900 I ,500 l .820“ * * * Year AI TI Difiemnce Rate D/I‘ Balance 1 l ,000 200 800 40% 320 2 l .000 52,000 3,000 50% l ,500 1-2 2,000 - l ,800 3,800 L. 1,820 to - 1820/3,800 - 47.89% 114 Note: If there is a timing reversal in the future, the deferred tax account is drawn down at the average rate of accumulation rather than the rate current for that year. This will cause the reported Tax Provision to depart from the ideal. Accrual Method Taxes Receivab1e* (200 x .4) 80 Tax Provision (Loss) (200 x (.4 c .5)) 20 Future Tax Benefit (200 x. .5) 100 Future Tax Benefit“ (~2,000 x .5) 1,000 Tax Provision (1,000 x .5) + (1,000 — 200) (.5 - .4) 580 Deferred Taxes ((1,000 - (4,000)) x .5 + (1,000 ~ 200) (.5 a .4) 1,580 * See previous page ** See previous page Note: The change in tax rates during the second year causes the reported Tax Provision to depart from the Ideal by $80. Also, electing to use the carryback causes the Tax Provision to depart from the ideal by an additional $20. Cumulative (AI - TI) x t; Future Tax Benefit Deferred Taxes 1,000 100 900 Cumulative *** Year _;A_I_ _'I_‘_I_ Difference Rate D/T Balance 1 1,000 200 800 40% 320 2 2,000 —1,800 3,800 50% 1,900 115 New Method Carrying Account Amount Cash $ 2,920 Taxes Receivable 80 Accounts Receivable 1,000 mverilory 4,000 Equipment Net M m Carrying Account Amount Accounts Payable $ (2,000) Net Futures Income Tax Liability* (1,000) Capital Received (12,000) Retained Earnings (1,0001 002%,} Taxable Temporary Difference Deductible Temporary Difference Net Taxable Temporary Difference Loss Carryforward Net Future Income Tax Liability Tax Basis NA. NA. 0 0 7,200 Tax Basis N .A. N .A. N.A. Taxable (Deductible) Temgoram Difference N .A. NA. 1,000 4,000 .__§Q_Q m Taxable (Deductible) Temgorafl Difference (2,000) N .A. N .A. “N413; new $ 5,800 (2,000) 3,800 x .50 $1,900 $( 1 ,800) x .50 (900) M Cumulative Net Taxable Temporary Difference x tt Net Future Tax Asset from Loss Carryforward 1,000 100 900 Net Future Tax Liability from Temporary Difference 116 Note: The Net Future Tax Asset from Loss Catryforward Account is set up as a contra to the Net Future Tax Liability from Temporary Difference Account Taxes Receivable (200 x .4) 80 Future Tax Expense (Loss) (200 x (.4 - .5)) 20 Net Future Asset from Loss Carryover (200 x .5) 100 Net Future Tax Asset from Loss Carryover (2,000 x .5) 1,000 Future Tax Expense (3,800 - 800) x .5 + 800 x (.5 - .4) 1,580 Current Tax Expense (—2,000 x .5) 1,000 Net Future Tax Liability from Temporary Difference (3,800 - 800) x .5 + 800 x (.5 ¢ .4) 1,580 In conclusion, there is no difference between the Accrual Method and the New Method except for terminology, procedure and emphasis, that is, the overall results are the same. 117 ...
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This note was uploaded on 08/02/2011 for the course ACCT 352 taught by Professor Freeman during the Summer '11 term at Windsor.

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Financial Income Tax Reporting - FINANCIAL INCOME TAX...

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