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Chapter16: Accounting for Income Taxes

Permanent Differences

So far, we've dealt with temporary differences between the reported amount of an asset or liability in the financial statements and its tax basis. You learned that temporary differences result in future taxable or deductible amounts when the related asset or liability is recovered or settled. However, some differences are caused by transactions and events that under existing tax law will never affect taxable income or taxes payable. Interest received from investments in bonds issued by state and municipal governments, for instance, is exempt from taxation. Interest revenue of this type is, of course, reported as revenue on the recipient's income statement but not on its tax return—not now, not later. Pretax accounting income exceeds taxable income. This situation will not reverse in a later year. Taxable income in a later year will not exceed pretax accounting income because the tax-free income will never be reported on the tax return.

 

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FINANCIAL
Reporting Case

Q3, p.873

   These permanent differences are disregarded when determining the tax payable currently, the deferred tax effect, and therefore the income tax expense. This is why we adjust accounting income in the illustrations that follow to eliminate any permanent differences from taxable income. Graphic 16-3 provides examples of differences with no deferred tax consequences.

Permanent differences are disregarded when determining both the tax payable currently and the deferred tax asset or liability.

p. 887

INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Non-tax Differences Affect Taxes. Despite the similar approaches for accounting for taxation under IAS No. 12, “Income Tax,”11 and U.S. GAAP, differences in reported amounts for deferred taxes are among the most frequent between the two reporting approaches. The reason is that a great many of the nontax differences between IFRS and U.S. GAAP affect deferred taxes as well.

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   For example, we noted in Chapter 13 that we accrue a loss contingency under U.S. GAAP if it's both probable and can be reasonably estimated and that IFRS guidelines are similar, but the threshold is “more likely than not.” This is a lower threshold than “probable.” In this chapter, we noted that accruing a loss contingency (like warranty expense) in the income statement leads to a deferred tax asset if it can't be deducted on the tax return until a later period. As a result, under the lower threshold of IFRS, we might record a loss contingency and thus a deferred tax asset, but under U.S. GAAP we might record neither. So, even though accounting for deferred taxes is the same, accounting for loss contingencies is different, causing a difference in the reported amounts of deferred taxes under IFRS and U.S. GAAP.

GRAPHIC 16-3
Differences without Deferred Tax Consequences

Provisions of the tax laws, in some instances, dictate that the amount of a revenue that is taxable or expense that is deductible permanently differs from the amount reported in the income statement.

 
 

  

Interest received from investments in bonds issued by state and municipal governments (not taxable).

 

  

Investment expenses incurred to obtain tax-exempt income (not tax deductible).

 

  

Life insurance proceeds on the death of an insured executive (not taxable).

 

  

Premiums paid for life insurance policies when the payer is the beneficiary (not tax deductible).

 

  

Compensation expense pertaining to some employee stock option plans (not tax deductible).

 

  

Expenses due to violations of the law (not tax deductible).

 

  

Portion of dividends received from U.S. corporations that is not taxable due to the dividends received deduction.12

 

  

Tax deduction for depletion of natural resources (percentage depletion) that permanently exceeds the income statement depletion expense (cost depletion).13



   To compare temporary and permanent differences difference between pretax accounting income and taxable income and, consequently, between the reported amount of an asset or liability in the financial statements and its tax basis that will not "reverse" resulting from transactions and events that under existing tax law will never affect taxable income or taxes payable., we can modify Illustration 16-1 to include nontaxable income in Kent Land Management's 2012 pretax accounting income. We do this in Illustration 16-5 on the next page. Note that the existence of an amount that causes a permanent difference has no effect on income taxes payable, deferred taxes, or income tax expense.

   To this point, we've seen that our objective in accounting for income taxes is to recognize the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions or events that already have occurred. To achieve the objective, we record a deferred tax liability or deferred tax asset for future taxable amounts or future deductible amounts that arise as a result of temporary differences. Permanent differences, on the other hand, do not create future taxable amounts and future deductible amounts and therefore have no tax consequences.

   You might notice here that because of the permanent difference, Kent's “effective” tax rate is less than its 40% statutory rate. The effective rate is the total tax to be paid (eventually), $56 million, divided by accounting income, $145 million, or 38.6%. Without the $5 million municipal bond interest, the effective rate would have been $56 million divided by $140 million, or 40%. Nontaxable revenues and gains, as we have for Kent, cause the effective rate to be lower than the statutory rate; whereas, nondeductible expenses and losses would cause the effective rate to be higher than the statutory rate. Companies report a comparison of their effective and statutory tax rates in disclosure notes, as in Graphic 16-4's example from Walmart's 2009 financial statements.

Permanent differences affect a company's effective tax rate.

p. 888

ILLUSTRATION 16-5
Temporary and Permanent Differences

Because interest on municipal bonds is tax exempt, it is reported only in the income statement. This difference between pretax accounting income and taxable income does not reverse later.

Kent Land Management reported pretax accounting income in 2011 of $100 million except for additional income of $40 million from installment sales of property and $5 million interest from investments in municipal bonds in 2011. The installment sales income is reported for tax purposes in 2012 ($10 million) and 2013 ($30 million). The enacted tax rate is 40% each year.

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GRAPHIC 16-4
Effective Tax Rate—Walmart

Real World Financials

 

Note 5: Income Taxes (in part)

Effective Tax Rate Reconciliation

A reconciliation of the significant differences between the effective income tax rate and the federal statutory rate on pre-tax income is as follows:

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p. 889

CONCEPT REVIEW EXERCISE

TEMPORARY AND PERMANENT DIFFERENCES

Mid-South Cellular Systems began operations in 2011. That year the company reported pretax accounting income of $70 million, which included the following amounts:

1.

 

Compensation expense of $3 million related to employee stock option plans granted to organizers was reported in the 2011 income statement. This expense is not deductible for tax purposes.

2.

 

An asset with a four-year useful life was acquired last year. It is depreciated by the straight-line method in the income statement. MACRS is used on the tax return, causing deductions for depreciation to be more than straight-line depreciation the first two years but less than straight-line depreciation the next two years ($ in millions):

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The enacted tax rate is 40%.

Required:

Prepare the journal entry to record Mid-South Cellular's income taxes for 2011.

SOLUTION

Because the compensation expense is not tax deductible, taxable income does not include the $3 million deduction and is higher by that amount than accounting income.

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Income tax expense is composed of: (1) the tax payable currently and (2) the tax deferred until later.

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11“Income Taxes,” International Accounting Standard No. 12 (IASCF), as amended effective January 1, 2009.

12When a corporation owns shares of another U.S. corporation, a percentage of the dividends from those shares is exempt from taxation due to the dividends received deduction. The percentage is 70% if the investor owns less than 20% of the investee's shares, 80% for 20% to 80% ownership, and 100% for more than 80% ownership.

13The cost of natural resources is reported as depletion expense over their extraction period for financial reporting purposes; but tax rules prescribe sometimes different percentages of cost to be deducted for tax purposes. There usually is a difference between the cost depletion and percentage depletion that doesn't eventually reverse.

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