Intermediate Accounting

Transcription

1 Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management, Dalhousie University PowerPoint slides by: Bruce W. MacLean, Faculty of Management, Dalhousie University

2 Chapter 17 Accounting For Tax Losses

3 Introduction When a corporation has a loss, a matching issue arises. A loss will normally have tax benefits, but the benefits may not be realized in the period of the loss. Should future benefits be recognized in order to achieve matching, or should their recognition be delayed in the interests of conservatism? This chapter begins with an explanation of the income tax benefits that arise from a loss. The focus in this chapter will be on the new CICA Handbook recommendations, which have been changed significantly with the introduction of section The new recommendations are much easier to implement than those of the older section 3470, which is being phased out by the year (Appendix to the Chapter)

4 Tax Loss Vs. Tax Benefits To help avoid confusion, it is necessary to keep track separately of the amount of the tax loss and the amount of the tax benefit. The tax loss is the final number of taxable loss on the tax return. The tax benefit is the present and future benefit that the company will be able to realize from the tax loss through a reduction of income taxes paid to governments. Basically: Tax benefit = Tax loss X Tax rate

5 Temporary Differences In A Loss Year It is quite possible for temporary differences (and permanent differences) to convert a pre-tax accounting profit to a tax loss. For example, assume the following facts for Michelle Ltd. for the fiscal year ending 31 December 20x8: Net income before taxes of $100,000, after deducting depreciation expense of $150,000; CCA totaling $280,000 deducted on the tax return; Net book value of capital assets of $1,700,000 and UCC of $1,200,000 on 1 January 20x8, a temporary difference of $500,000 that is reflected in an accumulated future income tax liability balance of $200,000 at 1 January 20x8; No permanent differences; Taxable income in the three-year carryback period of $360,000; and Tax rate of 40% in the current and previous years.

6 Temporary Differences In A Loss Year Michelle Ltd. s taxable income for 20x8 will be computed as follows: Accounting income subject to $100,000 tax Temporary difference: Depreciation +150,000 CCA 280,000 Taxable income (loss) $ (30,000) The CCA/depreciation temporary difference of $130,000 is recorded as usual, with an increase in the deferred tax credit balance on the balance sheet and a charge to the income tax expense for $52,000 (i.e., $130,000 40%): Income tax expense [I/S] 52,000 Future income tax liability capital assets 52,000 [B/S] The $30,000 tax loss is carried back, which results in a tax recovery (@40%) of $12,000: Income tax receivable carryback benefit [B/S] 12,000 Income tax expense [I/S] 12,000

7 Adjusting Temporary Differences Since the company had available taxable income in the carryback period against which the loss can be offset, good tax strategy calls for taking the maximum allowable CCA in 20x8 in order to obtain a refund of taxes previously paid. If the company did not have taxable income in the preceding three years a tax loss in 20x8 would not permit the company to realize any tax benefit in 20x8. Instead of having a tax loss, the company can simply reduce the amount of CCA that it deducts on its tax return for 20x8 by $30,000, from $280,000 to $250,000. CCA is an optional deduction, up to the permitted limit. A company will have a higher amount of undepreciated capital cost (and CCA) in future years if it claims less CCA in the current year.

8 Reducing CCA One way of increasing the likelihood that a company will fully utilize a carryforward is to eliminate CCA in the carryforward years. In some industries, CCA is very large, both in absolute amount and in relation to net income. Not claiming CCA has the effect of increasing taxable income, against which the carryforward can be used. After the carryforward benefits have all been realized, the company can resume deducting full CCA to reduce its future net income. A further strategy is to amend prior years returns to reduce or eliminate CCA. The relevant time frame is the three previous years, those to which carrybacks apply

9 Reassessment In Years Subsequent To The Loss Year If the future benefits of loss carryforwards are recognized in the year of the loss, the benefit should be given intraperiod allocation, as appropriate to the cause of the loss. Once the future tax benefit of a tax loss carryforward has been recognized as an asset, the asset is subject to review at each balance sheet date. If the probability of realization drops to 50% or less, the future income tax asset should be reduced [CICA (a)]. There is nothing unusual about this provision; assets are generally subject to review and to writedown if their value has been impaired. If an asset is unlikely to recover its carrying value, either through use or through sale, it should be written down.

10 EXHIBIT 17-1 Excerpt from Canadian National Railways Annual Report The 1997 annual report of Canadian National Railway Company (CN) provides an example of benefit recognition in a year that is neither the loss year nor the year in which the benefits are realized. CN s income statement includes the following lines shown in Exhibit The results for 1996 show a net income before income taxes of $142 million, increased by an income tax recovery MHR$694mi l li on. The report ednet i the pre-tax income In millions Income (loss) from continuing operations $ 746 $ 142 $ (1,111) before incom e taxes Income tax (expense) recovery from continuing (325) operations (Note 13) Income (loss) from continuing operations $ 421 $ 850 $ (1,092)

11 Recognition of the Future Benefits of Tax Loss Carryforwards Scenario 1: Assuming future recovery is Scenario 3: Partial recognition In judged to be probable in the year of the Scenario 2, we assumed that loss If the probability of realizing the future Parravano recognized all of the tax benefit of the carryforward > 50% when accumulated tax benefits in 20x6. It is the 20x5 financial statements are being possible, however, that a company s prepared, the estimated future benefit of management may decide that only the carryforward is recognized in the year part of the benefit is more likely than of the loss not to be recognized. Scenario 2: Assuming future recovery is Scenario 4: Write-off of previously judged to be improbable in the year of recognized benefit the loss, but becomes probable in the Like any other asset, the future benefit following year Now, suppose instead that, of a tax loss carryforward must due to Parravano s erratic earnings history, continue to have probable future realization not to be probable. The entry to benefit. If an asset no longer is likely record the tax benefit in 20x5 would then to be recoverable or realizable, it must be limited to the amount of taxes recovered be written down to its probable future through the carryback benefit

12 Which Tax Rate? What tax rate should be used to record the amount of a future tax asset or liability? The CICA Handbook recommends that future tax assets and liabilities should be recognized at the rate(s) that are expected to apply when the temporary differences reverse, which would normally be those enacted at the balance sheet date [CICA ]. The word normally is used because, in Canada, the government can announce changes in tax rates prior to the legislation actually being enacted. The CICA Handbook therefore refers to the substantively enacted income tax rate, and recommends that the substantively enacted rate be used instead of the actual rate at the balance sheet date.

13 Tax Rate Changes Once a future income tax asset has been recorded for a tax loss carryforward, the balance of that account must be maintained at the tax rate that is expected to be in effect when the carryforward is utilized. Suppose that the tax rate goes down to 38% before Parravano actually uses any of the carryforward. The asset will have to be revalued to $330,000 38%, or $125,400. This change will be included as part of the annual re-evaluation of the FIT asset or liability. Income tax expense ($132,000-$125,400)(I/S) $6,600 Future Income Tax Asset Carryforward Benefit (B/S) $6,600

14 Basic Illustration To illustrate the recognition of tax loss carryforward benefits over series of years, we will start with a fairly simple example that has no other temporary differences Dutoit Ltd. ($000 s) 20x1 20x2 20x3 20x4 Net income Before Taxes $100 -$300 $150 $250 Taxable Rate 45% 40% 42% 43% 20x1 was the first year of operations for Dutoit Assume that the tax rate for each year is determined during that year. For example, we do not know in 20x2 that the tax rate for 20x3 will be 42%.

15 Assuming Realization Is Not Likely Greater than 50% probability of not realizing the benefit 20x1 Income tax expense ($100,000 x 45%) 45,000 Income tax payable 45,000 20x2 Income tax receivable carryforward benefit ($100,000 x 45%) 45,000 Income tax expense (recovery) 45,000 unrealized tax loss carryforward of $200,000 20x3 Income tax on 42% is offset by loss carryforward benefit of the same amount entries offset 20x4 Income tax expense ($250,000 x 45%) 107,500 Income tax payable 107,500 Income tax payable carryforward benefit ($50,000 x 43%) 21,500 Income tax expense (recovery) 21,500

16 Assuming Realization Becomes Likely in 20x3 More likely (>50%) that tax loss benefit will be realized 20x3 Income tax expense ($150,000 x 42%) 63,000 Income tax payable 63,000 Income tax payable ($150,000 carryforward used x 42%) 63,000 Income tax expense (recovery) 63,000 20x4 Income tax expense ($250,000 x 43%) 107,500 Income tax payable 107,500 Income tax payable carryforward benefit ($50,000 x 43%) 21,500 Income tax expense (recovery) 21,500

17 Extended Illustration Birchall Inc. 20x1 acquire equipment costing $1,000,000 Depreciation straight line at 10% full year in year of acquisition CCA 20x1 $350,000 20x2 $200,000 20x3 $150,000 20x4 $100,000 Tax Rate 20x1 and 20x2: 40% 20x3 tax rate increases to 42% Earnings 20x1 $300,000 20x2 $(600,000) 20x3 $200,000 20x4 $600,000 Exhibit 17-2 shows the computation of Birchall s taxable income.

18 EXHIBIT 17-2 Extended Illustration Calculation of Taxable Income (Loss) and Taxes Payable 20x1 20x2 20x3 20x4 Tax rate (t) 40% 40% 42% 43% Accounting income (loss) subject to $ 300,000 $ (600,000) $ 200,000 $ 600,000 tax Temporary difference: + Depreciation 100, , , ,000 CCA 350, , , ,000 Taxable income (loss) for current year $ 50,000 $ (700,000) $ 150,000 $ 600,000 Income tax payable $ 20,000 Tax loss carryback used 50,000 Tax loss carryforward available (650,000) Tax loss carryforward used, 20x3 150,000 (150,000) Tax loss carryforward used, 20x4 500,000 (500,000) 0 Taxable income after tax loss carryforw ard 0 $ 100,000 Income tax payable $ 0 $ 43,000