Income Taxes Level I Financial Reporting and Analysis. IFT Notes for the CFA exam

Transcription

1 Income Taxes 2014 Level I Financial Reporting and Analysis IFT Notes for the CFA exam

2 Contents 1. Introduction Differences between Accounting Profit and Taxable Income Determining the Tax Base of Assets and Liabilities Temporary and Permanent Differences between Taxable and Accounting Profit Unused Tax Losses and Tax Credits Recognition and Measurement of Current and Deferred Tax Presentation and Disclosure Comparison of U.S. GAAP and IFRS Summary Next Steps This document should be read in conjunction with the corresponding reading in the 2014 Level I CFA Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and Chartered Financial Analyst are trademarks owned by CFA Institute. Copyright Irfanullah Financial Training. All rights reserved. Page 2

3 1. Introduction One of the key concepts we will discuss in this reading is deferred tax assets and liabilities. Deferred tax assets or liabilities arise because of differences in timing in recognizing revenues and expenses for financial reporting and tax reporting purposes. 2. Differences between Accounting Profit and Taxable Income Accounting Profit: It is also known as pretax income or earnings before tax (EBT) and appears on the income statement. Accounting profit is based on accounting standards. Taxable Income: It is the portion of income that is subject to income taxes under the tax laws where the company is operating. Why are accounting profit and taxable income different? Both report income before deducting tax expense, yet they are different because accounting profit is based on accrual method of accounting (revenues reported when earned and expenses when incurred). Whereas, taxable income is usually based on cash-basis accounting (revenue recognized when cash is collected and expense reported when cash is paid). A common reason for the difference between accounting profit and taxable income is that straight line depreciation is generally used in the calculation of accounting profit while accelerated deprecation is used in the calculation of taxable income. This can be illustrated through an example: A company buys an asset for 50. This asset is to be depreciated down to 0 in two years. The company uses straight line depreciation (25 each year) for accounting profit and accelerated depreciation (40 in year 1 and 10 in year 2) for tax reporting. As shown in the table below, the depreciation expense on the tax reporting side is much higher for the first year (2011) which results in a lower taxable income. In the second year (2012) the difference reverses. Copyright Irfanullah Financial Training. All rights reserved. Page 3

4 Accounting profit (Financial reporting) Taxable income ( Tax reporting) Revenue Revenue Cash expenses Cash expenses Straight Line Depreciation Accelerated Depreciation Profit before tax Taxable Income Provision for Income Tax Expense and Tax Payable Provision for income tax expense refers to tax expense shown on income statement which is created using financial reporting standards. It is calculated based on a given tax rate the accounting profit (profit before tax). Income tax payable is calculated based on a company s taxable income using the applicable tax rate. This is the amount that is generally paid to the tax authorities. Worked Example 1: Given a tax rate of 40%, what is the income tax expense and tax payable for 2011? Solution: For 2011: Income tax expense = 0.4*25 = 10. Income tax payable = 0.4*10 = 4 Deferred Tax Liabilities Note: This is an important section of this reading with high chances of testability. Deferred tax liabilities arise when accounting profit is temporarily higher than taxable income and hence the income tax expense (shown on the income statement) is temporarily greater than taxes payable (shown on the tax return). It is a liability because we pay less tax now, thereby creating a liability or an obligation to pay more in the future. Since the tax will be paid later, it is deferred. Copyright Irfanullah Financial Training. All rights reserved. Page 4

5 Such a situation can happen because: Revenue is recognized on income statement before being included on tax return (accrued/unbilled revenue). Expenses are tax deductible before being recognized on income statement. One example when this occurs is while using straight line depreciation for financial reporting and accelerated depreciation method for tax reporting. Elaborating the example we have seen earlier, we have the table below: Accounting profit (Financial Reporting) Taxable Income ( Tax Reporting) Revenue Revenue Cash expenses Cash expenses Depreciation (SL) Depreciation (Acc. Dep.) Profit before tax Taxable Income Tax expense Tax payable 4 16 Profit after tax Profit after tax 6 24 In the table above, what you see on the right is the actual tax paid and to the left is the income tax expense. Tax paid at the end of 2011 is 4 which is less than the obligation to pay i.e. 10. Extra $6 in taxes which is not paid becomes the deferred tax liability; so, at the end of 2011 DTL is 6. At the end of 2012, the total tax paid is 16, and the DTL of 6 from 2011 reverses to 0. DTL condition: Income Tax Expense (ITE) > Income Tax Payable (ITP) Deferred Tax Assets Deferred tax assets (DTA) arise when income taxes payable is temporarily greater than income tax expense. In other words, taxable income is higher than accounting profit. Since tax is paid in Copyright Irfanullah Financial Training. All rights reserved. Page 5

6 advance, it is considered an asset; it can be viewed as a prepaid expense. Such a situation can happen when: Revenue is taxed before being recognized on income statement (unearned revenue). A company may receive payments in advance but has not delivered the services yet. The tax authority may require the company to pay taxes since cash is received in advance; as a result, revenue recognized on the tax reporting side is higher. So, initially the tax payable is higher for the higher recognized revenue than the tax expense. In the future, when services are delivered, tax payable is less than tax expense on the financial reporting side. Expense is recognized before being tax deductible (accrued expense). The table below illustrates the creation of a deferred tax asset. Accounting profit (Financial Reporting) Taxable Income ( Tax Reporting) Revenue Revenue Cash expenses Cash expenses Profit before tax Taxable Income Tax expense (40%) Tax payable Profit after tax Profit after tax In contrast to DTL, here tax paid in 2011 is 28, higher than the expense of 20. The additional $8 of taxes is considered a deferred tax asset. This can be thought of as roughly analogous to a prepaid expense. At the end of 2012, the tax paid is less (12 versus 20) and the deferred tax asset of 8 is reversed. DTA condition: Income Tax Payable (ITP) > Income Tax Expense (ITE) Tax Base of an Asset: Tax base of an asset is the value at which an asset is valued for tax purposes. It is used to calculate tax payable. It is analogous to the carrying amount (net book value) concept. Copyright Irfanullah Financial Training. All rights reserved. Page 6

7 Worked Example 2: An asset is purchased for 50 and is depreciated over two years. On the financial statements, the depreciation is 25 and 25. According to tax rules, the depreciation is 40 and 10. Show the carrying amount and tax base at T = 0, T = 1 and T = 2. Solution: The table below shows how the carrying amount and tax base vary because of the difference in depreciation. In the end, both the carrying amount and tax base are equal to 0. Carrying amount or net book value is the term used in financial reporting; tax base is the term used in tax reporting. Carrying amount is the value of an asset according to financial accounting rules Tax base is the value of an asset according to tax rules T= T=1 25 (dep = 25) 10 (dep = 40) T=2 0 (dep = 25) 0 (dep =10) The carrying amount of the asset is greater than the tax base at the end of T=1 resulting in a temporary difference. Link between DTL and Tax Base It is important to understand and remember the link between DTL and tax base: DTL = (Carrying Amount Tax Base) * Tax Rate This is illustrated in the table below. At the end of 2011: DTL = (25-10)*0.4 = 6. This is the same figure we saw earlier when calculating DTL. There we calculated using tax expense and Copyright Irfanullah Financial Training. All rights reserved. Page 7

8 tax payable. Here we do so using carrying amount and tax base. The result is the same as the difference is caused by depreciation. At the end of 2012 the difference between carrying amount and tax base is reversed and the DTL also reverses. If the carrying amount and tax base are the same then DTL is 0. Accounting profit (Financial reporting) Taxable income ( Tax reporting) Revenue Revenue Cash expenses Cash expenses Depreciation (SL) Depreciation (Acc. Dep.) Profit before tax Taxable Income Tax expense Tax payable 4 16 Profit after tax Profit after tax 6 24 Link between Income Tax Expense, Tax Payable and DTL Income Tax Expense = Income Tax Payable + Change in Net DTL where net DTL = DTL DTA and change in net DTL is the ending value of net DTL beginning value of net DTL. This is an important relationship and is illustrated below: Financial reporting Tax reporting Profit before tax Taxable Income Tax expense Tax payable 4 16 Profit after tax Profit after tax 6 24 Copyright Irfanullah Financial Training. All rights reserved. Page 8

9 DTL: ITE = ITP + Change in net DTL End of 2011: DTL = (25-10)*0.4 = : ITE = 4 + (6-0) = 10 End of 2012: DTL = : ITE = 16 + (0-6) = 10 Worked Example 3: In 2012, the income tax payable is 100. During the year DTL increased from 20 to 25 and DTA increased for 0 to 10. What is the provision for income tax in 2012? Solution: ITE = ITP + DTL - DTA = = 95 Worked Example 4: Acme Inc. builds a factory which will be depreciated over 10 years for accounting purposes. Tax rules allow depreciation over 5 years. Acme is likely to record: A. A deferred tax asset B. A deferred tax liability C. No deferred tax asset or liability Solution: B Financial Reporting: Acme will follow straight line depreciation over 10 years => less depreciation => higher tax expense => higher accounting profit Tax Reporting: Acme will follow accelerated depreciation over 5 years => high depreciation => low tax payable => low taxable income Since ITE > ITP, it is a deferred tax liability. Worked Example 5: Acme Inc. receives advance payments from customers that are immediately taxable. The necessary service will be delivered next year. Acme is most likely to record: A. A deferred tax asset B. A deferred tax liability Copyright Irfanullah Financial Training. All rights reserved. Page 9

10 C. No deferred tax asset or liability Solution: A Financial Reporting: Acme will report lower revenue as services will be delivered next year => lower income tax expense. Financial Reporting: Acme will report higher revenue => higher tax payable Since ITP > ITE, it is a deferred tax asset. 3. Determining the Tax Base of Assets and Liabilities 3.1 Determining the Tax Base of an Asset Asset tax base is the amount that will be deductible for tax purposes in future periods as the economic benefits become realized. Note: From a testability perspective, it is important to know how to calculate the carrying amount, the tax base and the temporary difference. Worked Example 6: Complete the table below to validate your understanding of the three concepts. Item Carrying Tax Temporary Amount Base Difference 1. An asset is purchase for 50; for year 1 depreciation = 25 on income statement and 40 for tax purposes Capitalized development cost =100 at the start of the year. During the year, 30 was amortized. For tax purposes, only 25% amortization is allowed. 3. Research cost for the year = 100; entire cost was expensed. Tax rules require cost Copyright Irfanullah Financial Training. All rights reserved. Page 10

11 to be spread over 4 years. 4. Gross accounts receivable = 100. Provision for doubtful debt = 10%. Tax authorities allow 20% Solution: Item Carrying Tax Temporary Amount Base Difference Carrying amount of 70 after deducting 30 for amortization. Similarly after deducting 25 for depreciation from tax base No research costs in carrying amount provisio for doubtful debt on accounting side Determining the Tax Base of a Liability The tax base of a liability is the carrying amount of the liability less any amounts that will be deducted for tax purposes in the future. Let s understand this with an example. Item Carrying Tax Temporary Amount Base Difference Customer payments received in advance = Amount is taxable. Here, the amount of 50 is received in advance while the services will be delivered later. A liability called unearned revenue is created on the accounting side making the carrying amount of the liability to 50. On the tax side, 50 is shown as revenue and taxes paid for the same. Copyright Irfanullah Financial Training. All rights reserved. Page 11

12 3.3 Changes in Income Tax Rates The measurement of deferred tax assets/liabilities is based on current tax law. But, if there is any subsequent change in tax laws or new income tax rates, then existing deferred tax assets and liabilities must be adjusted to reflect those changes. When income tax rates changes, deferred tax assets and liabilities are calculated based on the new tax rate. We saw earlier that DTL = (Carrying amount tax base) * tax rate If the tax rate is decreased from 40% to 30% in the earlier example, what happens to DTL? DTL (old rate) = (25-10) * 0.4 = 6 DTL (new rate) = (25-10) * 0.3 = 4.5 DTL changes from 6 to 4.5 Decrease in tax rate reduces deferred tax liabilities and deferred tax assets. Increase in tax rate increase deferred tax liabilities and deferred tax assets. Worked Example 7: Firm A has a net deferred tax liability. The government announces a decrease in the statutory tax rate. Will this change benefit the income statement and balance sheet? Solution: A lower tax rate causes the net DTL to decrease. The equity increases and the balance sheet becomes stronger. A lower tax rate causes the tax expense to decrease and hence the income statement also becomes stronger. 4. Temporary and Permanent Differences between Taxable and Accounting Profit What we have seen until now is a temporary difference between tax base and carrying amount of assets/liabilities that lead to a deferred tax asset/liability. As we saw in all the previous examples, Copyright Irfanullah Financial Training. All rights reserved. Page 12

13 this difference reverses itself sometime in the future. This means that the cumulative value of book values and tax base will become equal. There are instances when the difference is irreversible. Permanent differences are differences between tax and financial reporting of revenue (expenses) that will not be reversed at some future date. These differences do not give rise to DTLs and DTAs. Examples include: Income or expense items not allowed by tax legislation. Tax credits for some expenditures that directly reduce taxes. Permanent differences => Effective tax rate Statutory Tax rate Reported effective tax rate = Income tax expense/ Pretax Income Worked Example 8: In 2012, Acme s provision for income tax was 20 against an EBT of 100. In the same year, the tax payable was 25 and the taxable income was 110. What was Acme s effective tax rate for 2012? Solution: Effective tax rate = 20/100 = 20% 4.1 Examples of Temporary Differences Some examples of situations that lead to temporary differences in carrying amount and tax base are listed below: Temporary differences between carrying amount and tax base Balance Sheet Carrying amount vs. Tax DTL or DTA Example Item Base Asset Carrying amount > Tax Base DTL Straight line depreciation for Copyright Irfanullah Financial Training. All rights reserved. Page 13

14 accounting profit. Accelerated depreciation for taxable profit. Asset Carrying amount < Tax Base DTA Research cost expensed for accounting profit. Amortized for tax. Liability Carrying amount > Tax Base DTA Cash from customers before revenue recognition. Cash from customers is taxed. Liability Carrying amount < Tax Base DTL Tip for remembering: Remember the first relation for how a DTL is created for an asset. Everything else follows. 5. Unused Tax Losses and Tax Credits Tax loss carry forward occurs when a company experiences a loss in the current period that may be used to reduce future taxable income. Tax loss carry forward reduces the taxes paid in future. Let s assume, in 2011, Acme Inc. records revenue of $500,000 and operating expenses of $750,000. It pays taxes at the rate of 25%. The company s net operating income for 2011 was ($250,000). Since the net operating income was negative, Acme would not pay any taxes for Now, let s assume, in 2012, the company turns profitable and records $500,000 of taxable income. Instead of paying a tax of.25*500,000 = 125,000, the company may choose to use the tax loss carry forward of -250,000 this year. This reduces the taxable income to 250,000*.25 = $62,500. Copyright Irfanullah Financial Training. All rights reserved. Page 14

15 Tax credit is the amount that a taxpayer can deduct from the tax owed. Governments may grant a tax credit to promote a specific behavior. For instance, to promote growth in the rural areas, the government may give tax credits encouraging companies to set up factories. Deferred tax assets may arise from unused tax losses and tax credits. Often, the tax loss carry forward and tax credits can be used only up to a certain time period in the future. If the company expects to be profitable in the future periods like we saw for Acme Inc. in 2012, it would be prudent to recognize tax loss carry forward. Instead, if it anticipates losses in the future periods, recognizing tax loss carry forward would be rendered useless. IFRS allows recognition of unused tax losses and tax credits only to the extent that it is probable that in the future there will be taxable income against which unused tax losses and credits can be applied. Under U.S. GAAP, a deferred tax asset is recognized in full but is reduced by a valuation allowance if it unlikely that the benefit will be realized. A few guidelines to assess the probability a firm will be sufficiently profitable in the future are listed below: If there is uncertainty as to the probability of future taxable benefits, a deferred tax asset as a result of unused tax losses or credits is only recognized to the extent of the available taxable temporary difference. Assess the probability that the entity will in fact generate future taxable profits before the unused tax losses and/or credits expire pursuant to tax rules regarding the carry forward of the unused tax losses. Determine whether the past tax losses were a result of specific circumstances that are unlikely to be repeated. Discover if tax planning opportunities are available to the entity that will result in future profits. These might include change in tax legislation that is phased in over more than one financial period to the benefit of the entity. Worked Example 9: Copyright Irfanullah Financial Training. All rights reserved. Page 15

16 Acme Inc. incurs an expenditure which results in a tax credit. This tax credit directly reduces taxes. Acme is likely to record: A. A deferred tax asset B. A deferred tax liability C. No deferred tax asset or liability Answer: C Here the keyword is directly. Since the tax credit directly reduces taxes, a permanent difference is created between tax expense and tax payable. As we saw earlier, a permanent difference does not lead to a deferred tax asset or liability. If the question had stated that the tax credit reduces taxes presumably in future periods, then a deferred tax asset would have been correct. This is again assuming there is a probability for the company to be profitable in the future. 6. Recognition and Measurement of Current and Deferred Tax The amount of current tax payable or refundable from tax authorities is based on the applicable tax rates at the balance sheet date. Deferred taxes should be measured at the tax rate applicable when the asset is realized or the liability settled. In short, the tax rate at the time when the reversal in temporary difference (taxable income and profit before tax) occurs. Let s illustrate the current tax and deferred tax concepts with the help of a simple example. The tax applicable for period 1 is 30% and the government has announced the tax for period 2 will be reduced to 25%. Current tax will use 30% while deferred tax will be calculated using 25%. All unrecognized deferred tax assets and liabilities must be reassessed on the appropriate balance sheet date and should be measured against their probable future economic benefit. In the example above, at the end of period 1, the profitability in future and beyond period 2 must be assessed to see if DTA/DTL can be recognized. The carrying amount of DTA may change even when there is no change in temporary differences during the period. This may occur due to change in tax rates, or reassessments of the recoverability of deferred tax assets. Copyright Irfanullah Financial Training. All rights reserved. Page 16

17 If a DTL will not be reversed, analysts should treat it as equity. Let s say, for period 1 in the example above, there is a DTL because of the different depreciation methods used for accounting and tax reporting purposes. Let s also assume the company is expected to grow at a rate of 30% in the foreseeable future making the depreciation amounts higher with no reversal in sight. In such cases, the liability will be treated as equity. If there is uncertainty about the timing and amount of tax payments, analysts should treat DTLs as neither liabilities nor equity. 6.1 Measurement of DTA and Valuation Allowance If DTA will not be realized because of insufficient future taxable income to recover the tax asset then the DTA must be reduced. Under U.S. GAAP, a DTA is reduced by creating a valuation allowance (a contra account). DTA and net income decrease in the period in which a valuation allowance is established. DTA can be revalued upward by decreasing the valuation allowance which would increase earnings. Note: For the exam, you may think of valuation allowance in terms of depreciation. When depreciation expense goes up, net income comes down. Similarly, if valuation allowance goes up, net income comes down. Depreciation is shown as an expense on the income statement. Similarly, an increase in valuation allowance is shown as a loss on the income statement. Worked Example 10: Acme Inc. presents financial statements in accordance with U.S. GAAP. In 2012, Acme discloses a DTA = 100 and valuation allowance = 10. In 2011, Acme disclosed a valuation allowance of 15 against DTA of 95. The change in valuation allowance most likely indicates: A. Deferred tax liabilities were reduced in 2012 B. Expectations of future earning power has increased C. Expectations of future earning power has decreased Answer: B. Copyright Irfanullah Financial Training. All rights reserved. Page 17

18 We begin by organizing the data into years as follows: DTA VA The valuation allowance has come down from 15 to 10. This means expectations of future earnings power has increased. 7. Presentation and Disclosure Key points of this section are listed below: Deferred tax assets and liabilities must be disclosed. Under IFRS, deferred tax assets or liabilities are classified as noncurrent. Under U.S. GAAP, the classification (current versus non-current) is based on the underlying asset or liability. The deferred tax asset and deferred tax liability amount should be shown in the balance sheet. But, details of how we arrive at the number should be disclosed in the footnotes. Here is an example of what might be disclosed in the footnotes: Deferred tax assets: Accrued Expenses 10 Tax loss carry forward 11 Deferred tax assets 21 Valuation allowance -1 Net deferred tax asset 20 Deferred tax liabilities: Depreciation 30 Retirement plans 15 Deferred tax liabilities 45 Copyright Irfanullah Financial Training. All rights reserved. Page 18

19 8. Comparison of U.S. GAAP and IFRS Note: This section is not highly testable. Only important points are highlighted below. This section details the similarities and differences in the treatment of income taxes between U.S. GAAP and IFRS. Accounting treatment of income taxes under U.S. GAAP and IFRS are similar in most respects. Some notable differences include: Upward revaluations are prohibited under U.S. GAAP. It is permitted under IFRS and the deferred taxes recognized in equity. Under IFRS, DTA/DTLs are classified net as non-current on the balance sheet. Under U.S. GAAP, they are classified as current or non-current based on the classification of the non-tax asset or liability for financial reporting. Valuation allowance is used by U.S. GAAP. Under IFRS, a DTA is recognized if it is probable that the taxable profit in future will be sufficient enough to use the temporary difference. Whereas under U.S. GAAP, a deferred tax asset is recognized in full but reduced by valuation allowance if it is likely that a deferred tax asset will not be realized. Summary Note: This summary has been adapted from the CFA Program curriculum. Income taxes are a significant category of expense for profitable companies. Analyzing income tax expenses is often difficult for the analyst because there are many permanent and temporary timing differences between the accounting that is used for income tax reporting and the accounting that is used for financial reporting on company financial statements. The financial statements and notes to the financial statements of a company provide important information that the analyst needs to assess financial performance and to compare a company s financial performance with other companies. Key concepts in this reading are as follows: Copyright Irfanullah Financial Training. All rights reserved. Page 19

20 Differences between the recognition of revenue and expenses for tax and accounting purposes may result in taxable income differing from accounting profit. The discrepancy is a result of different treatments of certain income and expenditure items. The tax base of an asset is the amount that will be deductible for tax purposes as an expense in the calculation of taxable income as the company expenses the tax basis of the asset. If the economic benefit will not be taxable, the tax base of the asset will be equal to the carrying amount of the asset. The tax base of a liability is the carrying amount of the liability less any amounts that will be deductible for tax purposes in the future. With respect to revenue received in advance, the tax base of such a liability is the carrying amount less any amount of the revenue that will not be taxable in the future. Temporary differences arise from recognition of differences in the tax base and carrying amount of assets and liabilities. The creation of a deferred tax asset or liability as a result of a temporary difference will only be allowed if the difference reverses itself at some future date and to the extent that it is expected that the balance sheet item will create future economic benefits for the company. Permanent differences result in a difference in tax and financial reporting of revenue (expenses) that will not be reversed at some future date. Because it will not be reversed at a future date, these differences do not constitute temporary differences and do not give rise to a deferred tax asset or liability. Current taxes payable or recoverable are based on the applicable tax rates on the balance sheet date of an entity; in contrast, deferred taxes should be measured at the tax rate that is expected to apply when the asset is realized or the liability settled. All unrecognized deferred tax assets and liabilities must be reassessed on the appropriate balance sheet date and measured against their probable future economic benefit. Deferred tax assets must be assessed for their prospective recoverability. If it is probable that they will not be recovered at all or partly, the carrying amount should be reduced. Under U.S. GAAP, this is done through the use of a valuation allowance. Copyright Irfanullah Financial Training. All rights reserved. Page 20

21 Next Steps Work through the examples in the curriculum. Solve the practice problems in the curriculum. Solve the IFT Practice Questions associated with this reading. Review the learning outcomes presented in the curriculum. Make sure that you can perform the implied actions. Copyright Irfanullah Financial Training. All rights reserved. Page 21