ACTG 30116 Week 2 - Income Tax Reporting-32031f2a-4a0b-4e5f-8b84-025af6189bd7.pptx

finanical statement analysis, tax reporting

1. Income Tax Reporting Accounting and Financial Analysis (Week 2)

2. Why is it important for you to know about income tax reporting? Taxes have a large impact on net income and cash flows EPS, PE, etc. Need to be able to understand tax disclosures Tax accounting has some limitations you may have to adjust for in your analysis (Case 1—Next week!) Tax info in financial reports is also used to: Make financial statements of two firms more comparable Assess accounting quality more generally 2

3. Tax topics we will cover Understanding income tax reporting: Underlying principles GAAP-tax differences and accounting for income taxes Income tax note Advanced topics: Net operating losses Valuation allowance 3

4. GAAP-tax differences ( don’t forget!! ) GAAP pretax income determined by rules promulgated by FASB, SEC, etc. Taxable income based on tax law (Internal Revenue Code, IRS regulations, case law) Accounting and tax choices are independent Two sets of different reporting (i.e., tax return ≠ GAAP financial statements ) Why do the rules for financial reporting differ from the rules that determine taxable income? What are the underlying reasons? 4

5. Tax return versus GAAP income 5 Not public Follows tax laws Establishes a tax basis Typically: Less discretion, create (dis)incentives for certain actions (e.g., invest in PPE) Public on SEC and firm websites If SEC registrant (e.g., public listing) Follows GAAP Decision making by external parties (e.g., equity investors or contracting)

6. Underlying principle no. 1 Accrual accounting implies income tax expense is based on the income tax consequences of the current period’s pretax income, regardless of when those income tax consequences are realized in cash. Note parallel to other areas of accounting – expenses matched with related revenues, regardless of when cash outflow occurs. 6

7. Underlying principle no. 2 Accrual accounting implies that in any given year, income tax expense does not equal income tax payments, requiring the use of balance sheet accounts, i.e., deferred tax assets (DTA) and deferred tax liabilities (DTL). Note parallel to other areas of accounting – when cash flow and income statement recognition differ, there is a change in an asset or liability balance. 7

8. Underlying principle no. 3 Deferred tax assets must be sufficiently likely to be realized in order to be recognized in the balance sheet. Note parallel to other areas of accounting – Accounts receivable, inventory, etc. on balance sheet at no more than net realizable value. 8

9. Terminology before the details Income statement Income tax expense , income tax provision , and provision for income taxes Used interchangeably and refer to the expense in the income statement Balance sheet Income tax payable Current liability owed to tax authorities (federal, states, other countries) Tax that must be paid for a given year Deferred taxes ( DTAs / DTLs ) Non-current asset or liability Tax must be paid in a different year Other Book purpose : What we do under GAAP Tax purpose : What we do in the tax return Taxable income : Income on tax return that firm pays tax on in a given year 9

10. Temporary vs. permanent differences GAAP pretax income and taxable income are almost never equal GAAP rules are different from the tax code Unsurprising given the different purposes we just discussed All GAAP-tax differences classified as temporary (timing) or permanent 10

11. Temporary difference The item is treated the same for book and tax, but in different periods Example: Depreciation Most common temporary difference is straight line depreciation for books and accelerated for tax. Results in higher (lower) tax depreciation than book depreciation in early (late) years of asset’s life. Over asset life, book and tax depreciation are equal. Other examples: Warranty expense, bad debt expense, revenues received in advance. (See Exhibit 14.1 in text for more examples.) 11

12. Permanent difference The item is treated differently for book and tax – not just a matter of when Example: Interest on state and municipal bonds Although reported as income under GAAP, interest on state/muni bonds is never included in taxable income. Other examples: Penalties and fines: Book expense but generally no tax deduction Executive compensation above $1 million: Book expense but no tax deduction Inter-corporate dividend exclusion: Tax deduction (depending on ownership portion) but not a book expense 12

13. Example with both temporary and permanent difference Firm’s inception is 2018 A depreciation method difference ( temporary difference ) Single fixed asset purchased for $500m at 1/1/18; five year economic life (until 2022), no scrap value Municipal bond interest income ( permanent difference ) $50m each year 21% tax rate (no state taxes) Revenue $1,000m and COGS $600m every year (firm is in steady state) 13

14. Temporary difference: Depreciations 14 What about the permanent difference (muni interest)? Originating diff. (2018+2019) Reversing diff. (2020-2022) Note: Straight-line book depreciations. MACRS for tax depreciations.

15. Diff. in total pretax inc. is $250 (i.e., perm. Diff.) GAAP pretax income vs. taxable income 15 Straight line depr . Accelerated Depr . Permanent diff. Same total depreciations (i.e., temp. diff.)

16. Calculating tax payments by year 16 How do we calculate the tax expense? Imagine how distorted net income would be if we just recognized tax paid as the tax expense (i.e., the tax expensed would not be match to pretax income) Pretax income is constant ($350) Tax rate is constant (21%) Using DTLs/DTAs ensures that the tax expense is matched to pretax income, regardless of when it is paid.

17. Calculating tax expense (based on portion of pretax income that ever affects taxable income. I.e., we exclude permanent differences ) 17 Total tax expense = Total tax payment Accrual that allows us to recognize an expense that is different from taxes paid

18. Income statement 18 INC STMT ($ in millions) 2018 2019 2020 2021 2022 Sales 1,000 1,000 1,000 1,000 1,000 Cost of sales (600) (600) (600) (600) (600) Depreciation (100) (100) (100) (100) (100) Muni interest 50 50 50 50 50 Pretax inc 350 350 350 350 350 Tax expense (63) (63) (63) (63) (63) Net income 287 287 287 287 287 The tax expense is now matched to pretax income , regardless of when taxes are paid (i.e., accrual accounting)

19. Accounting for income taxes: (Buildup/reversal of deferred tax liability) 19 Originating diff. (2018+2019) Reversing diff. (2020-2022) Relevant exercises: E14-6, P14-2

20. Calculating the DTL using the balance sheet approach 20

21. Income statement and cash flow statement 21 Year 2018: We paid $42m but recognized an expense of $63m. Difference ($21m) is a non-cash expense so we take it out of the cash flow statement to get back to cash.

22. Effective tax rate ( ETR ) 22 Effective tax rate (ETR) : the average rate at which its pre-tax profits are taxed regardless of when pretax income is taxed (Tax expense/Pretax income) Effect of muni. int.: (50*0.21)/350=0.03 Imagine how distorted net income/ETRs would be if we just recognized tax paid as the expense Pretax income is constant ($350) Permanent diff. constant ($50) Tax rate is constant (21%)

23. Deferred taxes for entire company v. individual item For an individual item , temporary difference always reverses eventually, and deferred tax asset or liability becomes zero. For company as a whole , there are always new items giving rise to temporary differences, so deferred tax asset or liability does not go to zero. 23 How do you expect DTAs and DTLs to change from year to year for a growth versus steady state firm ?

24. 24 Real example: Low growth firm

25. 25 Real example: Growth firm

26. Classification of DTAs and DTLs on balance sheet All DTAs and DTLs classified as noncurrent DTAs and DTLs netted against each other within a tax jurisdiction but not across 26

27. Financial statements Income Statement and Balance Sheet Income Tax Note Components of tax provision Reconciles to income statement Components of DTA and DTLs Reconciles to balance sheet Tax rate reconciliation (permanent diff.) Other, including uncertain tax positions Less important for this class 27

28. Income statement Where do taxes appear on the income statement? 28 Tax expense Pre-tax amounts When is the tax expense paid by Walmart?

29. Balance sheet Where do taxes appear on the balance sheet? (more complicated) 29 DTA ($1,748M) (footnotes) Current provision (what we pay for the year) DTL ($7,019M) (footnotes) (pay in a different year)

30. Income tax note: Summary of tax provision Breaks out income tax provision by jurisdiction and by current/deferred Shows what is recorded in the income statement 30 Last lines of income statement Journal entry for 2025: Dr. Tax expense (-RE) 6,152 Dr. DTL, net (-L) 663 Cr. Tax payable (+L) 6,815

31. Income tax notes: Summary of deferred tax assets and liabilities Lists deferred tax assets and liabilities according to temporary differences that gave rise to them. Explains the deferred tax assets and liabilities that appear in the balance sheet 31 Relevant exercise (to understand footnote): P14-18

32. Deferred taxes: Income statement v. balance sheet 32 Components of tax provision (what is recorded in net income) Components of DTA and DTLs (what is recorded in balance sheet) Decrease in DTL, net of $314M What is going on? The DTL, net change in the balance sheet is not equal to the deferred tax provision in the income statement!

33. OCI and income taxes Comprehensive Income (CI) is Net Income (NI) plus Other Comprehensive Income ( OCI ) CI = NI + OCI OCI is the Hicksian concept of income (remember from week 1?) IFRS/GAAP tells what goes into OCI as opposed to NI Certain fair value adjustments that result in unrealized gains and losses Discuss again when we talk about fair value accounting in Week 6 Tax effects associated with OCI amounts are also included in OCI , not in the tax provision (i.e., not in net income). As a result, the change in deferred tax position may not equal deferred tax provision. 33

34. Statement of other comprehensive income ( OCI ) 34 Almost impossible to reconcile deferred tax provision (income statement) and change in deferred taxes (balance sheet) in practice (always OCI)

35. Income tax note: Tax rate reconciliation 35 Explains difference between statutory and effective income tax rates (on either dollar basis or percentage basis) Two types of reconciliations until 2025 (now both required): If on percentage basis, begins with statutory tax rate If on dollar basis, begins with hypothetical income tax provision if it were pretax income times statutory tax rate Relevant exercise (to understand footnote): P14-20

36. Income tax note: Tax rate reconciliation (from 2025) 36 Note: NVIDIA adopted new disclosure rules early (we will discuss changes in accounting principles in week 8).

37. Tax rate reconciliation

38. Advanced Topics Net operating losses Valuation allowance

39. Advanced topic 1: Net operating losses ( NOLs ) Taxable losses do not result in “negative income taxes,” but offset otherwise taxable income from other periods. Profitability often vary by year Deduction for NOLs helps structure the corporate tax code so that the corporate income tax is levied on average profitability Note that other countries (U.S. states) have their own tax rules for NOLs 40 Through 2017 Beginning 2018 Carrybacks 2 years (optional) Not permitted Carryforward expiration 20 years No expiration Limit on carryforward use (% of taxable income before use) 100% 80%

40. NOL example : After 1 January 2018 41 Note: No book-tax differences (only NOLs to consider). Tax rate 21%. ($ millions)   2018 2019 2020 2021 2022 2023 2024   Total                     Taxable income (loss) before carryforward   20.0 25.0 (50.0) (30.0) 6.0 48.0 65.0   84.0 We will: Calculate tax payments Calculate deferred tax assets Calculate tax provision (current and deferred provisions) and effective tax rate

41. ($ millions)   2018 2019 2020 2021 2022 2023 2024   Total Tax payments:                     Taxable income (loss) before carryforward   20.00 25.00 (50.00) (30.00) 6.00 48.00 65.00   84.00 Carryforward used to reduce taxable income           (4.80) (38.40) (36.80)     Taxable income   20.00 25.00 (50.00) (30.00) 1.20 9.60 28.20     Tax rate   21% 21% 21% 21% 21% 21% 21%     Tax paid   4.20 5.25 0.00 0.00 0.25 2.02 5.92   17.64                       Carryforward reconciliations:                     Carryforward at beginning of year   0.00 0.00 0.00 (50.00) (80.00) (75.20) (36.80)     Loss incurred for this year   0.00 0.00 (50.00) (30.00) 0.00 0.00 0.00     Carryforward used this year   0.00 0.00 0.00 0.00 4.80 38.40 36.80     Carryforward at the end of year   0.00 0.00 (50.00) (80.00) (75.20) (36.80) 0.00     Calculation of tax paid each year 42

42. ($ millions)   2018 2019 2020 2021 2022 2023 2024   Total Tax payments:                     Taxable income (loss) before carryforward   20.00 25.00 (50.00) (30.00) 6.00 48.00 65.00   84.00 Carryforward used to reduce taxable income           (4.80) (38.40) (36.80)     Taxable income   20.00 25.00 (50.00) (30.00) 1.20 9.60 28.20     Tax rate   21% 21% 21% 21% 21% 21% 21%     Tax paid   4.20 5.25 0.00 0.00 0.25 2.02 5.92   17.64                       Carryforward reconciliations:                     Carryforward at beginning of year   0.00 0.00 0.00 (50.00) (80.00) (75.20) (36.80)     Loss incurred for this year   0.00 0.00 (50.00) (30.00) 0.00 0.00 0.00     Carryforward used this year   0.00 0.00 0.00 0.00 4.80 38.40 36.80     Carryforward at the end of year   0.00 0.00 (50.00) (80.00) (75.20) (36.80) 0.00     Calculation of tax paid each year 43

43. ($ millions)   2018 2019 2020 2021 2022 2023 2024   Total Tax payments:                     Taxable income (loss) before carryforward   20.00 25.00 (50.00) (30.00) 6.00 48.00 65.00   84.00 Carryforward used to reduce taxable income           (4.80) (38.40) (36.80)     Taxable income   20.00 25.00 (50.00) (30.00) 1.20 9.60 28.20     Tax rate   21% 21% 21% 21% 21% 21% 21%     Tax paid   4.20 5.25 0.00 0.00 0.25 2.02 5.92   17.64                       Carryforward reconciliations:                     Carryforward at beginning of year   0.00 0.00 0.00 (50.00) (80.00) (75.20) (36.80)     Loss incurred for this year   0.00 0.00 (50.00) (30.00) 0.00 0.00 0.00     Carryforward used this year   0.00 0.00 0.00 0.00 4.80 38.40 36.80     Carryforward at the end of year   0.00 0.00 (50.00) (80.00) (75.20) (36.80) 0.00     Calculation of tax paid each year 44 How do we calculate the DTA for each year?

44. Calculation the deferred tax asset 45 How much is the current and deferred tax provisions for each year? ($ millions)   2018 2019 2020 2021 2022 2023 2024   Total Tax payments:                     Taxable income (loss) before carryforward   20.00 25.00 (50.00) (30.00) 6.00 48.00 65.00   84.00 Carryforward used to reduce taxable income (80%)           (4.80) (38.40) (36.80)     Taxable income   20.00 25.00 (50.00) (30.00) 1.20 9.60 28.20     Tax rate   21% 21% 21% 21% 21% 21% 21%     Tax paid   4.20 5.25 0.00 0.00 0.25 2.02 5.92   17.64                       Carryforward reconciliations:                     Carryforward at beginning of year   0.00 0.00 0.00 (50.00) (80.00) (75.20) (36.80)     Loss incurred for this year   0.00 0.00 (50.00) (30.00) 0.00 0.00 0.00     Carryforward used this year   0.00 0.00 0.00 0.00 4.80 38.40 36.80     Carryforward at the end of year   0.00 0.00 (50.00) (80.00) (75.20) (36.80) 0.00                           Deferred tax asset at year-end   0.00 0.00 10.50 16.80 15.79 7.73 0.00     Change in deferred tax asset   0.00 0.00 10.50 6.30 (1.01) (8.06) (7.73)     DTA: 21% of this amount

45. Calculate tax provision 46 What will the effective tax rate ( ETR ) be each year? ($ millions)   2018 2019 2020 2021 2022 2023 2024   Total Tax payments:                     Taxable income (loss) before carryforward   20.00 25.00 (50.00) (30.00) 6.00 48.00 65.00   84.00 Carryforward used to reduce taxable income (80%)           (4.80) (38.40) (36.80)     Taxable income   20.00 25.00 (50.00) (30.00) 1.20 9.60 28.20     Tax rate   21% 21% 21% 21% 21% 21% 21%     Tax paid   4.20 5.25 0.00 0.00 0.25 2.02 5.92   17.64                       Carryforward reconciliations:                     Carryforward at beginning of year   0.00 0.00 0.00 (50.00) (80.00) (75.20) (36.80)     Loss incurred for this year   0.00 0.00 (50.00) (30.00) 0.00 0.00 0.00     Carryforward used this year   0.00 0.00 0.00 0.00 4.80 38.40 36.80     Carryforward at the end of year   0.00 0.00 (50.00) (80.00) (75.20) (36.80) 0.00                           Deferred tax asset at year-end   0.00 0.00 10.50 16.80 15.79 7.73 0.00     Change in deferred tax asset   0.00 0.00 10.50 6.30 -1.01 -8.06 -7.73                           Tax provision calculation:                     Current provision   4.20 5.25 0.00 0.00 0.25 2.02 5.92     Defered provision   0.00 0.00 (10.50) (6.30) 1.01 8.06 7.73     Tax provision (benefit)   4.20 5.25 (10.50) (6.30) 1.26 10.08 13.65    

46. Calculation of effective tax rate 47

47. NOL example: Journal Entries 48 2018 Income tax expense (-RE) 4.20     + Deferred tax asset (A) -     Cash (-A)      4.20   10.50                   6.30   2019 Income tax expense (-RE) 5.25     16.80       Cash (- A)      5.25     1.01                 15.79   2020 Deferred tax asset (+A)  10.50       8.06     Income tax expense (+RE)   10.50   7.73                     7.73 2021 Deferred tax asset (+A)  6.30     0.00       Income tax expense (+RE)   6.30                           2022 Income tax expense (-RE) 1.30             Deferred tax asset (-A)   1.01           Cash (-A)      0.25                           2023 Income tax expense (-RE) 10.10             Deferred tax asset (-A)   8.06           Cash (-A)      2.02                           2024 Income tax expense (-RE) 13.70             Deferred tax asset (-A)   7.73           Cash (-A)      5.92       Deferred tax asset at year-end   0.00 0.00 10.50 16.80 15.79 7.73 0.00 Change in deferred tax asset   0.00 0.00 10.50 6.30 (1.01) (8.06) (7.73) ($ millions)   2018 2019 2020 2021 2022 2023 2024 Relevant exercises: E14-10 E14-11

48. 49 Note: States that levy gross receipts taxes as their primary corporate tax – Nevada, Ohio, Texas, and Washington – do not, by definition, offer NOL deductions. At the state level there is substantial variation in carryforward rules….

49. 50 … and in carryback rules.

50. Advanced topic 2: Valuation allowance Deferred tax assets “de-recognized” to the extent it is more likely than not (50%) the benefit will not be realized. This is done with a contra-account to the DTA called a valuation allowance . Result is that income statement recognition of tax benefit is delayed until valuation allowance reversed when tax benefit is either: realized, OR sufficiently likely to be realized. 51

51. Assessing the more-likely-than-not threshold Assessment by jurisdiction E.g., federal vs. individual states or USA vs. other countries Subjective assessment but generally requires history of profitable operations Companies that often record valuation allowance: Start-ups Foreign subsidiaries (with no history of profitable operations) of otherwise profitable firms Companies expected to be unprofitable for several years 52

52. Example : Valuation allowance Suppose in the NOL example, we initially applied a valuation allowance for the full amount of the DTA, which was removed in its entirety once the company became profitable again. Note: “All or nothing” is not required with valuation allowances, but it makes it easier to see the effect in our example. 53

53. Example: NOL with valuation allowance 54

54. Example: Journal entries NOL with valuation allowance 55 2018 Income tax expense (-RE) 4.20     Deferred tax asset (A)       Cash (+A)       4.20   10.50   2020                 6.30   2021 2019 Income tax expense (-RE) 5.25     16.80         Cash (-A)       5.25     1.01 2022                 15.79     2020 Deferred tax asset (+A)   10.50       8.06 2023   Valuation allowance (+CA: -A)   10.50   7.73         Income tax expense (+RE)   0.00     7.73 2024                 0.00     2021 Deferred tax asset (+A)   6.30             Valuation allowance (+CA: -A)   6.30   Valuation allowance (CA)       Income tax expense (+RE)   0.00     10.50 2020                   6.30 2021 2022 Income tax expense (-RE) 1.30       16.80       Deferred tax asset (-A)   1.01   16.80   2022     Cash (-A)       0.25         Valuation allowance (-CA: +A)  16.80             Income tax expense (+RE)   16.80                               2023 Income tax expense (-RE) 10.10               Deferred tax asset (-A)   8.06             Cash (-A)       2.02                               2024 Income tax expense (-RE) 13.70               Deferred tax asset (-A)   7.73             Cash (-A)       5.92         DTA, net Relevant exercise: P14-14 P14-19

55. 56 Start-up example

56. Reported income 57 The year the allowance was reversed

57. Case study 1 : AT&T and Lyft Due next week Submit on Canvas midnight before class Part I: Understanding AT&T’s income tax notes Part II: Contrasting the tax information for AT&T and Lyft Including discussion of tax rate changes (question j) Part III: Pro forma analysis using Lyft’s income tax information 58

58. Typical interview questions related to today’s materials How is GAAP accounting different from tax accounting? General principles and some concrete examples What are DTLs/DTAs and how do they arise? Temporary difference plus example How do DTAs/DTLs arise in M&A? Step of book values (week 6 and Haresh Sapra’s Class in Spring) 59

59. Takeaways Important to understand the principles of accounting for taxes Large impact on net income (and EPS) Underlying principles of tax accounting are the same as accrual accounting in general … …but many special issues make it more complicated in practice Don’t forget: Accounting and tax choices are independent Temporary and permanent differences Temporary differences reverse and therefore create DTAs/DTLs 60

60. Extra materials (2017 tax law, Effect of tax rate changes) 61

61. Main changes in 2017 tax law Enacted on December 22, 2017 Main changes we will talk about in this class Tax rate change : From 35% to 21% Foreign earnings : From worldwide to territorial tax system One-time tax on unrepatriated earnings (8% on non-cash and 15.5% on cash) Net operating losses : No carryback, no expiration of carryforward but limited to 80% of taxable income 62

62. Main changes in 2017 tax law (continued) Other changes with accounting implications (less relevant to this class) Interest deduction limitation : 30% of taxable income before interest and depreciation. But carryforward of unused interest Immediate expensing : Certain asset purchases can be expensed immediately (phased out over time) Global Intangible Low-Taxed Income (GILTI) and Base Erosion Anti-abuse Tax (BEAT) 63

63. Advanced topic 3: Deferred taxes and tax rate changes DTAs and DTLs are valued at the enacted tax rate that, as of the balance sheet date, is scheduled to be in effect when the item reverses. Under IFRS, “substantively enacted tax rate”, a lower threshold. If tax rate changes, revalue DTAs and DTLs, affecting tax provision (i.e., tax expense) in year the rate change is enacted . The effect is often very large or small tax expenses (ETRs) in enactment year 64

64. Example from earlier today Now assume: Acquire asset in 2015 instead of 2018 Tax rate change is enacted on 12/22/17 : From 35% to 21% from 1/1/2018 and all future years 65

65. Calculating tax payments 66 Taxable income does not change so simply apply new percentage Tax expense more complicated because DTL is revalued from 35% to 21% in 2017 (when new law enacted, not when it becomes effective)

66. What happens to the DTL in 2017 (rate change from 35% to 21% from 1/1/2018)? 67 (CTD*0.35) (CTD*0.21) Path with no tax rate change (35% constant) New path with tax-rate-change enactment in 2017

67. Calculating the tax expense 68 Total tax expense and payment the same

68. Comparing ETRs with and without a tax rate change 69 Tax rate change from January 1, 2018 but already a financial statement effect in 2017 (when law enacted) Relevant exercises: P14-11 P14-12

69. Deferred taxes and tax rate changes depending on DTA vs. DTL In each of the four possible scenarios, what is the effect of a tax rate change on: Net income in year rate change enacted? Firm value of firm’s shares (i.e., future cash flows)? Tax Rate Increase Tax Rate Decrease Net DTA Position Net DTL Position 70

70. Deferred taxes and tax rate changes depending on DTA vs. DTL In each of the four possible scenarios, what is the effect of a tax rate change on: Net income in year rate change enacted? Firm value of firm’s shares (i.e., future cash flows)? Tax Rate Increase Tax Rate Decrease Net DTA Position NI up FV down NI down FV up Net DTL Position NI down FV down NI up FV up 71

71. Citigroup income statement 2017 ETR in 2017 is 29,388/22,761=129% (it was only 30% in 2016) 72

72. Effect of tax rate change 73

73. Non-GAAP measures for 2017 74 All ratios reported exclude the effect of the Tax Reform Does that make sense?

74. U.S. federal tax rates rarely change but often changes elsewhere Note: Top marginal tax rate includes state taxes 75 With the 2017 tax law, the United States is close to the worldwide average Takeaways for tax rate changes: Tax rate changes affect DTAs and DTLs and therefore net income EPS, PE ratios, etc. You will not miss large federal tax rate changes But it is easy to miss smaller state or foreign tax rate changes (and they are fairly common)