ADVANCED FINANCIAL ACCOUNTING I CH 1 PPT UG BY MSK 2024.pptx

Advanced financial accounting -I chapter 1 ppt

1. ACFN4031: ADVANCED FINANCIAL ACCOUNTING-I LECTURE PRESENTATION NOTES BY MESELE SHIFERAW FOR MASTER OF SCIENCE IN ACCOUNTING AND FINANCE IN WEEKEND PROGRAM 4/10/2024 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024 1 Wolaita Sodo University, P. O. Box 138, Wolaita Sodo, Ethiopia Home: [phone] • Cell: [phone] Email: [email protected] Institutional Email: [email protected] Office room: COBE, ACFN, B-42-19 CONSULTATION HOURS: SATURDAY,3:00-4:00 LT and SUNDAY, 3:00-4:00 LT CLASS TIME AND LOCATION: LH-ROOM-1

2. What is Your Expectations from the Course? 1 2 3 . . . . 4/10/2024 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024 2

3. COURSE OUTLINE : COURESE OBJECTIVE This course addresses the skills needed to apply some selected financial reporting standards in business environments. The topics covered in the course includes: Accounting for income taxes Accounting for share-based compensation Accounting for agriculture Accounting insurance contracts Revisiting statement of cash flows, and asset valuation. COURSE DISCRIPTION In this, course students examine several complex topics and their effect on financial reporting and disclosure. The course is designed to cover a selected group of financial accounting topics under IFRS. Upon successful completion of this course the student will be able to: Record, analyze and report financial information related to income taxes, biological assets, insurance contracts, share-based compensations, and employee benefits. Prepare and present statement of cash flows. Undertake valuation of financial assets for financial reporting purposes 4/10/2024 3 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

4. ACCOUNTING FOR INCOME TAXES Chapter one 4/10/2024 4 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

5. CHAPTER OBJECTIVES After studying this chapter, you should be able to: Describe the fundamentals of accounting for income taxes. Identify additional issues in accounting for income taxes. Explain the accounting for loss carry forwards. Describe the presentation of deferred income taxes in financial statements. 4/10/2024 5 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

6. Fundamentals of Accounting for Income tax Corporations use guidelines to report information to investors and creditors (IFRS) . Corporations also must file income tax returns following the guidelines developed by the Internal Revenue Service (IRS). Because of IFRS and tax regulations differ in a number of ways, a company reports as tax expense will differ from the amount of taxes payable to the IRS. 4/10/2024 6 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

7. Financial Vs Tax reporting 4/10/2024 7 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

8. Pretax financial income Vs Taxable income Pretax financial income i s a financial reporting term. It also is often referred to as income before taxes( IBT) , income for financial reporting purposes, or income for book pur poses . Companies determine pretax financial income according to IFRS to provide useful information to investors and creditors. Taxable income (income for tax purposes) is a tax accounting term. It indicates the amount used to compute income taxes payable. Companies determine taxable income according to the tax regulations. Income taxes provide money to support government operations 4/10/2024 8 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

9. ILLUSTRATION Financial Reporting Income 4/10/2024 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024 9

10. ILLUSTRATION Financial Reporting…… 4/10/2024 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024 10 For tax purposes (following the tax rules), Chelsea reported the same expenses to the tax authority in each of the years. But, as Illustration shows bellow, Chelsea reported taxable revenues of $100,000 in 2015, $150,000 in 2016, and $140,000 in 2017

11. Comparison of Income Tax Expense to Income Taxes Payable For this example Income tax expense and income taxes payable differed over the three years but were equal in total . SET BY:MESELE SHIFERAW,ACFN,MARCH,2024 4/10/2024 11

12. Differences b/n income tax expense and income taxes payable in this example arise for a simple reason ( treat account receivable differently). For financial reporting, companies use the full accrual method to report revenues. For tax purposes , they use a modified cash basis . As a result, pretax financial income of $70,000 and income tax expense of $28,000 for each of the three years. However, taxable income fluctuates. For example , in 2015 taxable income is only $40,000, so Chelsea owes just $16,000 to the IRS that year. Chelsea classifies the income taxes payable as a current liability on the statement of financial position. 4/10/2024 12 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

13. 4/10/2024 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024 13

14. As the above Illustration indicates, $12,000 ($28,000 − $16,000) difference between income tax expense and income taxes payable in 2015 reflects taxes that will be paid in future periods. This $12,000 difference is often referred to as a deferred tax amount . In this case, it is a deferred tax liability (future burden) . In cases where taxes will be lower in the future, we record as deferred tax asset (future benefit (tax save)) . 4/10/2024 14 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

15. Future Taxable Amounts and Deferred Taxes A temporary difference is a difference between the tax basis and book basis of assets and liabilities in the financial statements, which will result in taxable amounts or deductible amounts in future years. Taxable amounts increase taxable income in future years . Deductible amounts decrease taxable income in future years . In the previous example, the only difference between the book basis and tax basis of the assets and liabilities relates to accounts receivable that arose from revenue recognized for book purposes . The illustration indicates that Chelsea reports account receivable at $30,000. Per Books 12/31/15 Per Tax Return 12/31/15 Accounts receivable $30,000 Accounts receivable $–0– 4/10/2024 15 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

16. What will happen to the $30,000 temporary difference that originated in 2015 for Chelsea? Assuming that Chelsea expects to collect $20,000 of the receivables in 2016 and $10,000 in 2017, this collection results in future taxable amounts of $20,000 in 2016 and $10,000 in 2017. These future taxable amounts will cause taxable income to exceed pretax financial income in both 2016 and 2017. That is, companies recognize income taxes that are payable when they recover the reported assets . Recognize the amount of income taxes that are refundable when they settle liabilities . 4/10/2024 16 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

17. Reversal of Temporary Difference 4/10/2024 17 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

18. Deferred Tax Liability A deferred tax liability is the deferred tax consequences attributable to taxable temporary differences. In other words, a deferred tax liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year . Recall from the Chelsea example that income taxes payable is $16,000 ($40,000 X40%) in 2015 . In addition, a temporary difference exists at year-end because Chelsea reports the revenue and related accounts receivable differently for book and tax purposes. The book basis of accounts receivable is $30,000, and the tax basis is zero. Thus, the total deferred tax liability at the end of 2015 is $12,000, computed as shown in Illustration Book basis of accounts receivable $30,000 Tax basis of accounts receivable –0– Cumulative temporary difference at the end of 2015 30,000 Tax rate 40% Deferred tax liability at the end of 2015 $12,000 4/10/2024 18 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

19. Because it is the first year of operations for Chelsea, there is no deferred tax liability at the beginning of the year. I ncome tax expense for 2015 will be . Deferred tax liability at end of 2015 $12,000 Deferred tax liability at beginning of 2015 –0– Deferred tax expense for 2015 12,000 Current tax expense for 2015 (income taxes payable) 16,000 Income tax expense (total) for 2015 $28,000 4/10/2024 19 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

20. This computation indicates that income tax expense has two components current tax expense & deferred tax expense. Deferred tax expense is the increase in the deferred tax liability balance from the beginning to the end of the accounting period. For Chelsea, it makes the following entry at the end of 2015. Income Tax Expense 28,000 Income Taxes Payable 16,000 Deferred Tax Liability 12,000 4/10/2024 20 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

21. At the end of 2016 (2 nd year), the d/c b/n the book basis and the tax basis of the A/R is $10,000. Chelsea’s deferred tax liability is $4,000 ($10,000 × 40%), which it reports at the end of 2016. Income taxes payable for 2016 is $36,000 and the income tax expense for 2016 is $28,000. Chelsea records income tax expense, the change in the deferred tax liability, and income taxes payable for 2016 as follows Income Tax Expense 28,000 Deferred Tax Liability 8,000 Income Taxes Payable 36,000 Deferred tax liability at end of 2016 $ 4,000 Deferred tax liability at beginning of 2016 12,000 Deferred tax expense (benefit) for 2016 (8,000) Current tax expense for 2016 (income taxes payable) 36,000 Income tax expense (total) for 2016 $28,000 4/10/2024 21 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

22. 4/10/2024 22 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

23. Financial Statement Effects For the Balance Sheet i ncome taxes payable will be reported as current liability, and the deferred tax liability is reported as a noncurrent liability. Year-End   Income Taxes Payable   Deferred Tax Liability 2015   $16,000   $12,000 2016 36,000 4,000 2017 32,000 − − 4/10/2024 23 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

24. For Income Statement , Income Tax Expense will be Presented totally or separately as current tax and differed tax. For the Year Ended 2015 2016 2017 Income before income taxes $70,000 $ 70,000 $70,000 Income tax expense 28,000 28,000 28,000 Net income $42,000 $ 42,000 $ 42,000 4/10/2024 24 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

25. Future Deductible Amounts and Deferred Taxes Deductible amounts decrease taxable income in future years . Assume that during 2015, Cunningham Inc. estimated its warranty costs related to the sale of microwave ovens to be $500,000, paid evenly over the next two years. For book purposes, Cunningham reported warranty expense and a related estimated liability for warranties of $500,000. For tax purposes, the warranty tax deduction is not allowed until paid. 4/10/2024 25 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

26. When Cunningham pays the warranty liability, it reports an expense (deductible amount) for tax purposes. Because of this temporary difference, should recognize in 2015 the tax benefits (positive tax consequences) for the tax deductions that will result from the future settlement of the liability. Cunningham reports this future tax benefit in the Dec 31, 2015, balance sheet as a deferred tax asset . Deductible amounts occur in future tax returns. These future deductible amounts cause taxable income to be less than pretax financial income in the future as a result of an existing temporary difference. 4/10/2024 26 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

27. Cunningham’s temporary difference originates (arises) in one period ( 2015) and reverses over the future two periods ( 2016 and 2017). 4/10/2024 27 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

28. Deferred Tax Asset A deferred tax asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year. To illustrate, assume that Hunt Company has revenues of $900,000 for both 2015 and 2016. It also has operating expenses of $400,000 for each of these years. In addition, Hunt accrues a loss and related liability of $50,000 for financial reporting purposes because of pending litigation . Hunt cannot deduct this amount for tax purposes until it pays the liability, expected in 2016. As a result, a deductible amount will occur in 2016 when Hunt settles the liability, causing taxable income to be lower than pretax financial information. 4/10/2024 28 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

29.   IFRS Reporting           2015   2016 Revenues   $900,000   $900,000 Expenses (operating)   400,000   400,000 Litigation loss   50,000   − − Pretax financial income   $450,000   $500,000 Tax rate   40%   40% Income tax expense   $180,000   $200,000             Tax Reporting           2015   2016 Revenues   $900,000   $900,000 Expenses (operating)   400,000   400,000 Litigation loss   − −   50,000 Taxable income   $500,000   $450,000 Tax rate   40%   40% Income taxes payable   $200,000   $180,000 4/10/2024 29 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

30. In this case, Hunt records a deferred tax asset of $20,000 at the end of 2015 because it represents taxes that will be saved in future periods. Computation of the deferred tax asset at the end of 2015(assuming a 40% tax rate) will be. Book basis of litigation liability $50,000 Tax basis of litigation liability –0– Cumulative temporary difference at the end of 2015 50,000 Tax rate 40% Deferred tax asset at the end of 2015 $20,000 4/10/2024 30 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

31. Assuming that 2015 is Hunt’s first year of operations and income taxes payable is $200,000, Hunt computes its income tax expense as follows. Deferred tax asset at end of 2015 $ 20,000 Deferred tax asset at beginning of 2015 –0– Deferred tax benefit (Save) for 2015 (20,000) Current tax expense for 2015 (income taxes payable) 200,000 Income tax expense (total) for 2015 $180,000 4/10/2024 31 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

32. The deferred tax benefit results from the increase in the deferred tax asset from the beginning to the end of the accounting period. The deferred tax benefit is a negative component of income tax expense. The total income tax expense of $180,000 on the income statement for 2015 thus consists of two elements—current tax expense of $200,000 and a deferred tax benefit of $20,000. Hunt makes the following journal entry. Income Tax Expense 180,000   Deferred Tax Asset 20,000   Income Taxes Payable   200,000 4/10/2024 32 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

33. Income tax expense for 2016 Deferred tax asset at the end of 2016 Deferred tax asset at the beginning of 2016 Deferred tax benefit (Save) for 2016 Current tax expense for 2016 (income taxes payable) Income tax expense (total) for 2016 $ –0– 20,000 20,000 180,000 $200,000 4/10/2024 33 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

34. The company records income taxes for 2016 as follows. Income Tax Expense 200,000 Deferred Tax Asset 20,000 Income Taxes Payable 180,000 The total income tax expense of $200,000 on the income statement for 2016 thus consists of two elements. current tax expense of $180,000 and deferred tax expense of $20,000. 4/10/2024 34 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

35. Financial Statement Effects For Balance Sheet Hunt Company reports the following information on its balance sheets for 2015 and 2016 as shown in Illustration. Income taxes payable is reported as a current liability , and the deferred tax asset is reported as a noncurrent asset . 4/10/2024 35 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

36. For Income statement; On its income statement, Hunt Company reports the information as shown in Illustration. HUNT COMPANY INCOME STATEMENT FOR THE YEAR ENDING DECEMBER 31, 2015 Revenues     $900,000 Expenses (operating)     400,000 Litigation loss     50,000 Income before income taxes Income tax expense Current     $ 200,000   450,000 Deferred (20,000 )  180,000 Net income     $270,000         4/10/2024 36 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

37. Temporary Vs Permanent Differences Temporary Difference Taxable temporary differences are differences that will result in taxable amounts in future years when the related assets are recovered. Taxable temporary differences give rise to recording deferred tax liabilities. Deductible temporary differences are differences that will result in deductible amounts in future years when the related book liabilities are settled. Deductible temporary differences give rise to recording deferred tax assets. 4/10/2024 37 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

38. Temporary Difference ………… Cont;d Determining a company’s temporary differences may prove difficult. A company should prepare a balance sheet for tax purposes that it can compare with its IFRS balance sheet. Many of the differences between the two balance sheets are temporary differences. Originating and Reversing Temporary Differences. An originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability, regardless of whether the tax basis of the asset or liability exceeds or is exceeded by the book basis of the asset or liability. A reversing difference , on the other hand, occurs when eliminating a temporary difference that originated in prior periods and then removing the related tax effect from the deferred tax account. 4/10/2024 38 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

39. E xample A ssume that Sharp Co. has tax depreciation in excess of book depreciation of $2,000 in 2015, 2016, and 2017. Further, it has an excess of book depreciation over tax depreciation of $3,000 in 2018 and 2019 for the same asset. Assuming a tax rate of 30% for all years involved, the Deferred Tax Liability account reflects the following. The originating differences for Sharp in each of the first three years are $2,000. The related tax effect of each originating difference is $600. The reversing differences in 2018 and 2019 are each $3,000. The related tax effect of each is $900. 4/10/2024 39 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

40. 2. Per manent differences Per manent differences result from items that (1) enter into pretax financial income but never into taxable income, and vise versa . Congress has enacted a variety of tax law provisions to attain certain political, economic, and social objectives. Some of these provisions exclude certain revenues from taxation, limit the deductibility of certain expenses, and permit the deduction of certain other expenses in excess of costs incurred. Since permanent differences affect only the period in which they occur, they do not give rise to future taxable or deductible amounts. As a result, companies recognize no deferred tax consequences. 4/10/2024 40 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

41. Examples of Permanent Differences Items recognized for financial reporting purposes but not for tax purposes. Interest received on state and municipal obligations. Expenses incurred in obtaining tax-exempt income. Proceeds from (Premiums paid for) life insurance carried by the company on key officers or employees. Fines and expenses resulting from a violation of law. Items recognized for tax purposes but not for financial reporting purposes. “Percentage depletion” of natural resources in excess of their cost. The deduction for dividends received from Gov’t corporations . 4/10/2024 41 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

42. Illustrations of Temporary and Permanent Differences Assume that Bio-Tech Company reports pretax financial income of $200,000 in each of the years 2015,16, and 17. The company is subject to a 30% tax rate and has the following differences between pretax financial income and taxable income. It pays life insurance premiums for its key officers of $5,000 in 2016 and 2017. Although not tax-deductible , Bio-Tech expenses the premiums for book purposes. Bio-Tech reports gross profit of $18,000 from an installment sale in 2015 for tax purposes over an 18-month period at a constant amount per month beginning January 1, 2016 . It recognizes the entire amount for book purposes in 2015. 4/10/2024 42 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

43. The installment sale is a temporary difference, whereas the life insurance premium is a permanent difference.   2015   2016   2017 Pretax financial income Permanent Difference (Non-deductible expense ) $200,000   $200,000 5,000   $200,000 5,000 Temporary difference (Installment sale)   (18,000)     12,000     6,000 Taxable income 182,000   217,000   211,000 Tax rate 30%   30%   30% Income taxes payable $ 54,600   $ 65,100   $ 63,300 4/10/2024 43 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

44. Interpretation Bio-Tech deducts the installment-sales gross profit from pretax financial income to arrive at taxable income Because Pretax financial income includes the installment-sales gross profit; taxable income does not. Conversely , it adds the $5,000 insurance premium to pretax financial income to arrive at taxable income Because Pretax financial income records an expense for this premium, but not for tax purposes. Therefore, the life insurance premium must be added back to pretax financial income to reconcile to taxable income. 4/10/2024 44 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

45.     December 31, 2015   Income Tax Expense ($54,600 + $5,400) Deferred Tax Liability ($18,000 × 30%) 60,000 5,400   Income Taxes Payable ($182,000 × 30%)   54,600 December 31, 2016 Income Tax Expense ($65,100 – $3,600) 61,500   Deferred Tax Liability ($12,000 × 30%) Income Taxes Payable ($217,000 × 30%) 3,600   65,100 December 31, 2017 Income Tax Expense ($63,300 – $1,800) 61,500   Deferred Tax Liability ($6,000 × 30%) Income Taxes Payable ($211,000 × 30%) 1,800   63,300 4/10/2024 45 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

46. Bio-Tech has one temporary difference, which originates in 2015 and reverses in 2016 and 2017. As the temporary difference reverses, Bio-Tech reduces the deferred tax liability. There is no deferred tax amount associated with the difference caused by the nondeductible insurance expense because it is a permanent difference . Although an enacted tax rate of 30% applies for all three years, the effective rate differs from the enacted rate in 2016 and 2017. Bio-Tech computes the effective tax rate by dividing total income tax expense for the period by pretax financial income. The effective rate is 30% for 2015 ($60,000 ÷ $200,000 = 30%) and 30.75% for 2016 and 2017 ($61,500 ÷ $200,000). 4/10/2024 46 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

47. Revision of Future Tax Rates When a change in the tax rate is enacted, companies should record its effect on the existing deferred income tax accounts immediately. A company reports the effect as an adjustment to income tax expense in the period of the change. Assume that on December 10, 2017, a new income tax act is signed into law that lowers the corporate tax rate from 40%to 35%, effective January 1, 2019. If Hostel Co. has one temporary difference at the beginning of 2017 related to $3 million of excess tax depreciation, then it has a Deferred Tax Liability account with a balance of $1,200,000 ($3,000,000 × 40%) at January 1, 2017. If taxable amounts related to this difference are scheduled to occur equally in 2018, 2019, and 2020, the deferred tax liability at the end of 2017 is $1,100,000, computed as follows. 4/10/2024 47 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

48. . Hostel, therefore, recognizes the decrease of $100,000 ($1,200,000 – $1,100,000) at the end of 2017 in the deferred tax liability as follows. Deferred Tax Liability 100,000 Income Tax Expense 100,000 Corporate tax rates do not change often. Therefore, companies usually employ the current rate . However, state and foreign tax rates change more frequently, and they require adjustments in deferred income taxes accordingly.   2018   2019   2020   Total Future taxable amounts $1,000,000   $1,000,000   $1,000,000   $3,000,000 Tax rate 40%   35%   35%     Deferred tax liability $ 400,000   $ 350,000   $ 350,000   $1,100,000                           4/10/2024 48 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

49. ACCOUNTING FOR NET OPERATING LOSSES N et operating loss (NOL) occurs for tax purposes, when tax-deductible expenses exceed taxable revenues. For an established company, a major event such as a labor strike, rapidly changing regulatory and competitive forces, a disaster such as 9/11, or a general economic recession can cause expenses exceed revenues— a net operating loss . 4/10/2024 49 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

50. ACCOUNTING FOR NET OPERATING LOSSES Inequitable tax burden would result if companies were taxed during profitable periods without receiving any tax relief during periods of net operating losses. Companies accomplish this income-averaging provision (losses of one year to offset the profits of other years) through the carryback and carryforward of net operating losses. 4/10/2024 50 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

51. Loss Carryback CARRYBACKS. Deductions or credits that cannot be utilized on the tax return during a year and that may be carried back to reduce taxable income or taxes paid in a prior year. Through use of a loss carryback , a company may carry the net operating loss back two years and receive refunds for income taxes paid in those years. The company must apply the loss to the earlier year first and then to the second year. 4/10/2024 51 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

52. Example To illustrate the accounting procedures for a net operating loss carryback, assume that Groh Inc. has no temporary or permanent differences. In 2017, Groh incurs a net operating loss that it decides to carry back. Groh Inc must carries the loss back first to 2015. Then, Groh carries back any unused loss to 2016. Accordingly, Groh files amended tax returns for 2015 and 2016, receiving refunds for the $110,000 ($30,000 + $80,000) of taxes paid in those years. Year   Taxable Income or Loss     Tax Rate     Tax Paid 2014   $ 50,000   35%   $17,500 2015   100,000   30%   30,000 2016   200,000   40%   80,000 2017   (500,000)   —   –0– 4/10/2024 52 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

53. For accounting as well as tax purposes, the $110,000 represents the tax effect (tax benefit) of the loss carryback. Groh should recognize this tax effect in 2017, the loss year . Income Tax Refund Receivable 110,000 Benefit Due to Loss Carryback (Income Tax Expense) 110,000 Groh reports the account debited, Income Tax Refund Receivable , on the balance sheet as a current asset at December 31, 2017. It reports the account credited on the income statement for 2017. Since the $500,000 net operating loss for 2017 exceeds the $300,000 total taxable income from the 2 preceding years, Groh carries forward the remaining $200,000 loss. 4/10/2024 53 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

54. Loss carryforwards CARRYFORWARDS. Deductions or credits that cannot be utilized on the tax return during a year and that may be carried forward to reduce taxable income or taxes payable in a future year If a carryback fails to fully absorb a net operating loss or if the company decides not to carry the loss back, then it can carry forward. Because companies use carryforwards to offset future taxable income, the tax effect of a loss carryforward represents future tax savings. 4/10/2024 54 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

55. Example Return to the Groh exam ple In 2017, the company records the tax effect of the $200,000 loss carryforward as a deferred tax asset of $80,000 ($200,000 × 40%), assuming that the enacted future tax rate is 40%. Groh records the benefits of the carryback and the carryforward in 2017 as follows. 4/10/2024 55 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

56. Groh realizes the income tax refund receivable of $110,000 immediately as a refund of taxes paid in the past. It establishes a Deferred Tax Asset account for the benefits of future tax savings. The two accounts credited are contra income tax expense items, which Groh presents on the 2017 income statement . The current tax benefit of $110,000 is the income tax refundable for the year. The $80,000 is the deferred tax benefit for the year, which results from an increase in the deferred tax asset 4/10/2024 56 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

57. Computation of Income Taxes Payable with Realized Loss Carryforward For 2018, assume that Groh returns to profitable operations and has taxable income of $250,000 (prior to adjustment for the NOL carryforward), subject to a 40% tax rate. Groh then realizes the benefits of the carryforward for tax purposes in 2018, which it recognized for accounting purposes in 2017. Groh computes the income taxes payable for 2018. Taxable income prior to loss carryforward $ 250,000 Loss carryforward deduction (200,000) Taxable income for 2018 50,000 Tax rate 40% Income taxes payable for 2018 $ 20,000 4/10/2024 57 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

58. Groh records income taxes in 2018 as follows. The benefits of the NOL carryforward, realized in 2018, reduce the Deferred Tax Asset account to zero. Income Tax Expense 100,000   Deferred Tax Asset   80,000 Income Taxes Payable   20,000 4/10/2024 58 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

59. Carryforward with Valuation Allowance VALUATION ALLOWANCE. The portion of a deferred tax asset for which it is more likely than not that a company will not realize a tax benefit. Assume that it is more likely than not that Groh will not realize the entire NOL carryforward in future years. In this situation, Groh records the tax benefits of $110,000 associated with the $300,000 NOL carryback, as we previously described. In addition, it records Deferred Tax Asset of $80,000 ($200,000 × 40%) for the potential benefits related to the loss carryforward, and an allowance to reduce the deferred tax asset by the same amount 4/10/2024 59 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

60. FINANCIAL STATEMENT PRESENTATION 1. Balance Sheet Income taxes payable and income tax refund receivable are reported as a current liability and current asset, respectively, on the balance sheet. D eferred tax assets and deferred tax liabilities are separately recognized and measured and then offset on the balance sheet. The net deferred tax asset or net deferred tax liability is therefore reported in the noncurrent section of the balance sheet. 4/10/2024 60 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

61. Income Statement Companies are required to report income before taxes and income tax expense on the income statement. Income tax expense generally equals the sum of income taxes payable and the change in the deferred tax expense. Income tax benefit generally equals the sum of income taxes refundable and the change in the deferred tax benefit. For example, a company adds an increase in a deferred tax liability to income taxes payable. On the other hand, it subtracts an increase in a deferred tax asset from income taxes payable. 4/10/2024 61 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

62. Summary 4/10/2024 62 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024

63. END OF CHAPTER ONE THANK YOU 4/10/2024 63 SET BY:MESELE SHIFERAW,ACFN,MARCH,2024