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Video 8.4: Income Tax Disclosure Example
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Week 8: Deferred Taxes
There are two certainties in life, and we will cover one of them this week (the other is beyond the scope of the course). We will NOT teach you how to prepare your own tax return. Instead, we will discuss how companies have to prepare "two sets of books": their financial statements and their tax returns. The rules are different for these two sets of books, leading to permanent differences and to temporary differences. We will cover both types of differences, with a main focus on "deferred taxes", which are the byproduct of temporary or timing differences between tax reporting and financial reporting. Finally, we will touch on other tax issues, such as Net Operating Loss Carryforwards and the rule that requires companies to disclose how much they are trying to cheat on their taxes (sorry, that should say "use tax planning strategies to manage their taxable income").
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Brian J BusheeThe Geoffrey T. Boisi Professor
Accounting
Hello, I'm professor Brian Bushee.
Welcome back.
In this video,
we're going to take a look at a footnote disclosure related to income taxes.
So that you can see where to find all that great information about income taxes that
we've been talking about all week.
Hope you enjoy the video.
Before we dive into the disclosure example, I want to give you a quick
overview of the things we'll be finding when we go into the deferred tax footnote.
So first, there is a disclosure of the components of income before tax,
pre-tax income, how much of that is domestic versus foreign.
There is the components of income tax expense split up
into currently payable versus deferred.
So this is giving us that journal entry that we have been looking a lot so.
The total is the debit income tax expense, then there is disclosure for
how much is the credit to income tax payable,
that's the currently payable, and then we'll see the plug to deferred taxes.
There's a reconciliation from the statutory rate to the effective
income tax rate.
This will show us all the permanent differences, and
there's the components of deferred tax assets and
liabilities, which will show us all the temporary differences.
And here we'll get to see a listing of all the transactions that
create these temporary differences and how much deferred tax asset or
liability they create.
And this is where we'll also see the valuation allowance, if there is one.
There's also, I should note, some differences between what you will see in
the footnote and what you might see on the balance sheet.
First of all, deferred tax assets and
liabilities are often netted by jurisdiction on the balance sheet.
Which means that the totals you see in the footnote won't be the totals that you
see on the balance sheet,
because the balance sheet reflects some of this jurisdictional netting.
And deferred tax liabilities and assets can be split into current and
non-current portions on the balance sheet, whereas when we get into the footnote,
we see that we don't make that distinction.
>> Another inspiring opening slide.
You certainly have a way of making a dry and boring subject seem dry and boring.
Let me spice things up by asking a question.
What do you mean by jurisdiction?
And what about netting?
>> Good questions.
The term, jurisdiction, means any government that can tax you.
So, a country.
A state or
a province, a city, anybody that can tax you is a separate jurisdiction.
Netting, means that you net the deferred-tax assets and
deferred-tax liabilities in a jurisdiction to get one number.
So, let's say in Canada, you had more deferred-tax assets than
deferred-tax liabilities, you'd have a net deferred-tax asset in Canada.
But in Sweden, you had more deferred tax liabilities than for taxed assets.
You'd have a net deferred tax liability in Sweden, so on the balance sheet you
could see both a deferred taxed assets and a deferred taxed liability, and
it represents that you have different deferred taxes in different jurisdictions.
So the company that we're going to look at in our disclosure example is
Moth Incorporated which manufactures construction equipment.
The questions we're going to try to answer from the footnote disclosure are.
What's the effect of Moth's non U.S. subsidiaries on its effective tax rate?
We're going to try to do that summary entry journal for income tax expense where
you do income tax expense, income tax payable and now all the deferred taxes.
We're going to do a journal entry for the change in valuation during 2011.
Talk about why Moth made the entry and what that entry's effect on net income is?
We're going to look at was Moth's warranty expense for
tax purposes higher or lower than it's warranty expense for book purposes?
And then we'll do the same thing for depreciation expense, was it higher or
lower for tax purposes than for book purposes during 2012?
>> How about answering this question, why do we care if something is higher or
lower on the tax return than on the books?
What does it have to do with the price of fish anyway?
>> Well if there's a big difference between your books and
your tax return, it could indicate something fishy is going on.
So [LAUGH] there's a number of reasons why the books and
tax could be very different for these.
It could be different growth rates, levels of activity, can tell you how much
cash we're spending or getting because that's what you often see on a tax return.
Or it could indicate a problem with manipulation where you're manipulating
something on your income statement but not on your tax return, or maybe vice versa.
So the first step is just to see how big these differences are.
And then the second step would be to try to
understand what's driving those differences.
So, here is Footnote 6, which is Moth's income tax footnote.
One of the first sections is the reconciliation of the U.S.
Federal statutory rate to the effective rate.
So the top line is we have the U.S.
statutory rate which is 35% in all of these years.
Then we have a bunch of items which cause permanent differences, and so
then the line provision for income taxes, that's the effective tax rate.
So in 2012 the effective tax rate was 32%.
The question was what happened with the non-U.S.
subsidiaries?
And as you can see on this line here, Non-U.S.
subsidiaries taxed at other than 35% increase the effective tax rate by 1.9%.
So what that represents is essentially extra tax on the same pre-tax income.
So we have that extra tax for
the financial statements that affects our income tax expense.
But that doesn't ever show up on our tax return.
We can't use that extra tax as a deduction on our taxable income.
So it's a permanent difference.
It never reverses, and so
it's one of the things that shows up in this reconciliation.
And, just as a reminder, for all tax calculations, we're going to use
the statutory rate 35% because that effective rate of 32% were 30.6% in 2011.
Is biased by the effect of all of these permanent differences,
all of these unusual items listed in this table.
>> I know you are dying to give us the impassioned lecture about not
using the effective tax rate again.
So go on.
Let's hear it one more time for old times' sake.
>> I'm happy to.
Don't use the effective tax rate to do tax calculations.
This footnote provides a really good example why.
So if you look at effective tax rate.
It's affected by four things.
You've got the NOLs,
you've got the Benefit of a Foreign Sales Corporation, you've got the Non-U.S.
subsidiaries, and you've got Other-net.
So I guess if you were looking at the tax effect of something that had all four of
those things involved, 32% would be the right number.
But, if you were looking at tax effect of.
Interest or depreciation, then the 32% makes no sense at all because none of
these permanent differences have anything to do with interest expense or
depreciation expense.
So use 35%.
Thank you very much, enjoy the rest of the video.
So the next question we wanted to try to answer was could we provide the journal
entry for 2012 income tax expense for Moth incorporated?
So another part of the footnote shows the first of all the profit before taxes,
the pretax profit for U.S. and Non-U.S, subsidiaries.
But then the part that we're really going to focus on is the part below that.
The Provision for Income taxes.
Remember provision is another word for expense.
So the current tax provision, that's going to be the Income Tax Payable part.
What we owe the government, U.S. Government, Non-U.S.
Governments and States.
That's 390. Then there's Deferred tax provision.
These are the deferred tax part of the journal entry.
And at the bottom.
We have total provision.
That's the total income at tax expense of 455.
So we're debiting income tax expense 455 for that total provision.
Moth credited income tax payable of 390 for the current payable portion.
This is what we owe the government this period.
And then to balance it there was a credit to deferred taxes of 65 which
is what we need to balance this journal entry.
>> Is the Deferred Taxes line a deferred tax asset or a deferred tax liability?
Or, is it one of the innumerable errors that constantly populate your slides?
>> It's not one of the innumerable errors on my slides.
I try to reshoot these videos six or
seven times to remove all the typos on the slides.
You know, this credit to deferred taxes is vague because we
don't know whether it's deferred tax assets or liabilities.
But there's some additional information that we can get which will tell us.
How much of this is DTAs, and how much of this is DTLs?
So let's go and look at that.
So let's go ahead and see if we can provide more detail in this journal entry.
Now we don't have to do anything with the debit to income tax expense of 455 that,
that is what it is.
We can't provide any more detail on that.
But we can break down this credit to deferred taxes of 65.
Into components for
deferred tax assets deferred tax liabilities and valuation allowance.
So let's go to another part of the footnote.
So this part of the footnote summarizes all the deferred tax assets and
deferred tax liabilities and the valuation allowance.
We're going to go into the line items later.
But right now we want to pick up the totals for each group.
So if you notice, deferred tax assets increased from 1796 to 1916.
We make an asset increase with a debit so what we,
what Moth must have done during the year is debited deferred tax assets for 120.
So it's the 1916 minus the 1796.
For deferred tax liabilities, it looks like they went from 346.
Up to 521.
We make a liability go up with a credit.
So we had a credit to Deferred tax liabilities of 175.
That's the 521 minus the 346.
For the Valuation Allowance, it went up from 61 to 72.
That's an increase of 11.
Valuation Allowance is a contra-asset.
We make a contra-asset go up with a credit.
So there must have been a credit to Valuation Allowance for 11.
So instead of having just a credit to defer taxes for 65,
we can replace this credit with a debit to defer taxes of 120.
A credit to defer tax liabilities of 175.
And then to balance it out, a credit to the valuation allowance of 10.
Now this is not a journal entry where we need our debits to equal our credits.
Instead.
These 3 items are replacing the credit to 65 so we need
these 3 items to add up to a net credit of 65 and as I'll show you in a second we'll
place that in the journal entry but but I think there's a question first.
>> Speaking of typos, you credited the valuation allowance for 10 instead of 11.
Although, if it was 11, it wouldn't balance.
So, which mistake is the correct mistake?
>> That's a very existential question.
Which mistake is the correct mistake?
So, what we're seeing here are different effects of
rounding in different parts of the footnote.
So in the first part of the footnote, where we started the journal entry.
Moth had rounded in a way where the net credit to deferred taxes was 65.
In the part of the footnote with the detailed deferred tax assets and
deferred tax liabilities the rounding ends up with a net credit of 66.
So to try to get these 2 to reconcile I just knocked one off
the evaluation allowance down to 10.
So I got a net credit of 65 which will fit nicely into the journal entry that we
were doing based on the other part of Moth's footnote.
So, anyway, we're going to plug these three items,
the debit deferred tax assets, credit to defer tax liability, and
credit evaluation allowance in place of that credit to defer taxes of 65.
So now we have that broken out into details about
whether the change in deferred taxes came from deferred tax assets.
Defer tax liabilities and Valuation Allowance.
The last thing we can do is provide more detail on that credit to
income tax payable.
So going back to that part of the footnote which provided
the reconciliation between statutory rate and the effective rate.
There was a sentence at the bottom that we ignored before, but
comes in really handy now.
Where it says that Moth paid income taxes of 306 in 2012.
It's a required disclosure that somewhere in
the footnotes companies have to tell you how much they paid in cash.
For income taxes.
So we see it's 306 in 2012.
What that means is we can replace this credit to income tax payable of
390 with a credit to cash of 306 because we know they
have paid cash to the government for taxes of 306 during the year.
And a credit to income tax payable of 84, that's the 390 total minus the 306.
There were only 84 of current taxes that had not yet been paid to the government.
And again, what we're doing here is replacing the credit to
income tax payable of 390 with these other two credits, the credit to cash and
the true credit to income tax payable of 84.
So putting it back into the big journal entry,
we replace credit to income tax payable to $390, with credit to income tax payable to
only $84 cause that's how much is still payable at the end of the year, because we
know there's this credit to cash of $306, we paid $306 during the year.
And still we are actually able to find out a lot of information about changes in
all of the deferred tax asset liability evaluation allowance.
In addition to how much of the tax we owe the government this year.
Was paid in cash versus how much is still payable at the end of the year.
Here we're going to go back to the footnote on deferred tax assets,
liabilities and Valuation Allowance to look at this journal entry in 2011.
For the change in the Valuation Allowance.
So looking at 2011's, so between 2010 and 2011,
the Valuation Allowance decreased by 68, which is 61-129.
>> I am no Albert Einstein when it comes to math, but
apparently you are not either.
Negative 61 minus negative 129 would be positive 68.
So the valuation allowance actually increased by 68.
Well, actually, Albert Einstein was born in Holm, Germany.
I was born in New Holm, Minnesota, so there are a lot of
similarities between us, but I should have addressed this earlier.
You're right that if these were negative numbers, it would have actually been
an increase, but the numbers in brackets are not negative numbers.
They're all positive numbers they're just in brackets to
represent that they're credits.
So the way Moth does this is the numbers without brackets are debits,
the numbers that are in parenthesis or brackets are credits.
So anyway, if the valuation allowance is going down by 68.
The Valuation Allowance is a contra asset so it goes down with a debit.
So Moth debited valuation amount for 68.
There was no.
Cash involved there, this doesn't affect the taxes that you pay this period.
So the credit has to be to Income Tax Expense,
that's the only other thing that could change.
So we credit Income Tax Expense for 68 to reduce that expense.
By reducing income tax expense by 68, it increases net income by $68.
So, again, we talked about this was one of those things you'd want to find in
the footnote, because it's potentially last chance earnings management.
Every dollar that you reduce the valuation allowance increases net
income by a dollar.
So hopefully Moth has a good explanation.
For why the valuation allowance decreased in 2011.
One more part of their footnotes,
they give a discussion of these net operating loss carryfowards.
So they say as of December 31, 2012, here are the expiration dates of
NOL carryforwards in non-US jurisdictions, and all of these were non-US losses.
They say evaluation allowance has been recorded at certain non-US
subsidiaries that have not demonstrated consistent or
sustainable profitability to support the recognition of net deferred tax assets.
Which means they're not going to be profitable enough in the foreseeable
future to actually get these tax savings.
And then they say circumstances could change in the future, which would allow us
to reduce the remaining valuation allowance and recognize additional.
Net deferred tax assets.
And then here's the key, Moth says that in 2011, circumstances changed at certain
of our European subsidiaries which allowed us to reduce the valuation allowance and
recognize additional net deferred tax assets.
So there's our explanation,
circumstances changed in certain of our European subsidiaries.
I, I don't know about you, but that makes me feel a lot better, right?
Right?
Well, I, I guess I would like to see a little bit
more hard information about what actually has changed.
Which subsidiaries?
This is a very vague disclosure, and if we're concerned about
this being used as last chance earnings management, I would actually like to see
a little more convincing than what Moth has provided in this footnote.
Okay, next topic is we're going to look at the 2012 temporary difference in warranty
expense between the books, the financial statements, and between the taxes.
So we're going to hone in on the deferred tax asset that is
specifically created by the difference in accounting for warranty reserves.
We're going to see that the warranty defer tax asset increased by 43 during the year.
Now the reason why there is a deferred tax asset here.
Is that for financial statement purposes, warranties are expensed when you
sell goods, when you sell goods to the customers.
But for tax purposes, there's no tax deduction until you
actually pay the cash to fix the product down the road.
So it works just like bad debt expense,
where the financial statements get the expense first.
And a tax deduction comes later.
So what is this increase in deferred tax asset of 43 mean?
Well, if we go back to our, our summary journal entry,
we we know that we debit income tax expense.
We credit income tax payable, and
in this case we're debiting a deferred tax asset of 43.
Because we're doing that, we know that Income Tax Expense must have
been less than Income Tax Payable for these Warranty Transactions.
>> I see another mistake!
I see another mistake! You do not have numbers in
the journal entry for Income Tax Expense and Income Tax Payable.
>> How could you possibly know that income tax expense is less than
income tax payable if you do not know the numbers for either one?
>> No, this wasn't a mistake.
We, we don't need to know the numbers for income tax expense or income tax payable.
All we need to know is that debits have to equal credits, and
if we've got this debit to deferred tax assets of 43, then the only
way this'll balance is if income tax expense is less than income tax payable.
If you want to see it more clearly with numbers, then put in,
say, 100 for income tax expense, then income tax.
Payable would have to be 143.
Or if your income tax expense was 200,
then income taxes payable would be, have to be 243.
So you can see we don't really need to know the numbers to know that
income tax expense is always going to be less than income tax payable,
when we have a debit to a deferred tax asset.
So anyway, we have income tax expense on the financial statements.
There's less than income tax payable to the government by $43 for
warranty, or $43 million, but $43 for short.
If we had less tax expense on the books,
we had to have had less pretax income, right?
Less pretax income means you have less tax expense, so
pretax income was less than taxable income by 123.
And where we get that number from is we take the 43 tax difference, and
divide it by 35%.
Remember we did this earlier with changes in tax rates.
If you take the difference in a tax effect, divide it by the tax rate,
you get the difference in the pre-tax effect.
So the difference between pre-tax income.
And taxable income was $123, if we had less pre-tax income,
we must have had more warranty expense on the financial statements.
More expense gives you less income, less income gives you less taxes.
So our warranty expense on the books, on the financial statements,
was greater than our warranty expense on the tax return.
By this 123 million.
>> Would this be a good time for
you to tell us what we learn through this exercise?
I certainly learned how to use less than and greater than signs.
Thanks for that!
But what else?
>> So there is a couple of things that we can learn from this.
One is there still seems to be growth in our
sales because the book warranty expense is when we have new sales.
The tax warranty expense is when we pay cash to fix old sales so
it looks like we have more new sales in wholesales.
Or that are actual warranty payments are less than
expected because we're getting less tax expenses.
And that's sort of the second thing is we can figure out the actual cash paid for
warranties because if we found the warranty expense number on
the financial statements.
And then adjusted it by this 123.
It would tell us the warrant expense on taxes,
which would also be the amount of cash we spent for warranties during the year.
Now let's do another example for a depreciation expense so
we can go through exercise with a deferred tax liability.
So there's a deferred tax liability called Capital assets.
That's Moth's deferred tax liability related to depreciation.
That deferred tax liability increased by 120, so remember ignore the brackets.
It went from 263 up to 383.
So if we look at our summary journal entry, we always debit income tax expense.
We credit income tax payable.
Here we know we've credited a deferred tax liability by 120.
That's how we made the deferred tax liability go up.
So the only way this journal entry would stay in balance is if
income tax expense was greater.
Than income tax payable for depreciation purposes.
That's the only way that our debits can equal our credits.
So if we know that, and let me get rid of the deferred tax assets so
I have some room to operate.
We'll just slide the deferred tax liabilities up.
So we know that income tax expense is greater than income tax payable by $120
for the depreciation transactions.
If we had more expense, we must have had more pre-tax income, like more.
Pre-tax Income gives you more tax expense.
So pre-tax income is greater than taxable income by 343.
That's the $120 tax difference divided by the Statutory Rate of 35%.
So remember if we have a tax difference.
We always divide by the tax rate to get the pretax difference.
If we had more taxable income,
we must of had less depreciation expense on the books.
Right, because less expense gives you more income, more income.
Gets you more taxes.
So our Depreciation Expense in the financial statements was less than
our Depreciation Expense on the tax return by this 343.
And what we would make of this is that Moth must be growing it's capital assets,
because remember tax depreciation expenses accelerated so it's greater in
earlier years of the asset and less than book depreciation in later years.
so the fact that tax depreciation expense is higher means that we've been.
We have a lot of equipment that is in the early years of depreciation,
rather than in the later years.
So, Moth must be growing their capital assets quite a bit,
to have this deferred tax liability grow and
have this book depreciation expense less than the tax depreciation expense.
>> Having seen another example, I now think this makes sense.
>> I'm really glad to hear that these examples are starting to make sense.
By the way, what city has the most reasonable people in America?
Cincinnati.
Okay, and now that I'm making jokes about Cincinnati as Senseinnati.
I think it's time to wrap up.
In the next video, we've got a couple more topics about applications of
deferred taxes that I want to go through, and I will see you then.
>> See you next video.
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