The course builds on my Introduction to Financial Accounting course, which you should complete first. In this course, you will learn how to read, understand, and analyze most of the information provided by companies in their financial statements. These skills will help you make more informed decisions using financial information.
Video 8.1: Income Taxes: Overview and Terminology
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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").
Rencontrer les enseignants
Brian J BusheeThe Geoffrey T. Boisi Professor
Accounting
Hello I'm Professor Brian Bucher and welcome back.
There's an old saying that there are only 2 certainties in life.
Death, and taxes.
The first one is beyond the scope of this course, but
the second one is right in our wheelhouse.
So we're going to spend this entire week
talking about how taxes affect the financial statements.
I can't wait, let's get started.
Let's start with a big overview slide of the differences
between financial reporting and tax reporting.
So, on your financial statements, you come up with income tax expense,
which is going to be based on the pre-tax income computed using either US GAAP or
IFRS, whatever the accounting standards are in the country that you're located.
So on your financial statements, and just as a note for these videos if I talk about
books, or book income, or book taxes, book stands for financial statements.
It's a lot easier to say books a lot than to say financial statements,
financial statements, financial statements.
Okay, so anyway, on your books you have the pre-tax income per GAAP or IFRS rules.
You multiply that times something, times the effective tax rate, and
that's what's going to be the income tax expense on the income statement.
Then in another set of books, you calculate income tax payable, or
the tax that you pay in cash,
based on taxable income using the tax code rules in whatever country you are.
So for tax reporting you use all of the, in the US the IRS is the tax authority so
you would IRS rules if you're not in the US then whatever country's tax rules
are those are what you would use to come up with something called
taxable income which is not going to be the same as pre tax income
you take that times the statutory tax rate to get income tax payable.
Income tax payable is what you actually owe the government in taxes.
What you are going to have to pay them.
Now these two can be different, and as we're gong to see the differences that we
do are called permanent differences or two temporary differences.
>> Taxes.
I thought this video was about Texas.
I need to find my glasses.
Do you think you can talk about Texas?
This tax stuff sure looks boring.
>> Well people from Texas pay taxes.
So as I'm talking about taxes you can think about Texans paying taxes and
then you'll be thinking about Texas.
So let's quickly look at some examples of how specific accounting
policies differ between the financial statements and the tax return.
And these are also things that we'll look at as examples we go throughout this week.
So one example would be interest income from municipal bonds.
So according to GAAP, or IFRS, and I guess from now on, any time I say GAAP just also
assume and IFRS because they're going to be the same on the things we look at.
But anyway, on your financial statements you get to book this as interest revenue,
which increases your pre-tax income.
As far as your tax code.
This is tax exempt income so it's not even going to show up at
all on the tax return and it won't affect your taxable income.
When you get cash advances from customers, so
you get cash from customers before you deliver the goods or
services, on your financial statements we don't recognize revenue at that point.
We only recognize revenue when it's earned,
when you deliver the goods, in this case.
So, that's going to happen in the future.
So this won't affect your pre-tax income, but on the tax code,
as soon as you collect the cash, the revenue is recognized and
so you get revenue today from the advance from customers, but
you won't get revenue until the future on your financial statements pre-tax income.
Bad debt expense as we saw earlier in the course.
When you make a sale you recognize bad debt expense during that period.
An es, estimate of how many of those people won't pay you.
But for the tax code you don't get an expense until the accounts are actually
written off sometime in the future so
it won't effect taxable income until down the road.
And then finally depreciation.
As we've seen, companies can choose their own method of depreciation.
They can do straight line or accelerated, although they almost all do straight line.
But then they can choose salvage value, they can choose useful life.
But for the tax code, the depreciation schedule is
pretty much dictated by the tax authority, so we end up with different
depreciation numbers on the financial statements and on the tax return.
Y'all are being silly!
Why are the rules so different?
Are the tax accountants feuding with the financial accountants?
Y'all just need to get along and make one set of rules!
Yeah, little known fact is the Hatfields were financial accountants the McCoys were
tax accountants and so the great Hatfield and McCoy feud that's lived through
history was really a tax accountant, financial accounting battle at the start.
So anyway, we need two sets of rules because there's two
different objectives for these two sets of books.
Tax accounting and tax rules is all about raising tax revenue for the government.
It tries to do it in a fair and equitable manner.
Plus it tries to provide incentives for
companies to do certain kind of behavior as we'll talk about a little bit later.
Financial accounting the goal that's provide useful information to external
stakeholders like investors, creditors, customers,
suppliers, employees, and it just turns out that those two goals are not.
Easily reconcilable.
So we have two sets of rules and we just have to live with those two sets of rules.
We're going to go through an extended example through the rest of the video to
illustrate how the mechanics of this works and to get down all the terminology.
So in the example on the left side of the screen, or I guess the debit side of
the screen, we're going to keep track of what's going on in the books, or
in the financial statements.
And in the right side of the screen, or, or the credit side of the screen,
we're going to keep track of what's going on in the tax return.
We're going to start in the example with EBITDA, which is defined as
earnings before depreciation, municipal bond interest revenue, so that's the I,
and taxes, and we're going to assume that in the two years we're
looking at it's 50,000 for both books and it's 50,000 both years for taxes.
Now, that's a pretty unrealistic assumption because there's a lot of
other things that can cause taxable income to be different from pre-tax income, but
we're just going to focus on a limited number of items here to illustrate these
kinds of different differences.
The first type of different difference is a permanent difference.
So let's say the company has municipal bond interest revenue.
That interest revenue goes on the finance statements,
it goes on the books, as $1,000 of revenue in 2011 and 2012.
For the tax return, municipal bond interest revenue is tax exempt.
It doesn't count so it doesn't go on the tax return at all.
This is going to create a permanent difference.
A permanent difference would be revenues that are never included in taxable income,
or they could be expenses that are never deductible for.
Tax purposes.
Key word here is never.
So it shows up on the books, but it never shows up on the tax return.
So in addition to interest on tax exempt municipal bonds other examples would be
tax penalties, and tax credits, or state, and
foreign taxes that are above, and beyond what you get from your federal taxes.
These never reverse over time, and they're going to cause the effective tax rate.
To not equal the statutory tax rate.
>> What do you mean by reversing over time?
And what are these two different tax rates again?
Why isn't there just one tax rate?
>> By do not reverse over time what I mean is that this interest revenue that's on
the books will never, ever, ever appear on the tax return, and
this will be clear when we talk about temporary differences in a second.
because under temporary differences you'd have a situation where revenue would be on
the books now and then the same revenue would show up on the tax return later.
Whereas a permanent difference you never see that kind of reversal over time.
And there really is only one tax rate there's the statutory tax rate.
This effective tax rate is something that we calculate from
financial statement numbers.
It's, it's almost like a ratio, and what it does it measures how much
the firm's taxes are susceptible to these permanent differences.
How much they increased.
Or decrease their tax rate away from the statutory rate.
We'll talk more about the effect of tax rate later in the video.
Next part of the example is going to show you how temporary differences work.
So here a classic example would be depreciation.
So let's say we have an asset which we're only going to have for two years.
And on the financial statements, or
the books, we depreciate it straight line over those two years.
So the depreciation is 10,000 expense per year.
On the tax return we do accelerated depreciation,
which means we take more depreciation in 2011, early on, than we do later.
So we have 15,000 expense in the first year, 5,000 expense in the second year.
But the total is still $20,000 of depreciation expense over the two
years for both methods.
This is an example of a temporary difference.
That's where a revenue or expense is recognized in a different period for
tax purposes than for financial reporting purposes, and see for
tax purposes we basically have shifted 5,000 of expense from 2012 to 2011.
Compared to what we do on the books.
So in addition to depreciation, bad debt expense is going to be an example of this.
Unearned revenue.
In fact there's a lot more examples and we'll see them later in the week.
These differences are going to reverse over time and we're going to store up
these differences in something called deferred tax assets and
deferred tax liabilities which we're going to talk about later in the week.
Temporary differences reverse over time.
So, if I have absolutely no idea what you are talking about now,
will that reverse by the end of the video?
>> Yes, that's exactly how a temporary difference would work.
If you have absolutely no idea what I'm talking about now, then by the end of
the video you will know more than me, and actually be able to teach the class.
Although if this is a permanent difference, then we have a problem.
>> Next we're going to look at the differences between pre-tax income and
taxable income.
So we've got EBITDA, we've got our muni interest revenue,
we've got our depreciation, and that's all that we're going to have for this example.
On our finance statements or books we have pre-tax income.
Those are the earnings before taxes under GAAP rules and,
as you can see, it's 41,000 each year, 50,000 plus 1000 minus 10,000.
On our tax return, we calculate something called taxable income.
These are earnings before taxes under tax rules and
you can see the numbers are different.
35,000 in 2011, 45,000 in 2012 because the tax return we didn't have
the municipal bond interest revenue and of course the depreciation was different.
So what that means is the differences between pre-tax income on the books and
taxable income on our tax return arise from both these permanent differences.
Like muni interest revenue, and these temporary differences like depreciation.
Once we have taxable income we can calculate income tax payable which is
the money that we owe the government in taxes.
So we take taxable income times the statutory tax rate.
When we say the statutory tax rate that's the tax rate set by the government.
So whatever the government dictates the tax rate is for corporations.
So in the US right now the tax rate for corporations is 35%.
So if this was a US company you would take taxable income times the statutory rate
to get income taxes payable.
These are the taxes that you owe to the government.
Why is this income tax payable and not income tax paid?
Where do we show the cash taxes that we pay the government?
>> I use income tax payable instead of cash as the credit,
because usually when you're doing these kind of tax calculations for your books.
You haven't filled out the tax return yet, and so you don't owe the cash today.
Instead, you do an income tax payable.
Then later on when you do your tax return,
then you would debit income tax payable and credit cash to pay off that liability,
but the important thing is to view income tax payable as the amount of
cash that you will eventually pay to the government in taxes.
So this is what we owe the government in our taxes.
Now that we've calculated income tax payable on the tax return,
how much we owe the government, we're going to move back over to
the book side and calculate something called adjusted pre-tax income.
Adjusted pre-tax income is what we're
going to use to compute income tax expense for finance reporting purposes.
And it's simply pre tax income adjusted for the permanent differences.
So you have pretax income of 41,000 we subtract
the municipal bond interest revenue so we rep, to remove the permanent difference in
interest revenue we subtract it and we get to adjust the pretax income of 40,000.
Which represents just the EBITDA minus the appreciation at this point.
>> Wait a sec honey, I just noticed something.
>> You'll see that the difference between adjusted pre-tax income and
taxable income is simply the difference in depreciation?
>> I am sure that is just a crazy coincidence.
Right?
No it's not a coincidence.
It's an excellent insight.
Once we get to adjusted pre-tax income,
once we take out the permanent differences,
then the only differences between adjusted pre-tax income and taxable income.
Will be the temporary differences.
Now we can calculate Income Tax Expense.
Income Tax Expense remember is the number that's going to go
on the income statement.
It's going to be the adjusted pretax income.
That we calculated last slide times the statutory rate.
So, it's the same 35% statutory rate as on the tax return, and, so,
we end up with, in this case, a 14,000 of income tax expense in both years.
Now, this differs from income tax payable, so
in 2011 we have 14,000 of tax expense 12,250 of tax payable.
And two, in 2012, we have 14,000 of income tax expenses, 15,750 of tax payable.
The reason for those differences is due solely to the temporary differences,
solely to that difference in depreciation expense that reverses over time.
So let me quickly show you how that works.
So first, here's the difference between income tax expense and income tax payable.
We had an extra 1,750 of expense in 2011, and we had 1,750
less of tax expense in 2012 compared to income tax payable.
Now, if we flip up to the appreciation line, we can see that in 2011,
we had 5,000 of extra depreciation on the tax return.
In 2012 we had 5,000 less depreciation on the tax return.
If we take that times 35% we end up with an,
savings of 1,750 in taxes payable in 2011.
And extra taxes of 1750 in 2012, which are exactly
the same as the difference between income tax expense and income tax payable.
So these temporary differences reverse over time.
We have more income tax expense than taxes payable in 2011 but
then that exactly reverses in 2012 by the end of the depreciable life.
Now we'll look at examples later on where we'll look at more than 2 years and
see how these reversals play out over time.
>> Well I'll be.
I am starting to understand this.
But, instead of going through all of this fancy hoo hah,
why not just make Income Tax Expense equal to the Income Tax Payable?
You know, I'm asked this question all the time.
It would be much easier to have income tax expense just equal the taxes that
we pay the government, income tax payable, but it would also be much easier if
we just had revenue equal to cash collected from customers.
You know and it would also be much easier if we just had cost it has sold equal to
cash paid for inventory.
So you get the point.
We do revenues and expenses that are different than the cash paid because of
this notion of accrual accounting.
Trying to reflect this notion of business activities, did we charge enough for
our product or
services to cover all the cost of doing business, based on business activities.
Income tax expense is the same idea.
It's the cost of income tax that we've incurred this period by all
the activities we've done this period, and we want to recognize that as an expense,
even if it's not all paid in cash this period,
even if some of that will be paid in cash in the future.
So it's the exact same idea of acruel accounting that we've been using for
all of the other expenses so far.
Now that we have income tax expense calculated, we can go on and
looking at something called the effective tax rate,
which I had talked about on the first slide.
So the effective tax rate is defined as the income tax expense on the financial
statements divided by the pre-tax income on the financial statements.
So in this case it's 14,000 of income tax expense.
Divided by 41,000 of pre-tax income gives you 34.1%.
Now, notice that does not equal the statutory rate of
35% because of the permanent differences.
So, that municipal bond interest revenue.
Causes the Effective Tax Rate to not be the same as the Statutory rate.
It, it reduces it from 35% to 34.1%, and that's never going to reverse.
So this reflects all the permanent differences.
So going back to what we talked about earlier.
Permanent differences caused this Effective Tax Rate,
the Income Tax Expense divided by Pre-tax Income.
Caused that Effective Tax Rate to not equal that Statutory Rate of 35%.
>> Last week, we had the effective interest method.
Now, we have the effective tax rate.
Is there an ineffective interest method and an ineffective tax rate?
>> No, there is no ineffective interest method or ineffective tax rate,
although sometimes on student homeworks you do see pretty ineffective answers.
But what we're talking about here is not ineffective and
effective, we mean effective in the sense of in effect at the time.
So the effective tax rate is the tax rate that was in effect.
During the year which we define as the income tax expense divided by
the pre-tax income.
>> If we need to do tax calculations like computer after-tax interest for
ROA, should we use the effective tax rate or statutory tax rate?
No, don't use the effective rate for tax calculations.
This is a thing that I think a lot of people do, and I,
and I totally think it's wrong.
Because this effective rate reflects the impact of
this municipal bond interest revenue.
If you were then going to apply that to some other kind of transaction.
It's not the right rate to use.
You always want to use the statutory rate in tax calculations, Alway,
always, always.
Always use the statutory rate in tax calculations.
Don't use the effective rate because the effective rate is messed up
by these permanent differences which don't necessarily apply to
other things that you're looking at.
Did I make that clear?
OK, I'm going to just wrap this video up
with a quick overview, summary slide, of how all this stuff works.
So pre-tax income on the finance statements, on the books,
if you take out the permanent differences, you get adjusted pre-tax income.
If you take that adjusted pre-tax income times the statutory rate,
you get the income tax expense.
So, in 2011, 41,000 in pre-tax income.
Subtract the 1,000 in permanent differences to get 40,000 of
adjusted pre-tax income, times 35% gives you 14,000 of income tax expense.
Then if we take the adjusted pre-tax income and adjust for
temporary differences we get taxable income.
Taxable income times the statutory rate gives you the income tax payable.
So again in 2011, 40,000 of adjusted pre-tax income minus $5,000
difference in extra depreciation gives us taxable income of 35,000,
times 35% gives us the income tax payable of 12,250.
And then if you did the same calculation for 2012,
the only thing that changes is the temporary difference.
The permanent difference, of course,
doesn't change, and the temporary difference reverses so
that now we add back 5,000 depreciation expense to get taxable income.
And as a result their income tax payable goes up to $15,750.
So, I hope these examples have helped you get down some of
the terminology that we deal with when we talk about taxes and financial reporting.
What we're going to do in the next couple videos,
is dive more deeply into how these temporary differences work, and
how we end up with these deferred tax assets and deferred tax liabilities.
I`ll see you then.
>> See ya`ll next video!
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