Introduction



Income Taxes

Some definitions

1 Tax rates

1 Marginal tax rate – legislated tax rate on next dollar of earnings

2 Effective rate – average rate on after all the adjustments

3 Effective rate = tax expense/pre-tax income

2 Intraperiod cost allocation

1 Some items in income statement reported before tax

2 Some items in income statement reported net of tax

3 Interperiod cost allocation

1 Due to differences in tax reporting from financial reporting

2 Some taxes due after revenues and expenses are reported for financial purposes

3 Some taxes due before revenues and expenses are reported for financial purposes

4 Temporary differences

1 Flows for tax purposes and flows for financial purposes occur at different times

2 Flows are same over a several period horizon

3 Differences disappear over time

5 Permanent Differences

1 Differences never disappear (never reverse)

2 Revenues never taxed

3 Expenses never tax deductible

Temporary deferrals

1 Expenses that are tax deductible early

1 Depreciation expense

1 Straight-line for reporting

2 MACRS (accelerated for taxes)

2 Create deferred tax liabilities

1 Tax expense exceeds financial expense

2 Gets a tax shield

3 Tax expense now

Tax expense

Deferred tax liability

4 Pay taxes later

Deferred tax liability

Tax payable or Cash

2 Expenses that are tax deductible later

1 Bad debt expense

1 GAAP – matching

2 Tax – direct writeoff

2 Warranty expense

1 GAAP – matching

2 Tax – when expenses occur

3 Create deferred tax assets

1 Financial expense exceeds tax expense

2 No tax shield

3 Pay tax now

Deferred tax asset

Taxes payable or Cash

4 Tax expense later

Tax expense

Deferred tax asset

3 ‘Permanence’ of temporary deferrals

1 Discussion assumed single events

2 Each single event has same characteristics

1 Deferral

2 Reversal

3 New deferrals replace old ones as they reverse

Permanent differences

1 Income that is not taxable

1 Income on municipal securities

2 Income earned and retained in foreign subsidiaries

2 Expenses that are not deductible

1 Fines

2 Some insurance premiums

3 Deferrals are forever

1 Has an impact on the average tax rate the company pays

2 Tax free income reduces effective tax rate

3 Non deductible expenses increase the effective tax rate

Impact of losses for taxable income

1 Taxable income leads to taxes payable

2 Taxable losses leads to tax refunds

1 Refunds can come from adjustments to past tax obligations

2 One option – refunds from past and future tax obligations (carryback and carryforward incurred losses)

3 One option – refunds from future tax obligations only (carryforward incurred losses)

3 Carryback and carryforward option

1 Carryback two years against profits

2 Earliest year first

3 Get immediate refund – high present value

4 Carryforward for 20 years

4 Carryforward only

1 Carryforward for 20 years only

2 Useful if company has had two previous years of losses & carryback has no value

3 Useful if future rate expected to be greater

5 Reported as adjustment to current tax expense

Tax refund receivable (carrybacks)

Tax expense

or

Deferred tax asset (carryforwards)

Tax expense

Tax valuation allowance

1 Company determines deferred tax assets

2 Asks if there are any that ‘more likely then not’ will not be realized

1 Carryforwards that will expire soon

2 Can carryforwards be set against tax payments

3 If not realizable

1 Has no present value

2 Amounts that may not be used is reported in valuation allowance

4 Profitable firms can have valuation allowances

1 Depends on local profitability

2 Depends on local tax laws

3 Multi-nationals may have valuation allowances (allowances not really transferable across constituencies)

Reporting Taxes

1 Income statement and cash flow statement

1 Tax expense

2 Tax paid

2 Notes

1 Current and deferred tax expense

2 Domestic and foreign tax expense

3 Impact of permanent tax differences on tax rate

1 Start with marginal federal rate

2 Ends with effective or average rate based on all tax authorities

4 Temporary differences in balance sheet

1 Allocation of deferred tax assets by topic

2 Allocation of deferred tax liability by topic

3 Allocation to current and long-term parts of the balance sheet

4 Valuation allowance

5 Details

1 Tax expense

1 Tax expense in income statement

2 provision (current and deferrals) (foreign and domestic)

3 Income taxes only - excludes all other taxes

4 May not include all income related taxes

1 Some items reported net of tax

2 Discontinued operations could include items causing tax cash flows

3 Comprehensive income items reported net of deferred tax

2 Tax paid

1 Distinct bit of supplemental information

2 Can be dramatically different from tax expense

3 Current and deferred tax expense

1 Summary number in income statement

2 In notes

1 May reflect adjustments for changes in tax rates per liability method

2 Deferrals can be positive or negative

3 Entry for continuing operations

Provision for taxes

Deferred taxes

Taxes payable

4 Domestic and foreign tax expense

1 Taxes from different sources

2 Reflects different tax systems

5 Allocation of temporary differences

1 Reports beginning and ending balances in deferred taxes

2 Reports net change

1 Includes operations

2 Includes divestitures and acquisitions

3 Includes impact of net reported events

4 Cannot tell impact of tax differences due to operations alone

3 Reports a valuation allowance as well

4 Companies in trouble may have large allowances relative to deferred tax assets

6 Estimating the overall tax entry

Provision for taxes (IS)

Net Inc (dec) in deferred tax asset (Notes)

Current portion of provision for tax (Notes)

Net Inc (dec) in deferred tax liability (Notes)

7 Differences due to

1 Net items

2 Acquisitions and divestitures

8 Reporting permanent differences

1 Increase or decrease effective tax rate from statutory or marginal rate

1 Start with federal rate

2 Makes adjustments

1 For local taxes – increases effective rate

2 Non-deductible expenses increase tax rate

3 For tax advantaged income – decreases effective rate

3 Ends with effective rate of all income related taxes

Pensions (87, 132) and Other Post-Retirement Benefits (106)

Pensions and Post Employment Benefits

1 Focus

1 On pensions

2 Other post retirement benefits include health & life insurance

3 Reporting is basically the same

4 Differences will be summarized

2 Issues-

1 What are the guarantees or obligations?

2 What assets will cover the obligations?

3 Where do the contributions come from?

4 How is everything measured?

1 Value of pension-related assets

2 Value of pension-related obligations

1 Involves actuarial analysis

1 Expected careers

2 Expected life span

2 Involves present value analysis

1 Expected interest rates (discount rate)

2 Expected earnings on assets

3 Expected growth of employee salaries

5 How sensitive is the measurement to changes in assumptions?

6 How is everything reported?

1 Are market values used

2 What impact can accounting choices have on reported income and assets?

A few definitions for pension plans

1 Defined contribution plans

1 Generates pension expense of certain amount

Entry

Pension Expense

Cash

2 Must pay in specified amount (then obligation ends)

3 Retirement may be 30 years off, but obligation over

4 Basically, employee takes risk that contributions will grow

2 Defined benefit plans

1 Promised certain retirement benefit

2 Can pay in almost anything today

1 Can pay in more or less than necessary

2 Requirement to pay for tax deductibility encourages funding

3 But obligation is fixed for most workers

1 All employees in plan treated equally for tax deductibility

2 Company may have extra pension plan for top employees - not deductible

3 Most workers have vested (owned) benefits

4 New workers may not have vested benefits – benefits lost if they quit

4 Company has risk – must supply benefits

1 All vested benefits when due

2 All benefits including unvested benefits if firm closes plan

3 Obligation actually resolved only in retirement

4 Pension Benefit Guarantee Corp provides partial benefit in bankruptcy

5 Company pays insurance fee to PBGC each period

5 Ultimate benefit typically based on percent * years worked * final salary

6 Basic calculations

1 Estimate accumulated benefit today (ABO) – % * yrs * salary

2 Estimate projected benefit obligation earned thus far (PBO)– % * yrs * final salary

3 Agreements can change the contract (%) or adjust yrs or adjust salary

3 Primary focus is on DBP

1 This is the primary benefits reporting problem in the statements

2 Has in past been major issue in mergers & divestitures

3 Other post-retirement benefits reporting is very similar

4 Kill two birds with one stone

Valuation Issues for DBP – Most Issues the Same for Post-Retirement Benefits

1 Three Issues

1 Valuation of prospective benefits for current workers & retirees

2 Valuation of assets available to meet those benefits

3 Measurement of changes in benefits and obligations during the year

2 Benefits

1 Need to report a present value estimate of obligation to employees

2 Uncertain for any individual

3 Pattern can be estimated for an entire workforce

4 Estimate of future flows to workforce is partially actuarial

5 Estimate of present value of flows requires discount rate

6 Benefits can change

1 Change in interest rates

2 Change in expectations about salaries

3 Change in agreements with employees

3 Assets

1 Need to report the value of assets available to cover obligation

2 Need to estimate return and growth of those assets over long-term

1 May ignore short-term returns

2 Actual return to pension trust assets can be measured

1 Actual return varies widely from expected in short-term

2 Hope expected and actual are about the same in the long-term

Reporting DBP Pension Position

1 Four parts to presentation

1 Pension expense – reported in notes using accrual accounting

2 Pension Trust – only in notes – at market & present value

3 Pension obligation in balance sheet using accrual accounting

4 Reconciliation between Pension trust and balance sheet in notes

Pension expense

1 Introduction

1 Accrual number in income statement for period

2 Buried in several different accounts

3 Not affected by cash paid into pension trust

2 Primary components

1 Service cost – reflects present value of benefits earned this period

Pension Expense (Service Cost)

Pension obligation

2 Interest cost –

1 growth of obligation previously earned

2 Interest cost based on discount rate

Pension expense (interest cost)

Pension obligation

3 Less: expected long-term return on pension trust assets

1 (based on long-term investment rate)

2 Actual return sometimes better; sometimes worse

3 Smoothing to recognize long-term nature of investment

4 Actual return uncontrollable by company – could overwhelm operations – damage estimate of operations

Pension obligation

Pension expense (expected return)

Pension Trust

1 Presentation is really a fair value summary of the Pension Trust position and flows for the period

1 Plan assets (now available) at market value

2 Projected Plan obligations (PBO)(in future) at present value

2 Asset Beginning balance + inflows – outflows = ending balance

1 Inflows

1 From the company

2 From ACTUAL investment returns

2 Outflows are payments to retirees

3 Projected obligations follow same general concept

1 Not merely accumulated obligation

2 Inflows are new obligations

1 Service cost is new benefits earned by workers

2 Interest cost is the growth of previously earned benefits as they come closer to maturation (based on discount rate)

3 Prior service costs – as plan is changed, it is recognized immediately as an obligation in the pension plan.

3 Outflows are payments to retirees (discharge of the obligation)

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download