Ch 16 LO-2 DQs pt. 1

What is the difference between favorable and unfavorable book-tax differences?

"Favorable" book-tax differences are subtractions from book income when reconciling to taxable income. In contrast, unfavorable book-tax differences are additions to book income when reconciling to taxable income. That is, relative to book income, favorable book-tax differences decrease taxable income (i.e., they reduce taxable income and taxes payable so they are favorable) and unfavorable book-tax differences increase taxable income (i.e., they increase taxable income and taxes payable so they are unfavorable).

What role do a corporation's audited financial statements play in determining its taxable income?

A corporation generally starts with income from its audited financial statements and then reconciles to taxable income by determining book-tax differences.

Describe how goodwill recognized in an asset acquisition leads to temporary book-tax differences.

A corporation that acquires the assets of another business in a taxable transaction allocates part of the purchase price to goodwill (excess purchase price over the fair market value of identifiable assets acquired). The corporation amortizes this purchased goodwill on a straight-line basis over 15 years (180 months) for tax purposes. For book purposes, corporations acquiring the assets of another business also allocate part of the acquisition price to goodwill but recover the cost of goodwill for book purposes only when goodwill is impaired. Assuming the book and tax goodwill are equal (usually they are not), the corporation creates a deferred tax liability as the tax goodwill is amortized (that is, the tax basis will become less than the book basis). If the book goodwill subsequently is written off as impaired, the excess tax goodwill remaining creates a deferred tax asset. Thus, to determine the temporary book-tax difference associated with purchased goodwill, corporations need to compare the amount of goodwill they amortize for tax purposes with the goodwill impairment expense for book purposes, if any.

Describe the book-tax differences that arise from incentive stock options granted after ASC 718 (the codification of FAS 123R) became effective.

After ASC 718 , incentive stock options now give rise to permanent, unfavorable book-tax differences. Corporations are not allowed to deduct any compensation expense associated with incentive stock options for tax purposes, but for financial accounting purposes, corporations are required to deduct the initial estimated value of the stock options times the percentage of the options that vest during that particular year.

Describe the relation between the book-tax differences associated with depreciation expense and with gain or loss on disposition of depreciable assets.

Because tax depreciation methods generally provide for more accelerated depreciation than financial accounting methods, book-tax differences associated with depreciation are usually favorable in the early years of an asset's depreciable life. The difference reverses later on. However, when an asset is disposed of before it is fully depreciated, it is likely that the tax basis of the asset will be lower than the financial accounting basis. Consequently, for tax purposes, the corporation likely will recognize more gain (or less loss) for tax purposes than for book purposes resulting in an unfavorable book-tax difference. The book-tax difference on the sale is a complete reversal of the cumulative book-tax differences from depreciation.

Describe the book-tax differences that arise from incentive stock options and nonqualified stock options granted before ASC 718 (the codification of FAS 123R) became effective.

Before ASC 718 , no book-tax differences existed for incentive stock options because there was no book deduction and no tax deduction associated with the stock options. However, a favorable, permanent book-tax difference was generated when nonqualified options were exercised. On exercise, corporations were allowed a tax deduction for the bargain element of the options (the difference between the fair market value of the stock and the exercise price on the date the employee exercised the stock options). However, they did not deduct any compensation expense for book purposes. The tax benefits from the stock option exercise were reported in additional paid-in capital in shareholders' equity and did not run through the accounting tax provision.

How do corporations account for capital gains and losses for tax purposes? How is this different than the way individuals account for capital gains and losses?

For tax purposes, capital gains are taxed at the corporation's ordinary rates, and individuals are taxed on net long-term capital gains at preferential rates (lower than ordinary rates). Corporations are not allowed to deduct net capital losses. They carry back net capital losses three years and forward five years to offset capital gains in those years. Individuals can deduct up to $3,000 of net capital loss against ordinary income in a year. They carry over the remainder indefinitely to offset against capital gains in subsequent years and to deduct up to $3,000 of net capital loss against ordinary income each year.

Why is it important to be able to determine whether a particular book-tax difference is permanent or temporary?

Large corporations (assets of $10 million or more) are required to disclose their permanent and temporary book-tax differences on Schedule M-3 to their tax return. Second, the distinction is useful for those responsible for computing and tracking book-tax differences for tax return purposes and for calculating the income tax expense and effective tax rate to be reported in the financial statements.

Describe the book-tax differences that arise from nonqualified stock options granted after ASC 718 (the codification of FAS 123R)) became effective.

Nonqualified options generate permanent and temporary book-tax differences. Corporations initially recognize temporary book-tax differences associated with stock options for the value of options that vest during the year but are not exercised during that year. This initial temporary difference is always unfavorable because the corporation deducts the value of the unexercised options that vest during the year for book purposes but not for tax purposes. This initial unfavorable temporary book-tax difference completely reverses when employees actually exercise the stock options. The amount of the permanent difference is the difference between the estimated value of the stock options exercised (the amount associated with these stock options deducted for book purposes) minus the bargain element of the stock options exercised during the year (the amount that is deducted for tax purposes). If the estimated value of stock options exercised exceeds the bargain element of the stock options exercised, the permanent book-tax difference is unfavorable, otherwise it is favorable. The permanent book-tax difference is recognized in the year the options are exercised. The tax benefits related to the excess tax deductions over the estimated book amounts are recorded as "windfall" tax benefits in the company's additional paid-in capital section of shareholders' equity.

What is the difference between permanent and temporary book-tax differences?

Permanent book-tax differences arise from items that are income or deductions during the year for either book purposes or for tax purposes but not both. Permanent differences do not reverse over time, so over the long run the total amount of income or deductions for the items is different for book and tax purposes. In contrast, temporary book-tax differences are those book-tax differences that reverse over time such that over the long-term, corporations recognize the same amount of income or deductions for the items on their financial statements as they recognize on their tax returns. Temporary book-tax differences arise because the income or deduction items are included in financial accounting income in one year and in taxable income in a different year.

When a corporation receives a dividend from another corporation does the dividend generate a book-tax difference to the dividend-receiving corporation (ignore the dividends received deduction)? Explain.

The dividend could generate a book-tax difference depending on the level of ownership in the distributing corporation because this is what affects the method of accounting for receipt of dividends for book purposes. If the recipient corporation owns less than 20% of the distributing corporation there generally will not be a book tax difference (that is, the dividend will be income for book and tax purposes). If the receiving corporation owns between 20% and 50% of the distributing corporation, the book-tax difference generally will be the difference between the amount of the dividend and the amount of income the corporation recognizes on its books for its pro-rata share of the distributing corporation's earnings(that is, the recipient corporation likely reports its share of the distributing corporation's income under the equity method for book purposes, and the dividend is a return of basis for book purposes). If the corporation owns more than 50% of the distributing corporation, the dividend will be "eliminated" for book purposes in the consolidated income statement but only "eliminated" for tax purposes if the corporation owns 80% or more of the distributing corporation and files a consolidated tax return.

What are the common book-tax differences relating to accounting for capital gains and losses? Do these differences create favorable or unfavorable book-to-tax adjustments?

The first common difference arises when a corporation has a net capital loss in a year. The corporation deducts the net loss for book purposes but is not allowed to deduct it for tax purposes. As a result, the net capital loss generates an unfavorable temporary book-tax difference. When the net capital loss is deducted for tax purposes as a carryover it generates a favorable book-tax difference because the carryover is not deductible for book purposes.

Briefly describe the process of computing a corporation's taxable income assuming the corporation must use GAAP to determine its book income. How might the process differ for corporations not required to use GAAP for book purposes?

To compute taxable income a corporation starts with book income and makes book-to-tax adjustments for items that are accounted for differently for book and tax purposes. The end result is taxable income. In contrast, a corporation that is not required to (and chooses not to) use GAAP for tax purposes could use tax accounting methods to determine book and taxable income. In these situations, the corporations would not report any book-tax differences.