Financial Accounting Part - Accounting for income taxes - Permanent differences
20 important questions on Financial Accounting Part - Accounting for income taxes - Permanent differences
Until now, we discussed temporary differences that will reverse during the following years. There can also be permanent differences. Name four characteristics of permanent differences.
- They enter into pretax financial income but never into taxable income OR
- They enter into taxble income but never into pretax financial income
- They only affect the period in which they occur
- Do not give rise to future taxable or deductible amounts
Give an example of items recognized by financial accounting but not allowed by tax law.
What is a net operating loss?
Expenses exceed revenues for tax purposes for reasons such as strikes, crisis etc. for established firms or the expansion costs of start-up businesses.
It concerns a period in which a company's allowable tax deductions are greater than its taxable income --> this results in negative taxable income. This occurs when a company has incurred more expenses than revenues during the period.
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What can be a Net Operating Loss used for?
NOL can be generally used to recover past tax payments and/or reduce future tax payments.
Why is the Net Operating Loss important?
Because firms are required to pay taxes when they earn money, they also deserve to have some tax relief when they lose money. Otherwise there would be an inequitable tax burden if companies were taxed during profitable periods without receiving any tax reliefs during periods of NOLs.
How does the use of Net Operating Losses affect accounting?
Tax laws allows companies to use losses in one year to offset profits in other years. Companies realize this income-averaging through carryback and carryforward of NOL.
When companies use these offsets, they reduce income tax and increase net operating income.
What is a loss carryback?
Firms can carry the amount back to the preceeding year and apply it against any taxable income, which can generate an immediate tax rebate. It allows you to reduce taxes already paid, which results in refund of the taxes.
What is a loss carryforward?
Firms can carry the amount forward to next years. So the tax will be reduced in those years.
Was is a operating loss carryback?
An excess of tax deductions over gross income in a year.
How can the tax effect of a loss carryforward be described?
Because future taxable income is offset, the tax effect of a loss carryforward represents future tax savings.
Why is accounting for loss carryforward controversial?
Because there is:
- high uncertainty
- the term probable can be interpreted very subjectively --> what does probable mean?
- gives companies the flexibility/opportunity to manage the numbers (manipulation risk)
Decribe the term probable linked with a NOL carryforward in future periods.
If it is probable that a company may not realize the entire NOL carryforward in future periods, it does not recognize a deferred tax asset because it is probable that the carryforward will not be realized.
Or: if the deferred tax asset has already been recognized, it may be necessary to write down the deferred tax asset.
How are dividens affected when applying the cost method for financial reporting purposes?
When the cost method is used for financial reporting purposes, the dividends are recognized in the income statement in the period they are received --> which is the same period they must be reported on the tax return.
However, depending on the level of ownership by the investor, 70% or 80% of the dividends received from other U.S. corporations may be excluded from taxation because of a dividends received deduction. These tax-exempt dividends create a permanent difference.
Explain dividend received deduction?
Define divident received deduction.
When can triple taxation occur and what are the consequences?
Indicate whether this belongs to temporary or permanent differences: Expenses incurred in obtaining tax-exempt income.
Indicate whether this belongs to temporary or permanent differences: For some assets-straight-line depreciation is used for both financial reporting purposes and tax purposes, but the assets' lives are shorter for tax purposes.
Indicate whether this belongs to temporary or permanent differences: Proceeds are received from a life insurance company because of the death of a key officer. (The company carries a policy on key officers).
Indicate whether this belongs to temporary or permanent differences: Interest is received on an investment in tax-exempt municipal obligations.
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