Income Tax Accounting
This article focuses on how net operating losses and valuation allowances have an affect on income taxes. In addition, there is a discussion on income tax disclosures. Finally, the article compares and contrasts GAAP and tax code, especially as the two views affect non-profit organizations. A net operating loss occurs when the annual deductions are greater than the taxable income for the year. Studies show that change in the current period, income is a significant determinant of changes in valuation allowance. Changes in valuation allowance have a negative impact on changes in current income.
ACADEMIC TOPIC OVERVIEWS
Accounting > Income Tax Accounting
This article highlights some of the events that affect income taxes. Two of these events are net operating losses and valuation allowances. Each of these events is discussed in detail so that the reader has an understanding of the impact each of the two events has on income taxes.
Net Operating Losses
When does a net operating loss (NOL) occur? A net operating loss occurs when the annual deductions are greater than the taxable income for the year. Also, there is a net operating loss when the taxable income is negative. There are a number of reasons why a net operating loss is reported. For example, it could be due to deductions from a business, the cost of renting property, and casualty and theft losses. In most cases, net operating loss occurs as a result of a business operating in the red. The business may have a year where the expenses incurred exceed the revenue that has been generated. This is very common, especially for new businesses during the first couple of years.
Claiming a Net Operating Loss
The year that the NOL occurs is called the NOL year. However, the loss may be carried forward or back to another tax year and applied against the taxable income for that given year. The deduction for net operating loss can be claimed by individuals, estates and trusts. Unfortunately, partnerships and S corporations usually cannot claim a net operating loss. However, partners and shareholders of partnerships and corporations can take their individual shares of business income and deductions into account when calculating their individual net operating losses (Hagen,
Deductions not Included in Declaring Net Operation Loss
In order to claim a net operating loss on an income tax return, one must calculate the amount that can be taken as a deduction to be applied against the taxable income from another year. According to Hagen (n.d.), one must evaluate which deductions can or cannot be included in the net operating losses. Some of the deductions not included in net operating losses are:
* Personal exemptions
* Section 1202 exclusion of 50% of gains from the sale or exchange of qualified small business stock. One must add back any gain that was excluded when calculating the net operating loss.
* The excess of non-business capital losses over non-business capital gains (does not include the Section 1202 exclusion). There is a limit on the amount of business capital losses that can be included when calculating the net operating loss. The limit can be calculated as the total non-business capital gains in excess of the non-business capital losses and excess non-business deductions as well as the total business capital gains once the Section 1202 exclusions have been added back.
* Deductions that are not connected to the business or the owner's employment. Examples of this type of deduction include alimony paid, contributions to an IRA or self-employed retirement plan, and the standard deduction if the individual does not itemize. If itemization occurs, some of the deductions are taken into account in calculating a net operating loss while others are not. The net operating loss calculation includes casualty and theft losses, state income taxes on business profits, and employee business expenses.
Deductions Included in Declaring Net Operation Loss
The income tax preparer must keep in mind that there are limits for certain categories and one cannot use all tax deductions when calculating the net operating costs. Some of the deductions that are included in the net operating loss consist of:
* Moving expenses
* Employee business expenses can be claimed as an itemized deduction. These include work-related travel and entertainment expenses, education expenses, uniforms, tools, and union dues
* Casualty and theft losses, on either business or non-business property
* Deduction for one-half of the self-employment tax
* Deduction for self-employed health insurance
* State income tax on profits from the business
* Rental losses
* Loss on the sale or exchange of real or depreciable business property
* The owner's share of a loss from a partnership or S corporation
* Ordinary loss on the sale or exchange of stock in a small business corporation or a small business investment company
* The portion of an investment in a pension or annuity plan that is not recovered and is claimed on the final income tax return
Sole proprietors and independent contractors will have a net operating loss if their business expenses exceed their revenues. It should also be noted that there are some business deductions for NOL purposes that may not be connected with the business. These deductions include expenses connected with one's employment, and certain other losses, such as casualty and theft losses.
If a net operating loss has been calculated in the current year, the income tax preparer may carry this loss back to the two preceding years and apply the loss against the taxable income for those years. This action will allow the individual to receive a refund of previous income tax that has been paid. The two years mentioned above is referred to as the carry back period. If there is a situation where there are still net operating losses remaining after it has been carried back two years, the taxpayer can carry the remaining NOL forward. The taxpayer may carry forward any remaining NOL balance up to 20 years after the NOL year. This period is referred to as the carry forward period.
The Statement of Financial Accounting Standards (SFAS) No. 109 mandates that all organizations are to establish valuation allowances if there is a possibility that their deferred tax assets will not be realized (Financial Accounting Standards Board, 1992). Some of the main points of the standard include:
* Recognition of deferred tax assets for all temporary differences that are tax deductible in the future, and the more likely than not provision in valuation of such assets (Schatzberg & Sevcik, 1994)
* Discretion to assess the possibility of deferred tax assets occurring. For example, organizations may use estimates such as future profitability and the availability of tax planning strategies
Colley (2012), however, that "deferred taxes do not represent assets and liabilities as defined by accounting standards."
Organizations have the discretion to manage earning through a variety of accruals such as depreciation and allowance for questionable accounts (McNichols & Wilson, 1988). Some of the motives for earnings management include earnings smoothing, accounting numbers-based incentives in bonus plans, and debt covenants (Watts & Zimmerman, 1986). Some scholars have written on the topic of earnings management in order to provide support for motives such as asset sales and allowance for doubtful accounts (Bartov, 1993; McNichols & Wilson, 1988). The above-mentioned studies highlight how income from a specific accounting accrual is related in a systematic way to earnings management motives. Other scholars (Ali & Kuman, 1994) consider interaction effects when researching earnings management. Their studies assert that the relationship between the motives for earnings management and discretionary accruals may in turn depend on the amount of income generated by the discretionary accrual.
Sources of Income & Valuation Allowances
The guidelines provided by SFAS No. 109 need to be addressed in order to test earnings management as it relates to valuation allowance. These guidelines evaluate four sources of income in establishing the level of valuations allowances. The four sources are future taxable differences that reverse in time, history of profitability, expected future profitability, and tax planning strategies. Changes in these sources are considered in conjunction with changes in the current...
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